Capital revenue, or working capital, is essential to keep a business up and running. Every business has working capital requirements necessary to pay daily operating expenses and meet short-term debt obligations. If a business can’t generate a positive cash flow from income-producing activities, it may look to debt as a short-term cash flow solution. Because of this, the role debt plays as a percentage of capital revenue is a strong indication of the overall financial health of a business.
Capital revenue is money flowing into a business from sales revenues, accounts receivable and dividends on investments. Capital revenue figures figure into the profit equation in that every business needs enough revenue to pay working capital expenses such as wages, accounts payable and operating expenses before it can expect to turn a profit. A positive cash flow means that money flowing into the business is greater than the money the business is paying out. Cash flow issues leading to the accumulation of debt may arise during seasonal sales spikes or dips that require additional working capital to fund increased inventory or pay wages during an off-season sales slump.
Businesses look to lines of credit and short-term bank loans as the main sources of capital revenue debt. Factoring is another funding alternative for businesses that have significant accounts receivable. Lines of credit require that the business owner have a certain amount of equity built into the business and assets to use for collateral. Short-term bank loans usually don’t require collateral but most often need to be repaid in a lump sum payment within 30 to 90 days. Factoring involves selling all or part of the business’s accounts receivable to a third-party factoring company. The factoring company charges a fee of about 2 percent to 6 percent of the total receivables and forwards the remainder of the total to the business. Although factoring isn’t technically considered debt, it's included because it does reduce overall income.
Although short-term capital revenue dips most often don’t lead to long-term cash flow issues, in general, the higher debt is as a percentage of capital revenue, the greater the potential to negatively affect business profitability. Calculate a debt-to-capital revenue percentage using a debt-to-equity ratio calculation. Do this by dividing total debt by total capital revenue and then multiplying the answer by 100 to produce a percentage. For example, if total debt is $10,000 and total capital revenue is $25,000, debt is currently 40 percent of total capital revenue.
Keeping debt percentages low and sales revenue high is a best-case scenario. While almost every businesses will at one time or another find it necessary to assume debt to fund business operations, it’s the frequency and amount of debt the business takes on that creates financially risky situations. Business debt can become a significant problem if or when the total amount owed exceeds the company's ability to repay or begins to interfere with long-term plans.
