On March 16, 2022, the federal funds rate sat at 25 basis points (bps). The next day, the Federal Reserve, in an attempt to combat mounting inflation, raised the rate from 25 bps to 50 bps. May saw another 50 bps, then an onslaught of three 75-bps increases in June, July, and September.
Based on most indicators, the rate hikes have done little to stave off rising costs. A recent report showed Consumer Price Index prices (not including food and fuel prices) climbed by 6.6 percent during the 12-month period ending in September.
The Federal Reserve raised the funds rate another 75 bps when they met in early November and are expected to raise it another 50 to 75 bps in December.
“It’s a little bit hard to slow down without an apparent reason,” Alan Blinder, a former Fed vice chair, who is now at Princeton University, told the New York Times. “If you were [Chair of the U.S. Federal Reserve] Jay Powell and the Fed and slowed to 50, what would you say? They can’t say we’ve seen progress on inflation.
“That would be laughed out of court.”
If the last two rate hikes come to fruition, we would be kicking off 2023 with a federal funds rate of at least 4.50 percent. That means a prime rate of 7.5 percent. Seven-percent prime was last seen in December 2007.
“We’re not even sure that the problem is not getting worse, I’m not ready to declare a pause until we at least have that confidence,” said Neel Kashkari, President of the Federal Reserve Bank of Minneapolis, indicating he sees no reason to stop rates at 4.75 percent in 2023.
What Do Increased Rates Mean for Your Business
For consumers, rising interest rates make it more expensive to take out a car loan or carry a balance on a credit card. Mortgage rates have already soared to more than seven percent (for the first time in 20 years), up from less than three percent a year ago.
Same goes for businesses: borrowing money is becoming more expensive for both operating lines and term loans. Many lines of credit are repriced monthly, so higher interest rates hit the company almost immediately. Higher interest rates raise businesses’ cost of capital and negatively impact cash flow. Even if the company doesn’t have debt, upstream and downstream debt (suppliers and customers) will have an impact on liquidity.
The impacts will be felt across the supply chain, but could be particularly devastating to smaller suppliers that will have less access to capital from traditional lenders. The risk of bankruptcy is likely to rise at all tiers within the supply chain but especially lower-tier suppliers. While some businesses see payment-terms extensions for their suppliers as an answer to fix their working-capital crunch, the practice can increase the likelihood of supply chain woes if not coupled with some mechanism to allow suppliers to access early payments. The trickle-down effect of less capital for suppliers results in increased costs of goods and potential supply chain disruptions as suppliers have to scale back production or inventory simply because they don’t have the cash flow to maintain operations.
Succeeding in a Higher-Interest Rate Environment
With interest rates hitting 15-year highs – and more hikes on the horizon – the question becomes, what levers are available to businesses to protect themselves and their supply chains?
While all businesses are unique, generally speaking, accounts receivable and accounts payable finance programs provide great options for companies of all sizes to improve their working capital position in the face of more expensive money. By using solutions that leverage technology, buyers and suppliers can start seeing an impact almost immediately.
Couple higher rates with banks’ general tendency to be risk averse and businesses can greatly benefit from looking at non-traditional funding sources – especially supply chain (or accounts payable) finance (SCF) programs for mid-to-large enterprises. SCF reduces the cost of capital for mid-market and small suppliers, mitigating higher interest rates, and supporting supply chain health. By offering early payments, an SCF program can improve relationships with suppliers and lessen the likelihood of a price increase. SCF also allows buyers to optimize their cash flow with more favorable payment terms through pay-later options (without extending terms to suppliers), freeing up working capital for the buyer.
A Time for Discipline
In any interest rate environment, managing and mitigating risk is important for business success. As money gets more expensive, maintaining discipline around counterparty risk is critical to avoid disruption to a company’s operations. Simply put, higher interest rates drive tighter liquidity and high risk of defaults. With that in mind, now is a good time to re-evaluate and heighten monitoring of the creditworthiness and cash positioning of your customers, debtor concentrations, and the overall health of the supply chain.
Debtor concentration is the percentage amount of accounts receivable owed by a single debtor to your customer. If they do business with only one customer, their debtor concentration is 100 percent. If a single debtor accounts for one-third of their total accounts receivable, the concentration with that debtor is 33 percent. The higher the concentration with one customer, the greater the risk: if something goes awry with your customer’s customer, you are going to have a problem with that account (especially bad if you have a high concentration with them). Once again, your customers’ liquidity concern becomes your liquidity concern.
Another factor to consider when maintaining customer credit discipline is the aforementioned general risk aversion of most traditional banks; an aversion that increases with interest rates. The goal of higher interest rates is to take money out of the economy, which means less lending – or banks asking businesses to exit existing lines of credit. Even if you aren’t heavily leveraged, your customers or your customers’ customers may be, and either one’s inability to pay is bad for your business.
When looking to navigate a riskier macroeconomic environment, it’s important to have data at your fingertips to help make more informed decisions. Having a comprehensive, real-time source for insights into customer health can help mitigate counterparty customer credit risk (and, conversely, the risk of your suppliers if you buy inputs). Put simply, the financial situation of your customers can change quickly and making adjustments as needed (like adjusting terms or lowering your exposure) goes a long way to ensure your business’s long-term viability during volatile and uncertain times.
For the past year and a half, economists have predicted a slowdown that would throttle inflation – and are still predicting normalization. Based on the track record so far, it’s hard to say if those economists are right. What we do know is that the cost of money has gotten more expensive and will, most likely, get more expensive, and that drives uncertainty and risk for businesses of all sizes. It’s important to find the levers that help companies maximize liquidity and re-evaluate their appetite for risk. By getting ahead of those basic tenets, your business will be in a good position to weather most storms that may come.
Stay in the loop
Subscribe to our monthly newsletter
Working Capital Insights