Managing Interest Rate Risk When Cost of Money is High

Inflation is a complex issue, and the only mechanism with which the Federal Reserve (Fed) can address it is interest rate adjustments. To slow the economy, the Fed began raising interest rates in March 2022. Since then, there’ve been 11 Fed rate increases to curb inflation.1 At 4.75% - 5.00%, rates are higher than they’ve been in over 20 years.2

Such sweeping measures can upend business plans and forecasts, which are often based on inputs that include interest costs, as well as make cash flow management more difficult.

How do interest rate hikes affect companies?

Higher interest rates may affect both an organization’s access to and use of credit in multiple ways. Lending restrictions are often tighter during inflation which makes it harder to qualify for credit. For example, some lenders may require higher business credit scores to secure loans, lines of credit or credit cards.

Interest rate hikes increase financing costs, making loans more expensive and potentially extending the necessary repayment period. They also negatively impact a company's debt service coverage ratio, which includes the amount on hand to pay any principal and interest due.

Revenue and profit margins must keep pace to meet debt obligations. However, when interest rates rise consumers usually cut spending to reduce household budgets. If your industry or company caters to consumers, you may see a reduction in sales, revenue and profits. If so, debt repayment will limit cash flow.

Given the effect on consumer spending, loan costs and profitability, risk and interest rates make it harder to set goals during inflation. Companies may need to re-evaluate and adapt their business plans to adjust to current economic realities.

“Companies should always look to manage interest rate risk, regardless of whether rates are moving up, down, or sideways,” says Allan Causey, vice president, Synovus Capital Markets – Derivatives.

Managing interest rate risk requires insight.

During the pandemic, many companies saw cash reserves grow exponentially, so taking on new debt isn’t an issue for them. But that’s not true for all organizations. Depending on your risk tolerance, this could be either a suitable time to act or to wait for a clearer picture. “Many borrowers hedge the interest rate on their debt for certainty that they can hit their financial targets,” says Causey.

When interest rate hikes increase the cost of debt, you’ll face competing priorities ― sustaining or growing the business while defraying costs. In the short term, some companies may decide to pass along accelerating costs to customers. Others will choose to purchase “next-best” quality components or ingredients.

If high interest rates continue for an extended period, you’ll need to consider property, plant and equipment, as well as how to finance long-term assets and potential acquisitions. Of course, higher financing costs can have a negative effect on the balance sheet, increasing debts and lowering value.

How will you decide what’s the best move for your organization?

Assess financial performance and develop a plan for interest rate risk.

Organizations always need to know how they are performing financially. This is even more critical when the economy is unstable. For instance, does spending align with revenue and are there opportunities to unlock trapped cash instead of applying for a loan?

Evaluate your organization’s financial position, then create a plan with guidelines for utilizing available funds and maintaining liquidity, as well as pinpointing opportunities for improvement. Integrating five key elements will help better manage risk and interest rate hikes. 

• Determine current cash flow needs.

  A cash flow analysis reveals how much your company earns and spends. You can identify income sources and available cash, as well as track expenses and payments over a defined period.

• Establish and maintain a budget to control expenses.

  Budgets are necessary for financial stability, enabling organizations to track expenses and payments. In addition, budgeting will also uncover cash reserves, some of which might not be immediately visible. This “found” cash provides a cushion with which to pay down outstanding debt, reduce interest rate expense or plan for capital improvements.

• Minimize cash flow risks.

  Periods of high interest rates are ideal times to review potential risks to cash flow, such as investments and debts, and tailor your strategy to the company's risk tolerance. Investing can provide a reliable passive income stream with the right portfolio allocation. However, some investment options offer higher potential for rewards but also increased chance of loss.
  
  For example, savings accounts, CDs, money market accounts and mutual funds are reliable investments when loan interest rates are high. Short-term bonds, which are less sensitive to inflation than long-term bonds, may be good choices as well. Staggering maturities of investment instruments helps offset risks.

• Evaluate outstanding debt.

  When the cost of money is high, it’s best to determine current outstanding debt before borrowing more. If you’re concerned about debt, meet with your lender to discuss refinancing options or better payment terms. “Financial planning is much easier for an organization if it knows the cost of capital with the certainty interest rate hedges can provide,” says Causey.
  
  Interest rate hedging protects against fluctuations, making payments and cash flow more predictable. For example, an interest rate swap allows a borrower to exchange a variable interest rate for a more stable fixed rate with a specific term and principal amount.
  
  Interest rate futures leverage assets, like Treasury bills or bonds, to enter a contractual agreement to surrender the instrument or its cash equivalent upon expiration. They may accommodate short- or long-term instruments.
  
  Loan consolidation is another option to consider for reducing interest rates. Similarly, vendors may be willing to renegotiate terms or offer discounts for early payment.

• Plan for future capital outlays.

  The insights gained when evaluating current cash flow are valuable in forecasting future liquidity needs. Analyzing that data will help to answer questions like:
  • What is the company’s operating cash flow ratio?
  • How many weeks of liquidity does the company have?
  • What capital projects will require funding?
  • How are cash flow and capital needs increasing?

Scenario planning helps to anticipate future conditions, including risk and interest rates, and how they could affect your company. You’ll know how to manage highs and lows.

When developing a strategy to manage high interest rates and their impact on cash flow, get advice from trusted finance, accounting, banking and tax professionals. These experts can help further examine the implications of any intended changes.

Hedging improves interest rate risk management.

To address the unpredictability of interest rates and the effect on your company embrace a universal truth: no one can control the economy. However, you can better manage interest rate risk, as well as make informed spending and financing decisions. “Creating certainty around the cost of debt capital through interest rate hedging enables companies to focus on factors that can’t be controlled,” says Causey.

Contact a Synovus Commercial Banker for assistance or stop by one of our local branches for more details.