Our Context
To make our practical finance section as useful and practical as possible, all the definitions and insight will be in the context of a E-Bikes shop that we call E-Zee Bikes. This gives you a more hand ons view and more relatable to what the numbers actually mean.
IN A NUTSHELL
GLOSSARY DEFINITION
WORKED EXAMPLE
Our e-bike shop takes a loan of £10,000 at a 5% annual interest rate. After one year, the shop will owe £10,500 (£10,000 principal + £500 interest).
USED IN A PHRASE
DETAILED MEANING
Types of interest
Fixed Interest Rates: These rates remain constant over the loan’s life. For example, if the e-bike shop borrows £20,000 at a fixed interest rate of 6%, it will pay the same interest rate throughout the loan term.
Variable Interest Rates: These rates fluctuate based on market conditions. A loan with a variable rate might start at 4% but can increase or decrease over time
How interest impacts business
Borrowing Costs: Higher interest rates increase the cost of borrowing, which can impact a small business’s ability to finance new projects or manage cash flow. For instance, if the e-bike shop needs to borrow money for new inventory, higher interest rates would increase the cost of this loan, affecting profit margins.
Savings and Investments: On the flip side, higher interest rates can benefit the business if it has savings or fixed-income investments. The interest earned on these can be higher, providing additional income.
Consumer Spending: Interest rates can influence consumer behavior. High rates can lead to decreased spending, as loans for big-ticket items like cars and houses become more expensive. For the e-bike shop, this could mean a reduction in sales if customers are less inclined to finance big purchases.
Factors that drive the interest rate
Central Bank Policies: Central banks, like the Federal Reserve in the United States or Bank of England in the UK, set benchmark interest rates that influence the overall lending and borrowing environment. These rates are often adjusted to control inflation and stabilize the economy.
Economic Conditions: In a strong economy, interest rates may be increased to prevent overheating and control inflation. In a weak economy, rates might be lowered to stimulate borrowing and investment.
Inflation: Higher inflation often leads to higher interest rates, as lenders need to ensure that they’re compensated for the decreased purchasing power of the money when it’s repaid.
Credit Risk: For individual borrowers, including businesses, interest rates can vary based on creditworthiness. A business with a strong credit history may secure loans at lower rates compared to one with a poor credit history.
How to manage interest rates?
Locking in Fixed Rates: If a business anticipates that interest rates will rise, it might choose to lock in a fixed-rate loan now to avoid higher costs later.
Variable Rate Loans: If the market suggests that rates will fall, a business might opt for a variable rate loan to take advantage of potential lower rates in the future.
Interest Rate Swaps: Some businesses engage in swaps to hedge against interest rate fluctuations, exchanging their variable-rate loan interest payments for fixed-rate payments, or vice versa.
Monitoring Credit Scores: Maintaining a good credit score is vital for securing loans at favorable interest rates.
Budgeting for Interest Rate Changes: Businesses should prepare for rate changes by including potential increases or decreases in their financial planning and forecasting.
Interest and the financial statements
Income Statement: Interest expenses (for loans) or interest income (from investments or savings) are recorded on the income statement, affecting the net profit.
Balance Sheet: Loans and savings are reflected in the balance sheet. Changes in interest rates can affect the valuation of these items and, consequently, the business’s financial health.
Cash Flow Statement: Interest payments impact the cash flow from financing activities. A higher interest rate means more cash outflow, affecting the overall cash position.