Corporate Interest Rates Thwarting Competitiveness - Really?

By: Ian Campbell | Fri, Aug 10, 2012
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Why read: To think about whether a 2.5% change in a company's borrowing rates ought to materially affect a company's competitive position. Certainly that could be the 'takeaway' from a recent article.

Commentary: Assume a manufacturing company:

The following table shows the effect of an interest rate increase of 2.5% on that hypothetical company's profitability.

 

  Normal Times Abnormal Times - interest rate change only Abnormal Times with 20% revenue decline but same cost structure
Revenue 10.0 10.0 8.0
Gross margin (30%) 3.0 3.0 2.4
Overheads 2.0 2.0 1.6
Pre-tax, pre-interest earnings 1.0 1.0 0.8
Interest expense on $2.0 million debt      
@5% (normal times) 0.1    
@7.5% (abnormal times)   0.15 0.15
Pre-tax profit 0.9 0.85 0.65

 

In essence, for an optimally financed company that does not suffer in 'abnormal times' from a decline in revenue, but experiences a 50% increase in its interest rates, that company should be able to 'weather the interest rate storm' without much difficulty. However, superimpose:

and the company's circumstances can change in a radical negative way very quickly. For example, if our hypothetical company saw its sales decline by 20% and it had a capital structure of 20% equity and 80% debt (in the example, $1 million equity and $4 million debt) the results, as set out in the following table, would be quite different.

 

  Normal Times Abnormal Times with 20% revenue under revised scenario
Revenue 10.0 8.0
Gross margin (30% dropping to 25%) 3.0 2.0
Overheads (20% increasing to 25%) 2.0 2.0
Pre-tax, pre-interest earnings 1.0 0.0
Interest expense on $2.0 million debt    
@5% (normal times) 0.2  
@7.5% (abnormal times)   0.3
Pre-tax profit 0.8 (0.3)

 

In essence, a suggestion that Italian (or any other country's) companies competitiveness is materially impacted by a 2.5% increase in interest rates may be quite correct (the referenced article at one point suggested Italian interest rates have increased by 2%). However, this typically would only be the case where a company either suffered a drop in revenue, a drop in gross margins, an increase in operating costs, or a combination of those things in circumstances where it had over-levered its balance sheet in good (or better) economic times.

Like individuals and countries, companies are vulnerable when they carry too much debt against their equity positions.

Topical Reference: Analysis: Crisis stifles Italian firms' competitiveness drive, from Reuters, Lisa Jucca, August 5, 2012 - reading time 4 minutes, thinking time longer.

 


 

Ian Campbell

Author: Ian Campbell

Ian R. Campbell, FCA, FCBV
Business Transition Simplified

Through his www.BusinessTransitionSimplified.com website and his Business Transition & Valuation Review newsletter Ian R. Campbell shares his perspectives on business transition, business valuation and world economic and financial markets influences on those two topics. A recognized business valuation and transition authority, he founded Toronto based Campbell Valuation Partners Limited (1976). He currently is working to bring his business valuation and transition experience to both business owners and their advisors in our new economic, business and financial markets normal.

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