Its earnings season again and while times are great for big corporates, something have investors spooked – rising interest rates. While much of the news has focused on the possibility of inverted yield curves, c-suites across the country are becoming concerned about the cost of debt and what this means for their balance sheets.
Why is this a concern? Well, the historically-low interest rates of the last decade made it easy for corporates to binge on debt. That’s right, low-cost money was basically falling from the skies and for almost a decade companies large and small became addicted to this cheap money. However, these days are coming to an end and this article will explore what every CEO needs to know about interest rates.
This is not a Corporate Finance Course
The ins and outs of debt finance is a rather dull subject and therefore many CEOs leave the financial strategizing to their CFOs. But even if you are not a corporate finance specialist there are a few things that you need to know about interest rates.
First, the interest rates your company gets for its financing needs is essentially an indication of how banks and investors view your risk profile. Simply put, the higher the interest rate the higher the risk. Therefore, short-term bridge loans will have interest rates as high as 20 percent while capitalized loans, like a mortgage or a reverse mortgage, will have lower rates.
Besides the risk, the aggregate of your firm’s interest rates on its financing activities will help the finance department and even external analysts calculate the Weighted Average Cost of Capital (WACC) for your company. As the name implies this is how much your company’s debt activities (i.e. lines of credit, working capital loans, capital finance agreements, etc.) cost.
What does this mean for the man, or woman, in the corner office? If you want to lower your WACC, then you need to look at ways to take the risk out of your company’s financial profile. This could include improving financial ratios on your company’s balance sheet, or improving cash flow – either as measured by Earnings Before Interest Taxes Depreciation and Amortization (EBITDA) or Free Cash Flow to Equity (FCFE).
Don’t worry you don’t need to have a Ph.D. in Economics to understand these ratios but you probably need a good CFO to help you better understand their impact on your company’s financial health.
A State of Complacency
While interest rates over the past decade have been ridiculously low – heck, they were even negative in some European countries – the reality is that rates since 1994 have been significantly lower than they were in the 20 years prior.
This environment of low-interest rates has bred an air of complacency amongst many corporate planners. In fact, it has gotten so bad that few executives remember the impact the high-interest rates of the 1970’s and 1980’s had on capital planning and structuring.
Add to this collective lack of experience the fact that recent tax cuts pushed to near record corporate profits – at least for big businesses – through the rough. However, this hasn’t exactly led to the massive reinvestments that many policymakers thought would happen.
Instead, many executive boards have decided to use the windfall from corporate tax cuts to buy back shares while continuing to rely on near-record low-interest rates finance business activities. Ultimately, this leads to higher levels of corporate debt – something that could spell disaster when the next recession strikes.
In addition, rising rates make it harder for corporates to refinance their rapidly maturing obligations. For example, some economists have noted that close to $10 trillion in corporate debt will mature by 2022.
While the recent trend has been to refinance that debt at the same or even lower interest rates. An aggregate rate increase of 1 to 1.5 percent will price marginal companies out of the market because they will no longer be considered creditworthy.
Even though options such as repayment or accessing financing through the corporate junk bond market will remain, these are costly choices and will lead to less investment at a time of increased competition due to technology, globalization, and trade barriers.
What Can You Do?
Most market watchers agree that a) we are in the later stages of one of the longest periods of economic expansion in history (translation: we are due for an economic slowdown); b) interest rates will continue to rise over the next 12- to 24-months. As such, it is time for corporate leaders to take a good look at their loan book and make strategic decisions.
For those with variable rate loans, now is the time to lock in finance costs before it becomes too expensive. For those with high leverage – i.e. their debt-to-capital ratio is through the roof – the time has come to bring some order to their balance sheet. For those who will benefit from tax cuts, the time has come to prioritize what to do with this windfall as share buybacks and increased dividends might not be the best option.
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