High interest rates, at least in relative terms, are here to stay for the foreseeable future. And more increases could yet be on the way. We constantly hear from CEO’s asking for our crystal ball, and many of them very uneasy about the interest rate environment. While the long term effects of this are far from certain, and our crystal ball is as cloudy as anyone’s right now, business owners can act confidently by stepping back and really understanding the impact on their business.
How is your debt structured today? Lines of credit, which are almost always floating rates pegged to an index like Prime or SOFR, have increased along with the Federal Reserve’s actions. In the same way, should the Fed start cutting benchmark interest rates, those same lines would follow suit. Fixed rate date from a few years ago may actually look cheap today. You may also need new financing. What is the current and near term picture. For those businesses accelerating debt payments, does the current picture shift that strategy to different loans or even a pause altogether? While there are few general rules, a company with fixed debt at 4.5%, very cheap in today’s terms, may be well served to deploy capital in other areas of the business to drive returns than paying down debt faster. Or possibly it makes sense just to conserve more cash given continued uncertainty. The good news is that yields on cash are much higher today as well. The answer is less important than the thought process to get to it.
A great place to start is to model out your current and near term debt and debt service and then play with scenarios to see what further changes in interest rates does. How material is it to your business? Do you have a debt renewal approaching? What is the impact if rates continue to increase? This answer is often surprising at times to the high and low. There is no reason to be nonchalant or fearful until the impact is at least quantified.
How much margin for error do you have in your business? This is critical. Now that you know what the interest cost could be, how much can your underlying business absorb. A low margin business is much more susceptible to changing variables. While high interest rates are unfavorable for most businesses, it could be a difference between simply buckling down and weathering a storm in a safe harbor and seeing a small margin for error erode further that could necessitate immediate action like conserving more capital or deferring purchases.
How capital intensive is your business? Companies that generate revenue from real estate, heavy equipment and other long term assets are very capital intensive and typically rely heavily on outside funds. These business are the most sensitive to interest rate changes, and an environment like this could very easily make or break a deal. Manufacturing companies that might need to invest in equipment or businesses with high levels of inventory and long dated accounts receivable that depend on bank capital can also see significant impact. By proactively running the numbers, that potential impact can be quantified. It may necessitate shifts in strategy such as slowing innovation, revisiting terms or even altering inventory purchasing.
What about your customers? Or suppliers? Even after you understand the impact on your business directly, what about your key stakeholders? Do interest rates impact your customers ability to buy from you, leading to potential lost or deferred revenue? Might your suppliers get squeezed, causing them to get tighter on terms or possibly even leading to disruption of your supply chain. Do you know how susceptible to interest rates your customers or vendors are? Understand their businesses as best you can before it is too late.
And an ever cautionary tale – the impact of rates is unique to your business and where it is headed. Your neighbor’s structure, business model and strategy are equally unique so be careful to draw too many specific conclusions from what they are doing or saying. Know your numbers today, and what they could be tomorrow. Set your unique plan and execute on it with confidence.