Interest rates are always subject to a certain degree of fluctuation, but for the past decade we have seen interest rates remain relatively consistent. And while the historically low interest rates on home mortgage loans are a constant topic of conversation, interest rates for commercial lending also have been at a historical low. Until recently, long-term borrowing rates were unchanged for almost six years. The prime rate was changed to 3.50% in December 2015, which marked the first change since 2008 and the first increase since 2006. Since then, we have seen interest rate increases three additional times, and it is expected that another increase will come before the end of 2017.
During periods of rising interest rates, businesses face challenges as the cost to secure lending for business growth and expansion increases. In addition, rising interest rates impact business operations and company financial statements. Below are three key items to consider:
Interest Rate Swap Agreements
Securing debt financing has a direct impact on a company’s cash flow, since periodic repayments of principal and interest need to be forecasted. Many financing agreements are variable-rate agreements, where the interest rate is linked to market rates, which have an inherent risk in periods of increasing interest rates. To remove this risk, many companies enter into an interest rate swap agreement with their lending institution. These agreements swap out the variable rate the loan is tied to (for example, prime rate or LIBOR) for a fixed rate. At the time the agreement is signed, the fixed rate is likely to be higher than the variable rate; however, securing a fixed rate removes the risk of changes in interest rates and can provide stability in the expected cash flow for obligations.
Evaluation of Discount Rates
Assets and liabilities valued at present value on the balance sheet are impacted by changing interest rates. The discount rate used to calculate the present value of these assets and liabilities is linked to interest rates in the market. A higher discount rate will result in a lower present value calculation for the asset or liability, thus deferring income or expense to future periods as the asset or liability moves closer to its future payments. Discount rates should be reviewed and revised periodically, as appropriate, for changes in market interest rates. Examples of these types of assets and liabilities include deferred compensation liabilities, future lease payment obligations on capital leases, and receivables or payables with long-term payment terms.
Current Impact – Financial Reporting
Changes in interest rates also impact current business operations. Businesses with variable-rate debt (lines of credit or long-term notes) will experience a reduction in cash flow when interest rates rise. It is important to understand the impact an increase in interest rates will have on cash flow to determine whether the impact will affect the company’s ability to meet its other obligations such as employee payroll and vendor payments.
Increases in interest rates affect all businesses, regardless of size. It is important that businesses understand how changes in interest rates can impact their choices in lending, business expansion decisions, and current operations.