Does Unearned Revenue Affect Working Capital?

A company’s balance sheet is an important document if you’re considering a specific company as an investment because it shows you many things about the business, including its financial health. You can use it to see how much money a company has and how much it owes to its creditors, suppliers, and customers.

Two of the figures you’ll want to look at are the unearned revenue and working capital. But how does one relate to the other and are they directly related? Read on to learn more about unearned revenue, working capital, and whether the former has an impact on the latter.

Key Takeaways

• A company has unearned revenue when it receives compensation but still has to provide products for which the payment was made.
• Working capital is the difference between a company’s current assets and its current liabilities, which it records on its balance sheet.
• Unearned revenue decreases a company’s working capital because it is considered a liability.

Unearned Revenue

Unearned revenue typically arises when a company receives compensation for products and services not yet delivered. Also referred to as deferred revenue, it is considered a form of prepayment, where the purchaser pays for a product or service before they receive it. Since the consumer already paid, the supplier is responsible for delivering the product or service when it’s due.

When a company records unearned revenue, it does so as a liability on its balance sheet. That’s because the company still owes a debt to the customer in the form of the product or service for which it was paid.

Rent, cable, newspaper subscription services, retainers for legal services, and prepaid insurance are all examples of services that count as unearned revenue. For instance, when a customer pays $120 to a media company for an annual subscription to its monthly magazine:

• The company records a $100 debit to its cash balance and a $120 credit to its unearned revenue account.
• When the company ships the magazines each month, it can decrease its unearned revenue by $10 by recording a debit to the unearned revenue account and a $10 credit to its revenue account.

Major tech companies that utilize subscription models to sell annual access to services, such as Amazon Prime, Netflix, Spotify, and Dropbox, often use an unearned revenue account. They collect payments in advance and deliver the service later. The image below shows Amazon’s balance sheet for the 12 months ending Sept. 30, 2024, with unearned revenue under the current liabilities section.

Working Capital

Working capital is the difference between a company’s current assets and its current liabilities, which it records on its balance sheet. Current assets include things like cash and any receivables, while current liabilities include any bills that a company must pay. This means you’ll have to do a little math. From Amazon’s balance sheet above, we can determine that its working capital is about $14.31 billion ($175.79 billion – $161.48 billion).

If you want to see how liquid a company is, take a look at its working capital. This figure measures a company’s liquidity as well as its operational efficiency. As such, it’s a great indicator of how healthy a business may be in the short term.

So if a company’s current assets exceed its current liabilities, it has positive working capital and is, therefore, financially stable. If current liabilities outweigh its current assets—the company may be in trouble as it doesn’t have enough cash to meet its financial obligations.

Say a company has a balance of unearned revenue for services it intends to provide within a year, this balance is considered a current liability and would decrease the working capital.

Important

If a company overestimates its working capital by not making any adjustments for unearned revenue, it may create cash flow problems in the future.

How Unearned Revenue Affects Working Capital

So does unearned revenue affect a company’s working capital? Since it represents a company’s current liability, unearned revenue has a direct impact on a company’s working capital. That’s because it decreases this financial figure. Here’s how.

Unearned revenue is recorded when a firm receives a cash advance from its customer in exchange for products and services that will be provided in the future. Because a company can’t recognize revenue on this cash advance and because it owes money to a customer, it must record a current liability for any portion of the cash advance for which it expects to provide services within a year. Since current liabilities are part of the working capital, a current balance of unearned revenue reduces a company’s working capital.

There is a problem for companies that do not make any adjustments on their balance sheets for unearned revenue or current liabilities. By not doing so, a company overestimates its working capital, which could later cause issues by creating cash flow problems.

Where Do You Find a Company’s Balance Sheet?

The balance sheet is a financial statement that outlines a company’s assets, liabilities, and shareholder equity. Investors and analysts can use the balance sheet (and other financial statements) to assess the financial stability of public companies. You can find the balance sheet on a company’s website under the investor relations section and through the Securities and Exchange Commission’s (SEC) website.

What Are Current Assets and Current Liabilities?

The term current assets refers to any assets that a company can convert to cash within 12 months. This means they are easily liquidated. Examples of current assets include cash and cash equivalents, accounts receivable, certificates of deposit (CDs), and marketable securities.
Current liabilities, on the other hand, are short-term financial obligations. These debts must be paid within one year. Current liabilities include things like accounts payable, business taxes, operating taxes, and dividends.

You can find a company’s current assets and current liabilities on its balance sheet.

How Do You Calculate Working Capital?

Working capital is calculated by subtracting a company’s current liabilities from its current assets. These figures can be found on its balance sheet. A positive result indicates financial stability. Negative working capital means the company may be in financial distress.

The Bottom Line

Investors have many tools that can help them assess the viability of potential investments. If you’re interested in stocks, consider looking at company balance sheets and reviewing their unearned revenue and working capital. Unearned capital is any money earned for goods and services not yet delivered while working capital can tell you whether a company can pay off its short-term liabilities with its current assets. By looking at these two figures together, you can understand whether a company may have future cash flow problems.