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Rising Interest Rate Effect for Corporate Borrowing

March 2023 marked the initial interest rate increase by the Federal Reserve since 2018. Following this initial hike, interest rates have consistently ascended, transforming what used to be a minor concern for small business proprietors into a significant financial consideration.

The necessity for consistent and dependable financing drives small businesses to pursue loans or alternative lines of credit. Consequently, this will now lead to higher expenses for servicing that debt, especially when dealing with variable interest rates instead of fixed ones.

Increasing interest rates can limit a business’ capacity to manage its debt unless there is a simultaneous boost in revenue to counterbalance it. Companies might find themselves in a vulnerable position if a substantial portion of their retained capital is used to service high-interest debts. When these financial commitments take precedence over investments in innovative products, services, or marketing and advertising efforts to drive sales, businesses could curtail their overall growth potential.

When exploring capital structure, small business owners often underestimate the significant impact that interest rates can have. When the cost of borrowing becomes expensive, business owners may find it beneficial to consider alternative financing options: venture capital, private equity, loans from family and friends, or even personal savings. However, equity financing will dilute existing holdings because net income is now divided among additional owners.

Rising interest rates are not entirely unfavourable; some businesses can actually take advantage of such situations. For instance, when overall interest rates rise, affecting corporate loans, returns on interest-bearing securities also increase. Companies with healthy cash flows can utilize their surplus funds to invest in securities and ventures that offer higher returns to enhance their profitability and preserve liquidity. This expanded range of investment options with better returns can provide businesses with adaptability in managing adverse economic conditions, helping to balance the increased costs associated with servicing their corporate debt.

In essence, corporate loans may become more expensive and harder to acquire by small business owners as the Fed increases interest rates. Businesses will consider alternative financing options influencing their capital structure. However, certain companies with positive cashflows may offset the negative externality by taking advantage of the higher return on interest-bearing securities.