What’s the cost of borrowing money?

4 min read

Most food and beverage processors rely on some form of credit from financial institutions to manage and grow their operations, whether to finance projects like a new plant, equipment modifications and installations, or lines of credit to finance additional inventories.

According to Innovation, Science and Economic Development Canada, food and beverage processors carry an average debt-to-equity ratio of close to 80%, which means they use a lot of borrowed money.

So what’s the cost of borrowing money - that is, what is your interest rate - and how is that determined? When the financial stakes are so high, it’s critical to understand the many elements to answer that question.What’s the cost of borrowing money, and how is that determined?

Here are four key considerations of the cost of borrowing money:

1. Short-term borrowing

The factors determining the interest rate of short-term borrowed money for an operating line of credit differ from those that establish your interest rate on a longer-term loan or mortgage.

Short-term interest rates used to set variable loan and mortgage rates are determined directly by the Bank of Canada and its overnight (or policy interest) rate. This overnight interest rate is the main instrument the Bank of Canada uses to manage the general inflation rate in the economy.

The Bank of Canada has a mandate to achieve a low and stable rate of inflation of approximately 2% a year to maintain consumer confidence and encourage business investment.

Zero inflation harms the economy because it can lead to price deflation and economic stagnation as consumers delay spending. Conversely, high rates of inflation are similarly destabilizing.

During high inflation, the Bank of Canada raises the overnight interest rate to slow down the economy and consumer spending. As the inflation rate approaches the managed target rate, and when economic activity slows, it decreases the overnight rate to stimulate more borrowing and spending.

The overnight rates also determine the prime rates banks use to set the interest rates paid on deposits and those used forvariable rate loans.

If your food and beverage processing business has variable rate financing in the form of a mortgage or loan, those rates will rise and fall in tandem with changes to the Bank of Canada overnight rate.

Anticipating changes to the Bank of Canada's overnight interest rate and its impact on your variable loan interest payments can be tricky. It takes staying on top of the topic and frequently contacting your lender.

2. Long-term borrowing

Longer-term, fixed interest rates, such as those applied on a five-year mortgage or term loan, are based on the bond market.

The bond market is a free trading market for buyers and sellers of investment capital. It operates like any other commodity market and is not directly tied to the Bank of Canada's overnight rate policy.

Bond yields (the return you receive on a bond) and prices are influenced by expectations of broader long-term trends like inflation, economic growth and developments in the United States. They are, therefore, less dependent on short-term Bank of Canada policy decisions.

3. Weighing the options

Movements in fixed and variable rates can exhibit different trajectories. Bond trades, for example, are typically priced in anticipation of changes in the Bank of Canada overnight rates. Changes in variable loan rates from overnight decisions don’t immediately impact fixed-term loan rates.

The challenge for financial managers in food processing businesses is not only to understand and monitor the different factors that influence variable and fixed-term rates of interest but also how to use that information in choosing between the best mix of financing and managing overall financial risk.

Consider this: Sales growth and anticipated strong demand for your food product means you’re adding another processing line. The Bank of Canada has just lowered the overnight rate by .25%, and financial analysts suggest more cuts will be made over the next six months.

You can access a five-year fixed or variable loan to finance the new equipment. Which loan type will have the least interest expense over the life of the loan?

Fixed-rate financing is stable and predictable for cash flow planning. Variable rate financing, especially when interest rates are declining, holds the promise of potential interest savings over a loan term. Another essential strategy for using variable rate financing is to calculate the impact of changes to the prime rate on interest expenses.

4. Making a choice

While it’s impossible to predict future interest rate changes precisely, assigning probabilities to future rate change scenarios is possible. Lenders can provide forecasting options, which you can use to choose loan terms based on your risk profile and overall financial condition.

One of the best strategies in the face of uncertainty is employing a mix of variable and fixed-rate loans of various terms. This assumes capital requirements are large enough and it’s administratively feasible. Maintaining a diversified debt portfolio balances exposure to rate changes and reduces the impact on borrowing costs. The proper loan mix will also depend on the timing of capital investments, stability of cash flows and the value of various loan product features like pre-payment options.

More resources

For further details about interest rates and the Bank of Canada, check out FCC’s Ag Economics YouTube Channel and these resources.

Article by: Alan Archibald

Money & Finance