Back to business

by John R.Burgess

Higher interest rates affect bottom line

In the past two years, the Federal Reserve has raised interest rates by one quarter point intervals 16 times. Currently, the federal fund rate sits at 5%. This increase has precipitated 30-year mortgage rates to increase from slightly under 5% to 6.7%. Although this increase has a serious impact on the individual consumers and purchasing power, there is a far greater impact on small and medium-size business in America.

The impact on small and medium-size business in America is that it becomes more difficult for the individual entrepreneur to purchase equipment, goods and services due to the high carrying charge of paying higher interest rates on those purchases. In addition, the rising interest rates precipitate higher inflation in every aspect of society. As the cost of the individual entrepreneur is increased it causes them to raise prices or stand firm, which reduces margins.

Many business owners have difficulty tracking their ongoing expenses on a weekly or monthly basis. Rather, many are doing so on a far longer period. In light of the fact that these increases are not tracked, the various impacts of inflation erode, their profitability on a daily basis. And yet many have no wherewithal to make a determination toward how to stop, or modify this erosion of bottom-line profitability.

The long-term impact of rising interest rates is a slowing of the economy. Less goods and services will be utilized by the ultimate consumer due to higher interest rates and costs associated with inflation. The difficulty of the small and medium-size business owner in a slowing economy is that they will find it necessary to compete with larger than normal companies. The fact remains that larger companies see a declining revenue base, and thus, seek to establish the same revenue base that existed before.

The value of companies, as established by the stock market, is defined as a multiple of their P&E [price/earnings ratio] and is driven by revenue and the revenue growth of each large company. In order for the larger companies to maintain their position within the stock market hierarchy, as it relates to their stock price, they must continue to produce record profits and revenues. As the overall economy tends to slow due to inflationary pressures—meaning that the average consumer has less buying power and the overall revenue generated by all of the consumers decreases—the small and medium-size business owner is put in a crunch in order to maintain the same level of revenue growth.

What does all this really mean?

Running a business is an extremely complex endeavor. Every business owner must make sure that they dot every "i" and cross every "t" in following the basic tenets of business. The basic tenets of business have never changed. An owner must produce profitable sales, understand the doctrine of true cost, know all of the costs associated with producing goods and services, maintain strict control over the cost of goods sold (labor, materials, subcontractors) and any other related expense to production and service, all the while maintaining strict control of overhead. Treat profit as the first item of expense, refuse to let profit be a residual and maximize productivity as it relates to employees. In addition, one must minimize material costs as it relates to the acquisition of raw materials or product, and know what critical variables exist within his business at any given time that can cause the predetermined level of profitability to decline.

All of this may seem relatively simple, but in reality it is extraordinarily difficult. The average American business owner does not understand the relationship between inflation, rising costs, rising commodity prices, rising oil prices, declining business revenue and profitability as it relates to their own bottom line. Each one should make it their business to educate themselves on the basic tenets of business. Only if the small and medium-size business owner can be driven by maintaining control of the critical variables in their business, can they end up being as successful as they should.

Until next issue!