Why Rising Interest Rates Can Kill Companies

Generally speaking, rising interest rates have an opposite effect on lenders and borrowers. Lenders may like the increase because it presents them with a chance to increase profits on loan. Borrowers, by contrast, may now owe more on debts, and this costs borrowers more money in the long run. Businesses are among the biggest classes of borrowers. They borrow money from banks, in the form of loans, and individuals, in the form of bonds, each year to grow their profits. If interest rates rise faster than profits, a company may fall into negative cash flow.

Source of Rising Interest Rates

Interest rates rise when the market is responding to a high amount of cash flow. When interest rates are low, borrowers are more willing to take loans. Often, the Federal Reserve will lower its own interest rates, encouraging banks to do the same, during a recessionary period in the economy. This has a near immediate impact on the amount of cash that enters the market. At some point, too much cash will lead to inflation. To curb this, the Fed will raise its rates again, and lenders will do the same. This cycle occurs regularly over time, and depending on when a company took its loans, it may weather the cycle or it may fall victim to the cycle.

Impact of Rising Interest Rates on Business

The vast majority of businesses rely on some degree of debt in order to both form and expand operations. When getting started, a business owner needs immediate cash in order to purchase supplies, rent a location, market the business and otherwise set up operations. Once businesses have successfully operated for some time, many will consider taking expansion loans in order to grow. If a business takes a loan when interest rates are low, it may outpace the interest on that loan with even moderate profits. However, most expansion loans are actually lines of credit, meaning they often have floating or adjustable interest rates. If interest rates rise while the loan is still active, the business can quickly find its debt payments running out of control. On a similar note, a business may consider issuing bonds or stocks in order to raise funds. When interest rates are low, these instruments can promise only small to moderate payment. As interest rates rise, though, businesses will need to raise yields and dividends on these securities in order to continue to bring in investments and debts.

Solutions to Rising Interest Rates

A business can deal with rising interest rates with a few methods. First, they can attempt to pay off all loans immediately. This can solve the immediate problem, but it can also have the adverse effect of killing the business's growth. Another method is for a business to raise prices on its own product. Again, this may help counter the increased expense of higher rates on loans, but it can come with consequences. If another company is able to offer a more competitive rate, the company with higher rates may end up losing business.

blog comments powered by Disqus