Revenue Deficit Meaning Example Implications Of Revenue Deficit

Revenue Deficit Meaning

What Does Revenue Deficit Imply?

When a company enters into a revenue deficit, it implies it did not do enough business to cover the costs for the upcoming period. As a result, the net income for that quarter is not enough to let the operations run for one more quarter. In such a condition, the company has to borrow the required amount from an external source: which in most cases will either be debt or equity. When the company borrows via debt, it has to pay interest, which increases the financial leverage of the companyFinancial Leverage Of The CompanyFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more. But if the company raises money through equity, the company need not pay any additional interest. However, equity is a partnership in the company, and in a situation of revenue deficit, raising equity is generally seen as a bad signal for the company.

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Example of Revenue Deficit

Let us take an example of a fictional car company, Edison: a manufacturer of fuel cell cars. To make their cars, they import batteries and motors, add additional fittings, and form the car. Each car is sold at one hundred thousand dollars, and they predict they will sell ten thousand cars. But, to import the materials, they have two hundred million dollars for the battery provider and 600 million dollars for the motor provider. So, the company expects revenue of one billion ( or thousand million dollars), from which they have to pay 800 million dollars and keep the rest as net income.

If the company did not sell 10,000 cars as expected and only sold 8500 cars, their net income will be short by 150 million dollars.

Solution:

Sold Cars: 85,000Revenue : 850,000,000Operational Expenses: This does not change because the company prepays for the engine and batteries. Hence this will remain at 800,000,000.Net Income = 850,000,000 – 800,000,000 Net Income = 50,000,000

This is 150 million short of the expected 200 million.

It might negatively affect the company. For example, if the company is a growth company, the company might need to have additional capital to maintain inventory. If the company has taken a loan for which the interest costs are more than the current net income, then the company does not have enough working capital to cover the interest expensesInterest ExpensesInterest expense is the amount of interest payable on any borrowings, such as loans, bonds, or other lines of credit, and the costs associated with it are shown on the income statement as interest expense.read more. In such cases, the company has to sell off its assets to make sure they cover the expenses. It is the beginning stage of bankruptcy.

A revenue deficit does not mean the company has started losing money. However, it does have implications that go far beyond a single number. From analysts’ estimates to companies working, revenue deficit is a significant number used to gauge a company’s workings and how it might behave in the future.

Disadvantages

The most obvious way is how the analysts will look at the revenues in the upcoming periods. In most cases, analysts use predictions to analyze stock prices. Net income is one of the essential factors in predicting stock prices. A change in such prediction would adversely affect the analyst’s stock value and, in turn, market value.A revenue deficit would adversely affect the company’s performance in the upcoming period. The revenue deficit size tells us whether a company has enough money left to pay its interest charges. Or whether it is enough to have the growth rates predicted.Many corporations get their loans at interest rates determined by their credit ratings. In such a system, credit rating is one of the most critical metrics for a company. The process for credit ratings is that the company gives details regarding how it can manage its loans, and the credit rating agency considers that while giving out the credit rating. A revenue deficit might signal to the credit rating agencies that the company is not good enough and does not have as much expected business, market share, or operational efficiency as the agency has expected. This signaling might force the credit rating agencies to reduce the company’s credit rating. It increases the financial risk of the companyFinancial Risk Of The CompanyFinancial risk refers to the risk of losing funds and assets with the possibility of not being able to pay off the debt taken from creditors, banks and financial institutions. A firm may face this due to incompetent business decisions and practices, eventually leading to bankruptcy.read more.

There is no argument that the revenue deficit is bad. The point is to check whether the company is on the wrong path or the analysis is in the wrong direction. A company can correct itself by vertical integration, more operationally efficient, or creating a better financial structureFinancial StructureThe financial structure refers to the sources of capital and the proportion of financing that comes from short term liabilities, short term debt, long term debt, and equity to fund the company’s long term and short term working capital requirements.read more. It is obvious to the higher management in the company to determine if this is an operational failure, financial failure, or systematic market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more. The decision on controlling the revenue deficit depends on the root cause.