Following several years of historically low inflation and record-low interest rates, most economists and business owners would agree that interest rates are expected to rise over the next several years.
Comments by the federal reserve chairman also support that view. For borrowers, this is an excellent time to consider locking in their borrowing rates through fixed rate loans or interest rate protection products such as interest rate swaps or caps.
How much of your debt should be fixed? What is the cost of fixing a rate vs. continuing at floating rates that may be significantly lower?
The answer depends heavily upon one’s attitude toward risk. Often, there is a temptation to try to time the market as one would in buying any other commodity. This is risky, as the difference between short- and long-term rates (i.e. the steepness of the yield curve) occur very rapidly and are almost impossible to time.
A more pragmatic approach of looking at your company’s capital structure and operating leverage will yield the best results over time. This is the methodology practiced by the largest public companies that have ready access to all of the financial markets.
- Capital structure. Look at your total permanent financing needs over a five- to seven-year period. Excluded from these are the seasonal or cyclical requirements that will be financed primarily by short-term bank lines that will clean up from time to time and accounts payable.
Deduct from that total the equity in your business to arrive at a number that represents the amount of debt or interest-bearing funding that your company requires. How high is your current financial leverage or the amount of debt to equity? What is a desired level for your industry?
Once you have a view of your targeted capital structure, compare the possible impact on your income statement and cash flow.
- Income statement impact. For the first look, assume that all of your company’s debt is at a floating rate. Compare the interest you will pay at short-term borrowing rates, plus required principal amortization to your earnings before interest and taxes (EBIT) or earnings before interest, taxes and depreciation and amortization (EBITDA).
Capital-intensive companies with heavy annual expenditures will want to use EBIT; for others, EBITDA is more appropriate. Most lenders like to see a minimum debt service coverage ratio (DSC) of at least 1.2 or 1.22 to one.
Next, consider what would happen if short-term interest rates were to increase by 1 percent, 2 percent or 3 percent. What would be the impact on your DSC?
Add some fixed rate debt to your capital structure. What is the impact of the same changes in short-term rates? By running the calculations for different mixes of floating and fixed rates, you can arrive at a target capital structure to finance your business over time.
- Considerations on timing. Although market timing itself is not a good strategy, awareness of the steepness of the yield curve and any excess cash flows that may come available in the next three to five years is important when considering whether to rebalance your capital structure or add new debt.
For example, what is the premium for fixing the rate on debt that you plan to pay off in three to five years? When and by how much would short-term rates have to move to offset the savings in the first year or two?
Now is an appropriate time to look at your debt structure and consider fixing some or more of your company’s debt. Your banker can help you decide and discuss the appropriate risk management tool to use.
Richard A. Beutel is senior vice president, commercial banking, at MB Financial. Reach him at (773) 292-6273.