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  • Juanita Schwartzkopf

Managing Working Capital in a High Interest Rate Environment

Updated: Sep 7, 2023

For decades interest rates have been low, and companies have been able to readily afford the interest costs associated with funding working capital with debt rather than equity. The Fed Funds Effective Rate is at a level not seen since 1995/2000 and then again in 2007/2008. The current Fed Funds Effective rate is 5.12% as of July 2023 compared to 0.08% in January of 2022.

Asset based lines of credit have seen rates increase 5% or more since the beginning of 2022. Repricing of debt began occurring with renewals or refinancing in 2022 and has accelerated with rate increases in 2023.


The inventory to sales ratio provides insight on the number of times inventory would turnover during a year. A ratio of 1:1 means inventory turns at least once a year. A ratio above that means the company has more than one year of inventory on hand.


Looking at the inventory to sales ratio for retailers, the June 2023 ratio is 1.3:1. That means the average retailer has more than a year of sales on hand in inventory.


The total business inventories to sales ratio as of June 2023 is 1.4:1. All parts of the supply chain are dealing with increased inventory levels.


When the current interest rates are coupled with the increase in inventory levels in 2022 and 2023, the cost of working capital financing is stressing financial performance of many businesses.


Inventory has increased to the point ABL structures are significantly stressed. A higher level of ineligibles is created when inventory ages past the agreed upon acquisition date calculation, which is typically one year, or the speed of turnover decreases. Companies have been experiencing these issues for several quarters, and the steadily increasing interest rates serve to compound the problem. In addition to the impact of changing eligible inventory amounts, inventory appraisals have been coming in lower than previously reported and advance rates have been decreasing.

 

Let's explore the additional cost and financial impact experienced by a sample company


Assume the sample company has been able to maintain its 2022 sales level, but the operating cycle is stressed by increased inventory levels. The investment in inventory increases from $16.4 million at year end 2022 to $24.4 million as of June 30, 2023, based on the number of days sales invested in inventory increasing during the same period from 50 days to 80 days. The amount of cash or line of credit needed to fund the company increases from $14.8 million at year end 2022 to $22.9 million in June 2023.



Next let’s consider an ABL structure and the possible impacts of inventory stresses caused by ineligible changes and appraised values resulting in the advance rate on gross inventory reducing to 50%. In this example, the working capital debt would increase from $13.2 million in 2021, to $14.8 million in 2022, to $22.9 million as of June 30, 2023.



Next let’s consider the impact of the changing interest rates. In this example, the working capital line of credit had a 3.5% interest rate in 2021, which increased to a 5.0% rate during the 2022 rate increases, and then increased to 9.0% in 2023. The interest rate changes result in interest expense increasing from $460,274 in 2021, to $739,726 in 2022, to $1,031,250 for the first six months of 2023. The annual interest expense for 2023 would be expected to exceed $2.1 million.


The financial performance impact of this changing environment moves interest expense as a percent of sales from 0.46% in 2021 to 1.88% as of June 2023. To achieve the same financial performance as 2021, a company would have to be able to absorb increased costs to operate of nearly 1.5% of sales, before considering inflationary impacts.



What can a business do?

Expecting the interest rate environment to change prior to 2024 seems too hopeful. Projections for 2024 will need to anticipate at least the same level of interest rates.


Working capital management is key to survival.


Sell excess inventory!

For example, if the sample company sells $1.0 million of inventory, even at cost, the Company would generate between $500,000 to $1.0 million of cash. The range would be driven by whether the inventory sold was eligible inventory in the borrowing base. If the inventory sold was eligible inventory the sale could create $500,000 of cash after paydown of the line of credit. If the inventory sold is not eligible inventory the company could generate $1.0 million of cash to use for operations. Plus, a $500,000 change in outstanding debt would save $45,000 for this company. Now, rather than a $1.0 sale of excess inventory, consider that a $5.0 million sale of inventory could generate $2.5 million to $5.0 million of cash.


The sale of excess inventory at less than the typical sale price will impact gross margin, which in turn would impact EBITDA. If the company has financial covenants with its lender, negotiating any needed changes to financial performance or other ratios before the sale would be beneficial. Lenders understand the need to reduce reliance on debt and they will consider the requests to accommodate inventory reductions that generate cash.


Improve all aspects of working capital management!

This sample company experienced an operating cycle change from 48 days in 2021 to 75 days for the 2023 year to date period. For this company, each day of improved operating cycle is worth $275,000 to $305,000 of cash. A five day change in operating cycle could provide cash of $1.5 million.



Interest cost savings based on a $1.5 reduction in cash needs could generate additional cash of $145,000.


The combination of the cash generated from working capital management plus the reduced level of debt could result in additional cash of $1.65 million.


Conclusion

Today business managers must be laser focused on working capital management. Interest rates are unlikely to reduce quickly, but each company controls its working capital management decisions. Now is the time to use all the working capital management tools available. No approach to improve working capital management should be off the table. Any plans to improve the operating cycle that would impact income statement performance should be discussed in advance with the lenders to be sure any needed waivers are discussed in advance.


Focus on working capital management. Especially today.

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