The Impact of Rising Interest Rates

Updated: May 31, 2024

Current Landscape

To suppress demand and inflation, the Bank of Canada continued its policy tightening in July 2023 by increasing its policy rate to 5% which pushed the Canadian prime interest rate over 7% for the first time since 2005. While the benchmark was held in the September BoC announcement, another increase of 25 BPS is anticipated in the near term by many market participants. A growing consensus expectation for higher interest rates for longer is working its way through the market even if policy changes in 2024.

Most companies and borrowers continue to experience pervasive challenges in their business whether on capital, labour, or supply chain. These issues have had a profound effect on profitability and working capital across industries. Loan loss provisions announced in recent Canadian bank earnings are up over 100% year over year. Without question, it is becoming more difficult to access credit in Canada. This reality will require borrowers to be incrementally more succinct in their borrowing asks, and patient during lender due diligence and may require borrowers to seek alternatives in the private credit markets as Canadian banks pull back from underperforming industries.

Implications for Private Companies

Rising interest rates can have broad implications for private companies, most notably:

Free Cash Flow – Increasing interest expenses directly impact the underlying profitability and free cash flow generation of a business. Depending on the leverage position of a company and debt structure, free cash flow available for reinvestment or owner distribution can be greatly impacted.

Tightening Credit – Rising interest rates can impact the risk tolerance of lenders which is often managed through tightening of credit policies. This can make borrowing more challenging and could result in lower loan-to-value ratios, stricter financial & personal covenants, and lenders seeking additional security.

Lower Valuations – Raising interest rates generally increases a company's underlying cost of capital and reduces potential leveraged IRRs for inbound participants. These factors coupled with inherent market uncertainty will generally result in lower valuations for private companies.

Mitigating Strategies

While there is limited scope to influence macro-economic conditions, a number of proactive steps can be taken to counterbalance the impact, including:

Optimization – Focus internally on the levers that can drive financial performance including operational improvements, divesting underperforming businesses or non-core assets, and eliminating redundancies. Carefully managing working capital can increase free cash flow generation and underlying profitability. See Bonfire’s insight on working capital for more details.

Planning Ahead – Financial forecasting and capital allocation planning for various scenarios can help the business stay ahead of any sudden changes in economic conditions. This should include sensitivity analysis under various interest rate assumptions to understand the implications.

Stakeholder Communication – Proactive communication with lenders and other stakeholders is often overlooked and is critical for ongoing support.

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