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How Interest Rates Affect Businesses

Interest rates – the cost to borrow money – has always been an important consideration on investors’ minds. But why? How do varying interest rates affect the typical business?

In this two-part article, I will look at (1) how interest rates affect businesses, and (2) how investors react to interest rate changes.

Consumer spending

The most obvious impact that varying interest rates can have is its effect on consumer spending. When interest rate increases, the cost of borrowing goes up. This results in consumers having less cash available and thus, decreasing their purchasing power. On top of that, the interest rates also increase the incentive for consumers to save money, further decreasing consumer expenditure.

For businesses, this is not a good thing. Less spending power from the consumer means less revenue and profit for businesses.

On the other hand, a lower interest rate will mean that consumers can borrow money cheaply. This, in turn, leads to greater spending power. Businesses benefit from this, as increased consumer spending will boost its top and bottom line.

Directly impact business cost of borrowing

Businesses tend to borrow money to fund their operations. This is essential for them to maximise their profits and grow their businesses. But being leveraged means that businesses are directly impacted by changes to interest rates. If interest rates rise, the cost of borrowing goes up, and this leads to higher expenses. This will have an impact on a business’ bottom line.

The opposite occurs if interest rate decreases. Lower interest rate means lower cost of borrowing and less interest expense. More revenue can now trickle down to the bottom line, resulting in higher profits.

Businesses that are highly leveraged, such as real estate investment trusts and property developers, are more exposed to changing interest rates. To counter these risks, they may lock in fixed interest rates for their borrowing as a hedge.

Business planning

Not only do interest rates have a very real impact on business profits and expenditures, it can also affect business decisions. This is because it can affect management’s confidence on expanding their businesses. Increasing interest rates will lead to business managers thinking twice about taking on more risky leverage as a means to grow.

On the flip side, decreasing interest rates will improve confidence in the business climate and lead to managers willing to borrow to expand.

Returns on investment

Higher interest rates, however, can sometimes positively affect businesses that are reliant on investments for their earnings. This can be seen with many of the investment holdings and insurance companies that make use of cash to invest as a way to earn income.

A higher interest rate environment can lead to these businesses having greater returns on their investments. On the other hand, a low-interest rate situation may lead to these companies having subdued returns.

This is most commonly seen in companies with cash in hand and very little debt.

The Foolish bottom line

Interest rates can have varying effects on businesses. It can have both a real and perceived impact on businesses that in turn affect business decisions. As investors, we should take note of how interest rates can affect our investments so that we can make smarter investment decisions.

Meanwhile, for more (free!) investing insights, sign up here for your FREE subscription to The Motley Fool's investing newsletter, Take Stock Singapore. It will teach you how you can grow your wealth in the years ahead.

The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Jeremy Chia doesn't own shares in any companies mentioned.