Fixing interest costs can help reduce uncertainty in variable costs
Recent activity by the Federal Reserve has been driving an increase in short-term interest rates. Since the middle of 2016, long-term interest rates have also trended higher.
I believe choosing your loan interest rate program should be put into the context of your unique financial and operating situation. Agriculture is a diverse industry with many different variables. Often, broad statements and generalizations just don’t apply.
To step away from generalizations around choosing whether a fixed rate product is right for you, considering some questions in specific areas has been helpful to me in reaching a thoughtful decision.
Consider your balance sheet. How much total debt is present? More debt increases potential risk associated with interest rate upswings. What is the value of your cash or near cash assets compared to your short-term obligations – the amount you have to pay during the current operating cycle of your business? Liquidity is the ability to pay short-term obligations. Decreased liquidity occurs when the value of your cash assets subtracted from your short-term obligations is low. The less liquidity present in a balance sheet the lower the ability to take on additional risk or operate through adversity without special action to increase liquidity. When total liabilities are higher and liquidity is lower, fixed interest rates should be considered to limit the additional pressure on liquidity which increasing interest cost will bring.
Think about your cash flow. How much positive margin is present? How material on a percentage basis is total interest expense in relation to income and profit margin? How much would a 1 percent increase in interest impact the profit margin? If a modest increase in interest rate materially impacts income and ultimately profitability, then fixing interest cost is a risk limiting tool which should be considered.
Where in the life cycle is the business? Growing a business many times means using debt capital to supplement equity in supporting that growth. Typically, that means there will be debt outstanding over a number of years. Duration of the time there will be a loan balance outstanding is an important factor to weigh as you make a decision whether to lock in a fixed interest rate. If you expect to be growing the business scale and using debt capital to support growth, using some longer term fixed interest debt can be valuable in limiting overall interest rate uncertainty.
Additionally, a loan duration of more than 15 years regardless of growth plans has a substantial life cycle for market changes to interest rates. If interest rates are historically low in the cycle, trends are moving higher and duration for the debt is long term, fixed rates should be a consideration for limiting future risk of increased cost which negatively impact profit margins.
Compare historical interest rate trends to what is being offered today. If the rate of interest you can lock in on a long-term loan is in the lower range of historical rates, and, if overall market trends are rising, then history would support locking in a rate.
Finally, in many cases, it comes down to a management choice. There are countless variables and risks present for business operators to deal with. Managing those that have the greatest potential impact on the business and that management has the most control over generally returns the best rewards. Fixing interest costs on debt which has a longer duration in the lower range of historical interest rate levels in a rising rate environment can help limit upside risk and reduce some uncertainty associated with variable costs for a business.
Jeff Houts is the FCS Financial chief operations officer and executive vice president
