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Before Anyone Asks

The second effect

· 4 min read

When a market price moves, it reaches a company twice.

The first time is direct. Rates go up, and the company earns more on its cash and pays more on its debt. A currency moves, and what the company owns abroad is worth more or less. This effect is quick to calculate, and it is the one that tends to get measured.

The second time is through the business. Rates go up, and customers borrow less, buy less, or leave. That arrives later, in a different part of the results, and usually under a different name. It rarely gets added to the first.

Fig 1 · Two paths

A market price reaches a company twice.

A market price reaches a company twiceA price moves: an interest rate, a currency. First, through what the company holds and owes: its cash and its debt, and what it owns abroad; interest earned and paid, value converted back home; quick to calculate, the one that tends to get measured. Second, through its customers: what they pay to borrow, what they can afford; they buy less, or leave, later and somewhere else in the results; under another name, as churn, lower sales, slower growth. A price moves An interest rate, a currency First · What the company holds and owes Its cash and its debt and what it owns abroad Interest earned and paid value converted back home Quick to calculate the one that tends to get measured Second · Through its customers Its customers what they pay to borrow, what they can afford They buy less, or leave later, and somewhere else in the results Under another name churn, lower sales, slower growth A market price reaches a company twiceA price moves: an interest rate, a currency. First, through what the company holds and owes: its cash and its debt, and what it owns abroad; interest earned and paid, value converted back home; quick to calculate, the one that tends to get measured. Second, through its customers: what they pay to borrow, what they can afford; they buy less, or leave, later and somewhere else in the results; under another name, as churn, lower sales, slower growth. A price moves An interest rate, a currency First · What the company holds and owes Its cash and its debt and what it owns abroad Interest earned and paid value converted back home Quick to calculate the one that tends to get measured Second · Through its customers Its customers what they pay to borrow, what they can afford They buy less, or leave later, and somewhere else in the results Under another name churn, lower sales, slower growth

The second arrives later, in a different part of the results, and rarely gets added to the first.

Before Anyone Asks

Here is a real example. I am not going to name the company, but everything below comes from its annual reports and its earnings calls.

One rate rise, two effects

The company sells software to banks and lenders. When interest rates rose in 2022 and 2023, it felt it in two places, in the same financial year.

The first effect: its own cash. Higher rates meant more interest on the money it kept in the bank. Its interest income rose by about $2.2 million that year. The company put that down partly to higher rates and partly to having more cash in accounts that earn interest. In the part of its annual report that deals with interest-rate risk, it talks about this cash, and concludes that a change in rates would not have had a material effect on its results.

The second effect: its customers. Some of its customers are independent mortgage lenders. By the autumn of 2023, mortgage rates had reached their highest level in more than 20 years. Fewer people were taking out mortgages, some of those lenders were struggling, and some cancelled the company’s software. In one quarter, management said, those cancellations came to about $5 million a year of subscription revenue. By the end of the year, it put the total lost to the mortgage downturn at about $13 million.

So the same rise in rates added a little income in one place and took away revenue in another. The two figures are not the same kind of number. One is extra interest earned in a year. The other is yearly revenue that stopped coming in. But they point in opposite directions, and the second is several times the size of the first.

Read the first effect on its own and rates look like a small tailwind. Read both and they were a headwind.

Fig 2 · The example

One rate rise, two effects.

One rate rise, two effectsRates rose in 2022 and 2023; both effects fall in the same financial year. The first effect, its cash: more interest on the cash it keeps in the bank, partly from higher rates and partly from more cash earning interest; interest income added about 2.2 million US dollars. The second effect, its customers: some independent mortgage lenders cancel the software; yearly subscription revenue lost to the mortgage downturn, about 13 million US dollars, shown as a loss. Source: the company's annual reports and earnings calls. Rates rose in 2022 and 2023 · Same financial year Took away Added The first effect · Its cash More interest on the cash it keeps in the bank Interest income rose: partly higher rates, partly more cash earning interest aboutUS$2.2M The second effect · Its customers Some independent mortgage lenders cancel the software Yearly subscription revenue lost to the mortgage downturn about(US$13M) One rate rise, two effectsRates rose in 2022 and 2023; both effects fall in the same financial year. The first effect, its cash: more interest on the cash it keeps in the bank, partly from higher rates and partly from more cash earning interest; interest income added about 2.2 million US dollars. The second effect, its customers: some independent mortgage lenders cancel the software; yearly subscription revenue lost to the mortgage downturn, about 13 million US dollars, shown as a loss. Source: the company's annual reports and earnings calls. Rates rose in 2022 and 2023 Same financial year First effect · Its cash More interest on the cash it keeps in the bank Interest income rose: partly higher rates, partly more cash earning interest aboutUS$2.2M Second effect · Its customers Some independent mortgage lenders cancel the software Yearly subscription revenue lost to the mortgage downturn about(US$13M)

The same rise in rates added a little income in one place and took away revenue in another.

Source: the company’s annual reports and earnings calls.

Before Anyone Asks

Why the second effect is easy to miss

Nobody hid any of this. Management talked about the lost customers openly. The annual report says that higher mortgage rates hurt part of the business, and names those customers as one reason its growth from existing clients slowed.

The difficulty is that the second effect does not arrive labelled as a rate effect. A customer who cancels does not say “interest rates”. The loss shows up as churn, in a conversation about sales and retention. The first effect shows up as interest income, in a conversation about cash. They are the same move in the same price, discussed in two different rooms.

That is not anyone’s mistake. It is how the numbers are organised. Each one is reported where it lands, not where it came from.

Fig 3 · Two rooms

One rate rise, two conversations.

One rate rise, two conversationsOne move in one price: rates rise. The first effect shows up as interest income, talked about in a conversation about cash, and is quick to calculate. The second effect shows up as churn, talked about in a conversation about sales and retention, and arrives later, under a different name. A customer who cancels does not say interest rates. One move in one price Rates rise The first effect Shows up as Interest income Talked about in a conversation about cash Quick to calculate. The second effect Shows up as Churn Talked about in a conversation about sales and retention Arrives later, under a different name. A customer who cancels does not say “interest rates”. One rate rise, two conversationsOne move in one price: rates rise. The first effect shows up as interest income, talked about in a conversation about cash, and is quick to calculate. The second effect shows up as churn, talked about in a conversation about sales and retention, and arrives later, under a different name. A customer who cancels does not say interest rates. One move in one price Rates rise The first effect Shows up as Interest income Talked about in a conversation about cash Quick to calculate. The second effect Shows up as Churn Talked about in a conversation about sales and retention Arrives later, under a different name. A customer who cancels does not say “interest rates”.

They are the same move in the same price, discussed in two different rooms.

Before Anyone Asks

What you learn by putting them together

Measuring the second effect is not about getting a more complete disclosure. It is about understanding the business.

The interest on a company’s cash tells you very little about how the business works. The customers who leave when rates rise tell you a lot. They show how much of the revenue depends on what customers pay to borrow, which customers those are, and how quickly that revenue moves when rates do. That is a measure of how sensitive the business is to rates, and so how sensitive its margins are. The first effect on its own cannot give you that number.

It also changes the question. “What do higher rates do to our cash?” has a quick answer. “What do higher rates do to our business?” is the one that matters, and it can have the opposite answer.

Fig 4 · The question changes

One question has a quick answer. The other matters.

Two questions about the same rate riseLeft: what do higher rates do to our cash? The interest on its cash tells you very little about how the business works. A quick answer, right as far as it goes. Right: what do higher rates do to our business? The customers who leave when rates rise show how much of the revenue depends on what customers pay to borrow, which customers those are, and how quickly that revenue moves when rates do: how sensitive the business is to rates, and so how sensitive its margins are. A quick answer “What do higher rates do to our cash?” The interest on its cash tells you very little about how the business works Right as far as it goes. The one that matters “What do higher rates do to our business?” The customers who leave when rates rise show how much of the revenue depends on what customers pay to borrow which customers those are how quickly that revenue moves when rates do How sensitive the business is to rates, and so how sensitive its margins are. Two questions about the same rate riseFirst: what do higher rates do to our cash? The interest on its cash tells you very little about how the business works. A quick answer, right as far as it goes. Second: what do higher rates do to our business? The customers who leave when rates rise show how much of the revenue depends on what customers pay to borrow, which customers those are, and how quickly that revenue moves when rates do: how sensitive the business is to rates, and so how sensitive its margins are. A quick answer “What do higher rates do to our cash?” The interest on its cash tells you very little about how the business works Right as far as it goes. The one that matters “What do higher rates do to our business?” The customers who leave when rates rise show how much of the revenue depends on what customers pay to borrow which customers those are how quickly that revenue moves when rates do How sensitive the business is to rates, and so how sensitive its margins are.

“What do higher rates do to our business?” is the one that matters, and it can have the opposite answer.

Before Anyone Asks

The same is true of other prices. A currency move changes what the company’s foreign earnings are worth when they are converted. It can also change what a foreign customer can afford to buy, or what a competitor abroad can charge. The first is easy to calculate. The second is often the bigger story.

This is what I mean when I say market risk is some of the best information a CFO has about the health of the business. Not the direct effect, which is mostly arithmetic, but the second one, which shows where the business is exposed, and where it could grow.

Before anyone asks

When rates move, someone will ask what it means for the business. The first answer is the easy one, and it is usually right as far as it goes. The useful answer includes the second effect: the one that arrives later, somewhere else, under another name.

Key terms

Economic exposureBalance sheet exposureRate effect

Keep reading

More from Before Anyone AsksIs that all of it?Your exposure report is right, but is it complete? The four places a currency balance can sit, and how to close the gap.Read

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