Impact of Interest Rate Changes

Increases

  • Consumers with savings will save more due to higher reward

    • Spending less

  • Discourages borrowing from consumers

    • Less loans taken out due to it becoming more expensive to do so

  • Demand for goods and services is likely to fall

  • Existing consumers’ variable debts will cost more to service

    • Less spending

  • Business interest costs increase - less profitable

  • Businesses discouraged from future investments - needs higher ARR to go ahead with a project

  • Less innovation due to less investments, lower quality, less competitive

  • Less sales

Decreases

  • Consumers borrowing more

  • Consumers spending more

  • Consumer debts less

  • Demand for goods and services increases

  • Business existing debts reduce

  • Encourages the business to invest more - cheaper to borrow, less ARR required to go ahead with projects

  • Increased innovation, quality, more competitive

  • Increase in sales

Banks more profitable when interest rates increase.

GEARING - measures the proportion of a business’ capital provided by debt

Capital - finance provided to enable it to operate over the long term

  1. Equity - finance provided by the owners/shareholders

    1. Share capital

    2. Retained profits

  2. Debt - finance provided by external parties

    1. Loans

gearing % = non-current liabilities/total equity + non-current liabilities x 100

50%+ is said to be high

20%- is said to be low

DEPENDS ON BUSINESS AND INDUSTRY

The higher the percentage, the more sensitive you are to interest rate increases as you are renting money.

High gearing ratio is good when there are lower interest rates, consistent and high profit, if you want to avoid using shares as a way of expanding

A low gearing ratio is more appropriate in a high interest rate environment, if there are low and inconsistent profits, don’t mind increasing shareholder base

Benefits of high gearing

  • Debt is cheap

  • Less capital required to be invested

  • Easy to pay interests if profits and cash flows are strong

Benefits of low gearing

  • Less risk that the business will fail due to debts

  • Has capacity to add debt