ARR and GAAP-based earnings serve as a starting point for a software investor’s valuation of a Target, but those metrics don’t capture all of the true cash dynamics of a software business. At Maxwell Locke & Ritter, we bridge GAAP-based earnings to “Cash EBITDA” to help investors understand the Target’s true cash generation (or lack thereof). A critical element of this calculation involves converting GAAP-based revenue into invoices to give investors a proxy for cash collections.
The conversion from GAAP-based revenue into invoices is typically calculated as GAAP revenue plus the change in deferred revenue minus the change in accrued revenue. As part of ML&R’s detailed invoice to revenue recognition spread procedures, we conduct a “Proof of Billings” analysis to validate that the invoice dataset (including all credits memos issued) used to re-calculate revenue reconciles to this calculation. However, after the conversion to invoice-based revenue, it is critical to interpret the underlying attributes of the data including [1] invoice service terms and [2] invoice timing.
Bifurcating the change in short-term deferred revenue versus the change in long-term deferred revenue is critical to understanding the sustainable annual cash flow of a Target, especially if the Target has changed its invoice cadence over time. For example, if a Target historically sent annual service period invoices but subsequently changed to three-year service period invoices in the most recent annual period, then the most recent annual “Cash EBITDA” would be inflated.
Furthermore, invoices are often sent months before or after the actual service period start date, which can distort “Cash EBITDA” in annual periods. Invoices are often sent early when the Target wants to accelerate cash flow and invoices are occasionally sent late as the Target negotiates renewals. For example, if a Target historically sent annual service period invoices in January but subsequently changed to invoicing in December in the most recent annual period, then the most recent annual “Cash EBITDA” would be inflated. As a result, ML&R normalizes “Cash EBITDA” by ensuring that the timing of invoices sent early or late are adjusted to the normalized period.
Accordingly, it is important to analyze invoice and credit memo data in detail, as inconsistencies in invoice service terms and invoice timing can materially impact the calculation of “Cash EBITDA.”
