How High Interest Rates and Inflation Eat your Cash Flow

Due to the impact high inflation has on both the economy and society in general, the major central banks around the world have committed to ongoing interest rate increases to bring it under control. The US Federal Reserve has implemented four consecutive 0.75% rate hikes in recent months bringing the base interest rates in the US to between 3.75% and 4%.

While reports have shown headline rate of inflation has softened in the U.S. recently, it remains stubbornly high in most places despite the recent aggressive rate rises. Also, it is widely expect that the era of cheap money is over and higher interest rates are here to stay. Therefore, in companies of all shapes and sizes, controlling and treasury teams, and pretty much anyone responsible for managing cash flow, must get ready for a period of both elevated inflation and interest rates that will profoundly impact cash flow.

How does high inflation and interest rates impact cash flow?

In this environment, if cash is not managed properly, it will literally disappear before your eyes as multiple factors eat into it, at the same time. The major factors impacting cash flow are.

1. Increased Cost

The price paid for everything within your business will increase. Existing supply contracts or hedging may protect you, to an extent, but when these roll off, expect the cash spend on major inputs to your business to increase significantly.

2. Reduced Demand

Inflation makes most goods and services less attractive as they become more expensive. The goal of central bank interest rate rises is to cool demand which they hope will in turn cool prices. Plan for demand for your company’s products and services to be impacted in some way in the coming months which will be reflected in top line cash flow.

3. Slower Cash Collections

As everyone grapples with the implications of the new environment expect collections to slow as your own customers manage cash more tightly. This will have an impact on your entire working capital cycle and the cash you will have on hand will reduce as it’s tied up in collections.

4. Increased Bad Debts

Unfortunately, the coming economic cycle will result in business failures and most companies will experience bad debts as their customers struggle or don’t pay for goods and services already delivered. This will impact your debtor book and result in non-payment of goods and services already delivered.

5. Increased Interest Costs

Even for highly leveraged businesses, interest rates over the last 10+ years have meant that interest costs have been manageable in many cases as earnings have provided good coverage. This is changing and with interest rates in the UK and US increasing over threefold in recent months, and further increases expected in Europe in the coming months, any business with floating rate debt or term-based facilities can expect higher cash interest outflows in the near term.

6. Decreased Value of cash holdings

The net effect of all of this is a double pronged reduction in value of the cash you hold. Firstly, it’s likely you will have less cash due to the factors outlined above. Secondly, due to inflation, the purchasing power of the cash you hold will be lower, effectively reducing its value.

How to respond

With low interest rates, low inflation and plentiful sources of financing available in recent years many businesses haven’t had to think about cash too much. It has just been there and the cost of managing cash poorly has been low. This has changed. Controlling and treasury teams in companies worldwide now need to build stronger and more resilient cash flow muscle in their business.

The way to do this is:

1. Build a Strong Cash Culture

This may be too fluffy for some, but a strong cash culture is the bedrock of good cash management. It simply means that efforts are made to ensure that everyone who has a stake in cash management understands the importance of the role they play and the difference they make. Without everyone rowing in the same direction, managing cash efficiently will be an uphill battle.

2. Get Cash Visibility

Getting clear and reliable visibility over current and forecasted cash flow on a regular basis will have the single biggest impact on your ability to manage cash operationally. Without visibility over the full spectrum of cash flow including future needs, cash management activities will be disconnected and reactive. A single source of visibility brings it all together.

3. Give Cash Visibility

Giving all stakeholders ongoing visibility over cash flow and what drives it will be key to building and maintaining a healthy cash management culture. The cash flow reporting and analysis done within the finance and treasury teams are not the preserve of these teams. Cash flow impacts everyone and therefore visibility should be shared.

4. Ensure Excess Cash is Earning a Return

Idle cash should always be yielding a return. There are two straightforward ways to do this. Firstly, invest in short term cash investments such as deposits which are now paying much higher interest rates than they have been for close to 15 years. Secondly, use cash not needed in the very short term to repay revolving cash facilities and overdrafts, reducing interest cost and, by extension, earning a return.

5. Manage AR and AP Strategically

This doesn’t mean hounding your customers for payment or holding back supplier payments. It means keeping a tight control of how you manage both AP and AR starting with gaining a clear insight into both external and internal payment behaviour and the key metrics that drive your cash flow. Tight control of AP and AR and clear visibility over key working capital metrics allow you to take action to buffer you cash flow before problems arise.

The new world

Cash management is a core financial discipline but one that is often neglected when times are good. The road ahead will be bumpy but those who take proactive steps to master cash management will ensure that, as a business, they will be best placed to take advantage of opportunities that lie ahead.