Originally created 03/15/04

Rising interest rates could squeeze profits



NEW YORK -- No one expects interest rates to stay at near rock-bottom levels forever, but there are plenty of companies probably hoping that they don't rise anytime soon.

That's because even a slight blip in rates could spell trouble for debt-laden firms. It will put pressure on their cash flows and may even leave some scrambling to cover their newly elevated interest payments. In the process, profits will get squeezed.

The Federal Reserve cut interest rates 13 times over the last three years in an attempt to lift economic growth. The Fed's main lever to influence economic activity, called the federal funds rate, has been at a 45-year-low of 1 percent since last June.

The Fed's efforts have paid off. Low rates have given companies easy access to borrowed capital, which they have used to invest and grow their businesses.

But there is a downside to those low rates: They can mask a company's problems.

For instance, a company might appear in healthy shape because its loan obligations are being met while vendors are still getting paid and products are moving out the door. But what's boosting performance isn't an improvement in operations. It's the reduced interest payments thanks to low rates.

That kind of health can deteriorate fast when interest rates rise.

Fed Chairman Alan Greenspan acknowledged in a speech last week that rates can't stay low indefinitely and at some point - though he didn't give any indications of when - rates will have to rise.

Economists think a Fed rate move could come as soon as this summer and, while expectations are for a slow trend up, it could quickly hurt those companies with little wiggle room when it comes to covering the cost of their debt.

A new study by the consulting firm Getzler Henrich & Associates looked at the potential impact of higher rates on publicly traded companies that have at least some variable-rate debt and that report their interest expense.

Of the 2,000 companies included in the study, 308 use at least half of their operating earnings to pay interest expense. That is, they spend 50 cents on interest for every $1 earned.

Should interest rates rise just 1 percentage point, around 45 of those 308 companies would need to spend at least two-thirds of their operating income on interest payments, and that could potentially cause them to then default on their loan covenants. If rates rose 2 percentage points, the number in that squeeze would jump to around 80.

Industries that could be hardest hit by rising rates include financial services, manufacturing, transportation and energy.

"As we've moved along with low interest rates, companies have shown positive cash flow and bottom lines," said William Henrich, vice chairman of the consulting firm, which specializes in corporate restructuring and turnarounds. "But when interest rates eventually rise, that will place stress on companies by forcing additional cash requirements on the company and hurting their cash flow."

So what can investors do to sniff out those companies that could potentially be in the danger zone?

They can start by looking in the financial statements to see what kind of debt a company has, and how much is based on a fixed or floating rate. Some companies also break out the potential effect of higher interest rates on earnings.

Also, they can easily calculate something called the interest coverage ratio, which gauges the company's ability to meet its interest payments on outstanding debt. That's done by taking the earnings before interest and taxes for a given period and dividing that by the interest expense during the same time frame.

When the ratio is about 1.5 or lower, a company's ability to meet its interest expenses may be questioned, and when it falls below one, it indicates that a company might not be generating sufficient revenues to cover those expenses. That means if interest rates do start to climb, those numbers could be further reduced.

Sooner or later, interest rates will rise, and when they do, that will show which companies are really taking care of business.