Mitigating Risk in a Higher Interest Rate Environment

As interest rates rise, companies have to take extra precautions and do their due diligence mitigating increased customer credit risk.

For the first time in more than a decade, we find ourselves in an environment where the cost of working capital is rising quickly. In the past three months alone, we have seen three interest rate hikes from the Federal Reserve: 0.25 percentage points in March, 0.5 percentage points in May, and another 0.75 percentage points last week. 

And the Fed isn’t done yet; according to Fed Governor Christopher Waller, the Federal Reserve should raise rates at each of their meetings until inflation is under control. 

“I am advocating 50 basis point (0.5 percentage points) hikes on the table every meeting until we see substantial reductions in inflation,” Waller said in late May. “Until we get that, I don’t see the point of stopping.”

The progressive hikes are a risky measure and a difficult balancing act to slow down rising prices without throwing the country into a recession.

Rising rates and a potential recession will (and could) have tremendous effects on businesses of all sizes. Primary among those risks is customer credit. With capital getting more expensive, the potential for a buyer to slow down or default on payments increases. Even if your customer isn’t overly leveraged, the downstream impacts to their customers could put your accounts receivable in jeopardy. Remember, your customers’ working capital crunch can easily become your working capital crunch. Then, coming full circle, money becomes more expensive for you if you have to find a line of credit or other traditional financing to keep your operations running. Simply put, higher interest rates drive tighter liquidity and high risk of defaults.

Factors like your customers’ debtor concentration become even more critical. Debtor concentration is the percentage amount of accounts receivable owed by a single debtor to your customer. If they do business with only one customer, their debtor concentration is 100 percent. If a single debtor accounts for one-third of their total accounts receivable, the concentration with that debtor is 33 percent. The higher the concentration with one customer, the greater the risk: if something goes awry with your customer’s customer, you are going to have a problem with that account (especially bad if you have a high concentration with them). Once again, your customers’ liquidity concern becomes your liquidity concern.

Another factor to consider is the general risk aversion of most traditional banks; an aversion that increases with interest rates. The goal of higher interest rates is to take money out of the economy, which means less lending – or banks asking businesses to exit existing lines of credit. Again, even if you aren’t heavily leveraged, your customers or your customers’ customers may be, and either one’s inability to pay is bad for your business. 

So the question becomes, how do you mitigate all this rising risk? 

The simple, and most effective, answers are increased monitoring of your customers’ financial health and being judicious with customer credit; something LSQ has 25 years experience doing.

LSQ FastTrack®’s credit engine uses in-house data to make instantaneous credit decisions about your customers. We process millions of invoices and billions in payments across thousands of businesses every year to make informed, real-time credit decisions about your customers and potential customers. We also use financial data of companies, firmographic data, and third-party data from sources like Dun & Bradstreet and Experian to help in the decisioning process.

We generate unlimited, instant credit assessments of new, potential, or existing customers, providing a more accurate assessment of their financial viability and counterparty risk. 

When the financial condition of your customers changes, we keep you informed. We monitor the major credit bureaus and our own payment data to look for changes in behavior that may indicate financial issues with your customers.

While they add a level of difficulty to doing business, increasing interest rates don’t have to be a detriment to the financial health of any company. By being thoughtful about the greater risk exposure and finding a partner that can help you mitigate those risks can put your business in a position to thrive during volatile and uncertain times.