Article by Alan Shannon (Executive: Small business and private clients at Nedbank)
Businesses in South Africa have faced significant challenges in recent years as a result of the increasing interest rates. Apart from the impact of higher rates on the discretionary income of prospective customers, higher borrowing costs have strained cash flows, limited investment opportunities, and hampered growth. Many companies have struggled to manage their debt, leading to tighter budgets and reduced financial flexibility. However, with the South African Reserve Bank having begun to cut interest rates with a prospect for more cuts in the coming months, businesses now have a unique opportunity to reassess their financial strategies and reverse the damage caused by high interest rates, enhance debt management, and capitalise on a stronger economy.
Lower rates and borrowing costs stimulate economic activity by encouraging consumer spending and business investment, ultimately driving economic growth. For businesses, reduced interest rates make it more affordable to finance new projects, expand operations, and invest in research and development as the cost of capital decreases.
From a macroeconomic perspective, decreased interest rates can boost aggregate demand, which is a combination of consumer spending, investment by businesses, government spending, and net exports. This combination creates a favourable environment for businesses. Another immediate benefit of lower interest rates is the potential for substantial cost savings on servicing existing debt.
The importance of a strategic approach to debt management
As interest rates decline, businesses need to take a strategic approach to proactively reducing their debt burdens and improving their financial health. In a declining rate environment, reassessing your overall debt structure is crucial. Businesses need to carefully evaluate the cost-effectiveness of their current debt portfolio and explore opportunities to refinance existing debt at lower interest rates. This can result in significant reductions in interest expenses and, consequently, improved cash flow. Consolidating multiple high-interest loans into a single loan with a lower rate can also simplify debt management and often results in lower overall interest payments.
To effectively manage debt, businesses should create a comprehensive debt inventory, detailing all credit facilities and loans, interest rates, outstanding balances, and repayment schedules. This helps you to prioritise high-interest debts and focus on settling those first by allocating additional funds towards principal repayment. Even a small extra amount allocated to the loan capital on a regular basis, particularly as interest rates come down, can significantly save on the total interest and the loan repayment term.
Setting up a realistic budget that accounts for debt repayments and regularly updating cash flow projections are another two vital components of a debt repayment strategy as they ensure you have sufficient funds available to meet your debt obligations.
Maximising your financial flexibility
Prudent financial planning is essential for maintaining and enhancing financial flexibility in a fluctuating interest rate environment. The fact that rates start coming down doesn’t mean that they will continue to decline. As has been seen globally, inflation has become ‘sticky’ and there’s no guarantee that the interest rates will continue on a downward trajectory, or that it won’t be a bumpy ride. With that in mind, business owners need to remain vigilant and adaptable to changing economic conditions, as any decision by the South African Reserve Bank on interest rates can significantly impact borrowing costs and have a knock-on effect on cash flow management. Developing robust financial plans that can withstand interest rate volatility is crucial.
Ensuring financial flexibility in the face of uncertainty is therefore another reason why allocating any surplus savings towards debt reduction when interest rates are low, to improve balance sheets and lower interest expenses. Freed-up capital from reduced interest expenses can be strategically reinvested into growth initiatives, such as expanding operations, developing new products, or entering new markets, driving long-term growth and profitability.
Establishing a healthy cash reserve also provides a buffer against unforeseen expenses or economic downturns, ensuring smooth business operations even during periods of reduced revenue or increased costs.
Looking forward – applying risk management lessons
As many businesses have discovered in recent years, over-leveraging poses significant risks to businesses, particularly in volatile economic environments. Excessive borrowing can lead to difficulties in meeting debt obligations, especially if interest rates rise unexpectedly or revenue decreases, thereby jeopardising a company’s financial stability and long-term sustainability.
To mitigate these risks, businesses should consider diversifying their revenue streams and investment portfolios, regularly conduct stress tests on financial models, and undertake scenario analysis to evaluate potential outcomes under different economic conditions. This enables the development of flexible strategies to navigate uncertain environments and make informed decisions.
The high-interest rate operating environment of the past few years has taught us that adopting a balanced approach that prioritises debt reduction while maintaining strategic flexibility is essential for long-term financial health. Focusing on reducing existing debt, avoiding unnecessary new debt, and maintaining a healthy cash reserve is crucial for managing liquidity and ensuring the business can meet its obligations during economic downturns. However, while taking advantage of lower interest rates to reduce or pay off debt is vital, so too is leveraging some of the cash that lower rates unlock to take advantage of opportunities to invest in long-term business growth and resilience growth and resilience. It’s something of a balancing act, but one that, if approached correctly, has the potential to optimise your cash flow now and reduce your reliance on costly debt in the future.