Four ways to navigate through rising interest rates

Debt levels for mid-market companies are at historic highs. As interest rates rise, so does the likelihood of a wave of restructurings.

In brief

• Interest rates are rising just as corporate debt is reaching historic levels, signalling a likely financial shakeout for unprepared companies.
• Many CFOs, accustomed to the easy credit of recent years, may be surprised when financing becomes expensive, limited or unavailable.
• Proactive CFOs can take steps now to improve their companies’ financial health and build resiliency to withstand the coming credit shock.

Aless-accommodating credit environment is upon us, and many companies, especially midsize organizations, are overleveraged, unprepared and vulnerable to tightening liquidity.

While companies have faced tremendous stress over the past couple of years from the pandemic, supply chain crisis, war in Ukraine and other shocks, one bright spot has been the steady availability of credit that has persisted for more than a decade. For the many organizations that have leaned on easy borrowing to weather disruptions and challenges, that ready access to cash appears likely to end. 

The Chicago Fed’s National Financial Conditions Index (NFCI)1 has been notably low for several years, reflecting loose financial conditions and easier access to financing. However, this measure of financial conditions, often used as an inverse proxy for market liquidity, has risen sharply since the beginning of 2022. This indicates a tightening of financial markets as reflected in rising rates, falling equity values, a firming US dollar and elevated volatility. We believe these trends foreshadow a future increase in debt reorganizations through refinancing, out-of-court restructurings or bankruptcies.

When credit tightens, Chapter 11 filings rise

Organizations that have become accustomed to addressing short-term problems with cheap borrowing may be shocked in the coming months, as that approach becomes prohibitively expensive or restrictive — or not available at all.

Fortunately, there are steps companies can take now to avoid painful restructurings or Chapter 11 filings. CFOs should take the opportunity to review and improve their position through a proactive approach to shoring up their financial and operational health.

Companies, especially those that are highly leveraged, should take steps now to build and secure liquidity to be better prepared for uncertain market conditions and to manage the impacts of potential disruptions between operations and finance. While the appropriate financial improvement steps may seem familiar (reduce costs, improve productivity, increase prices to combat cost inflation, enhance working capital management), the exact circumstances and implementation may vary widely, and experience tells us that waiting too long to take action will limit the available options.  

How companies can navigate through turbulent times

There are numerous ways to strengthen company finances, depending on an organization’s circumstances. Below, we outline four examples that indicate degrees of risk and possible solutions.

1. Leveraged but otherwise healthy: The right data insight drives better strategic decision-making 

Many companies may be highly leveraged, compared to sector peers or historical norms, but not facing financial stress. Organizations in this situation may find it useful to assess their finances against a less-accommodating credit market and consider taking steps now to prepare. It may be difficult for some companies to do this if the steps seem painful and (for the time being) optional. It also may be less obvious what proactive measures to take. 

Companies that can take pre-emptive steps have more opportunities to get ahead of the curve. For example, one midsize product distribution company implemented customized analytic capabilities, including new product- and portfolio-level profitability dashboards, to help drive an operational and cash flow improvement plan. EY-Parthenon helped improve efficiency of manufacturing and distribution facilities and assisted with commercial price negotiations and strategic sourcing decisions, all of which added millions to earnings before interest, tax, depreciation and amortization (EBITDA), as well as other working capital augmentations that yielded over $40 million in additional liquidity. 

The EY-Parthenon analysis helped decision-makers distill the right data and drive accountability at the division and plant levels. EY-Parthenon worked directly with company leaders to embed skills and raise expectations so that the new analytical tools and reporting capabilities would remain as part of the company’s culture. Although the company was not in immediate financial trouble, the actions helped cut costs, strengthened the balance sheet and significantly improved operational efficiency, resulting in greater resilience to face future tight credit or other stresses.

2. Treading water: A comprehensive operational turnaround plan identifies hard choices early

Companies that are underperforming or experiencing early signs of stress can benefit from reducing costs before the situation worsens. Potential steps include strategic sourcing, supply chain redesign, administrative cost reduction and working capital optimization. 

A PE-owned distribution company nearly tripled EBITDA and generated tens of millions of dollars of liquidity in six months with a combination of similar steps. EY-Parthenon helped the company carry out an operational reorganization that reduced administrative costs while improving freight and delivery efficiency and sales effectiveness and set the company up to achieve further gains from the implementation of additional automation. The company stands to see further gains from plans to implement new automation, including an updated online sales environment to improve the customer experience and reduce sales costs. A planned implementation of new strategic sourcing measures can also help lower costs. 

3. Overextended: A focused liquidity enhancement plan supports a turnaround 

For those that may be facing possible loan covenant breaches or default, it may be necessary to identify a combination of immediate, impactful steps as well as longer-term profit improvements.

For example, an automotive supplier that was overleveraged and facing difficulties with lenders made a dramatic turnaround by taking steps, including working capital improvements, deferral of capital expenditures and sale of non-core assets. EY-Parthenon helped the company develop and implement a phased turnaround plan combined with profit-growth initiatives. The company reduced its cost of goods sold and lowered administrative expenses by 10%. Improvements to inventory management, supplier credit cycles and cash flow management also yielded positive impacts on the balance sheet and working capital efficiency going forward.

4. Distressed suppliers: It pays to know your partners

Something for executives to keep in mind in today’s interconnected world is the potential vulnerability of suppliers and customers, as sudden financial distress at a business partner can bring unwelcome surprises for supply chains or sales channels. Even companies with strong balance sheets and earning profiles can be impacted by upstream or downstream disruptions. 

For example, a major aerospace manufacturer was faced with the risk of supply chain disruption when a parts supplier ran into financial trouble. The supplier was overleveraged because of acquisitions it had made and was suffering from operational issues, losing money and defaulting on loans. At the request of the manufacturer, EY-Parthenon engaged directly with the distressed supplier to help create financial transparency, negotiate an accommodation agreement and assist in establishing a resolution process. The solution, which concluded with the sale of the supplier to the manufacturer’s preferred acquirer, achieved significant cost savings and helped secure the manufacturer’s critical parts pipeline.