Chirag Shah, founder of Nucleus Commercial Finance and MyPulse.io explores how SMEs can protect themselves against soaring interest rates.
Interest rates affect everyone. From governments and businesses to consumers, investors and mortgage owners.
Over the last year alone, the current UK base rate set by the Bank of England has risen by 3.75% to five per cent, driven by the need to curb inflation. The end result has been higher borrowing costs, while savings returns, in the main, haven’t been passed on to investors.
But what is the wider-reaching impact on small and medium-sized enterprises (SMEs)? And how can they tackle the problem?
Understanding Interest Rates
In order to understand what effect rising interest rates are having on SMEs, first it’s key to understand how interest rates work and what they mean for businesses in real terms. Here’s how.
Essentially, interest rates determine the cost of borrowing money and the return on the capital that is loaned. They are influenced by a host of factors, including central bank policies, inflation and overall economic conditions.
Given that small businesses often rely on loans and credit facilities to fund their operations, manage their expenses or invest in growth opportunities, therefore, interest rates play a vital role in working out how much they can afford to borrow and the impact of that on their business. Ultimately, it will determine their cashflow, profitability and financial viability.
The recent spike in interest rates is predominantly down to rising inflation. As inflation has continued to climb, so central banks have stepped in to increase interest rates in order to maintain price stability and keep consumer spending in check.
Subsequently, SMEs face a host of challenges, not least in terms of maintaining their financial stability. The biggest impact of rising interest rates is on the cost of borrowing.
As rates continue to go up, so the cost of obtaining loans, credit lines or financing also increases. If firms rely heavily on borrowing to keep their business going or to expand, this will put a greater burden on their finances.
Because repayment obligations are higher, so their cashflow will be potentially reduced, as will their profit margins. This means that it will be more challenging for them to meet financial obligations, such as paying suppliers, covering operating expenses or maintaining sufficient working capital. The knock-on effect may result in missed payment deadlines, damaged supplier relations or supply chain disruption. They will also have fewer funds available to direct to other critical areas of the business, such as hiring new talent, research and development, and marketing.
As well as the day-to-day expenses, rising interest rates can have a detrimental impact on investment and growth plans. As the cost of borrowing increases, the return on investment in potential projects may diminish.
The net result is that by opting not to invest, companies may stymie not only their own growth but also that of the wider economic environment due to a lack of investment, job creation, innovation and development.
In order to address these issues, SMEs need to be proactive in their financial contingency planning and look at ways of mitigating potential risks. By first carrying out a thorough assessment of their financial position and the potential impact of rising interest rates, including cashflow projections, debt obligations and financial commitments, they can identify areas that need to be acted on. They can also prioritise any threats and vulnerabilities, and put a contingency plan in place to protect against them.
A good starting point is to establish an effective cash flow management strategy. That requires keeping a close eye on cashflow and finding ways to optimise it, for example, by negotiating better payment terms with suppliers, putting in more stringent credit control and accelerating receivables collection.
As traditional bank loans may become increasingly expensive due to increasing interest rates, it’s best to reduce reliance on them and look to alternative financing. Venture capital crowdfunding and peer-to-peer lending all provide viable alternative funding sources. Or if their need is more urgent, firms could leverage their assets, such as accounts receivable or inventory, to secure short-term financing.
Another tactic is to use hedging mechanisms, such as interest rate swaps or options, allowing SMEs to fix their interest rates for a set period so that their loan repayment amounts remain constant and to protect against future hikes. It’s best to work with a financial advisor or expert to find the most suitable instrument based on their needs and risk appetite.
AI and Open Accounting
Artificial intelligence (AI) and Open Accounting can also play a key role in cashflow management. By integrating accounting software, bank feeds and other relevant platforms, Open Accounting can provide real-time access to and insight into financial data. Combined with AI, it can be used to afford unparalleled visibility and, thus, accurately monitor and forecast cashflow.
By adapting to and mitigating against rising interest rates, SMEs can maintain a strong cashflow position, and meet their debt obligations, while continuing to invest in new growth opportunities. As rates eventually start to come down, they will also be far better placed to take advantage of more favourable borrowing conditions.