Managing business debt in a higher interest rate environment

Higher borrowing costs are forcing businesses to rethink traditional budgeting. This article examines practical strategies for managing debt, protecting cash flow and preparing for both growth opportunities and downside risks. 

Managing business debt in a higher interest rate environment

For much of the past decade, businesses benefited from a relatively low-cost lending environment that made debt an effective tool for funding growth, acquisitions and capital investment. Today, many organisations are operating under a different reality. Higher interest rates have increased borrowing costs, reduced free cash flow and placed greater scrutiny on the financial assumptions underpinning existing debt facilities.

For businesses carrying significant debt, the challenge is no longer simply generating profit. It is preserving cash flow, maintaining lender confidence and ensuring the organisation can withstand multiple economic scenarios without compromising its long-term strategy.

In this environment, our business advisory team are helping vulnerable clients reframe budgeting as a risk management tool that helps management identify vulnerabilities, test assumptions and make proactive decisions before financial pressure becomes a problem.

Budget for debt servicing capacity, not just profitability

One of the most common mistakes that our business advisers see, made by highly leveraged businesses, is building budgets around revenue growth and profitability while paying insufficient attention to debt servicing capacity.

A business may report healthy profits but still experience financial stress if cash flow is not available when loan repayments fall due. This becomes particularly relevant when interest rates increase and a greater proportion of operating cash flow is redirected towards servicing debt.

Rather than focusing solely on revenue and net profit, businesses should model key measures such as Debt Service Coverage Ratio (DSCR), interest cover and free cash flow generation. Understanding how these metrics change under different operating conditions provides a more accurate picture of financial resilience than profit forecasts alone.

For example, a business may forecast EBITDA of $5 million and assume it is performing strongly. However, if annual interest costs total $1.2 million, principal repayments require a further $1.5 million, and an additional $1 million is needed to fund working capital growth, the business is left with only $1.3 million before considering tax, capital expenditure or unexpected costs. A modest decline in revenue or increase in borrowing costs could quickly erode that remaining buffer, leaving management with limited capacity to invest, absorb shocks or respond to changing market conditions.

Use interest rate sensitivity analysis

Many businesses prepare budgets using current borrowing costs despite recognising that interest rates remain outside their control.

A more sophisticated approach is to build interest rate sensitivity analysis directly into the budgeting process.

This involves modelling multiple interest rate scenarios and measuring the impact on profitability, cash flow and debt servicing capacity.  

Questions management should ask include:

• What is the annual impact of every 0.5% increase in interest rates?
• How would a 2% increase affect free cash flow?
• How much additional revenue would be required to offset higher interest costs?
• At what point would debt servicing begin restricting strategic investment?

Consider a business carrying $10 million in variable-rate debt. A 2% increase in interest rates adds approximately $200,000 in annual interest expense. That additional cost generates no new revenue, improves no operational capability and creates no competitive advantage. It simply reduces available cash.

Understanding this sensitivity allows management to make informed decisions around refinancing, debt reduction, pricing strategies and future capital allocation.

Build a multi-scenario budget rather than a single forecast

One of the biggest flaws in traditional budgeting is the assumption that only one future is likely to occur.  

Businesses carrying significant debt should develop multiple operating scenarios rather than relying on a single annual forecast.

Plan A: Growth scenario

The primary budget should reflect expected market conditions and strategic objectives.

This scenario may assume:

• Revenue growth targets are achieved
• Margins remain stable
• Interest rates remain unchanged or ease modestly
• Planned capital expenditure proceeds as intended

Under this scenario, surplus cash flow may be allocated towards accelerated debt reduction, technology investment, strategic acquisitions, expansion opportunities or workforce growth.

Plan A represents the future management is working towards.

Plan B: Stress-test scenario

Equally important is developing a downside scenario that stress-tests the business against potential risks.

This model may assume:

• Revenue declines below expectations
• Gross margins contract
• Debtor collections slow
• Interest rates remain elevated
• Economic conditions weaken

“The purpose of Plan B is not to predict failure. It is to identify management intervention points before financial pressure becomes critical,” says Evan Brownsmith, Managing Partner of PKF Tamworth and Walcha.

For example:

• If EBITDA falls below a predetermined threshold, discretionary capital expenditure is suspended.
• If interest cover drops below lender comfort levels, debt reduction initiatives are accelerated.
• If debtor days exceed acceptable limits, working capital strategies are activated.
• If cash reserves fall below a minimum target, contingency measures are implemented.

The businesses that navigate uncertainty most effectively are rarely those with the most optimistic forecasts. They are usually the organisations that have already determined how they will respond if conditions deteriorate.

Protect working capital before chasing growth

Businesses carrying high levels of debt often focus heavily on increasing sales while overlooking one of the most important drivers of liquidity: working capital.

Growth consumes cash.

Additional sales frequently require additional inventory, increased staffing, larger supplier commitments and longer debtor balances. While revenue may increase, the resulting working capital requirements can place additional strain on cash flow and borrowing facilities.

As a result, budgeting should extend beyond profit forecasts and include operational measures such as:

• Accounts receivable ageing
• Debtor collection periods
• Inventory turnover
• Supplier payment terms
• Cash conversion cycles

A business may increase revenue by 15% yet experience deteriorating cash flow because additional working capital is required to support that growth.

In many situations, the fastest way to improve financial flexibility is not by generating additional revenue but by releasing cash already tied up within the business.

Reducing debtor days, eliminating excess inventory and improving cash conversion efficiency can often deliver immediate improvements to liquidity without increasing debt.

Budget around refinancing risk

Many organisations focus heavily on monthly repayments while paying insufficient attention to what happens when debt facilities reach maturity.

This can create significant risk in a higher interest rate environment.

When facilities require refinancing, businesses may face:

• Higher borrowing costs
• Reduced lending capacity
• Tighter covenant requirements
• Additional security requests
• Increased lender scrutiny

A robust budgeting process should therefore assess refinancing requirements well before lender discussions commence.

Management should consider questions such as:

• Could the business absorb materially higher borrowing costs?
• Would current cash flow comfortably satisfy lender requirements?
• Are leverage ratios within acceptable levels?
• Does the balance sheet require strengthening before refinancing discussions begin?

The earlier these issues are identified, the greater the range of strategic options available to management.

Balance debt reduction with strategic investment

When interest rates rise, many businesses instinctively direct all available cash towards repaying debt.

While reducing borrowings may be an appropriate strategy, it should not occur at the expense of investments that improve long-term competitiveness and profitability.

The challenge is determining whether available capital creates more value through debt reduction or strategic investment.

For example, a technology investment that significantly improves productivity, reduces labour dependency or streamlines operations may generate returns that exceed the savings achieved through accelerated debt repayment.

Similarly, investments that strengthen margins, improve pricing power or increase operational efficiency may enhance the organisation's ability to service debt in the future.

“Effective budgeting requires management to evaluate these trade-offs carefully rather than automatically prioritising one objective over the other. The goal is not simply reducing debt. It is strengthening the overall financial position of the business,” says Evan.

Building resilience in a higher interest rate environment

Businesses operating in a higher interest rate environment face a different set of challenges than those experienced during periods of cheap capital. Assumptions around borrowing costs, profitability and growth can no longer be taken for granted.

For organisations carrying significant debt, budgeting must evolve beyond a static annual forecast. It should become an active framework for assessing risk, protecting cash flow and preparing for multiple potential outcomes.

Ensure your business is prepared regardless of what future arrives.