The consulting field, particularly the part of it focused on small and medium-sized businesses, is helping the lifeblood of America thrive. While revenue-based standards vary based on industry, a definition based on number of employees is a more equal measure of what classifies a small business and a mid-sized business. A small business is a business with fewer than one hundred employees, while a mid-sized business ranges from one hundred employees up to 499 employees. (SBA.gov) They employ 50% and 25% of US citizens, respectively. (Census, 2019) Three out of every four American workers are employed by these companies. As they go, America goes.
These companies are affected by interest rates analogous to the American public. When rates rise it becomes more difficult for them to borrow, just as it does for you or me. Loans made to smaller companies are often based on the personal credit rating of the owner. They do not have the luxury of borrowing solely based on their company’s credit rating. Increased interest rates syphon cash out of the business, lowering the available cash on hand for business operations. Interest rates are impacted by many factors, but chief amongst them are the actions of the Federal Reserve and the market for US Treasuries, and these are impacted by the level of debt and deficits maintained by our government.
Deficit is the annual difference between the amount of government spending and the amount of revenues collected through taxes and fees. When the government takes in more than it spends, it runs a surplus – something the U.S. has not done since the late 1990’s. When the government spends more than it takes in, it runs a deficit – the U.S. deficit for the last fiscal year was $1.7 trillion or 6.3% of GDP. (cbo.gov) The national debt is the total debt for the country, or the accumulation of all deficits – currently $34.5 trillion or 123% of GDP. (axios.com)
The topic of debt and deficit can quickly become political, but it is not political to say that interest rates rise more quickly and fall more slowly as our overall debt grows. Acknowledging that increased borrowing costs hurt small businesses and make it less likely that they can expand and hire more people is also apolitical. So, it behooves those seeking to help small business to become more knowledgeable on the topic.
While many factors impact interest rates, the competitive issuing of additional treasuries is a major contributor. Investors require a return on investment that justifies purchasing the securities in the first place. Likewise, business owners investing in new projects require an internal rate of return that justifies higher borrowing costs. These two trends operate in tandem but also against each other.
Rising deficits and increasing interest rates work against each other in solving the problem too. As rates increase economic growth slows, since businesses cannot afford to take on new projects and hire new employees to work them. As economic growth slows, tax receipts lower as economic activity lessens, and incomes fall. This makes it more difficult to pay down deficits, which would help to lower interest rates and spur economic growth.
Understanding the concept of a favorable internal rate of return for a project is important in being that trusted advisor that the business can depend on to guide them in expansion efforts, regardless of what is happening with interest rates. Internal rate of return (IRR) is a financial calculation used to estimate the potential return on a particular investment. It helps businesses determine which project to take on and which ones to reject. It discounts the future value of cash flows to the net present value of the investment. While its technical equation is Finance 501 gobbledygook – 0 = CF t = 0 + [CF t = 1 ÷ (1 + IRR)] + [CF t = 2 ÷ (1 + IRR)^2] + … + [CF t = n ÷ (1 + IRR)^ n] (wallstreetprep.com), there is a simply way to get a good estimate that can help the business make a solid decision.
By dividing 100% by the anticipated number of years of the project, then multiplying this figure by 75%-85%, you will get a good approximation of the project’s internal rate of return. (breakingintowallstreet.com) For example, if you expect a project to take 5 years to complete you would calculate IRR as such:
100/5=20 x 0.75=15%
In this example, if the cost of funding such a project is higher than 15%, you would lose money and be a fool to recommend it to your client! Understanding the concept of IRR in relation to overall interest rates and the cost of funding a project is key to being successful, not just as a business owner, but also as a business consultant.
In an environment of rising interest rates, the decision to take on new projects, and to afford the labor, materials, and other capital expenditures to complete those projects, becomes more difficult. The costs, including all overhead costs and the minimum mandatory profit, must be less than (or at least equal to) the internal rate of return. As borrowing costs rise, this becomes a taller task.
Another impact of debt and deficits is how they lower the value of the US dollar. This is because we print money to pay our bills, and when there are more dollars (increased supply) their value declines. While net exporters benefit when this happens, most small businesses do business in their own communities and are hurt by the falling dollar, since many of their materials are imports and therefore more costly because their spending power decreases. It is not hyperbole to say that small businesses are uniquely disadvantaged by increasing debt and deficits.
The edge that small business has over larger corporations is nimbleness. Small businesses can maneuver challenging times more deftly than medium or large businesses. Expanding on a niche offering, even while taking on debt at higher rates, can make sense (based on IRR) for a business with less overhead and a lower required minimum mandatory profit. New revenue is also more immediate and impactful to a smaller firm. This is how a small business, and their trusted advisor, can exploit opportunities presented by a higher interest rate environment. Understanding this advantage, and constantly looking for new and creative opportunities, will make small businesses less vulnerable than they otherwise would be, and it is a must for any consultant seeking to serve their clients.
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