How Has the Bank of Canada Policy Rate Impacted Small Businesses?

By Daryl Ching, CFA | Managing Partner Vistance Capital Advisory After a fairly stable interest rate environment since the financial crisis in 2008, we have seen interest rates rise dramatically in a very short period of time, resembling a hockey stick graph. As of March 2020, the Bank of Canada policy rate was steady at 1.75% and as we entered an inflationary environment, the rate increased to 5% by July 2023. That is a 3.25% increase in just over 3 years. While there are fixed rate term loans available, the most usual form of business loan is a line of credit that is based on a bank prime rate, which in turn is tied to the Bank of Canada Policy Rate (overnight lending rate to banks). These interest rates fluctuate based on the prevailing interest rate environment. Personal lines of credit that are often used to lend to small businesses are also priced based on the Prime Bank Rate. Prior to COVID, businesses in good standing were borrowing at about 6-7% interest rates based on the bank prime rate at the time. These same loans by July 2023 were charging 9.25%-10.25% interest. On a loan of $300K, this is an additional $10K of interest annually business owners are suddenly paying. For businesses that are breaking even or in a loss position, the additional interest is crippling, and entrepreneurs are faced with some significant decisions that include cost cutting, pivoting the business strategy, refinancing or in some cases shutting down their business. For small businesses looking for financing, a higher interest rate makes it much more difficult to qualify for business loans because they will struggle to cover the interest payments, so as a result, they do not pass the debt coverage tests. Therefore, many small businesses are now priced out of the market but could conceivably have qualified for a loan prior to COVID. The greatest impact is on early-stage businesses and businesses withlow profitability that can no longer consider debt as an option. As a result of all this, the most interesting trend we have seen since COVID is a move towards the equity market. Business owners have opted to sell shares of their business for growth capital and in some circumstances to pay down their high interest debt. Early-stage equity investors have a very different profile from a lender. They seek much more upside and therefore push companies to riskier business models that can result in a higher valuation upon exit. For high growth businesses looking for the same return, this works out well as an equity raise was likely the right path for them. However, for more conservative businesses that have a lower risk and reward profile or for business owners that were looking to steady organic growth, equity is not an attractive option, but they have no where else to turn. A full equity raise is very time consuming. Business owners shift their attention to preparing investors presentations, 3–5-year financial forecasts, and taking meetings with investors. They get locked up in long due diligence sessions only to have deals fall apart at the 11th hour for various reasons. Early-stage businesses often end up handing over control of the company due to a lower valuation. The high interest rate environment has pushed many businesses into raising equity, even though this was not a great option for them. As of July 2024, we have seen the Bank of Canada drop interest rates twice. While it is a great sign and a step in the right direction, 0.50% is not going to have a significant impact on business financing in the grand scheme of things. However, if small business loan rates can return to the 6-7% range we saw before COVID, this opens up the door for small businesses to seek debt financing as a viable alternative if they are looking to grow. Considering the lack of funding available for entrepreneurs in Canada compared to our US counterpart, we need a healthy debt market for companies to thrive. About Daryl Ching Daryl Ching is the founder and owner of Vistance Capital Advisory, providing accounting, capital raising and fractional CFO services to SMEs. He has over 10 years of investment banking experience, starting his career at RBC Capital Markets where he structured multibillion-dollar transactions moving to smaller investment banks where he completed smaller debt and equity transactions in various asset classes. After leaving investment banking, Daryl started to work with small businesses as a CFO preparing financial statements, strategic planning, budgeting and forecasting, and raising capital through investors and banks. Mr. Ching has been well recognized as an expert in structured finance, making numerous appearances on the Business News Network and has been quoted in major newspapers and magazines across Canada. Mr. Ching completed the Honors Economics Program at the University of Western Ontario and is a CFA Charterholder.