How to Answer “How does deferred revenue impact free cash flow and valuation in a DCF?” in Investment Banking Interviews

Start by anchoring the accounting. Deferred revenue (contract liability / unearned revenue) arises when you receive cash before recognising revenue under the revenue recognition rules. On the balance sheet, it’s typically a current liability (sometimes split current/non-current). On the income statement, it does not directly appear—revenue is recognised as the performance obligation is satisfied. On the cash flow statement, the cash collection is captured in operating cash flow via the working-capital bridge.

For interview clarity: deferred revenue is a timing item, not a profitability driver by itself. It changes when cash arrives versus when revenue is booked, which is why it matters for the deferred revenue impact on cash flow even when margins are unchanged.

In an unlevered DCF, you usually calculate:

• Unlevered FCF = EBIT × (1 − tax rate) + D&A − Capex − ΔNWC

Deferred revenue is part of NWC (often within “other current liabilities” or explicitly shown). The key sign convention:

• Increase in deferred revenue = you collected more cash in advance than you recognised as revenue → cash inflow → reduces NWC (because it’s a larger current liability) → boosts FCF (a negative ΔNWC term).
• Decrease in deferred revenue = you recognised revenue without equivalent new prepayments (or you deliver on prior prepayments) → cash outflow / less inflow → increases NWC → reduces FCF.

Say this explicitly; it’s the core of the dcf interview answer.

Next, connect to valuation intuition. A DCF discounts future FCF at WACC, so pulling cash earlier (via growth in deferred revenue) increases present value because you receive cash sooner. However, it is not “extra” cash created from nowhere—over time it typically reverses as services are delivered.

So valuation impact depends on the pattern:

• If deferred revenue grows steadily with the business (e.g., subscriptions, annual pre-billing), it can be a persistent source of working-capital funding and can raise enterprise value versus a business that bills in arrears.
• If growth slows, deferred revenue growth can flatten or reverse, creating a FCF headwind in later years.

In other words, deferred revenue can shift value between explicit forecast years and later years; it can also affect terminal value if the steady-state level of deferred revenue (as a % of revenue/billings) differs from what you model in the final year.

Give a simple modelling approach the interviewer can trust. Common options:

1. Percent of revenue: Forecast deferred revenue as a % of next-period revenue (works when billing and revenue are tightly linked and contracts are stable).
2. Percent of billings/bookings: More accurate for subscription/SaaS—project billings (revenue + change in deferred revenue) and then back into deferred revenue.
3. Days-based: Use a “deferred revenue days” metric (deferred revenue / revenue × 365) and hold it constant or trend it.

Then compute Δ deferred revenue year-on-year and include it in the working-capital line (often “other current liabilities”). Mention a reasonableness check: deferred revenue shouldn’t grow faster than the underlying contracted/billed activity indefinitely unless contract terms are changing.

Wrap by proving you won’t flip the sign in a model:

• If the company starts pre-billing more (bigger contract liability), cash comes in earlier → operating cash flow rises → FCF rises.
• If the company starts billing in arrears (contract liability shrinks), cash comes in later → operating cash flow falls → FCF falls.

Also separate it from non-cash items: deferred revenue is not like D&A; it is a balance sheet timing item. Finally, connect to interpretation: in valuation interview prep, you can say deferred revenue is effectively a form of customer financing that can reduce the need for external funding, but it must be modelled consistently so you don’t overstate sustainable cash generation.