These last few years have challenged business leaders to navigate through a pandemic, supply disruptions, social unrest, and labor shortages. Likely, there were additional difficulties that were unique to your business or industry. My colleagues and I would often joke that we were rapidly filling in our disaster bingo card. Now we add to that list our first major inflationary environment in over 40 years.
This article looks at our current challenge of inflation as it affects companies in the United States. Its purpose is to help you as business owners and leaders recognize the stages of inflation and to consider the ways it might impact your operations. Most of us have been through a recession, yet few currently in leadership were managing an organization through any significant inflationary environment. Inflationary periods also trigger recessions and require the ability to respond to both economic impacts. Financial history books will give ideas of what to expect, but the reality is this time is unique, and it may play out differently.
Businesses can be complex, and my goal is to give you some foundational truths to get you thinking about whether they apply to your business. And if so, how they can apply to your strategy? There is a natural bias towards a quick return to the way things were, and I am challenging you to examine your current course and consider changes. Research has shown that there is seldom a quick or painless recovery once the symptoms of inflation have started.
Areas to consider for your operations
Revenues may drop – Identify and protect essential products and services.
Depending on your industry, revenues will likely drop during a recession. This is something that most of us have experience with. Identify recession proof products and services. What part of your business provides these? Prepare to bolster that. For instance, if you sell products, you may find that the more economical lines will continue to sell and repair services will sustain you through lean times. Again, identify what you provide that is essential regardless of economic times and prepare to protect it. Who are your customers? Is there a segment that you have not pursued in the past due to entry requirements or lower margins?
Costs can continue to increase. As mentioned above, unlike in a normal recession, wage pressures will continue. Supply costs will increase and continue to see disruptions. Your knowledge of the cost to bring a product or service to market is critical. That part is not new, but what is key is the change in how you measure costs. There needs to be a shift to understanding not only the cost of the item sold, but on the cost to replenish the product or service you just sold. Give this aspect consideration as this is a foundational shift.
1. Property and equipment
Look at your financing needs over the next five to ten years. If you need property or equipment you may want to negotiate acquisition now. Purchase if you can; lease if you must. If you lease, insist on favorable terms, including a buyout clause. Without a buyout clause in the lease, the inflation impact will be a hard hit at the end. And about leases, in an inflationary environment, the asset can quickly value higher than the lease liability. Remember to protect those leases as they are locked in at increasingly favorable rates. Stay compliant and watch for renewal and election timelines.
2. Cash Is King
We have all heard this so many times that it starts to lose meaning. Even so, having an adequate supply of currency is always true, but especially during trying economic times. The above discussion of understanding the cost to bring your product to market illustrates the need to watch your cash. Also consider that the line of credit, equipment loan or extension of credit from a supplier may be reduced, cost more or even evaporate. The difference in an inflationary environment is that cash is still critical, but now is more similar to a depreciable asset that has a cost of doing business.
The best tool to watch your cash is a cashflow forecast. Develop one that incorporates not only the income statement, but also the balance sheet, cashflow statement and key performance metrics. Build it to allow easy updates and centralize your formula references to model several scenarios.
Early on, my exposure to investments provided me key takeaways and the biggest one was the staying power of quality companies, no matter the challenges of the economic climate. As we will see in the charts later in this article, there are many businesses that will thrive in an inflationary environment. I say that with the caveat that black swans and governments can greatly change the course of an industry.
4. Debt and Notes Payable
If you have variable rate debt, consider refinancing to a fixed rate. Current rates are still historically low and especially as we look forward. If you need financing to purchase a revenue producing asset, now is the time to get that in place. The reason to emphasize revenue producing assets is to ensure its coverage of debt service. This is not the time to invest in non-revenue producing assets. Understand sunk costs and the importance of saying no and reversing course.
5. Accounts Receivable
Slower payment is common behavior in any economic condition. Watch carefully for slow paying accounts or any change in the business of your customers. Look at your agreements and insure they include best practices.
Inflationary Exercise for your Financials
Try taking your organization’s balance sheet and place the balances into the categories on the left column. Note that impact of inflation on each balance sheet class.
Consider putting the balances in a spreadsheet and model increasing rates, such as a 10% or 15% inflation rate and higher interest rates as well. You may feel, that’s too high, but in some cases, we are already there or beyond with price increases. You can always adjust based on what you see as the reality and customize by item inflation rates (e.g., equipment, food, energy, etc.). Try modeling a few heated years and then reduce in the last couple years. Initially, keep it simple before adding complexity.
To illustrate, using an annual inflation rate of 15%, cash of $100k after a year decreases to a purchasing power of $85k and at year two, will decline to $72k. This goes to my comment where I said holding cash now has a cost of doing business. For another example, let’s say you have a revenue producing asset that you financed. Normal revenues, useful life, depreciation, loan payments and interest costs still apply. The difference that occurs in an inflationary environment is that the revenues from the asset increase, the net remaining value of the asset increases and the effective loan liability decreases. Generally, physical asset values increase and provide for revenues that increase and effective debt values decrease. This dynamic doesn’t play out in a service industry that relies on current dollars to pay current labor. A service industry requires extra diligence on costs and revenues. Run a couple years of this exercise for your own situation; it can help you to spot risks and opportunities.
Modelling your debt in the above exercise will show you the power of leverage and why this term had much more meaning in the 70’s and 80’s. If you are in a business that has long-lived, revenue producing assets, essential services, and fixed debt, keeping everything else balanced, you are set to do well in this period. If this is not your situation, use this example and cashflow modeling to see what adjustments will be needed. Either way, this is survivable with the right financial tools and decisions.
Phases of inflation
Your management and risk strategy should change at different phases of inflation. Recognizing these phases and being flexible during them can mean surviving and even thriving through these periods. I’ll identify and discuss these phases with a focus on our current phase and what got us here.
Inflation can take a while to heat up and, likewise, takes time to cool down. The phases of inflation center on whether it is heating up or cooling down. For reference, I’ll call the phases of inflation as Stable, Pre-Inflationary, Inflationary, Leveling and Recovery.
1. Stable Phase
The Stable phase has been, for the most part, been consistent since the mid 1980’s. This is marked with relatively normal access to credit, low interest rates, and low inflation. As far as inflation is concerned, it has been substantially “business as usual” for decades.
2. Pre-inflation Phase
We have been in the Pre-Inflation stage for several years. This stage is when influences that cause inflation are in place but have not yet triggered high inflation. Deficit spending, excess printing of money, over easing of the money supply are all inputs to inflation. Other influences, both counter and supporting can delay, contribute, or accelerate the timeline. These other influences create confusion and disagreement on the causes of inflation. The reality is that this is a supply and demand issue pertaining to our currency. If either or both sides of that balanced equation are disrupted, economic fallout will result. The stronger the disruption the more severe the inflationary environment will be. Later on, here, I will show historical inputs to that equation to help understand how we arrived at the next phase.
3. Inflationary Phase – What to Expect
In this current phase of inflation, what corrections should we expect from our government and the federal reserve? And as I mentioned previously, although it will be painful, it would be exponentially worse if these steps are not done.
The Federal Reserve will significantly restrict the money supply available to banks to lend. They have already stated that this is planned over the next two years. They will also increase the interest rates, a change which they have begun in the first part of 2022. Both moves will translate into the banks raising rates and having fewer funds to lend. Borrowing could be difficult and more expensive, and perhaps only the strongest companies get financing. It’s not ideal to have variable interest rates or balloons coming due during this phase. Recognize that derivatives depend on the solvency of the financial institution that backs them.
A recession will be triggered from the retraction that needs to occur. Normal recession impacts are less consumer spending, increased bankruptcies, job losses, reduced wages, a decline in GDP, etc. An inflationary recession is stagflation. This means that inflation occurs while the economy is “stagnant” or with reduced production. Because of that, expect wages and supply costs increases to continue. On the labor side, the impact is proportionate to the labor’s power to demand more wages. Their earnings are being eroded, and they will negotiate hard to minimize that. A focus on actions that will increase GDP without additional deficit spending is the only way out.
The federal government will need to substantially curtail spending. It doesn’t matter who is in office; this will not be popular. But if it fails to do this, deficit spending will continue to drive inflation. This can be painful as more spending is expected during a recession. The recession is secondary and less damaging than inflation. There is a reason inflationary periods don’t normally hit a country twice per generation.
4. Leveling Phase
This next phase is marked by inflation rates that have stopped increasing but are at their peak. Interest rates are high, borrowing is still restricted and there is very low confidence in the economy. With correct government responses, you will see the inflation trend slow and then level. We currently do not have what is needed for this to happen in place. Hopefully, we will get there soon and, when we do, you will need to change your strategy again. Confidence will be at its lowest point here, but there will be many opportunities. Speculative investing is very dangerous, but can be lucrative in this phase, although it requires nerves of steel and large reserves.
This phase is marked with falling interest and inflation rates. The trends change course and currency values stabilize. The economy is recovering. The stock market starts healthy growth again. Confidence on all sides will be shaky for a while. The strategy that worked in an inflationary phase will again need to be adjusted. It’s important to recognize that your operational strategies will need to change at each phase.
My hope is that this article provided some clarity and got you thinking. It is likely that much of it was familiar information. The goal was to pull together the sound bites you hear in the news and place some context to them. Many are quick to blame this group, that event or a particular industry. Use that as a sign that they are not fully understanding all the dynamics at work or perhaps over complicating the issues. This is easy to do as the economy is an extremely complicated subject. Even the experts can get it wrong. A short-sighted viewpoint will be the first to demand recession-type fixes such as, continued government spending, bailouts, and overregulation; exactly the opposite of what is needed in an inflationary environment.
With all economic volatility, keep an eye on the horizon and be ready to adjust plans. When running a business, risk analysis and mitigation strategies are ongoing responsibilities. Accelerate your work to prepare, forecast and plan. That risk mitigation must be spread across several factors. Don’t plan for absolutes or home runs; spread your risk. We cannot predict everything but looking for and recognizing shifts will give you an advantage over complacency and the related bias towards normalcy.
For your benefit, I’ve provided some historical analysis and background here covering some key terms and a historical look at some of the signs and inputs to inflation including money supply, US debt, interest rates, and other inflationary pressures.
Helen Dow joined Warren Whitney as Director of Warren Whitney. She has more than 30 years of experience helping companies improve their financial performance and enhance all finance and accounting functions. Helen generally serves Warren Whitney’s clients in the role of Fractional CFO/Controller. To learn how Helen or our other consultants can support your business, contact Stephanie Ford at firstname.lastname@example.org or 804.282.9566.
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