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Today's enterprises are able to benefit from an extremely low cost of capital. In fact, the costs of borrowing money have never been better. Regardless of whether you are a consumer looking to purchase your first home, an individual looking to buy your first car, or a business looking to invest in its future, the costs to borrow money are very competitive. Unfortunately, companies are likely to see their costs of financing increase over the next couple of years. Simply put, these interest rates won't stay low forever. As the economy grows so will the interest rates charged on bank loans and business credit lines. It's merely a question of the supply and demand for money.
Quantitative Easing & Government Monetary Policies
So why do interest rates rise and fall? What is the mechanism that directly impacts the supply of money? More importantly, what role does the government play and can it impact the interest rates charged on bank loans and business credit lines? In order to answer these aforementioned questions, it's important to understand how a government uses its monetary policies in order to influence the interest rates charged on loans.
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The United States central bank uses a process referred to as quantitative easing, or more commonly referred to by the acronym “QE.” The first round was entitled QE1. It took place from Nov. 25, 2008 to Mar. 31, 2010. The second round was aptly titled QE2. It took place from Nov. 3, 2010 to Jun. 30, 2011. Finally, the most recent was QE3. It was only recently started on Sept. 12, 2012. It will continue each month until the job outlook in the United States improves and the unemployment rate decreases to a more acceptable level. However, what exactly is quantitative easing and what impact does it have on interest rates?
What is Quantitative Easing?
The process of quantitative easing is fairly simple and straightforward. In essence, the United States central bank buys mortgage backed securities in an effort to increase the supply of money and drive down interest rates. The most recent round of quantitative easing started with the central bank buying upwards of $40 billion of mortgage debt. The plan is to continue to purchase this amount of mortgage debt each month in order to drive down interest rates. Lower interest rates will increase business investment and spur economic growth.
In order for quantitative easing to work, the central bank must literally create money. It does this by crediting the accounts of the banks from which it buys the mortgage backed securities. In essence, the United States central bank advances banks money. Quantitative easing works because the interest rates the banks earn on the amount credited to them by the central bank is incredibly small. In fact, that interest rate is currently a quarter-of-a-percentage point. The idea is that the banks will lend money to businesses in order to secure a higher rate of return. By increasing the money supply, the central bank hopes to drive down interest rates, which in turn will increase business investment and drive economic growth. More money in the system at lower interest rates means people are more likely to spend and businesses are more likely to invest. In essence, people and businesses are more likely to make purchases and investments because the costs to borrow money are lower.
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Why Would Interest Rates Increase?
Eventually, as the economy stabilizes, and job growth becomes more consistent, the central bank will stop the process of quantitative easing. In this case, the central bank will effectively reduce the money it supplies the market, or put differently; it will reduce the amount of money it credits to the banks' accounts. However, as the economy grows, the demand for capital will increase. Consumers will need more credit in order to make more purchases. Businesses will need more credit in order to keep up with customer demand. The demand for capital will increase, but with less “cash” in the system, the interest rates will increase in response to the higher demand for credit.
It's merely a question of supply and demand. Increase the money supply during a slow economy and the low interest rates will incentivize banks to lend money to businesses and consumers. As the economy recovers, demand for credit increases and the amount of mortgage backed securities purchased by the central bank decreases. This reduces the supply of money, thereby increasing the interest rates charged on bank loans and credit lines. What effect will an increase in interest rates have on businesses?
1. How Will Higher Interest Rates Affect Capital Expenditures? Companies need financing in order to support their long-term plans for growth. Higher interest rates mean that financing on large capital expenditures will increase. Companies that decide to support their growth by purchasing equipment and machinery will invariably see their financing costs increase. Ultimately, decisions on capital expenditures come down to deciding whether to treat the expenditure as a onetime purchase, or whether to capitalize the asset and depreciate its value over time. A company can use depreciation in order to reduce its earnings and lower its tax burden. Regardless, the company will still have higher financing costs as interest rates increase.
2. How Will Higher Interest Rates Affect Inventory Financing? Companies finance their inventory by borrowing capital from banks, credit unions and private investors. Companies must have inventory available in order to properly take advantage of an increase in customer demand. This means they must purchase raw materials and finished goods well in advance. Every day a company holds inventory is one where it must cover the costs of financing. An increase in interest rates drives up a company's costs of financing by making it more expensive to hold product within its warehouse. It is similar to carrying an outstanding balance on a credit card. The higher the interest rates, the more it costs consumers to cover their outstanding amount owing on that card. For a company it's no different. The company must quickly sell inventory and then immediately collect on its receivables in order to cover its costs of financing.
3. How Will Higher Interest Rates Affect Receivables Financing? After a company ships product, it must cover another financing cost for every day it takes its customers to pay their invoice. The longer it takes the customer to pay their invoice, the higher the costs to the company. Again, the same rules apply; higher interest rates will increase a company's costs to finance its receivables.
4. What Impact Will Higher Interest Rates Have on Gross Profit? Ultimately, higher financing directly impacts the company's gross profit on sales. It must cover a higher financing cost on inventory and a higher financing cost on receivables. Both costs reduce gross profit.
Reducing the Impact of Higher Interest Rates
There are several things companies can do to reduce the effects of higher interest rates. These strategies focus on reducing the time companies hold inventory and reducing the time companies must wait for customer to pay their invoices.
• Reduce Inventory Financing: Companies can reduce financing by increasing their inventory turnover rates. Faster moving inventory is less expensive to finance because companies are able to reduce the time they hold inventory in their warehouse. Companies can increase turnover rates by immediately liquidating slow moving inventory, reducing pricing and using high volume discounts. In addition, companies can also reduce financing and improve their cash flow by immediately selling damaged inventory. Still, there are other solutions. Purchase order financing is one such solution. Companies can reduce their inventory financing costs by using their open purchase orders and confirmed backlog as a form of business credit. This allows them to purchase inventory only when they are guaranteed to make sales, thereby reducing how long they hold inventory in their warehouse.
• Reduce Receivables Financing: Companies can also reduce the impact of higher interest rates by reducing their financing on receivables. For instance, they can provide prepayment and prompt payment incentives in order to get customers to pay sooner. They can also use alternative financing solutions like receivables factoring. This asset-based financing option allows companies to use their open invoices as a form of business collateral. Companies sell their invoices to a third party financing company, one who advances the company capital based on a percentage of their receivable's value.
Interest rates are likely to increase over the coming years. However companies don't have to accept their fate. They can be proactive and put plans in motion to reduce the impact of higher interest rates on their costs of financing. Success involves reducing the costs of financing on inventory, reducing the costs of financing on receivables and capitalizing large capital expenditures in order to reduce a company's tax burden.
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