The news is filled with articles on inflation – either warning us inflation is imminent or telling us not to worry. While politics and the news from day to day address the topic of inflation with a degree of hysteria, companies and their lenders need to be aware of the possibility of inflation and work to understand the impacts and minimize the risk to financial performance. A business cannot operate in a constant state of fear about outside influences. But a business can develop strategies for monitoring impacts and for dealing with uncertainty.
What is inflation?
The simplest definition of inflation is the decrease in purchasing power of a currency over time. This decline in purchasing power is measured by an increase in average price levels for goods or services over a period of time. The US Bureau of Labor Statistics (“BLS”) tracks both a Consumer Price Index (“CPI”) and a Producer Price Index (“PPI”), and reports on these at least monthly.
As the economy recovers from the impact of Covid-19, concern has turned to inflationary pressures resulting from increased economic activity, stimulus programs, and new government spending proposals.
The BLS formally reports statistics monthly, and the April 13, 2021 reporting for the CPI showed the following increase in inflation during the first quarter of 2021, with the impact of food and energy changes leading the increase.
The PPI 12-month percentage change from 2011 to 2021 is reported in the BLS graph which follows.
If there is 5% annual inflation, $100 of cash reduces to $95 of purchasing power. That is a simple explanation, based on Albert Einstein’s premise that a person doesn’t understand a concept if they aren’t able to explain it to a six year old. These statistics are complicated in their development, and can become overwhelming for an individual business to interpret and deal with. It is clear, however, that coming out of 2020 the economy is at risk for inflation and businesses need to include inflationary impacts in their planning for the future.
What can a company do?
The first area to consider is costs, both cost of goods sold and operating expenses. The largest components of expenses for businesses are typically labor costs and product input costs.
Labor costs have been experiencing upward pressure as a result of the call for a $15 minimum wage, increased competition for available employees, and the increased unemployment benefits paid by the Federal government under the various stimulus programs. This has caused many employers to consider signing bonuses, stay bonuses, higher hourly pay rates, and increased benefit costs. With upward pressure on food and energy, employees will continue to be looking for increased pay levels. If a company reporting $50 million in revenues had a 5% or 10% increase in its labor costs, a 7% EBITDA performance level could decrease to 5.75% or 4.50% respectively. The company’s fixed charge coverage ratio would be impacted by a $625,000 or $1,250,000 reduction in cash available to service debt.
Input costs are increasing as a result of energy price increases and commodity price increases. Depending on the industry these impacts can be severe. In the next table we consider a company currently reporting input costs at 15% of revenues. In addition to evaluating the impact of a 5% increase and a 10% increase, the table also shows the impact of a 25% increase in input costs. Corn prices have risen to over $7.00 per bushel from a recent historic level of $4.00 per bushel. That type of an increase in one component of inputs at a food processor could be material. In this example the 25% increase in input costs reduces EBITDA by almost $2 million.
The combination of rising labor costs and rising input costs is serious. The next table shows a company experiencing the increased labor costs and the increased input costs.
Without customer price increases, the 10% increase in labor costs and the 25% increase in input costs reduces EBITDA from $3.5 million to a negative $0.7 million.
Companies need to employ best practices in terms of managing their client relationships. Companies need to understand:
Profitability by customer.
Profitability by product.
Profitability by location or division.
Without an understanding of profitability in this level of detail, a company is not able to make the changes necessary to continue to report profitable operations and service debt.
Contracts with vendors will need to be evaluated for the potential to lock in input costs for a period of time, and for the potential for vendors to increase prices.
Contracts with customers will need to be evaluate for the potential to increase sales prices as a commodity price increases, or if inflation exceeds a certain percentage.
A successful company will be one that is clearly able to analyze profitability by customer, product and division, and make appropriate operating cost changes as needed, with the ability to pass along cost increases where contracts allow.
The second area to address is working capital management. This involves accounts receivable (“AR”), inventory, accounts payable (“AP”) and the line of credit.
Inflationary pressures will result in companies experiencing pressure for extended payments from customers who are experiencing the same impacts of inflation, and pressure for faster payments to suppliers from vendors who are also having price increases. Just as Covid-19 impacts forced successful businesses to intensely manage their working capital in both directions, inflation causes the same issues.
Inventory levels may need to be increased to protect against unusual price swings or to allow better matching of costs to produce to revenues.
The impacts on AR, inventory and AP put significant pressure on the line of credit. In some cases, while the working capital management is successful, the overall size of the line of credit may be limited by a borrowing cap which is below the collateral at the new price levels.
To address this, a company needs to be monitoring and reporting on price and volume variances. When inflationary pressures are weak, this type of analysis and reporting may not be as critical as it will be going forward. Companies need to be able to identify what amount of the change in revenues or the changes in costs are attributed to volume changes versus attributed to price increases. Without this level of analysis and understanding, a company will be unable to clearly articulate line of credit needs and the explanation for the changes required to continue to operate.
What can a lender do now?
These are already challenging times for borrower lender relationships. Inflationary pressures will increase the level of risk.
As financial information is received lenders could steer their discussions with borrowers into areas that would address the impact of potential inflationary pressures.
✔️Ask for profitability by customer, by product and by division. Instill that level of analysis now.
✔️Ask for a summary of key vendor and customer contracts. Look for abilities to increase prices, and any lag between input increases and the ability to increase prices. Look for the ability to lock in input costs for a period of time. Discuss the approach the company is using with its vendors and its customers.
✔️Ask for price volume variance analysis on a monthly basis – possibly for key customers, or key products.
✔️Discuss labor rates, ability to find adequate staff, the need to provide additional benefits, overtime, and other labor related topics.
A lender can help a borrower develop strategies today that will improve performance in the future.
We are able to show companies the best practices to use in the areas of costing, pricing, and working capital management. Call us today.