Will The Fed Doom Your Working Capital Program?

Scott Pezza

News of increasing interest rates has led to questions about what it might mean for both 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 programs focused either on self-funded early-payment discount programs or third-party-funded supply chain finance arrangements. Will higher interest rates make these programs 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 you can do to mitigate any risk to program success.

Just the facts

Interest rates are going up. In announcements on December 14, 2016, and March 15, 2017, the U.S. Federal Reserve raised its target for the federal funds rate (FFR) by 25 basis points (one-quarter percent), from 0.5% to 0.75% and then on to 1.0%. Members of the Fed’s Board of Governors have shared their views that multiple additional increases will (or should) happen in 2017. That could result in a fed funds rate of 1.5% or more by the end of the year. But why does that matter?

The fed funds rate 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 U.S., the prime rate follows closely along with changes in the fed funds rate. 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 $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 U.S., of course. Loans throughout the world, including some in the U.S., can be indexed to LIBOR, or the London Interbank Offered Rate. 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 programs, 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 fed funds rate: it was 0.99% in April (compared to 1.0% FFR), and was 0.43% a year ago when the federal funds rate was 0.50%.

Impact on working capital programs

When thinking about working capital programs 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, bank deposits, and other instruments go up, again decreasing the margin of a discount program 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 supply chain finance program 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 programs does not.

Your next steps

While these interest rate changes will likely have minimal impact on your working capital programs, 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 throughout 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, 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.

For more insights into the challenges and opportunities for today’s treasurers, read this complimentary report from specialized treasury consulting firm Strategic Treasurer: “Leading Practices for Treasury in the Financial Supply Chain.

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Scott Pezza

About Scott Pezza

As part of SAP Ariba's Digital Transformation Organization's Center of Excellence, Scott researches, compiles, and shares best-practice information to help SAP Ariba's customers get the most out of their investments. He has a dual focus on the emerging technologies (AI/ML, IoT, Blockchain, etc.) across the source-to-settle cycle, as well as a specific interest in the financial supply chain (invoice management, payments, discounting, and supply chain finance). His research helps inform strategic planning, performance measurement, and program execution. He has spent the past 17 years in the B2B technology space, in roles ranging from software development and support to research and consulting. Scott earned his BA in English and Philosophy from Clark University, his MBA from Boston University Graduate School of Management, and his JD from Boston University School of Law, where he served on the Executive Board of the Annual Review of Banking and Financial Law.