How to forecast deferred revenue for better insights in your SaaS business

Basic accounting principles suggest that a business should not recognize income until it has earned it. But, what does this mean for your SaaS business where customers typically pay upfront for subscriptions? How do you forecast revenue from services sold but yet to be delivered?

This is where forecasting deferred revenue comes in. Accurate forecasting of deferred revenue ensures compliance in financial reporting and also provides insights into future cash flows and the financial health of your business.

In this article, we will explore everything you need to know about forecasting deferred revenue for your SaaS business — including methodologies, a step-by-step process, the challenges involved, and the use of technology to facilitate the entire process.

Understanding deferred revenue in SaaS

In SaaS, not all payments are “earned” right away because subscription-based services get used over time. When customers pay upfront, the amount received in advance is known as “deferred” or “unearned revenue”. Deferred, in this context, means the act of delaying the recognition of certain revenue.

Deferred revenue is treated as liability in your balance sheet because it’s unearned. Over time, as services are consumed (i.e. the product is delivered) the associated revenue is moved from your balance sheet accounts to your income statement as revenue.

How to calculate deferred revenue 

You can calculate deferred revenue by subtracting recognized revenue from the total value of invoices:  

For example, imagine a customer opts for a yearly subscription with a total contract value of $24,000. When the customer pays upfront for the year on January 1st, you record the $24,000 as deferred revenue because you haven't provided the services yet. 

As you deliver the service each month, you recognize $2,000 (one-twelfth of the total subscription cost) as earned revenue. So, by the end of January, $2,000 is moved from deferred to accrued (earned) revenue, and you have $22,000 in deferred revenue remaining.

The same process continues throughout the contract. The deferred revenue balance decreases as the amount of recognized revenue increases. 

In our example, the deferred revenue by the end of the second month would be $20,000. At the end of the third month, it would be $18,000 and so forth. 

By the end of the contract, once all obligations are met, all revenue will be recognized, with none deferred. 

Why should you forecast deferred revenue?

Forecasting deferred revenue gives you a glimpse into how your SaaS business will perform in the future. For instance, a consistently growing deferred revenue indicates upcoming growth as more customers subscribe to the service. Conversely, a decline in deferred revenue indicates potential customer churn.

Tracking and forecasting your unearned revenue also allows finance teams to forecast cash flows. Being able to time your cash flows further enables you to do better sales capacity planning, invest in new initiatives, and manage other expenses better. 

Forecasting deferred revenue begins with forecasting revenue

Revenue forecasting in SaaS provides the foundation for deferred revenue forecasting. This is because forecasting deferred revenue is only relevant in the context of the revenue you expect to generate. Thus, revenue and deferred revenue are intrinsically related. 

While you can do revenue forecasting in SaaS using spreadsheets, it’s always going to be more accurate and efficient if you combine one/more technologies such as financial forecasting software and revenue forecasting tools with the following best practices:

• Define the key revenue metrics you want to measure based on your business's services.
• Gather historical data based on past performance.
• Choose a revenue forecasting model. Some of the standard models include historical forecasting, lead-driven forecasting, lifetime value forecasting and opportunity forecasting.
• Leverage scenario planning that includes best case, worst case, and normal scenarios, to account for market trends, different factors, and uncertainties.

How to forecast deferred revenue

Once you have a revenue forecast, you can forecast your deferred revenue. There are two main approaches to this, which we refer to as the “accurate to a cent” method and the “back of the napkin” method. 

“Accurate to a cent” method

Forecasting deferred revenue down to the penny requires a detailed and precise technique for calculating and forecasting deferred revenue. It involves tracking every single contract  and every single transaction for each over its entire term to determine exactly how much deferred revenue remains at any given time.   

There are some pros and cons with this method. It is indeed highly accurate, however it involves tracking a lot of data and as such can be very time consuming. So, it follows that this method is probably most ideal for smaller businesses. 

Larger businesses can use the method too. However, given the amount of data involved, the effort will be more easily managed if the business has clearly definable segments for which individual forecasts can be created as opposed to creating one for the entire business.  

Here are the main steps in forecasting deferred revenue with this method: 

1. Create a revenue recognition schedule based on all the existing contracts you have with customers, including the average contract value (ACV), the contract length, and the start date for each. With this information, you’ll map out the expected payments for all your customers over time, through the end of their contracts. 
2. You’ll also need to create a deferred revenue schedule for the same contracts. The deferred revenue begins with the ACV for each contract as of the start date, which will decrease over time as services are rendered and revenue is recognized.
3. Ideally, you would update both schedules with every transaction, moving the deferred revenue for the customer from the deferred revenue schedule to the revenue recognition schedule as the services are rendered. If your schedules are not up to date, you will need to update them with any new transactions and new contracts prior to doing your forecast.  
4. With your revenue recognition and deferred revenue schedules up to date,  forecasting deferred revenue for your existing contracts is simply a matter of summing up the total deferred revenue in the deferred revenue schedule.

“Back of the napkin” method 

The “back of the napkin” method” includes applying the expected market growth rate to the current growth. It is a simplified approach to forecasting deferred revenue with which you make rough estimates and quick calculations based on historical data and broad assumptions rather than detailed contract specifics. 

This method provides a higher-level view than the previous method. It’s far less time-consuming than trying to develop a highly detailed forecast. And, while it isn’t as precise as the “accurate to a cent” method, it can still provide a reasonably accurate result. 

Whether or not the lack of precision with this method is a drawback really depends on how accurate and precise you need your forecast to be. 

Large companies with multiple contracts and different contract terms will likely find this a much easier approach. While less precise than the accurate-to-a-cent method, the back-of-the-napkin method provides a quick snapshot of expected revenue trends. It can be helpful in initial planning or high-level strategic decision-making.

Here are the basic steps:

1. Gather historical data for revenue as reported on your past income statements and historical data for deferred revenue reported on your balance sheets for the same period. 
2. Use the historical data to calculate a ratio for deferred revenue as a percentage of revenue. Then apply these percentages as a rolling average to each month of your forecast period.  
3. Next, forecast your revenue for the same period. Then, multiply the forecasted revenue for each month in the period by the corresponding deferred revenue ratio to predict the amount of deferred revenue.   

Analyzing historical trends and prorating is another “back of the napkin” approach to forecasting deferred revenue that can yield relatively reliable results. This approach also involved looking at historical data and applying the same assumptions you apply to forecast growth to forecast deferred revenue. 

For example, let’s say your total revenue for the current year is $1 million and you aim to grow to $2 million next year. This means you anticipate doubling your revenue. So, to forecast your deferred revenue, you would apply a similar growth rate. 

Choosing the best deferred revenue forecasting method

We have described two general approaches to forecasting deferred revenue both of which vary significantly in the time and effort they require. The decision of which to use in your business can be a bit of a quandary, but ultimately boils down to finding the right balance between the level of accuracy you need in your forecast and the time required to achieve it.  

Do note that if you decide to use the more detailed, “accurate to a cent” approach, you may encounter more complexities related to contract terms. This is because that method involves tracking at the individual contract level.  

For example, depending on how your contracts are structured, you may want to calculate your deferred revenue based on the contract length or the manner in which services are provided: 

• Contract length: Begin by examining the average contract periods from the previous year. Analyze these durations to predict the average period for future agreements. 
• Services rendered: Forecast deferred revenue based on historical trends of task completions. For instance, if a contract stipulates that revenue is earned upon completing tasks A, B, and C, then your deferred revenue forecasts need to reflect the terms and conditions.

In both cases, it’s important to factor in any changes in the structure of your contracts that might impact how you calculate deferred revenue. This might include new service offerings, contract term modifications, such as how customers pay (e.g., annual, semi-annual, quarterly), or business process changes that can affect revenue recognition.

Tips for forecasting deferred revenue

Here are some tips to help you improve the accuracy of your deferred revenue forecast:

1. Stay up to date on contract terms 

To the extent possible with the technologies you use, it’s important to track the details of all customer contracts, including payment schedules, contract lengths, and specific service deliverables. Try to standardize your contract terms as much as possible, which will make them not only easier to track but also simplify forecasting deferred revenue. 

2. Revenue recognition

Determine how your company recognizes revenue. For example, is revenue recognition  based on time (e.g., monthly, quarterly) or upon completing specific obligations (e.g., milestones, deliverables).

3. Follow applicable accounting standards

Standard accounting frameworks, such as GAAP, IFRS, etc., have different rules and guidelines for financial reporting and revenue recognition. Follow these guidelines to ensure compliance, credibility, and reliability of your forecasts. 

Challenges of forecasting deferred revenue in SaaS startups

Like revenue forecasting, forecasting deferred revenue in SaaS startups can be pretty complex, especially as their customer base grows. Two of the biggest challenges are discussed below. 

Difficulties associated with contracts for usage-based pricing  

Generally, the simpler your contracts, the more straightforward deferred revenue forecasting will be. But what if your contracts are structured for a usage-based pricing model? Usage-based pricing can introduce a whole lot of uncertainty into revenue forecasting, which can in turn, make deferred revenue forecasting more difficult.  

Let's say a client is billed a minimum of $1,000 per month over 12 months, totaling $12,000 paid in advance. However, the actual usage can vary, potentially exceeding or falling short of this minimum. 

Initially, upon billing $12,000, $1,000 is recognized as revenue for the current month, and the remaining $11,000 is deferred to subsequent months. But what if the usage increases to $1,500 the following month or the customer incurs additional charges related to add-ons, training, etc.?

In these cases, the amount of revenue recognized will change for that month as will the amount of deferred revenue.  

Challenges due to market fluctuations

Sudden market fluctuations can prompt changes in customer contracts. For example renegotiations of terms or conditions may impact how deferred revenue is recognized over time. 

For example, you might have a customer who originally subscribed to your highest-tier plan at $5,000 per month. However, during a market downturn, that customer began struggling financially and downgraded the subscription to a lower-tier plan priced at $2,000 per month. 

That downgrade now introduces a level of uncertainty into future revenue forecasts, making the calculation of future deferred revenue more challenging. The previously deferred revenue that was based on the expectation of $5,000 per month now needs to be recalculated based on the lower-tier plan's subscription fee of $2,000 per month.

Leverage technology to make deferred revenue forecasts more accurate with less effort

Deferred revenue forecasting, along with revenue forecasting, is critical to ensuring your company’s ongoing financial health. However, many still rely on manual processes and spreadsheets for these key financial processes. While spreadsheets are useful, they are prone to manual errors and are not ideal for recurring calculations like forecasting deferred revenue. They also become unwieldy pretty quickly as your business grows, especially if you need your forecasts to be accurate to the cent. 

Leveraging financial forecasting solutions can help to address both the challenges described above and help improve the accuracy of both your revenue forecasting and deferred revenue forecasting. 

Using a more comprehensive SaaS financial planning and analysis (FP&A) platform like Drivetrain, however, will provide additional value-added benefits to make the whole process far simpler, allowing you to achieve a higher degree of accuracy in your forecasts with far less effort.  

For example, Drivetrain offers 200+ integrations, which means you never have to struggle to find and validate your source data. It provides robust scenario analysis tools that will help you more reliably predict revenue outcomes under various market conditions. Drivetrain was built with a lot of power under the hood – capable of handling even the most complex financial modeling and forecasting tasks – yet simple to use. 

Ready to optimize your financial forecasting? Take some time to explore Drivetrain today.