Earlier this year, the Federal Reserve began to increase interest rates in response to high levels of inflation and is likely to continue increasing rates through 2022. Over the past couple years, demand/supply imbalances for many items have resulted in inflationary rates exceeding 8%, which is significantly higher than the target rate of 2-2.5%. Interest rates are one tool used to combat higher costs associated with many items and services we buy. The underlying strategy is by increasing interest rates, the cost of the goods will increase and reduce the demand for these items. Over time, demand lessens, and the costs come back down.
Higher interest rates impact most households and businesses negatively with increased costs associated with borrowing money. For a business, costs of financing new equipment, land/building or simply managing working capital have all increased. Stated another way, the value of what you can buy today has decreased compared to the same cost of what you could have bought months ago. As an example, the financing cost for a $350,000 building today would have bought a $450,000 building in 2021.
There are many ways a business can reduce its interest costs. The most obvious is to have no, or very minimal, debt. For those businesses that utilize debt, look for opportunities to reduce the amount or reliance on debt. This may include delaying capital expenditures (autos, equipment, buildings) or selling unnecessary or seldom utilized assets. When buying assets, look to put more money down or financing terms that are shorter in length. If you are concerned that interest rates may continue to increase, a fixed rate might be the preferred option.
Working capital is often financed on lines of credit or with credit cards. Both loan types are usually tied to the prime rate with variable interest, which adds increased interest cost risk. When using credit cards, which is a high-cost source of debt, paying off the monthly balance will typically eliminate interest costs. When using lines of credit, look at ways to reduce operational costs or improve your cash flow cycle, decreasing the time between sales and collection of payment. This might include shortening your accounts receivable payment terms or offering a slight discount for more prompt payment, including accepting credit card. It may also include buying or holding less inventory or discounting stale inventory to incite sales. Consider negotiating longer payment terms or inquiring about prompt payment discounts. Lastly, avoid using credit cards or lines of credit for the purchase of fixed assets as they often will take years to repay.
Reach out to one of our experienced 1st State Bank bankers for assistance or seek the advice and expertise of an accountant to help your business navigate the changing rate environment.