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Spud’s model of how interest rate rises cause inflation

That’s his starting point, which then changes to this:

The big increase is, however, in interest costs. The company pays interest at 3% over bank base rate. So, the rate has grown from near enough 3% to 8%, or a growth of about 160%.

So, he’s assuming at that start a base rate of zero, so a 3% interest bill.

OK. So, how much debt does the company have? Well, to be paying 5 when the interest rate is 3 then they must have outstanding debt of 170 (-ish).

Now it’s true that I’m not an accountant, nor am I a banker or financier. But a services comany – which Spud says this is – with a debt burden of 170% of sales? 170% of sales, note.

I don’t know, really, I don’t. But would that be considered – by an accountant – to be a reasonable modelling assumption?

18 thoughts on “Spud’s model of how interest rate rises cause inflation”

  1. Lots of “IF”, mostly around the nature of the service being provided and the nature of what the debt bought. A big warehouse for your storage service? Some swanky limos for your hen-night hire company?

    Another consideration for that would be the life of the asset v the life of the debt.

  2. That depends upon the projected return on capital, of course. With a ROCE above 40%, one can get away with appalling levels of debt.
    For normal companies, however, debt/EBITDA of more than 5x is viewed as high-risk, so it should be paying a higher interest rate than 3% over LIBOR

  3. The Meissen Bison

    I agree with John77. A profitable service start-up that is growing rapidly could justify this type of gearing in the short term because retained earnings would improve the position relatively quickly. However, that’s not the case here so the business is simply badly under capitalised.

  4. Dennis, CPA to the Gods

    But would that be considered – by an accountant – to be a reasonable modelling assumption?

    We aren’t talking about an accountant here; we are talking about Richard Murphy.

    There’s a difference, and the difference is important.

  5. Interesting point Tim and we should all wait, breath bated, to see if the BoE takes up the Prof’s offer:

    “The Bank of England is welcome to use this model and think about the consequences which they have created.”

  6. Dennis makes the point worth emphasis!

    He is not an accountant (at least not by the standards of any Finance department I have ever worked with) He doesn’t understand either GAAP or IFRS at any level. He seems very unsure of depreciation as a concept let alone terms like interest rates or return on investment.

    The often rumoured story that he used his brother as a ringer to obtain his qualifications continues to present itself as the most likely tale.

  7. Ah but V_P, the important thing is none of the people he’s writing for understand those things either. The only question I have is; would that include the BoE?

  8. As you say Tim, it would need a particular type of service to justify that kind of balance sheet, unless it owns its own office premises rather than rents (or something like that). Normally trade debtors less creditors, minimal fixed assets, next to no stock, etc.

    In addition to Geoffers’ thoughts, (human) WIP is a possibility in a number of areas, but rarely needing that much funding.

    Any clues at all as to what the nature of the service is?

  9. The Meissen Bison

    My guess is that what we’re looking at is the forecast for the soon-to-be opened Choo-Choo Wonderland in Ely. Masterminded by a triple professor with an OO-gauge brain, the wage bill is understandably high and maintaining the fatness in the controller is a significant cost. Punters looking for some after hours coach-on-coach action with Clarrie and Annabel will be able to find what they need on Only Fens.

  10. @ Dennis, CPA to the gods
    Murphy claims to be an accountant but his career mostly comprised supplying tax-avoidance advice to actors, so the borderline between reality and fantasy may occasionally have become blurred.

  11. He missed off companies tax on wages (Eers NI) which has gone up, and tax on profits, which has gone up. And energy costs, which have gone up.
    What is it about government policy making it more expensive to employ people, pay a return on investment capital, and light and heat the damn building that’s making things more expensive?

  12. If interest rates are high, then paying off the interest is effectively profit.

    When I was young and interest rates were actually high, some farmers in NZ were making out like bandits with a profit of zero. Because when they sold the farm the capital gain was enormous.

  13. It’s an illustration, an example even
    It ain’t a model
    Spud going in for another kind of inflation

  14. I was about to throw some real figures together but noticed…. hold on. Interest payments. Hmmm. Where’s the capital payment? That “company” is permanently indebted, and by Lord Spudcup’s rules, is bankrupt.

    Ok, some real numbers.
    I bought my shop with a mortgage of 130 zarbles. The income before outgoings was 20 zarbles. My debt burden was 750% of sales. I don’t know how much interest I was paying, but I was paying interest plus capital as any sane person would of about 7 zarbles. By Tim’s rules I seem to have been bankrupt for 25 years. I’m probably as much an accountant as Tim, and it’s more likely I’ve misunderstood our host’s explanation.

  15. Bloke in the Fourth Reich

    If you have borrowed so much that interest rate rises that have been overdue for, ooh, 15 years, sink you, then you are the problem.

  16. Have seen Murphy on Al Beeb this week. Not sure whether he was talking bollocks but he did like the sound of his own voice, talking over the presenter a lot of the time. They like him for some reason (dumb and dumber?).

    Also, I have wondered why they and other channels allow convicted perjurer Vicky Pryce to infest our screens so often…….

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