Tag Archives | interest rates

Don’t get caught swimming naked!

Has anyone ever warned you, “don’t get caught swimming naked”? It may sound strange, but it’s a reference to Warren Buffet’s famous quote “Only when the tide goes out do you discover who’s been swimming naked”. As a financial leader, it is your responsibility to know when the tide is going out so that you can prepare not to be caught swimming naked. Here’s your warning..

The tide is getting ready to go out and may reveal some troubling things in your business as a result of the Fed (the Federal Reserve System – the United States’ central banking system) adjusting its interest rates. This has huge consequences for not only businesses in America but also companies that do business with America.

Background on US Interest Rates

don't get caught swimming nakedTo protect the US from falling into another Great Depression after the 08-09 housing market crash, interest rates were lowered to encourage borrowing for both companies and individuals. This has resulted in interest rates being at an all time low AND a flood of money in the marketplace.

The Fed lowered the short term interest rates from 0.25pt from 3-4pt in the wake of the housing market crash. They issued money through bonds to the marketplace for mortgages. Consequentially, this dropped the long-term interest rate.

The Fed: Interest Rates are Going Up

The Federal Reserve has given notice as of March 15, 2017, that the interest rates will be increasing over the next few years (estimated 5 years). There’s already been some movement over the past couple of months. Janet L. Yellen, the Fed’s Chairman, plans to slowly adjust the interest rates so that it will have the time to react to President Trump’s infrastructure spending and tax cuts.

The goal of the Fed is to raise the short-term rate without exceeding the long term rate. This act of leveling the interest rates is to essentially balance their financial statements and get it back to a normal level.

The Financial Times released an analysis on what is happening and how it’s going to impact us. One of the things noted is that the interest rates will increase slowly and cautiously. This may seem like a great idea, and it is, especially when considering any fiscal policy that President Trump rolls out in the next 3.5 years.

But what exactly does the incremental increase of interest rates mean for your company?

What does that mean for your company?

This slow increase of interest rates could be catastrophic for companies that neglect to prepare now. The tide is going out – meaning in a couple of years, there won’t be any cushion to break your fall.

One of the biggest responsibilities I have as the leader of The Strategic CFO is to network with business leaders around the city of Houston. When I discover events or adjustments that will impact the financial leader’s role, I start asking questions. As of late, my question has been… How is the increase of interest rates going to impact your company?

That’s a loaded question. What I’m finding out is even more interesting: nobody is really paying attention to what’s going on. They have their nose so close to their business that they aren’t really looking at the bigger issue in the room. Don’t get caught swimming naked!

Private Equity Firms

Over the past few years, the oil and gas industry has been hurting (especially in Houston). Thankfully, this crisis hasn’t been nearly as bad as the oil and gas crisis in the 1980s overall. However, the reason why companies that would have gone under 40 years ago have survived is because of the substantial amount of private equity money being pumped into these companies. With low interest rates, there’s naturally more money in the economy that can be invested into companies in troubled times.

Barrel of Water

Picture the economy as a barrel of water where money is the water. Right now, the barrel is full of water sloshing around. This is a really unique position. However, the Fed is going to start draining the water incrementally. People aren’t really focused on it because all they see is that there is still water in the barrel.

BUT what happens when people look up in 5 years to find that the interest rates have increased from 2% to more normal levels of 7-8%? Right now, the economy is in a period where if you can fog a mirror, you can get money. But not for long…

How does that change the role of a financial leader?

Over the past 15 years, corporations of all sizes have taken advantage of these low interest rates and have potentially even changed their business model entirely. I have to warn you… Money is getting tighter.

Money is Getting Tighter

For those later in their careers, this is just another cycle. But as a professor for the Wolff Center for Entrepreneurship, money getting tighter has a real impact on my students who are just starting their careers. With money increasing its value and decreasing its quantity, the time to start preparing is NOW.

How to Prepare for Increased Interest Rates

First, identify if you rely on low interest rates as well as the areas of your business that rely on low interest rates.

Once you identify those areas in your business, it time to start assessing and anticipating the worst-case scenario for your company. Download our External Analysis whitepaper to start charting the external factors that impact your company. When you’ve made a list of those potential outcomes with your current business model, it’s time to start prioritizing what needs to be adjusted.

I can’t say for certain how high the interest rates are going to go or how it’s going to impact your company, but I do know that the tide is going out. Soon, we’ll find out who is too over-leveraged, had business models predicated on low interest rates. Have you started preparing for this?

Should you pay down debt?

YES. The reason why is that when interest rates increase, payments increase. Pay your debt down as quickly as possible before you feel the pinch.

Should you raise your prices?

It depends… A better question might be: can you raise your prices? If you are in a competitive industry where there is no option to raise prices, then that’s not possible. You’ll have to find cash elsewhere to respond to increased interest rates.

Frog in a Boiling Pot

Ever try to cook a frog?  If you throw it in a pot of boiling water, it will just jump out.  But if you put it in the pot and slowly increase the temperature of the water, the frog won’t notice the temperature change until it’s too late. We’ve become accustomed to cheap money, but we can’t afford not to react to the slow increase in temperature that the Fed is planning with interest rates. The result could be disastrous.

Conclusion – Don’t Get Caught Swimming Naked

There’s change in the wind. If you haven’t reacted yet, this is your warning. The tide is going out and you don’t want to get caught swimming naked. Download the External Analysis whitepaper to gain an advantage over competitors starting your preparation to respond to the increase of interest rates.

Don't get caught swimming naked

Strategic CFO Lab Member Extra

Access your SWOT Analysis Execution Plan in SCFO Lab. The step-by-step plan to prepare for any internal or external forces.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

Don't get caught swimming naked

0

What is Inflation?

What is Inflation?

What is inflation and what does it measure? Inflation measures the rate at which prices increase for consumer goods and services. Inflation also measures the rate at which a currency’s purchasing power declines. If consumer goods and services are getting more expensive, then inflation is rising. As inflation rises, the relevant currency’s purchasing power declines. As prices increase, the amount a consumer can purchase with one unit of currency decreases.

Inflation Information

Inflation is a consistent increase in the general level of prices in an economy. The inflation rate is a measure of this phenomenon.

What causes inflation? Many economists point to an increase in the rate of growth of the money supply in an economy as the primary culprit. In comparison, others point to sudden changes in aggregate demand and aggregate supply, following a Keynesian approach to macroeconomic analysis.

Inflation Rate Example

For example, let’s take the price of a can of soda. Let’s say last year a can of soda cost $1.00. And let’s say the inflation rate for the past 12 months is 5%. We could then assume the cost of a can of soda today is $1.05. The price has gone up by 5%. The dollar’s purchasing power has gone down – one dollar is no longer enough money to buy a can of soda.

Inflation Measures

There are two important inflation measures in the U.S. They are the headline inflation rate and the core inflation rate. In addition, these inflation rates are published monthly by the U.S. Bureau of Labor Statistics.

The headline inflation rate, also called the consumer price index (CPI), measures the rate at which prices are rising for a wide selection of consumer goods. Headline inflation is designed to measure the rate at which cost of living expenses increase over time.

The core inflation rate is the headline inflation rate but without food and energy prices. Food and energy prices are considered more volatile than other consumer prices. Therefore, some consider it important to view the inflation rate excluding these two components.

There are a variety of other approaches to estimating the inflation rate, such as calculations based off of the US Producer Price Index (PPI) and the US Gross Domestic Product (GDP Deflator).

Inflation and Monetary Policy

Most central bank’s have a target inflation rate. For example, the U.S. central bank, the U.K. central bank, and the European Central Bank prefer to keep inflation at around 2%. A nation’s central bank can use certain monetary policy tools to influence inflation. These includes the following:

  • Foreign exchange market intervention
  • Open-market operations
  • Adjusting the reserve requirement ratio
  • Adjusting key interest rates.

Central banks often implement monetary policy tools to influence the inflation rate towards the target inflation rate.

Market Intervention

Foreign exchange market intervention refers to a central bank buying or selling currency in the open market in order to influence the nation’s money supply. Increasing the money supply devalues the currency and increases inflation. Whereas, decreasing the money supply appreciates the currency and decreases inflation. Ergo, a nation’s central bank can purchase currency in the open market to fight inflation.

Open Market Operations Definition

Open-market operations refer to a central bank buying or selling government securities. Buying government securities increases the money supply and spurs inflation. But selling government securities decreases the money supply and curbs inflation. Therefore, a nation’s central bank can sell government securities to fight inflation.

Reserve Requirement Ratio

The reserve requirement ratio is the amount of cash a commercial bank must hold relative to the value of its customer deposits. For example, if a bank receives customer deposits totaling $100, and the reserve requirement is 10%, then that bank must always have at least $10 cash on hand. A central bank can either increase or decrease the reserve requirement ratio for the nation’s commercial banks, thereby decreasing or increasing the domestic money supply. Furthermore, increasing the reserve requirement curbs inflation, decreasing the reserve requirement spurs inflation.

Key Interest Rates

Central banks can also raise or lower key interest rates in an effort to influence inflation. In the U.S., the central bank’s key interest rate, the fed funds rate, is the rate at which banks lend to each other overnight. Raising the interest rate can reduce the money supply, damp economic activity, and curb inflation. But lowering the key interest rate can increase the money supply, stimulate the economy, and increase inflation. A central bank can raise interest rates to fight inflation.

Inflation Protection

When faced with the threat of rising inflation, which can erode the value of investment returns, investors may seek investments that are protected from inflation. One option is to invest in U.S. Treasury Inflation Protected Securities (TIPS).

TIPS are U.S. Treasury securities that are protected against inflation. The coupon payments and the principal value automatically adjust according to the headline inflation rate. This protects investors from the negative effects inflation can have on investment returns. The downside is that TIPS offer a comparatively low interest rate.

Download your free External Analysis whitepaper that guides you through overcoming obstacles and preparing how your company is going to react to external factors.

what is inflation

Strategic CFO Lab Member Extra

Access your Projections Execution Plan in SCFO Lab. The step-by-step plan to get ahead of your cash flow.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs


what is inflation

See Also:
Economic Indicators
Consumer Price Index
Supply and Demand Elasticity
The Feds Beige Book
Z-Score Model

0

Interest Expense Formula

Interest Expense Formula

Interest expense calculations involve 4 parts: Principal, Rate, Time, and Compounding.

Use the following formula to calculate simple interest expense (which excludes compounding):

Interest Expense = Principal X Rate X Time

To calculate the compound interest rate, use the following formula:

Principal X (1+ (R / N))(N X T)

Where:
R = Interest rate
N = Number of times interest is compounded in a year
T = Time in years

Interest Expense Calculation Principal = $50,000 Interest Rate = 7% Time = 3 years

$50,000 X .07 X 3 = $10,500 in interest expense

(NOTE: Want to take your financial leadership to the next level? Download the 7 Habits of Highly Effective CFOs. It walks you through steps to accelerate your career in becoming a leader in your company. Get it here!)

Interest Expense Journal Entry

When recording an interest expense journal entry, the interest expense account is debited and the cash account or the interest payable account is credited. This represents money coming out of the cash or interest payable account and going into the interest expense account.

If you have already recorded the interest payment as a liability, then it may show up on the balance sheet as interest payable. If it has not already been recorded as a liability on the balance sheet, then the amount used to pay for the interest expense will come out of the cash account or the prepaid interest account on the balance sheet. Make this journal entry when the interest expense is recognized.

Journal Entry Example

Depending on the circumstances, the journal entry may look like one of the following:

                                 Debit                Credit

Interest Expense                  $1,000
Cash                                          $1,000

Interest Expense                  $1,000
Interest Payable                              $1,000

Interest Expense                  $1,000
Prepaid Interest                              $1,000

Interest Expense Example

Dwayne has started a company which rents party equipment. The equipment in which he rents are too expensive to buy straight up. Dwayne is considering financing some equipment, mainly the additional trucks he needs to move supplies, so that he could provide a high level of service. Dwayne wonders what his interest expenses would be. He looks on the web to find an “interest expense calculator”. Dwayne calculates these results:

Principal: $50,000 Interest: 7% Time: 3 years Compounding: None

So:

$50,000 X .07 X 3 = $10,500 in interest expense

As you calculate the interest expense in your company, learn how to be a highly effective CFO or financial leader. Download the free 7 Habits of Highly Effective CFOs whitepaper.

interest expense formula

Strategic CFO Lab Member Extra

Access your Flash Report Execution Plan in SCFO Lab.

Click here to access your Execution Plan. Not a Lab Member?

Click here to learn more about SCFO Labs

interest expense formula

2

How Low is Too Low?

Recently, I read an article by Dan Patrick of the Wall Street Journal detailing how superlow interest rates, while certainly beneficial to borrowers, are hurting bank profits and the industry’s ability to recover from the financial crisis.  According to Mr. Patrick, some of the negative effects of these artificially low rates we could see are more Americans being pushed out of the financial system altogether due to higher costs for banking services as well as an accelerated “shakeout” of smaller banks.  This begs the question, how low is too low?  Here’s an excerpt from the article:

Superlow U.S. interest rates are squeezing bank profits, complicating the industry’s nascent recovery from the financial crisis.

An important gauge of lending profitability, known as net interest margin, has dropped to its lowest level in three years. The measure tracks how much banks earn when they borrow from depositors and then lend or invest those funds.

The squeeze is the flip side of the Federal Reserve Board’s four-year effort to revive the sluggish U.S. economy, with near-zero short-term interest rates and repeated rounds of bond purchases that aim to reduce long-term rates as well. Ten-year U.S. Treasury yields hit 1.43% in July, their lowest level since World War II.

Banks will be forced to consider new ways to make money by changing the services they offer, industry observers said. At the same time, higher costs for banking services could push more Americans out of the financial system altogether, adding to the millions of customers viewed by regulators as under-banked, or lacking access to affordable financial services.

 

Read the full article here.

0

Create Jobs By Reducing Risk

There has been a lot of press lately regarding all of the cash that companies are sitting on. In addition, the government is talking about making it easier for companies to borrow money. Between the cash on hand and the loans they obtain companies will then be able to hire employees. It just doesn’t work that way!

The worst part of being a manager or business owner is letting people go. Consequently, employers are not going to hire new employees until they are confident that they have enough sales demand to prevent them from having to let them go in six months.

People are sitting on cash because they have no confidence. In order to increase confidence you must reduce risk.

Whether you are a consumer or business any time you chose to spend money you are taking on risk. Rishk that you will have a job or a sale in the future. That is economic risk. You also take a risk that you will perform. That is execution risk. Finally, you take the risk that the rules and laws will be consistent. That is legislative risk.

We have had a period where the economic risk is higher than normal. Coupled on top of that is the legislative risk. How much tax am I going to pay? What new regulations are going to be imposed? What are my health care costs in the future?

Any time you have such high risk in the business environment people are going to “sit on their hands” until things stabilize. We need to slow down the pace of change in order for consumers and the business community to feel confident enough to spend money that demands jobs!

0

Fed Open to Raising Rates….

Fed Chief Ben Bernanke recently stated that the Fed might raise rates to cut off future financial asset bubbles, but mounted a defense against critics who claim that the Fed’s failure to do so led to the most recent financial asset bubble.

I think this belies the dichotomy present in the mandate put to the Fed by Congress. Per the Humphrey-Hawkins Full Employment Act, the Fed is to pursue actions which promote….full employment, with low inflation and economic growth.

That seems like a recipe for financial asset bubbles.

While the Congress debates auditing the Federal Reserve, perhaps it should reconsider the mandate it has placed on the Fed.

0

 Download Free Whitepaper Today!

ACCESS NOW!