The Increase in Interest Rates Effect on Small Biz - what to watch

A recent Wall Street Journal article noted that small businesses are facing interest rates over 9% vs. an average 4.6% only two years ago, as reported by the National Federation of Independent Businesses (NFIB). While interest rates were relatively low for a long times, businesses, both big and small, tended to worry less about the cost of debt due to low rates. Now, it's becoming an issue.

What is Return on Assets Invested?

Return on Assets Invested is a financial performance metric that measures the efficiency of a company in generating profits from its invested capital or Assets Invested (AI). Assets Invested typically includes the sum of the firm's equity and all debt where interest is being paid (Interest Bearing Debt or IBD).

ROAI is calculated using the formula:

ROAI = Earnings before Interest and Taxes (EBIT)/Assets Invested where Assets Invested equals Shareholder Equity + Interest Bearing Debt (i.e., both short term and long term liabilities where interest is being paid).

Why EBIT?

EBIT, which stands for Earnings Before Interest and Taxes, is an important financial measure for several key reasons:

1. **Operational Performance**: EBIT focuses purely on a company’s operational performance by excluding interest and taxes, which are influenced by factors outside of the company’s core business activities, like debt structure and tax laws. This provides a clearer view of the company's operational profitability and efficiency.

2. **Comparability Across Companies**: Since EBIT excludes interest and taxes, it allows for better comparability between companies with different capital structures and tax situations. This is particularly useful when comparing companies across different countries or industries where tax rates and financial leverage (debt) can vary significantly.

3. **Investment Analysis**: For investors and analysts, EBIT is a key metric to assess a company’s potential profitability and to make apples-to-apples comparisons when evaluating investment opportunities. It helps in understanding the fundamental earning power of a business without the noise of financing and tax strategies.

4. **Debt Servicing Ability**: While EBIT excludes interest, it is a useful indicator of a company's ability to service its debt. A higher EBIT suggests that the company is generating sufficient income to cover its interest expenses comfortably, a crucial factor for creditors and investors.

5. **Basis for Other Metrics**: EBIT is a starting point for calculating other important financial metrics, such as EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) and operating margin. These metrics provide further insights into a company's financial health and performance.

6. **Budgeting and Forecasting**: For internal management, EBIT is a crucial measure for budgeting and forecasting. It helps in setting targets and performance benchmarks, and in making strategic decisions about operational improvements, expansions, or cost-cutting measures.

In summary, EBIT is a valuable tool for evaluating a company's core operational profitability, making it an essential component of financial analysis for investors, creditors, and company management.

Assume the following example of Wazoo Inc, to show an application. Here is some selected information from their Income Statement.

Below is an example balance sheet from the same year:

If Return on Assets Invested is calculated for the year:

Where Assets Invested is comprised of:

The critical benchmark for ROAI, assuming it's positive, it so compare it to your firm's average interest rate you pay on your debt or the Cost of Debt (Interest Expense/Interest Bearing Debt). It's imperative that the ROAI is at least 2% more than the Cost of Debt. In Wazoo's case, the Cost of Debt is:

ROAI is 14% higher than Cost of Debt (18.62% - 4.44%). As a result, the firm is earning enough on hits invested capital to cover their interest expense, pay their taxes and have plenty of profitability left over for shareholders or reinvestment.

The ROAI benchark presents a better profitability and productivity indicator than ratios like the Return on Equity. By looking at Operating Profit instead of Net Income and including the entire investment base (both debt and equity) in the denominator, ROAI provides a clearer picture on the how well management is performing in their financing and managerial decisions.

In our next blog post, we'll examine wh it means if the ROAI is not above the 2% spread over Cost of Debt and steps a firm can take to improve their profitability position.