Starting a new business is a risky proposition. Quite apart from concerns over whether the business model will sink or swim, for many, there is the issue of taking out and managing a loan in order to cover start up costs.
Understanding how the ongoing interest rate is likely to affect the cash flow in such a business is key to its success. It’s also wise to understand what causes the Reserve Bank Of Australia (RBA) to change rates, as this can drastically affect how loan-based businesses operate.
What purpose does the RBA serve?
The Reserve Bank of Australia (RBA) uses interest rates as a tool to stimulate or slow the economy, depending on how poorly or well it’s performing.
“The RBA uses interest rates to stabilise and encourage economic growth, depending on what point of the economy we’re in,” explains Bernard Curran, partner of the private and entrepreneurial client group at financial advisory firm BDO. It does so by setting what is referred to as the official cash rate. This rate directly informs how banks and financial institutions in Australia set the interest on products like business loans and credit cards.
“On top of the cash rate, interest rates are then set by banks based on their cost of funding,” continues Curran. “The banks then build in a premium to do with risk, specific to the small business owner. Depending on the [size of the] lend, security and type of business, the rate charged by the bank will cover what the bank’s perceived risk is [to lend] to that particular business.”
Changes in the official cash rate set by the RBA inevitably filter down through all interest rates on products offered by banks and other financial institutions in Australia. If the economy is performing well, the RBA boosts the cash rate to encourage it to prosper. If the economy looks like it might be slipping, it lowers the cash rate to avoid slipping into a recession.
“During the global financial crisis (GFC), that had a severe impact on the economy,” says Glenn Baker, chief financial officer at ING Direct. “Globally, things started to slow down, and Australia was impacted by that. When that happens, you get this potential of running into a recession – the economy is going to run at too low a level of performance, which is going to cause unemployment and all sorts of things. So, they slashed interest rates aggressively.”
As the Australian economy continues to find its feet post-GFC, despite its strength relative to the rest of the world, the RBA is trying to discourage cheap borrowing, as this results in an excess of stimulus which in turn leads to things like inflation and price pressures, as Baker explains.
“The rising interest rates in the past couple of years have actually been in response to removing a high level of accommodation, or ‘easy money’, in the system, so that we don’t overheat the economy,” he continues. “We slashed rates initially to avoid a recession, and then we’re starting to take them back to normality. It’s not like they’re going up and tightening the economy, they’re going to get us back to where we’d normally be. Interest rates would normally travel at around a 5% level.”
How does this affect small businesses?
“The big criteria for [lending to] small businesses, particularly ones not long in business, is the security provided,” says BDO’s Curran.
Security, in this sense, is essentially assets that the bank could reclaim should the business default on its loan.
“Unfortunately, banks lending to small businesses are looking for property security, or assets, that they can touch and feel and grab. The other things they look at in assessing interest rates and lending to small business is the ability to repay,” he continues.
Other factors in risk assessment include the strength of cash flow in the business – something that’s non-existent in most startups – and whether or not it’s operating in a cyclical or high-risk industry.
One way in which the GFC continues to affect small businesses is the difficulty of finding a loan to cover startup costs. As startups typically have little in the way of security, banks are currently more reluctant to take the risk of lending to them, causing many entrepreneurs to turn to other sources of cash flow, like credit cards.
While the interest rate on most business loans would fall somewhere in the vicinity of eight and 12%, it’s common for a cash advance rate on a credit card to be charged an interest rate of over 21%. It’s this kind of cost that makes credit cards unviable as a long-term source of cash flow for small startups.
Jan Barned, financial management coach and director of FMTrainer, suggests businesses that started during the GFC using personal credit should use the current economic security in Australia to redress their cash flow arrangement as soon as possible.
“They need to go back and speak to their bank again, and point out the reasons why they had to [use a credit card], and see if they can actually get out of that sort of situation,” she says. “What they want to do is try to get themselves into a cashflow positive position so that they’re not exposed to interest rate risk at all.”
Failing this, Barned suggests a number of ways that businesses burdened with credit card debt can try to reduce or abolish it altogether.
“Look at your business and trying to improve your working capital. Review stock levels, and make sure you understand how your stock moves,” she advises. “If you have got aged or excess stock, move it out, get rid of it and get some cash in the door. Secondly, get out there and chase your customers. You would be surprised how many small businesses don’t like asking for money. They can have debtors out there 60 to 90 days. A sale is only a gift until you get the money in the bank. These are the only ways that they’re going to get on top of their cashflow issues, and remove themselves from being exposed to interest rate risk. It’s as simple as that.”
How to reduce risk and prepare for rate changes
Ideally, businesses should consider interest rates and their associated risk when writing business plans long before they approach a bank.
“If you’re running a new business, you’ve probably got a budget and a forecast around what you can do,” says ING’s Baker. “One of the critical elements in terms of whether you’re going to make money might be the level you pay on your borrowing, so put that into your budget. If that goes up it could damage your business prospects.”
BDO’s Curran suggests businesses incorporate what they expect to pay on interest into their cash flow plans, and then test them with some hypothetical situations to see how well they stand up.
“I’ve always suggested business owners look at some ‘what if’ scenarios in their budgeting to assess the impact a movement of interest rates might have on their business and their cashflows,” says Curran.
If a business planned monthly installments based on an advertised rate of 8.5%, for instance, Curran suggests they should see if the business can still operate if the rate were to change to 10%.
Based on what they learn from this kind of calculation, businesses should carefully consider whether to opt for a fixed or variable rate of interest on loans offered by the bank before they commit to a particular offer. Fixed rates are usually offered with a set, premium interest rate, but give the business security against massive changes in the cash rate. Variable rates are often considerably lower, but expose the business to sudden fluctuations.
“That’s a very hard game to play, because you’ve obviously got to consider how interest rates are going to move in the future,” says Curran.
The choice, explains ING’s Baker, depends on the nature of the business itself, and whether or not it has cash reserves to fall back on in case of unforeseen financial pressures.
“If interest rate rises would blow you away and ruin your business, you should take out the insurance [of a fixed rate],” he says. “If it’s not critical, then maybe half of your borrowings might be fixed, and half not.”
Given that current rates are unlikely to rise rapidly, choosing a fixed interest rate is effectively a step towards protecting a business against the unknown.
“We can get a bit of a guide on where we think rates are going, but it’s the ‘x’ factors that tend to do damage,” says Baker. “If something occurred that suddenly means that rates are going to go up sharply, it’s too late to want to fix it later. Particularly for startups, I think it’s probably more appropriate to have an attitude of fixing your borrowings so that you have some degree of insurance.”
According to BDO’s Curran, a marginal increase in interest rates is much more likely than any substantial drop over the next two years.
“Again, if you’re talking a quarter of a percent of movement, that’s where the planning is important; to assess whether the risk is worth fixing or not fixing,” he says.
Curran also notes that any major and unforeseen changes depend largely on fluctuations in overseas markets.
“Significant impacts could be [caused by] a dramatic slowing in China, or a dramatic movement in the Australian dollar, which is really linked to how what happens in the US economy,” says Curran. “I think those issues and perhaps what’s happening in the European debt issues debate are probably the biggest factors that are going to influence interest rates in the next little while.”
ING’s Baker claims that the most likely development in the foreseeable future is the rising of the current cash rate from 4.75% to 5%.
“It’s risen closer to normality, but we still see there’s an improving economy and it’s highly likely that will lead to a need for interest rates to go up again,” he explains. “We have low unemployment now, and there could be pressures coming through with respect to wages, costs and things like that which could feed into inflation.”
The good news for small businesses is that, although consumer spending is unlikely to improve considerably, the current cash rate represents a relatively level playing field with respect to interest rate risk for startups, as well as those trying to fight down bad debt.
“We’re really quite stable right now,” says Baker. “I don’t think the RBA is in a rush to do anything, but it is watching for inflation to emerge, because we are growing faster over time, and we have low levels of unemployment. When they do start to tighten rates, it’s to slow things down, so it will have an impact on consumer confidence and spending.”
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