4 Key financial indicators for business stability in periods of high interest rates

The global economic landscape is currently characterized by high interest rates, a phenomenon driven by central banks' responses to inflationary pressures that spiked due to pandemic disruptions and geopolitical tensions. These rates, which were near historical lows during the pandemic, have now reached levels not seen in over 15 years.

During periods of high interest rates, the economic landscape changes dramatically, highlighting the need for businesses to closely monitor their financial health through key indicators. This monitoring helps businesses not only understand their immediate debt position but also to devise strategies for maintaining or improving their financial stability. In this article, we outline several key financial indicators that offer critical insights into a company’s ability to withstand and adapt to these challenging economic conditions.

1. Net Debt to EBITDA Ratio

Net Debt / EBITDA

This ratio provides a snapshot of a company’s leverage in relation to its operating earnings (EBITDA), reflecting the number of years it would take to repay the debt if net debt and EBITDA remain stable. Net debt is calculated by subtracting cash and cash equivalents from total debt and is itself a significant indicator as it shows the borrowing level remaining if the company uses all its “excess” liquidity.

Example: If a company has €10 million in total debt, €2 million in cash, and €4 million in EBITDA, the net debt to EBITDA ratio is (10-2)/4=2. This means it would take two years, using the current EBITDA and all available cash, to clear the total debt. Generally, a value below 4-5 is desirable, with this flexibility decreasing when interest rates are high.

2. Cash Conversion Cycle

Average Age of Inventory + Average Collection Period - Average Payment Period

The Cash Conversion Cycle measures the time a company needs to convert inventory purchases or resources into cash flows. It is crucial for maintaining liquidity, especially when every euro counts more due to higher interest expenses.

Example: A company takes an average of 30 days to sell its inventory (Average Age of Inventory), 40 days to collect its receivables (Average Collection Period), and pays its liabilities in 45 days (Average Payment Period). Its Cash Conversion Cycle would be 25 days (30+40-45), indicating effective cash management.

The Cash Conversion Cycle is one of the most important indicators of a business's liquidity, as it gives the time between when a company buys raw materials and when it receives payment for the final products. This time gap, determined by the Cash Conversion Cycle, must be funded either by internal cash reserves or bank loans, hence its importance during periods of high interest rates.

3. Fixed Charge Coverage Ratio (FCCR)

Earnings Before Interest & Taxes (EBIT) / (Interest Paid + Lease Payments)

The FCCR assesses a company's ability to cover fixed obligations, such as interest and leases, from its operating income. It is crucial for evaluating how comfortably a company can meet its financial obligations.

Example: With €5 million in EBIT, €1 million in interest expenses, and €500,000 in lease expenses, the FCCR would be 5/(1+0.5)=3.33, indicating a strong fiscal health.

An FCCR greater than 2.5 implies a strong ability to fulfill fixed obligations, a key advantage when interest expenses rise.

4. Interest Expense to Revenue Ratio

Interest Expenses / Revenue

This ratio highlights what portion of a company’s revenue is consumed by interest expenses, indicating the impact of debt on operating income.

Example: A company with €10 million in revenue and €1 million in interest expenses has a 10% ratio, reflecting a moderate burden of interest expenses on revenue.

Keeping this ratio low is critical in times of high interest rates, indicating that interest expenses do not overly burden the company’s revenues.

Debt Management Strategies

The role of financial management during high interest rate periods is crucial for ensuring a company’s financial stability. To navigate high interest rates effectively, multiple strategic actions should be considered in combination, such as:

1. Reducing Net Debt by taking actions such as reducing inventories and their average age, tightening credit terms with customers, and extending payment terms with suppliers to minimize the calendar gap that needs to be financed.
2. Converting Variable Rate Debt to Fixed Rate Debt through actions like issuing fixed-rate bonds or using other financial instruments like derivatives.
3. Negotiating Loan Terms with Lenders to extend loan durations or reduce the spread over the Euribor (central bank interest rate), significantly lowering interest expenses.
4. Selling Non-core or Non-productive Assets for quick cash inflows, reducing reliance on external financing.
5. Increasing Equity Capital if feasible, to reduce debt levels and strengthen the balance sheet.

These above strategies, although effective, require careful handling and an experienced financial management team to avoid negative impacts on EBITDA and ensure long-term sustainability.

Navigating a high interest rate environment requires a meticulous approach to financial management. By carefully monitoring the described financial indicators and implementing strategic adjustments, companies can strengthen their resilience against economic pressures, ensuring sustained operational success and long-term stability. These practices not only protect against current financial stress but also position the business favorably when market conditions improve.

This article intends to inform the reader and in no way substitutes the specialized consulting services. For more information, please contact MDC Stiakakis SA