The CPI and PPI for March 2022 have been released and both show continued increases in inflationary pressures. Businesses and lenders are challenged to deal with 2022 actual performance and 2022 forecasts in this complicated environment. This article will discuss approaches to identify performance risk, and related impacts on loan covenant compliance.
What did the March CPI and PPI tell us?
The March CPI is 8.5%, up from 7.9% in February. The categories with the highest increases are energy at 32.0%, gasoline at 48.0%, new vehicles at 12.0%, and food at 8.8%. These are basic food, shelter, and getting to work expenses for employees, and result in financial pressures that may drive employees to move to new employers to increase income. This inflationary pressure and the resulting labor issues should be expected to continue throughout 2022.
The March PPI is at 11.2%, up from 10.0% in February. The highest increases were in foods at 16.2%, energy at 36.7%, and transportation/warehousing at 21.0%. These are basic components of the expense structure of businesses. Not all price increases have been passed from vendor to customer; therefore, increased upward costs will be occurring throughout 2022.
Why will inflationary pressures continue?
It is important to consider that the CPI and PPI are reporting inflationary levels not seen in 40 years. Most business owners and managers have not experienced this level of inflationary performance disruption. Only one third of the US population is over 50 and lived through the prior disruption in the 1970’s and 1980’s. Businesses have attempted to respond to increased costs but have not yet passed along all the price increases to their customers, whether the customers are the end consumers or other businesses. Until costs stop increasing, businesses need to anticipate continued waves of inflation as prices rise throughout the chain from producer/manufacturer/processor/distributor/consumer.
Inflation will also be impacted by the expected increase in interest rates and by quantitative tightening, which will further pressure interest rates. Economists, bankers, and business leaders are expecting the Federal Reserve to increase interest rates throughout 2022. When the Federal Reserve increased the federal funds rate by .25% on March 17, 2022, the Chairman of the Federal Reserve, Jerome Powell, suggested more rate increases would be needed to combat inflation. At that time Powell expected inflation to drop below 3% by the end of 2022 and anticipated six additional federal funds rate increases during 2022. It appears clear inflation will not be down to 3% by the end of 2022; therefore, additional rate increases may occur. However, if you assume interest rates will increase by a total of 1.75% during 2022, that will increase the interest costs for businesses tied to variable rate lending or placing new term debt. Those increased interest costs will further feed expense growth for businesses and will hit businesses who rely on variable rate debt, such as asset-based lines of credit, more severely.
How do you assess performance risk?
When evaluating 2022 performance risk, consider these waves of expense structure impacts.
1) First Wave.
a) Labor cost increases.
b) Transportation cost increases.
c) Commodity price increases.
Consider if the business has been able to pass those costs already experienced along to its customers or if the business needs to further evaluate contracts and bid procedures to increases sales prices or to lock in costs.
2) Second Wave.
a) Escalator clauses, and impact dates.
b) Supplier increases to costs.
Consider lease and rent escalator clauses tied to CPI levels. Evaluate whether those increases have been considered at the current CPI levels, and the timing of those impacts. Consider any other escalator clauses for revenues or expenses.
Evaluate the level of initial supplier cost increases the business has experienced, and how many line items on the income statement have the potential for near term cost increases.
3) Third Wave.
a) Interest rate increases.
b) Further supplier increases based on PPI and CPI readings.
Evaluate the impact of interest rate increases between .25% and 1.75% on the financial performance of the company.
Specifically evaluate income statement line items that include energy costs, transportation and warehousing costs, and food costs. Apply the PPI March inflation factors to those line items to determine potential cost increases.
4) Fourth Wave.
a) Increased labor costs.
b) Further supplier increases, including costs associated with reduced supplier networks created by financial performance problems at the supplier level.
Evaluate the impact of 10% to 25% increases in labor costs. Consider the impact of labor or skill shortages on output, resulting in sales impacts.
Continue to evaluate the level of increase in each line item of the income statement. Where the expense item has not increased at the level of inflation for that category or for inflation overall, then consider the performance impact on the company when those inflationary impacts do occur.
5) Fifth Wave.
a) Commodity price changes.
When considering the financial impact of this wave of inflation, consider current commodity price changes, but also anticipate 2023 impacts. For example, 2023 fertilizer costs should certainly be expected to increase given the amount of imported fertilizer the US uses. Food costs should be expected to increase based on the Russia / Ukraine conflict’s impact on acres planted during 2022.
6) Continuing Waves
As shocks occur after each one of the waves of inflation identified above, there will be trickle down impacts throughout the expense structure of businesses. Each of those shocks and trickle-down impacts will create an additional wave of inflation.
2022 Forecast Evaluation
When evaluating performance to plan, develop a performance risk analysis table. Use each key line item in the expense structure of the business, such as labor, energy, transportation, leases/rents, commodity purchases, and interest expense, and identify the high and the low potential impact. Also consider price increases for all other expenses at the current PPI level. By preparing this type of analysis, it will be easier to identify areas of performance risk and it will be easier to put energy into areas that will have the highest probability of positive impacts on financial performance.
Then evaluate the cushion a business has in terms of meeting its loan covenants. For example, a company with a 2022 forecast resulting in a 2.5x fixed charge coverage ratio certainly has more room to absorb performance risk than a company with a 1.2x fixed charge coverage ratio forecast.
Overall, this can sound depressing or daunting, and to some extent it is. But this is when winner and losers will be determined. Businesses that dive into the analysis and work to evaluate ways to minimize financial impacts will be the ones that succeed. Businesses that hope this economic environment goes away, or ignore the impacts, will be the ones that lose.