Interest rates are rising. It’s time to shock-proof your balance sheet
It’s no surprise that debt-carrying entrepreneurs have been on edge of late. They’ve watched interest rates climb steadily over the past 18 months, pushing well past the historic lows that became normalized in the soft recovery that followed the Great Recession of 2008-09.
Indeed, the Bank of Canada raised its benchmark rate several times over the past year as the Canadian economy’s red-hot run continued. It currently sits at 1.75 per cent, while the retail bank prime rate is 3.95 per cent. However, recent bad news from the closure of the General Motors plant in Oshawa to falling oil prices, as well as the looming threat of an escalation in the global trade war, has given the BoC reason to hold off on another increase.
The hard reality is that business owners are facing a far more expensive rate environment than just a year ago, with significant bottom-line consequences. And prevailing trends show no signs of a rate rollback in the near future.
It pays to take a proactive approach
Dealing with rising interest rates is of particular concern for organizations operating in lower-margin industries such as basic manufacturing or discount retail. For them, rising financing costs could not only erode profit, but in extreme cases could even put them out of business. While rate-weary CEOs can’t force a macroeconomic shift in policy on the part of the BoC, they can take proactive steps to maintain profitability and avoid many of the pitfalls that inevitably impact organizations that fail to take the financial realities of interest rate hikes into account.
The first step: look at your credit terms. If your accounts receivable extend beyond 30, 60 or 90 days, consider charging clients a higher interest rate given the drag in collection. At the same time, your company can offer a price discount if invoices are paid within 10 to 15 days, all to offer an incentive for swift payment. The goal is to free up cash from accounts receivable to repay any outstanding business lines of credit while also reducing overall borrowing costs.
Next, consider analyzing bank loan covenants on any outstanding personal or corporate loans. In some cases, it’s worth breaking a loan contract to renegotiate a better rate, potentially even locking into a longer fixed-term contract to avoid riding what could well be an unpredictable interest rate roller coaster in the months ahead. Depending on your specific circumstances, this could also be an opportune time to pay down business lines of credit, which will only become more expensive if rates continue to climb. Make no mistake, managing rapidly increasing borrowing costs such as these are a major risk area for entrepreneurs. Worse, lines of credit are open loans that can be called in at any time, making them a particular threat in the event of an economic downturn or other circumstances when bank underwriters may become nervous and search for ways to improve their balance sheets.
Think holistically when adjusting to rising rates
Another option for business owners who have significant personal mortgages as well as extra cash in their corporations would be to consider drawing dividends and using that extra money to pay down—or pay off—a mortgage. This could make sense if the company is earning less on its funds than the interest rate on the owner’s mortgage. In that case, taking dividends to pay down a personal mortgage can be a smart financial move. But don’t forget that dividends also come with a tax bill.
Nevertheless, doing so would not only deliver a boost to an entrepreneur’s personal finances, but could also help avoid tax-mitigation challenges stemming from the federal government’s new rules limiting the amount of passive investment income that can be generated from a corporation in a single year.
The last point to consider as borrowing costs rise: a full review of the organization’s product and service pricing structure. Specifically, business owners could consider raising prices to cover increased financing costs. That said, the decision to raise prices should be weighed carefully after an analysis of comparative pricing models across the industry, and even key clients’ potential tolerance for a price increase. In certain cases, raising prices just won’t work; in others, even a small hike could save a business from financial ruin.
Entrepreneurs should understand that even though interest rates may be on the rise, they still have a wide range of accounting tools at their disposal. Our recommendation is to work with your personal financial team including a chartered professional accountant, tax lawyer and financial planner to determine which strategy makes the most sense based on your unique financial circumstances.
Be proactive, run your own stress test to better understand how rising rates will impact your balance sheet, then act accordingly to shock-proof your personal and corporate portfolio.
Jenny Lian, Partner