I found something like this “Increasing customer advances (unearned revenue) will not require outflow of cash in the future so are less onerous than other liabilities.”
The conclusion is that growing unearned revenue increases accounting financial leverage, but true nature of leverage is not growing.
Do you agree?
From my point of view:
You got unearned revenue cash for products you still did not provide to the customer. So unearned revenue does not cause future cash outflow but causes future product outflow. From this point of view you are indeed truly leveraged more as you will have to put off inventory from your BS and it lowers your “true equity” and so on…
I think you can make the argument of profit margins. If you pay me $1,000 for a piece of equipment to be delivered in a month, that equipment could only cost me $600. That means even though it does increase my leverage, it only increases it by $600 instead of $1,000. I think that’s what they are getting at.
I agree with your question and here is your answer, you’re increasing your accrual ratio here, so you’re actually increasing your assets but not really increasing your assets, if you get what I mean.
I don’t understand how you’re lowering your ‘true equity’? With unearned Revenue you increase Assets by cash and increase liabilities via Unearned Revenue acct. You wouldn’t reduce Inventory until you recognize the revenue.
Worst case scenario with Unearned revenue is that the customer cancels their order and you give them their money back. In most cases you are going to deliver the product at a future date, and not return cash, so its not like a true interest accruing liability.
You are in truth increasing financial leverage according to the true definition of TA/Eq. But how would we compare two companies with the exact same Fin Lev ratio, but one has twice the amount of Unearned Revenue? You would assume that the company with 2x the amount of unearned revenue was in a much better financial position, because a good portion of their liabilities are just going to disappear in the future via revenue recognition instead of a cash outflow.
Of course you would want an explanation for why the company is allowing so much unearned revenue to accrue, and to understand their revenue recognition policy and their policies concerning canceled work orders. But if the explanation of the accrued revenue was legitimate than the company is in a clearly better financial position than the company with lower unearned revenue.