Does unearned income affect working capital?

A business balance sheet can show you many different things about the business, an important document if you view it as a potential investment. As an investor, you can use the balance sheet to see how much money a business has, as well as how much it owes its creditors, suppliers, and customers.

The balance sheet can give you an idea of ​​how healthy a business is from a financial standpoint. Two of the numbers you’ll want to look at are a business’s unearned income and its working capital. But how does one relate to the other – and do they even have a direct relationship with each other? Read on to learn more about unearned income, working capital, and if the former actually impacts the latter.

Key points to remember

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

Unearned income

Unearned income typically arises when a business receives compensation but has yet to provide products for which payment has been made. Also called deferred income, unearned income is considered a form of prepayment, where the buyer pays for a product or service before actually receiving it. Since the payment is already made by the consumer, the supplier is responsible for tracking the delivery when he is ready to do so.

When a business records unearned income, it does so as a liability on its balance sheet. This is because the business still owes a debt to the customer in the form of the product or service for which it was paid.

Prepaid services that count as unearned income include rent, cable and newspaper subscription services, legal fees and prepaid insurance. Take the example of a media company that asks its customers to pay $ 120 up front for annual subscriptions to its monthly magazine. When a customer sends a payment of $ 120, the media company records a debit of $ 100 on their cash balance and a credit of $ 120 on their unearned income account. When the business ships magazines to a customer once a month, they can reduce their unearned income by $ 10 by posting a debit to the unearned income account and a $ 10 credit to their income account.

There are several modern examples of large tech companies using the unearned income account. These are companies that use subscription models to sell annual access to services, such as Amazon Prime, Netflix, Spotify, and Dropbox. These tech companies collect the payments up front and provide the service later. Here’s a look at Amazon’s unearned revenue in Q2 2021 (ending June 21, 2021):

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 items such as cash and receivables, while current liabilities include all the bills a business has to pay.

If you want to see how liquid a business is, be sure to take a look at its working capital. This figure measures a company’s liquidity as well as its operational efficiency. As such, it is a great indicator of the health of a business 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 the current liabilities exceed its current assets, the business may be in difficulty because it does not have enough cash to meet its financial obligations.

Suppose a business has a balance of unearned revenue for services it intends to provide within a year, this balance is considered a current liability and would reduce working capital.

How unearned income affects working capital

Since unearned income is a company’s current liability, it has a direct impact on a company’s working capital. It actually decreases that financial figure. Here’s how unearned income affects working capital.

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

If a business overestimates its working capital by not making any adjustments for unearned income, it can create cash flow problems in the future.

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

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