Cash & Liquidity ManagementCash ManagementWill the Fed doom your working capital programme?

Will the Fed doom your working capital programme?

With four hikes since late 2015 - three of them in the past six months - US interest rates are moving higher in line with a strengthening economy. However, for many American corporates the trend has raised concerns over their working capital management.

News of increasing interest rates in the world’s biggest economy has led to questions about what it might mean for both US buyers and suppliers when it comes to the costs of borrowing and financing their businesses.

One area where this concern rises is in working capital management, focused either on self-funded early-payment discount programmes or third-party-funded supply chain finance arrangements. Will higher interest rates make these programmes more difficult to execute? Do strategies need to change greatly?

The short answer is no, but let’s walk through the details to understand the issue, the impact and what treasury departments can do to mitigate any risk to programme success.

Just the facts

While in Europe, the European Central Bank (ECB) and the Bank of England (BoE) have yet to act, interest rates are already going up in the US and the first hike in seven years by the Federal Reserve, from just 0.25% to 0.5%, came in late 2015.

Since then, in announcements last December and again in March and June this year, the Fed subsequently raised its target for the federal funds rate (FFR) by 25 basis points (one-quarter percent), from 0.5% to 0.75%, then on to 1.0% and 1.25%. Members of the Fed’s board of governors have shared their views that further increases will – or should – happen later this year. That could result in an FFR of 1.5% or more by the end of 2017. But why does that matter?

The FFR is the interest rate at which banks can borrow from each other, typically during overnight trading, to maintain required reserve balances. When their borrowing rates go up, yours likely will as well. In the US, the prime rate follows closely along with changes in the FFR. All sorts of borrowing, from consumer home mortgages to business lines of credit, are based on (or “indexed to”) the prime rate, with an added margin on top.

For instance, a US$20,000 line of credit for a small business might come with an interest rate of prime + 9.0%. As the prime rate goes up, so does the interest rate on the portion of the credit line in use.

A global concern

This issue is not unique to the US, of course. Loans throughout the world, including some in the US, can be indexed to the London Interbank Offered Rate, aka Libor. Again, it is the rate at which banks loan money to each other and directly influences the rates at which they loan to you.

In working capital programmes, we most often see this rate in relation to supply chain finance offers, which are quoted at one-month Libor plus some percentage – typically 2% at present. Libor has been consistently close to the FFR: it was 0.99% in April (compared to 1.0% FFR), and was 0.43% a year ago when the FFR was 0.50%.

Impact on working capital programmes

When thinking about working capital programmes and the potential impact of rising interest rates, we want to look at the issue from both the buyer’s and supplier’s perspective. Here’s how that breaks down:

  • The buyer:Your borrowing costs are going up slightly. If you had been making money on the margin in between your borrowing rate and the rate of return you could get from early payment discounts (say borrowing at 10% to generate 20% APR returns), then your margin has narrowed.
    Rising interest rates also mean that the potential returns on idle cash invested in money market funds (MMFs), bank deposits and other instruments go up, again decreasing the margin of a discount programme over passive short-term investments. You will want to keep an eye on these changes to know if you’ll need to raise your discount term APRs to preserve your margins.
  • The supplier: For suppliers that depend on finance indexed to these benchmark rates, their borrowing costs are going up as well. Even larger suppliers that can issue commercial paper or other corporate debt to raise capital will face upward pressure on the borrowing rates they would pay to compete with higher rates on treasury bonds.
    Existing discount rates would become a little bit more attractive (unless you raise them), as the difference between your APR and their borrowing rate grows. Supply chain finance (SCF) rates, because they are indexed as well, may be slightly less attractive to your top suppliers, if the gap between SCF and their other funding options was narrow to begin with.

So, where does that leave us? Suppliers may be more likely to find discount terms more attractive because they do not automatically go up alongside interest rates. This is especially true for suppliers that have already agreed to a fixed APR for dynamic discounting, where they hold the option of accelerating payment on an invoice-by-invoice basis.

Some larger suppliers with stellar credit may be somewhat less likely to engage in a SCF programme where it was a close call previously. Suppliers – especially those borrowing at indexed rates – will experience borrowing-cost increases, so while the numbers change a bit, the business value of these programmes does not.

Your next steps

While these interest rate changes will likely have minimal impact on your working capital programmes, there are a few things that you can do to ensure that you make informed decisions in this area:

  • Talk to treasury about borrowing costs and hurdle rates.
    If your costs are going up and eroding your margins on discounts, you may wish to increase the effective APR of your discount terms when negotiating contract renewals and onboarding new suppliers. The same logic applies if these higher interest rates make alternative investments more attractive: you may need to raise discount APRs to keep pace.
  • Review your supply base to identify suppliers with strong credit ratings who may not have the appetite for higher discount or supply chain financing rates.
    While it may be an exceptional case where a percentage-point difference in rates swings a supplier’s decision-making, it is a possibility – especially at the top end of your base. Understanding which suppliers might be affected can help you get out in front of the conversation, or lead to the strategic decision to absorb the rate increase and accept your own lower margin rather than attempting to pass it on.
  • Don’t panic.
    While rates are beginning to increase, and very well may continue over the second half of the year, they are still at historic lows. That’s why the impacts are really only in exceptional cases on the margins, where small changes can push a supplier over what’s already close to its limit. For the vast majority of your supply base, these increases won’t change their decision-making one way or the other at this time.

Wrapping up

While it’s true that interest rates have risen moderately and are expected to continue to do so throughout the year, the cause for concern when it comes to your working capital management projects is minimal. Nevertheless, there are a few questions you can ask – and a few steps you can take – to mitigate these potential impacts.

If nothing else, this provides a great opportunity to make sure that accounts payable (AP), procurement and treasury are in close communication so that any necessary changes can be done in an informed and aligned manner. That collaboration is a best practice itself, and now is as good a time as any to make sure that it’s in place.

  • This is an edited version of an article that originally appeared in SAP’s Digitalist Magazine

Whitepapers & Resources

Transaction Banking Survey 2019

Transaction Banking Survey 2019

TIS Sanction Screening Survey Report

Payments TIS Sanction Screening Survey Report

Enhancing your strategic position: Digitalization in Treasury

Payments Enhancing your strategic position: Digitalization in Treasury

Netting: An Immersive Guide to Global Reconciliation

Netting: An Immersive Guide to Global Reconciliation