Effects from an Applied Stress Test

The following is a follow-up to the post Stress Testing for Margin Compression during Economic Volatility, which can be found here. Leading economists are anticipating prime interest rates could reach as high as 7.0% by year-end. For some loans, such as equipment purchases, the additional costs from the debt can be absorbed. However, it is not uncommon for the price of a business in an acquisition to include, but not be limited to, a 6.5x EBITDA multiple. The following analysis reveals the impact current and projected interest rate increases will have on a loan for an acquired business, including inflation effects.

Effects from an Applied Stress Test

The most recent 75-basis point rate hikes will make business debt more expensive as increased monthly payments on variable loans put pressure on cash flow. In assessing rate hikes in a stress test, analyzing the impact on the debt service coverage ratio (DSCR) can be a direct path to monitoring risk, especially for lenders. Applying a stress test is useful for businesses of varying sizes; however, the example analyzed below is a small business, many of which are often intertwined with their larger counterparts. Also, this stress test only analyzes outward pressures and does not include revenue declines or cost increases, which require deeper analysis.

For this test, a $3.8mm business closed on a $2.2mm variable rate loan in April. The business has an EBITDA margin of 9.5% and a net margin of 5.2%. Interest on the loan is calculated at a base prime rate plus a 1.5% markup on a 10-year amortization schedule, and adjustments are made as rates change. Results from projections show DSCR within covenant requirements at 1.25.

At closing, the annual interest rate was 5.0% for an annual debt service of $290,600 per year. While tight, the business generates $363,000 in EBITDA income. However, since origination, prime interest rates have increased in May (+0.5%),?June (+0.75%), and July (+0.75%), with another expected increase up to 75-basis points by the end of Q3. Assuming the Q3 increase, the prime rate increases will increase the interest rate on the loan from 5.0% to 7.75%.

Applying this loan through a stress test revealed the following:

-???????Given all the above prime rate increases, debt service increased from $290,600 to $318,000 per year.

-???????For the borrower to maintain a DSCR covenant of 1.25, EBITDA will have to increase by 9.4%, or nearly $35,000. For perspective, this is the average wage of a part-time employee.

-???????If revenue, gross margin, and operating expense ratios are assumed to all remain the same, to highlight the impact of the interest rate increases, the DSCR drops to 1.14 by the end of Q3. Once year-end financials are presented, this company could wind up in a covenant default situation with its lender.

To add another layer, inflation affects the cost of goods (COG) more rapidly than operating expenses, and they are easily expected to adjust. When applying inflation expectations of 0.3% from July and -0.2% by October to COGs, and combining them with the effects of increased interest rates, the revised DSCR drops to 1.13, even as the inflation rate is decreasing. As inflation hits other costs in the business, and if revenue decreases, as the DSCR continues to approach 1.0, principal payments will have to come from other sources.

Additionally, consider the compression effects on DSCR for the same loan originated in an SBA 7(a) structure, especially with inflation adjustments. As of August 2022, the maximum rate for SBA 7(a) loans is the prime rate plus a 2.75% markup on a 10-year amortization schedule, and adjustments are made quarterly. Lenders often consider a 1.2 DSCR at closing to be safe; however, there are no covenant requirements post-closing, financials are typically reviewed annually, and as long as the payment is made, borrowers remain in good standing. In this example, by the time financials are reported in January, the DSCR will have dropped to 1.05 in Q4, and with a potential additional rate increase, be pushing 1.01 in Q1.

We are in an era of high but capricious inflation, which means persistently higher interest rates. For many businesses, any positive reductions in inflation may not be seen for over a year, but the issues are occurring now. Moreover, history has shown that inflation is volatile and can come roaring back, and additional rate increases could easily happen in Q4 and beyond. Considering annual financials normally show up in Q1, margin compressions happening now could ultimately trigger a lender to downgrade a loan originated less than one year ago to a watch list or worse for a business that was projected to be healthy.

Better for a business to know what is coming and make efforts to manage the impact than wait for a lender to send a default letter.