Rising Interest Rates

Rising interest rates contribute to expense creep and an erosion of profits because many small businesses rely on a business line of credit (LOC) with a variable interest rate. A typical LOC is rated “Prime plus”, meaning the current Prime rate plus X%. As Prime moves, so does the variable interest rate.

A look back at the history of Prime reminds us that another 5% increase to this key rate would not be unusual. On a $25,000 balance, such an increase erodes profits by $1,250 per year.

Even more vulnerable are businesses making interest only payments on their LOC. A line of credit should go up and down with a company’s seasonal, purchasing, or A/R cycle. If you run up the balance and just let it sit there, then you’re using a short-term financing instrument as a permanent source of working capital, which can be symptomatic of a number of problems — cash flow management, profitability, or overall debt structure. Looking longer-term, a company today might be vulnerable if it defers capital expenditures — purchases of computers, vehicles, and other operating equipment — because such items are essential to improving quality and increasing efficiency. Buying them on credit will only get more expensive as interest rates rise, and falling behind might put a company at a disadvantage relative to competitors with a lower cost structure.

Most borrowing comes with covenants-compliance conditions your business must honor to retain the right to borrow the money. These may include the need to zero out a line of credit for 30 days, maintain certain balance sheet ratios, submit tax returns and financial statements, or even to limit an owner’s compensation. Failure to meet loan covenants is a red flag. It likely means your company’s financial condition has deteriorated and you run the risk of the bank calling your loan - demanding immediate payment in full.

Two common financial statistics can help you spot weak financial ratios — the current ratio (current assets divided by current liabilities) and debt:equity ratio (total liabilities divided by total equity). There’s no “right” number, but a general rule of thumb: current ratio should be at least 2.0, and debt:equity should be no more than 2.0.

Another sign of vulnerability is excessive concentration: when your company relies too much on too few customers. When one of those customers “goes away”, the results can be devastating. Find out before your banker does: in QuickBooks, pull a Sales by Customer Summary report and sort by total, descending order. Calculate what percentage of sales your top few customers represent.

Most lenders require you to put up collateral to secure their loan or line of credit. This might be inventory, fixed assets, Accounts Receivable, or personal assets, most typically your home. Watch for an erosion of your collateral base, which can stem from two sources: either the collateral has gone down in value or you’ve already pledged it to another lender. A lack of collateral limits your company’s ability to borrow, which can limit its ability to grow or even survive.

Finally, if your company consistently finds it difficult to meet payroll or pay rent, vendors are calling about late payments, or you’re checking the bank balance daily to see what’s cleared the bank, then that’s the biggest red flag of all: a chronic cash flow shortage. It means you have no margin for error and corrective action is needed.

Thankfully, there are a number of things you can do in response to the warning signs above.

12 Ways to Reduce Financial Risk

1. Set goals. Managing company debt is a little like responsible gambling: know how much you’re willing to lose before you start playing. How much exposure will you tolerate? How much of your personal assets are you willing to risk as collateral for business financing? How weak will you let your balance sheet ratios get? Set a debt ceiling.
2. Update your personal financial statement. Your banker can supply one, and we favor creating an Excel version so you can update it easily. This lists your personal assets and liabilities, then calculates the difference - your net worth, in economic terms. The book value of your business should be included in this.
3. Create a debt schedule. We’ve found this to be one of the most effective tools to help clients manage their debt — a spreadsheet that lists business and personal debt (for major shareholders), interest rate, credit limits, available credit, monthly payment minimums, renewal or termination date, and relevant details such as when a zero-interest credit card offer jumps up to 27%. It’s an objective look at an often emotional topic.
4. Analyzing your debt schedule (#3 above) may suggest ways to restructure your debt. For example, if you have personal credit card debt that is not tax deductible, it might be worth paying that off through a home equity line of credit, which is usually tax deductible. Or if you’re unable to pay down a business revolving line of credit, you might need to “term it out” into a fixed rate term loan with monthly payments that ensure you’ll make progress against principal. This also allows you to lock in a fixed rate.
5. Monitor your personal credit. Personal financial advisors suggest we monitor our personal credit report through www.annualcreditreport.com, a free service that permits you one credit report per year from each of the three major bureaus. Promptly fix any mistakes. It might also make sense to monitor your FICO score, but we’ve seen and heard evidence that the FICO score a lender gets can differ markedly from what we can get as consumers.
6. Negotiate terms. When negotiating a bank loan or line of credit, ask for a lower interest rate, or a reduction in up-front closing costs. Within a certain range, banks have negotiating room with regard to how they price their product - money. Discuss your financing needs with two or three lending sources to get a feel for the market. Consider moving your operating account to the new bank - it makes your company a more attractive customer.
7. Comply with covenants. Don’t give your banker an excuse to call your loan or not renew. Read your loan docs if you’re unsure what covenants are in place. We’ve seen financial ratios and even owner’s compensation listed as covenants. Put them on your debt schedule (see # 3 above) if need be. Calendar them in. #8 / Ask for money before you need it. Leave 3-6 months to arrange financing for a new line of credit, a term loan for equipment, etc.
8. Diversify your client base. Don’t depend too much on any one client. Keep looking for new clients. Sometimes more revenue from a client is not a good thing. It can be a crutch upon which your company relies too heavily, at the expense of addressing a key structural weakness.
9. Spread out capital expenditures. Maybe buy new computers this year, a vehicle the next, make leasehold improvements the third, and so on. Buying fixed assets all in one year, unless there’s sufficient cash flow and a compelling tax reason, taxes your working capital and financing limits.
10. Don’t lock up assets without thinking about overall strategy. If you give one lender a first on your house, for instance, any new lender’s going to have to get in line behind that one - and many will be unwilling to do so. Keep your collateral available for the most critical lending need. So if you pledge your house to buy a new car but then can’t use it to buy essential operating equipment, you may be hurting your long-term chances of generating wealth from your business.
11. Don’t become a financing junkie. If your company’s ratios are weak, cash flow is tight, you’re not paying down debt, and profit margins are thin or non-existent, then more debt is usually not the answer. Increase sales, cut costs, and accelerate cash flow. You’ll probably have to change your behavior, but if you’re willing to do so, there are hundreds of proven techniques that, taken together, can restore your company’s financial health.