How are businesses affected by high interest rates?

Written by dwight chestnut
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How are businesses affected by high interest rates?
The Bank of England controls interest rates in the UK. (Jupiterimages/Photos.com/Getty Images)

Interest rates are best defined as the cost of capital. Capital is the lifeblood of business. So when the cost of capital rises, the cost of doing business rises. Once the cost of doing business goes up, it affects the cost of goods sold (supplies), the price that businesses must charge for their product, wages paid to employees, the unemployment rate and virtually every direct and indirect activity that has to do with doing business.

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Start-up loans

Start-up businesses are immediately vulnerable to high interest rates as they seek to raise start-up capital. Since interest rates reflect the cost of capital, start-up businesses have to pay more to get it. They pay in the form of higher monthly payments. In addition, more of that monthly payment goes toward paying the interest, not the principal. This means new businesses will carry more debt on their books longer. All of this assumes that start-ups can qualify for the higher interest rate loans because, as interest rates rise, less start-ups can qualify for loans. So it is safe to say that higher interest rates are devastating to new start-ups.

Operating capital

Once businesses are up and running, they often need an ongoing line of credit with a bank. This is required to meet payroll and other day-to-day expenses during times when business revenues and cash on hand are not sufficient. Securing a line of credit is also subject to the negative effect of higher interest rates just as with start-up loans. The higher the interest rates, the less businesses can qualify for the line of credit they need.

Product pricing

The more a business must pay monthly to service loans and/or a line of credit, the more it has to charge for its product or service in an effort to make the payments. This becomes a major stumbling block because consumers may not be willing, or able, to pay the higher price. So the profits of a business will suffer if it is unable to charge what it needs to offset the cost of higher interest rates.

Cost of goods sold

Every business has a supplier of some sort and that supplier is also affected by higher interest rates. The supplier will often raise his price to adjust for the higher interest rates. So in addition to paying higher interest rates, a business must also pay a higher price for supplies.

Employees

Once a business reaches a point at which it cannot charge its customers what it needs to maintain operating expenses and make a reasonable profit, it must cut costs. Cost cutting often starts with simple solutions such as looking for cheaper suppliers. But as the need continues it can lead eventually to laying off employees.

The downward spiral

Higher interest rates will ignite a downward spiral in economic activity. As businesses lay off workers and the unermployment rate rises, consumers have less and less to spend on goods. As a result, businesses have to dismiss even more workers. This cycle continues until interest rates are reduced.

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