V4B Business Finance

How rising interest rates affect businesses

Inflation

It’s becoming increasingly costly for businesses to get crucial financing for growth as interest rates continue to rise.

The latest increase in the cost of borrowing has intensified the business communities’ focus on questions such as:

  • Why are interest rates consistently rising?
  • Will interest rates ever come down?

And most importantly:

  • Will rising interest rates hurt my business, and what can I do about it?

You’ll find the answers to these questions here.

What is the base interest rate?

The base interest rate is set by the Bank of England about every six weeks. It dictates the cost of business financing and other forms of borrowing money.

The BoE – the central bank of the UK – typically raises the base rate, also known as the Bank Rate, to counter high inflation. This results in banks and other lenders increasing the rates they charge borrowers.

The aim is to reduce demand for goods and services by encouraging less spending and more saving – it’s more expensive to borrow but rewards for saving are higher.

Why borrowing has become more expensive

Interest rates tend to rise and fall according to the rate of inflation.

Since December 2021, the UK has seen a series of base interest rate increases aimed towards achieving the two percent inflation target set by the Government.

In March 2023, with the annual inflation rate at 10.4 percent, the central bank’s Monetary Policy Committee (MPC) raised the interest rate for the 11th time in a row. It went up from 4 percent to 4.25 percent – the highest level in 14 years.

Two members of the MPC argued that the rate should stay at 4 percent but were outvoted by the other seven committee members.

Further interest rate rises are expected in 2023. Some observers predict the base rate will increase to 4.6 percent in August before gradually falling over the next five years to around 3 percent.

The Monetary Policy Committee will meet on May 11, 2023 to set the next base interest rate.

Impact of interest rates on business financing

Cash flow is the lifeblood of any business, and interest rates can have a big impact on capital structure and profitability.

Funding enables businesses to meet increased costs, maintain growth potential, and increase competitive advantage.

Business loans provide a flexible funding tool across critical areas of a business. They keep operations running smoothly and cover day-to-day expenses while maintaining the capability of growth.

This is why businesses need to a keep a close eye on interest rate fluctuations. Rising interest rates may damage a business by jeopardising the ability to take on and finance debt.

How rising interest rates can hurt businesses

Rising interest rates can have a significant negative effect on businesses in several ways.

Slower growth

Interest rate increases push up costs with no corresponding increase in revenue to offset the extra expense.

As the cost of financing increases, businesses may need to scale back operations and plans in order to ensure short-term liabilities don’t exceed income.

And potential for growth may be reduced if servicing debt takes priority over strategies to increase revenue.

In some cases, precarious situations can arise if too much capital has to be used to repay high-interest funding. Marketing campaigns or investments in new products or services may have to be curtailed, for example.

In more serious situations, cost-cutting measures like redundancies may loom on the horizon.

Impact on the top line

Interest rate hikes can affect a business’s top line as well as the bottom line.

Slower economic activity tends to result in less demand for businesses’ goods or services. Consumers become reluctant to shop on credit. And although individuals with savings will see a higher return, increases in interest rates take time to catch up with rising prices.

Knock-on effects

Even if your business isn’t directly affected by interest rate rises, it may be hit by the knock-on effects.

Suppliers may increase the cost of your materials, for example, forcing you to increase your own prices to avoid supply disruptions.

If this happens with a lot of businesses, inflation could be pushed even higher, further eroding sales.

How to manage interest rate rises

Just as interest rate rises affect businesses through different channels, managing the effects may entail more than one consideration.

Capital structure

Understanding your capital structure helps to identify, predict and influence the effect of interest rate rises on your business. This facilitates potential adjustments to business models to help maintain growth.

Realising the amount and type of capital you’re utilising – earned or loan based – will help to pinpoint vulnerabilities and identify areas that could potentially benefit from higher interest rates.

For instance, perhaps your business could do more with surplus funds, and set up an investment portfolio. When interest rates rise, so will your return on those investments.

Your business plan

You may need to revisit your business plan in the face of rising interest rates. This can help you to:

  • Decide whether your existing business strategy is still workable.
  • Ensure your goals are flexible enough to withstand interest rate rises.

You may then need to assess whether your available capital is enough to sustain you, and/or if you need to reconsider the types and levels of your financing.

Business financing

When interest is high, a variable-rate loan can be a significant and sometimes overlooked source of business risk.

If you have this type of loan, the solution may be to replace it with fixed-rate funding before interest rates rise further.

On the brighter side

An environment of increasing interest rates leads to new challenges for many businesses. But it can also create opportunities, and it may be possible in some cases to make the most of rising interest rates.

While the increasing cost of borrowing is typically seen as a means of slowing growth, there are several measures businesses can take to insulate themselves from the negative effects while capitalising on the opportunities rising interest rates present.

These steps include:

  • Investing positive cash flow into higher-yielding securities.
  • Slowing production to avoid an excess of products.
  • Taking advantage of fixed-rate business financing ahead of further interest rate rises.
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