Did your customers load up on debt during the days of super-low interest rates? And, if they did, are they going to have trouble paying you time as rates rise? We asked an expert for his opinion. The gist: Probably minimal effects this year, but there could be problems in the three years after that.
Kip Read, senior vice president of Old Second National Bank, is also a member of the Association of Credit Executives (ACE), a group made up mainly of trade credit managers. With his combined perspective of both lenders and creditors anxious about their customers' bank debts, we met with him with some questions:
Credit Today: After years of low-interest rates many companies are now highly leveraged. As interest rates rise, will this slow and even hold up trade payments?
Read: When rates rise, borrowing money becomes more expensive. However, there are several things in the works that should enable customers to maintain debt payments. With inflation coming, these customers should be able to raise their prices. In some cases, they will be paying more for supplies, labor, parts, energy, and raw materials, but they should be able to maintain or even improve their margins. Even if they just maintain their margin at, say 20 percent, 20 percent of a $50,000 order is less than 20 percent of a $75,000 order. So if contribution margin, as a percentage, stays the same, the margin dollars should grow.
From that perspective, inflation will likely exceed increases in interest rates. Should inflation outpace interest rates, it could provide the needed cushion for handling the increase in the interest expense. Now if the unwinding of the Fed stimulus package results in faster rate moves to quell inflation, then it would be possible for interest hikes to outpace inflation. But I don't believe that businesses will feel that until after the current year-end.
I also don't know if I believe that balance sheets are more levered today than prior to the pandemic. I think that the PPP and Employee Retention Tax Credits have actually buoyed balance sheets and that there is less leverage than pre-pandemic…for most businesses.
CT: How has Covid 19 federal funding affected this?
Read: With small and mid-market businesses, with $100 million or less in annual revenues, in most instances, their balance sheets have been buoyed over the last two years by PPP as well as by Employee Retention Tax credits. These influxes of cash, along with reductions in taxes, have made many balance sheets today much stronger than they were in 2019.
Assuming a flat line growth scenario of most of these businesses, what a lot of companies did with their PPP funds, once they were forgiven, was to just leave them in the company, paying down debt and reducing lines of credit where possible. Now they're sitting with a lot less leverage on the balance sheet than they would have had historically. Of course, that doesn't apply to every company. There are some, especially in the restaurant industry, that have suffered terribly from the effects of Covid. They've potentially just replaced earnings with the PPP and ERCA. They may have been at breakeven for the past two years (after the inclusion of the PPP and ERC) and are not necessarily paying down debt. With interest rates rising, it's possible that leverage on those balance sheets will get more expensive and challenging to service.
CT: So, the average customer may be in better shape than two years ago with historically low-interest rates?
Read: Yes, even though they may be paying somewhat more in interest on their debt in the near future and are likely already paying more for goods and services. The thing that I watch on a regular basis is usage on Lines of Credit. So, if usage averaged historically 40 to 50 percent of approved lines, post-pandemic they're significantly less unless they are growing.
And if they are growing, the usage is starting to spike. For example, consider a company with a $10 million business and a $1 million line of credit in the professional staffing arena, and their run rate at the start of 2021 was 70 professional staff placed in client companies working and generating revenue. Now projects have ramped up again as of Q4 ‘21, and their run rate is at 100-110 folks in seats and they're generating close to $15 million in revenue.
During the last quarter of 2021, they would have started to borrow on their line again. Growth requires working capital because there's a mismatch between when they have to pay their people and when they're paid by their clients. They're funding that gap, and a big piece of that will remain outstanding.
So they may have borrowed up 75 percent of their line as they ramped up. That borrowing may go down again to 40 or 50 percent of the committed amount as they continue on that growth path, but that initial spike of new business certainly ate up their working capital and required more borrowing, initially. I don't think that a 50 to 100 basis points increase in interest expense in 2022 is really going to have much effect.
If the Federal Reserve chooses to increase rates at a faster pace due to inflation, energy scarcity, or the war in Ukraine, then rate challenges may have a dramatic impact.
CT: Are the interest rates on bank lines normally adjustable?
Read: Yes. However, some banks institute floor rates on credit lines, regardless of where rates go. If prime goes to 4 percent and they have a floor of 4 percent, the customer will continue to borrow at 4 percent until their prime-based line, plus its margin goes up beyond 4 percent.
So, if the first couple of rate bumps really don't get them to that floor rate, they aren't going to feel much pain. But once you start moving beyond that floor rate, you start seeing increased interest costs.
We're talking about small businesses. When you move up to larger middle market companies and above, their borrowing arrangements don't necessarily have floor rates. So they'll be hit faster than the smaller businesses. But to the extent that they can weather a 1 percent increase from their Libor/SOFR plus 2.50 line of credit, a 50 to 100 basis point increase in borrowing costs won't likely have a dramatic effect.
CT: How about in future years?
Read: Future years may or may not create other challenges. There is potential for greater impact moving out two, three, or four years. The combination of rising inflation, relatively weaker consumption, higher taxes, rising interest rates, US involvement in Ukraine, and greater energy costs, could have a dramatic impact beyond the one-year horizon.
Contact Information:
Phone: 312-900-9935
Email: kread@oldsecond.com
