Why US small businesses are on a surprisingly strong footing as interest rates rise

Published on01 DEC 2023

As small US businesses contend with tighter credit, they appear to be in a good position to absorb the impact of higher interest costs, according to Goldman Sachs Research.

It’s surprising because small businesses, on a relative basis, are more vulnerable to funding stress than big companies. They typically pay higher interest rates — our economists estimate small businesses paid an effective interest rate of roughly 10.5% in 2019, compared with 6.5% for the corporate sector. Small businesses spent around 6% of the sector’s gross output on interest payments in 2021, compared with only 2% for large businesses, Goldman Sachs Research economists Manuel Abecasis and Spencer Hill write in the team’s report.

The impact of higher interest rates is still feeding through to smaller firms. The Federal Reserve has hiked its main policy rate to the highest level in more than 15 years, but the full effect of those increases has yet to be felt because small business debt is roughly split down the middle between short-term, floating-rate obligations and longer-maturity term loans, according to Goldman Sachs Research.

Abecasis and Hill estimate that higher rates will increase the interest burden for small businesses, as a share of revenues, by just over one percentage point by 2024, from roughly 5.8% of revenues in 2021 to around 7% next year. They forecast this share is likely to increase further to just under 8% as term loans gradually mature. That’s above pre-pandemic levels but similar to the mid-1990s.

Higher interest expenses, meanwhile, may have a modest effect on small businesses’ investing and hiring. Interest payments for these enterprises as a share of output is expected to increase by a little under one percentage point in 2023, which is likely to reduce capital expenditures by around 0.1% and labor costs by 0.17% as a share of the sector’s gross output.

And while small, non-corporate businesses are a critical part of the US economy, Goldman Sachs Research expects the headwind to these enterprises from higher interest expenses  to have only a moderate impact on economywide GDP growth. Our economists expect the GDP growth drag from small business borrowing costs to peak this year at just 0.1 percentage point. In their baseline forecast, they forecast this growth headwind will wane in 2024 before rising modestly later in the decade as term loans are refinanced.

Some small businesses have found other funding

Maria Burns Ortiz, co-founder and CEO of 7 Generation Games, says her business is only seeing an indirect impact from higher rates because of the availability of other funding sources. Her company, a maker of immersive video games and interactive apps that teach math, history, and languages, sought early assistance from Goldman Sachs’ 10,000 Small Businesses program, which helps entrepreneurs by providing access to education, capital, and support services. Ultimately, Ortiz and her co-founders were able to secure start-up funding through a combination of Small Business Innovation Research grants from the federal government and venture funding.

More recently, she said, she pursued a small business loan when investors started to “tighten up some” in the face of higher rates, but she found the terms unattractive. “We looked at taking out a loan, but it wasn’t a good fit for us when interest rates started going up,” said Ortiz, who also didn’t want to put her house up as collateral since she has a family. “As a small business owner, you always have to be scrappy and thinking about how you’re going to make this work without a lot of resources.”

Instead, Ortiz and her co-founder decided to look to other potential revenue streams to boost their finances and reach school districts in more states. They found a way to scale their technology platform to make games for others at a fraction of what it cost to design themselves as a gaming studio. “We’ve been able to evolve to meet the demand that’s out there,” she said. 

Solid growth can blunt the effect of rising rates

WATCH GUARD 24/7 is experiencing solid growth that’s blunting the impact of higher borrowing costs. The New York-based security staffing company, another graduate of the 10,000 Small Businesses program, has grown from about 20 full-time employees to more than 1,000 since its founding in 2009. The company is growing by about $9 million per year but still regularly taps its bank line of credit to cover the gaps between signing a new contract and starting to get paid, during which time it needs to add new personnel to the payroll to handle the new business.

“When you start multiple jobs close together, that’s where your cash flow really starts to get pinched,” said John Rafferty, WATCH GUARD 24/7’s president and CEO. “We don’t worry as much about rates as other expenses that are more challenging for us, such as insurance.”

Rafferty said he’s in the process of borrowing more and is awaiting approval on larger lines of credit to continue to ensure the growth of his company, including through a possible acquisition.

Developing new banking relationships could be a challenge

Setting up new banking relationships could pose a concern to some small businesses, according to Goldman Sachs Research. “One risk is that small businesses prove more sensitive to interest costs because of difficulty developing new banking relationships and difficulty accessing alternative sources of financing,” Abecasis and Hill write. Still, they point out that the share of businesses reporting that credit was harder to get relative to a few months ago stands at about 8% — higher than during the pandemic but in line with the average share in the early 1990s.

In the meantime, strong profits and ample cash on hand are making small businesses more resilient to higher rates.

Goldman Sachs Research estimates of retained earnings (the profits that would be available after distributing an estimated base salary to each owner-operator and an estimated dividend payment to owners) signal the sector is running a financial surplus — estimated at 2.5% of US GDP in the second quarter — reflecting strong profits that have outpaced wage growth.

“This financial surplus argues for resilience in small business capex and employment in the face of higher borrowing costs, because that surplus represents a recurring cash flow that, if desired by business owners, can permanently finance growth in capex and employment,” Abecasis and Hill write.

They further estimate that the small business sector has a financial surplus of 9.1% as a share of revenues, which amounts to a tailwind to growth in capital expenditures (other things being equal). Similarly, small business cash holdings and net worth are both the highest they’ve been in years. That’s giving a lift to their interest income, since deposit rates are climbing, dampening the increase in borrowing costs.

Added up, Abecasis and Hill say small businesses appear to be in good shape to weather the ongoing impact of higher interest costs.

This article is being provided for educational purposes only. The information contained in this article does not constitute a recommendation from any Goldman Sachs entity to the recipient, and Goldman Sachs is not providing any financial, economic, legal, investment, accounting, or tax advice through this article or to its recipient. Neither Goldman Sachs nor any of its affiliates makes any representation or warranty, express or implied, as to the accuracy or completeness of the statements or any information contained in this article and any liability therefore (including in respect of direct, indirect, or consequential loss or damage) is expressly disclaimed.

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