In today’s economic environment, macroeconomic rates – inflation, Fed Funds, interest rates, Prime and LIBOR, for example – are increasing across the board, pushing production costs higher and straining the wallets of consumers. For companies, one of the most obvious consequences is the higher interest that they will need to pay to service their debt. In addition, a rising rate environment exposes companies to other risks that can significantly impact revenue growth, cash burn rates, capital investments and, in the worst-case scenario, company ownership.
Let’s review a few key risks that companies ought to consider in a rising rate environment.
Higher Interest Payments
The interest rate in a variable rate loan is tied to a macroeconomic rate like the Prime Rate, which is itself loosely tied to the Fed Funds rate set by the Federal Reserve. As the Fed Funds rate rises, the Prime Rate rises, and so does a company’s interest rate on its debt. Likewise, as the Fed brings down the Fed Funds rate, the Prime Rate falls, and so does the interest rate on a company’s variable rate loan.
After nearly two years of a flat rate environment in which the Fed Funds rate was set to 0.00%, the Federal Reserve has made borrowing more expensive by raising rates. At its last meeting, the Federal Reserve raised interest rates by 75 basis points, or 0.75%, in its attempt to tamper growing inflation. This can have a significant impact on a company’s interest payments in servicing its debt, which in turn impacts net income. For example, the interest payment on a $10,000,000 loan increases by $75,000 per year, which in turn decreases net income by $75,000 per year.
Consider the likely scenario of future Fed Funds rate increases later this year and next. Should the Federal Reserve raise rates by an additional 200 basis points, the same company will need to spend $200,000 more per year just to service the interest on the debt. These are dollars that would have otherwise gone directly to the bottom line, yet now the company must decide how best to absorb the extra expense. If there is room in the budget, the company may simply accept $200,000 in higher interest expense. Alternatively, if the company must adhere to a strict budget, it may need to accommodate the higher interest expense by foregoing its plan to hire four customer support staff, a senior software engineer, or a VP of Product. In either case, a rising rate environment can cause significant disruption to a company’s profitability, budget and operations.
Customer Spending: Staple vs Discretionary
As a rising rate environment increases costs and decreases purchasing power, customers will be spending more for less. They will grow more cautious and await further economic certainty, which will lengthen sales cycles. They will prioritize spending towards staple goods and services – must-have purchases that cannot be delayed, like food, gas and utilities. Meanwhile, spending on discretionary items, like vacations, furniture and electronics, will decrease. Customers will align their spending away from premium, higher-margin products and towards mass-market, affordable products with lower margins. The ultimate impact to a company’s performance depends upon how well-positioned it is to capture opportunities brought about by changes to customer spending habits and priorities.
Companies will need to evaluate how a rising rate environment impacts their customers along with their own financial performance. Does the company provide a product or service that is a staple or must-have? If the product or service is in a mandated field like compliance, then the company is likely providing a staple that is essential to the customer. However, if the product or service is an enhancement or addition, then it is likely discretionary and is at risk of being delayed or cancelled.
A rising rate environment can alter customer spending patterns. Therefore, it is important to understand which parts of a company’s product portfolio is staple versus discretionary, and how changes in customer consumption will impact the company’s revenue and profit.
As higher inflation degrades purchasing power and consumers pull back their spending in response, many companies will inevitably face stagnant, if not decreasing, financial performance. While finance leaders will be brainstorming ideas to cut costs and implementing strategies to reestablish growth, they must also pay equally close attention to any existing debt covenants.
The quickly changing dynamics brought forth by a rising rate environment can lead to equally quick changes in a company’s financial performance. This may catch the company unaware and place it at risk of violating debt covenants if preemptive action and attention is not taken. Debt covenants are highly variable and can be based on financial ratios, growth percentages or expense targets. Covenants from typical retail lenders are more likely to be easily-determined, well-known financial ratios and KPIs, whereas those from private equity lenders may be more esoteric and obscure. In either case, a company can inadvertently violate a covenant if it is not paying attention to how rising rates impact its business.
For example, we have explored how a rising rate environment can decrease customer spend and company profitability. We have also explored how rising rates can significantly increase interest expense in a short amount of time. Coupled together, a business can be caught unaware that its latest coverage ratio (EBITDA/interest expense) falls below the mandated level, and therefore is in violation of its debt covenant.
Violation of debt covenants is never good. At best, it will require time and effort to report and remediate. At worst, the lender will require the immediate repayment of the principal at a time when the company needs it most – or the violation may lead to a change in control. It is best for the company to understand how its ability to satisfy debt covenants changes in a rising rate environment.
Financed and Lending Portfolios
As customers become increasingly stretched in a rising rate environment and become unable to service their debts, companies with financed and lending portfolios – where customers have financed their purchases and are paying for them over time – will see higher default rates. Given the plethora and growth of “buy now, pay later” credit companies like Klarna and Affirm, whose lending portfolios are overweighted in consumer discretionary, it will be interesting to witness the strategies they implement to mitigate higher default rates. The loss from these higher defaults may only be slightly offset from the subset of customers who manage to continue making payments at the higher interest rates.
In anticipation of higher default rates, such companies can take early and proactive measures when they notice deterioration in their financed portfolios, often through skipped or late payments. For those customers identified at the early stages of duress, companies can proactively offer revised loan terms that lower the customer’s monthly payments – for example, through an extended loan term, a forbearance or a partial forgiveness. Allowing the customer to continue servicing the loan avoids the company’s worst-case scenario of default.
Companies can size their total default risk by determining their level of exposure in different “good-better-best” scenarios. Conducting such an analysis will help them anticipate and prepare their financial forecasts should any of these possibilities come to fruition.
Financial Models in a Rising Rate Environment
Companies utilize financial models to understand the future cash flows of a capital investment. In financial models that deploy rate-based methodologies, such as discounted cash flow (DCF) analysis, the rate plays an integral role in the ultimate valuation – and ultimately, the decision of whether to move forward with the investment or not.
The rate in a DCF analysis reflects the cost of financing the investment, or the opportunity cost of investing in an equally-risky alternative. Even small changes in the rate can have a significant impact on the analysis. Since the interest rate on loans (i.e., the “cost of borrowing”) increases in a rising rate environment, the higher interest rate should be reflected in the DCF analysis to provide updated cash flow estimates. If the updated cash flow estimates continue to satisfy the company’s minimum threshold, then they may be incorporated into the company’s cash flow forecast. Likewise, if the higher interest rate produces a cash flow estimate that falls below the company’s minimum threshold, then the company may decide to postpone the project or cancel it altogether.
Stress Testing and the Regulatory Environment
Through the Federal Reserve’s statements and an examination of the Fed Funds Futures market, a rising rate environment will likely persist in the near future. But much remains uncertain… How high will rates go? How long will they stay there? How long it will take to get there?
With so many unknowns, it is helpful for companies to understand how they may be impacted regardless of how the rate environment plays out. They can be prudent in stress testing their balance sheets under various rate scenarios to form an understanding of what possibly to expect – in a rapidly increasing rate environment, in a steadily increasing rate environment and in a slowly increasing rate environment. This is often referred to as a company’s “Beta” or “Response Rate,” the degree to which a company’s balance sheet responds to movements in the Fed Funds rate. Companies can include such factors as their own responses to the economic environment and impacts to customer spending. Then, companies can prepare contingency plans once they understand the impact of each scenario and can implement strategies that mitigate any negative effects. In addition, for highly regulated consumer sectors like financial services, expect heightened interest and engagement from government agency regulators as they seek to understand the ultimate consequences of a rising rate environment on the consumer.
How to Respond in a Rising Rate Environment
The last dozen years have been marked with relative calm and modesty in inflation and Fed Funds. In fact, today’s Fed Funds rate of 1.75% is still far from reaching its 2007 high of 5.25%. Only within the last several months have rates garnered more attention, so it may be easy to overlook their impact and become complacent. However, a rising rate environment has the potential to touch so many facets of a company that it is important to know how to respond.
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About the Author
Danny has 20+ years of experience combining finance and analytics to produce and implement data-based business strategies. He has worked across a range of companies, from large multinational firms to early-stage VC-backed startups, in capacities ranging from product management and finance to administration and capital raising. His industry exposure includes financial services, SaaS, real estate, edtech, fintech, adtech, crypto and consumer services. Danny’s work portfolio spans FP&A, financial modeling, data analytics and decisioning, venture funding, investor relations, accounting, contract negotiations, human resources, payroll, treasury management and systems implementation. He is versed in SQL, GIS and statistics, as well as recurring revenue and transaction-based business models. Danny received his BA and MA from Stanford University, and his MBA from the Haas School of Business at the University of California, Berkeley.
Categorized in: Financial Planning & Analysis