Rates Projected to Rise
With the projected interest rate hikes inbound for 2022, the Fed plans on hiking the rate 3 times, in quarter-point increments. The current interest rate is 6 percent +/- for business acquisitions. Expected to climb to 6.75 percent to 7 percent by the end of 2022, there will also be additional increases in 2023 and 2024.
There are very few outside influences that affect business valuations more than interest rate changes. In fact, there is a direct correlation between changes in interest rate and the selling price of businesses.
Breaking Down the Interest Rate
The reason for this is the business for sale must have enough profit to meet a certain debt coverage ratio. The ratio is calculated by subtracting the profits of a business by the sum of the owner’s compensation and capital expenses, divided by annual loan payments. For example, if you have a company that has profits of $500,000, the purchaser needs $150,000 to live on, and the business has capital expenditures of $80,000 per year. The business would have a net income of $270,000 after these expenses. If the buyer had a loan for $1.5 million on a 10-year amortization at 6 percent interest they would have a 1.35 debt coverage ratio, making this acquisition financeable.
But if the interest rate increased to 8 percent, the debt coverage ratio would only be 1.23. This makes it difficult to get bank financing for this transaction. A lower ratio means the buyer will have more difficulty paying back their loan, which discourages banks from financing. The more money used to pay interest on a loan means the less money the buyer will have available. This means they will pay a higher purchase price for the sale of the business.
With that in mind, the seller would have to reduce the selling price for the bank to make the loan. For every 1 percent increase in interest rate, you should expect a 4 percent to 5 percent decrease in purchase price.
Put Our Experience In Your Corner
If you’ve been thinking about selling your business, consider it now before we have interest rate increases. This may be your last chance to sell while the rate is at its lowest for a good while. Bring the experts from Gateway Mergers & Acquisitions into your corner! Call now for a free, no-obligation pricing analysis at (972) 219-6961, or contact us to start the process.