Most people use Revenue CAGR/ YoY growth figures to check the growth of the business and why wouldn't they, one is obviously on the lookout for businesses which are constantly growing!
In most of the business this method is correct but what if we have a company whose revenue is coming from locking customers in long term contracts like for example Just Dial. Do you think for this type of business checking revenue CAGR would make sense? Let's take a proper look.
Let’s assume the average tenure of their contract is 5 years and in a particular year they have sold a very high number of contracts to the customers in the last week of the financial year.
As we saw earlier revenue recognition for long term contracts happens on a prorata basis of the tenure. This will imply that a very little revenue is recognised in the current financial year ((1/52)*(⅕) of total revenue~0) and for the next year, it will be for entire year (1/5th of overall revenue) which would give a crazy growth illusion in revenue figures, even if let’s say not a single new contract would be sold in the coming entire financial year.
So, due to the accrual nature of revenue recognition, we get a false illusion of revenue growth in such a case when even a single new contract wasn't sold in the entire year. As a result, for such companies, it's a terrible idea to use revenue CAGR to judge growth of business on the revenue front.
Instead, what one may have already taken a hint from above discussion, what should be taken as a proxy for growth of business is the rate of growth of existing contract values! I.e. we would want to take a look at how many new contracts are being grabbed every year!
Case Study: Just Dial
So for this type of business to check their actual growth we need to check “How many contracts were sold in that particular year”. Below is the footnote of revenue from operations of just dial,
The revenue figure shown above is the recognised effort of previous years contracts services delivered in current year + current year contracts services delivered in the current year. As discussed earlier, for this type of businesses we have to check growth in “Contracts sold during the year” which can be found in Contract Liabilities footnotes shown in the snapshot below.
Note, Contract liabilities are basically liabilities (since the customer has already paid up) or Advance from customers for which your work has already started but not finished yet. Which means, in reference to the Just Dial example, these would be the Open contracts values as of year-end.
As highlighted in the above screenshot, they have also provided Additions during the year which would mean new contract values added/ sold during the year. BINGO! Exactly what we were looking for.
Just dial is providing this number calculated in their annual report but many businesses don't give this number calculated so for that we need to calculate this on our own. Let’s understand how you can do this on your own.
Contract liabilities contain previous year’s sold contracts and current year additionally sold contracts, So the contracts which are expiring would go onto income statement as recognised revenue and would be backed out of Contract liabilities since your job is done and you have delivered your end’s bargain now. At year-end, the open contracts would still remain as part of Contract Liabilities.
Hence, Opening Contract Liabilities + New Contracts issued this year- Revenue Recognised this year = Closing Contract Liabilities
Rearranging,
Closing contract liabilities - opening contract liabilities + Revenue = New/Additional contracts during the year.
Let’s apply the same and see if genuinely revenue growth has happened for Just dial or the accruals are playing an illusion in 2020?
Step 1: Take previous year’s (preceding year’s number) closing contract liabilities number as opening number i.e 40544 in our case (Taken from above snapshot contract liabilities as on march 31, 2019).
Step 2: Closing contract liabilities as of 31st march 2020 is 33604 (current year)
Step 3 : 33604 - 40544 + 95311 (taken from 1st snapshot) = 88371.
Our calculation and the calculation shown above is matching so for businesses who sell contracts (long term or short term) your metric for their growth should be additional contracts sold during the year.
As explained earlier, The point of calculating this number on our own is that many companies don’t give this directly calculated number like for example mahindra holidays. The importance of this data is that analysts use this data to forecast future revenue of this type of business.
Above snapshot explains that if an analyst were to compute Revenue growth rate, one would conclude that in 2020 there has been a 7% growth in Revenue YoY (Year on year) whereas there has been a degrowth in the New contracts by almost 8%. Hopefully this example should give you a clarity why Contract Liabilities growth rate/ contract value growth rates are a much better way of measuring the business growth rather than Revenue YoY growth or CAGR for such businesses.
This concludes the Revenue analysis piece for Long term contract companies! Hope you enjoyed it!