Over the past few years, businesses have faced many challenges including labor shortages, supply shortages, and inflation. Many commodities and input costs reached record highs before experiencing deflation over the past year. While many input costs have fallen back to earth, the cost of capital has increased significantly over the past two years.
Since early 2022, the Federal Reserve was fighting inflation through a series of interest rate hikes. It has raised its benchmark interest rate from near zero to a 22-year high of between 5.25% and 5.5%. This means it is more costly for businesses to borrow money.
As a business consultant, I’ve seen many business owners focus on increasing revenue without much concern for the bottom line or the ability to service debt. Profits are the key to a sustainable business. Business debt can negatively impact the profitability of a business. As interest rates increase, businesses can have higher interest payments which result in less income and reduced ability to reinvest in the business.
Here are a few tips for small businesses in a rising rate environment:
- Stay laser-focused on the product or service that you provide to your ideal client.
- Practice the “Profit First” ideology by determining your desired net profit (after taxes and interest expense) and pay yourself first!
- Run a lean business by reducing all unnecessary expenses.
- Think like a banker by stress testing your business. A bank will look at your business financials and determine your ability to service debt as interest rates rise. What happens when the rate resets from 4% to 8%? Can the EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) service the principal and interest payments at a coverage of 1.2x?
- Build up your cash reserves and equity.
- Do not take on debt to finance a project until calculating your return on investment.
- Communicate with your banker. If your existing debt payments are a burden, talk to your banker and look for consolidation or refinance options.
In summary, higher interest rates can result in higher cost of capital and potentially lower profits. In this increasing interest rate environment, it is important to streamline your business, increase your profitability, build up your cash reserves, and think twice before taking on additional debt.
To learn more about LonaRock, LLC and our fractional CFO services, please email us at email@example.com or contact us directly at 234-217-9033. We look forward to helping you reach your financial goals.