With inflation at its highest level in 40 years, it is important to reevaluate the financial analysis tools being used when reviewing past performance and considering opportunities for future performance and performance risk. Businesses need these tools to adjust in real time to maintain performance levels. Lenders need these tools to evaluate the performance risk specially related to cash flow adequacy and covenant compliance for borrowers.
What can we learn from the indices?
The CPI in May 2022 was 8.6%. The categories with the highest increases year over year in May were energy at 34.6%, gasoline at 48.7%, and food at 10.1%. These categories with the largest increases are the ones that impact employees by contributing to increases in basic food, shelter, and costs to drive to work to earn a living.
The May PPI was at 10.8%. The highest increases were in foods at 13.0%, energy at 45.3%, and transportation/warehousing at 23.9%. The PPI has been at or above 10.0% since December 2021. The components that experienced the highest increases impact every business – energy, transportation and warehousing are a part of every business. The food increases impact the food and agribusiness sectors more directly than other sectors. Increases in other categories may more directly impact specific industries and should also be evaluated.
In addition to the CPI and PPI, looking at commodity price changes shows agribusiness inputs and outputs are not moving together. Businesses using a rising price commodity, such as corn or sunflower seeds, have not seen a similar change in the sale prices of their products.
This means that businesses have already reported increased costs in many categories on their income statements. Be aware that there are more increases to come.
Year over year comparisons
The first step in preparing a performance risk analysis is a year over year comparison of the income statement and balance sheet. A year over year comparison for 2019 through 2021, and year to date 2022 is a key base for analysis of future performance. In preparing this year over year analysis it will be important to consider the following when identifying run rates:
CARES Act program funding.
Specifically understand the financial reporting used for PPP loans and loan forgiveness, ERCs, Provider Relief Funds, and all the other government stimulus programs.
CARES Act funding typically impacts 2020 and 2021 but may also impact 2022.
Build Back Better program funding.
This typically impacts 2021 and 2022.
Working capital needs.
Increased levels of inventory – quantity.
Increased cost of inventory – price.
Increased levels of accounts receivable resulting from price changes, and customer demands.
Accounts payable stresses resulting from higher levels of inventory and higher cost of inventory.
Consider the business’ use of offshore sourcing and changing funding needs for in transit inventory and base inventory levels.
Labor costs.
Evaluate regular, overtime, commission and bonuses paid in each year.
Evaluate changes in head count versus changes in hourly rate.
Consider each line item on the income statement and determine if:
Cost increases have already occurred.
Cost increases are scheduled to take place at contract renewals.
Cost increases have been requested by suppliers.
Cost increases have not yet occurred.
With this information, it is possible to anticipate where there will be additional increases in expense line items.
Consider each component of working capital and determine:
Price volume variance changes.
Is the cash on hand sufficient to fund the company’s portion of working capital needs in an ABL structure?
With this information, anticipating additional performance changes will be expanded to include the changing pricing of inputs and management of inventory levels. This will improve forecasting working capital needs and opportunities for enhanced management.
Evaluating performance risk in the 2022 and 2023 projections
The tools that are needed to evaluate performance risk in the 2022 and 2023 projections are a combination of financial analysis tools that many businesses and people have not used in 40 years coupled with new creativity to deal with the reality of today’s situation.
The need to clearly evaluate the performance impact of the CARES Act funding is necessary to develop a run rate for future performance. Many of the businesses that are in trouble today are businesses that survived 2020 and 2021 as a result of the PPP loan programs, the ERCs, and a variety of other government programs for small, middle, and large size businesses. The performance base level used for performance risk analysis must be a clear picture of financial performance, excluding the windfall cash impacts from the CARES Act program and the Build Back Better program.
A line item by line item review of the income statement and development of a high and low cost increase range will be critical for performance risk analysis. Here are several approaches that will be needed as performance risk is considered.
For expense components that have identifiable PPI areas, such as transportation and warehousing, energy, or gas, use the approach of comparing already experienced cost increases to the PPI averages. If transportation costs have increased 15% but the PPI average is 23.9%, anticipating additional increases will be key to performance risk analysis.
For commodity price impacts on both sales prices and costs, consider the current commodity prices, futures prices, and the contracts the company has that fix pricing.
Direct inputs: If a company is utilizing corn as an input and has not yet contracted both price and volume for its usage during the forecast period, anticipating supply issues and costs increases will be important. Developing a forecast that shows the impact of a $1.00 per unit change in pricing is key to evaluating risk. Considering a high and low commodity price on financial performance should be completed.
Second and Third Level Inputs: Consider that a commercial bakery using flour has an input that depends on the price of wheat. Analyzing impacts of commodity price changes will need to go down one, two or more layers to ensure commodity price changes have been thoroughly considered.
For labor related expenses, the continued stress on consumers has worked against companies wanting to manage labor costs and bring staff members back to the office. According to the Bureau of Labor Statistics, wages have increased 11.67% from April of 2021 to April of 2022. Health care has experienced serious labor shortages and increased costs. Trucking continues to experience labor shortages which are driving per mile costs up even more than just fuel cost increases. Therefore, when evaluating performance risk, it is important to consider that every line item on the income statement that relies on people doing work is experiencing increased costs. That cost pressure is increasing as the labor participation rate remains at 62.3% in May 2022 and there are 0.5 people looking for each available job opening.
Consider the cost of debt. With the Fed’s 75 basis point rate increase during the week of June 13, 2022, the cost to borrow will be increasing. For companies with floating rate debt, interest rates have shifted from being tied to LIBOR to being tied to SOFR and rate increase expectations have intensified as the Fed attempts to combat inflation. The interest expense a company pays should be expected to increase further in 2022.
Waves of Inflation
The inflation cycle is not over. There will be waves of cost inflation on a company’s income statement. Using the approach described above, it will be easier to identify areas of stress on an income statement during the remainder of 2022.
It will also be necessary to consider volatility in 2023. Let’s consider two examples, food and gasoline, and the outlook for price changes. Food has already experienced a 10.1% CPI increase and a 13.0% PPI increase year over year in May. Now consider that the DTN Fertilizer Index reports that fertilizer costs have increased between 50% and 123% when compared to the same time last year. Ag producers that had fertilizer for 2022 contracted at lower costs, will be contracting future needs at higher rates. This could impact plantings occurring today, as well as the planting season in 2023. Related to fuel costs, AAA reports the average cost of diesel was $3.222 per gallon one year ago and is $5.815 per gallon today. That means any company that relies on fuel to produce or deliver goods will continue to see increased costs, which will have to be passed along to customers if the company expects to maintain operating performance levels. Policies related to the transition away from fossil fuels continue to pressure the fuel costs consumers and companies will be experiencing.
We are not seeing downward pricing opportunities for food or fuel at this point; therefore, forecasts today need to consider the impact of continued upward pricing pressures.
These are difficult times to prepare forecasts
These are difficult times to prepare forecasts but that is exactly why a business needs a forecast. To be successful it is important to anticipate performance risk. Successful businesses will watch and analyze financial performance. Today key areas to consider are income statement line items, working capital price volume analysis, and costs to borrow. This is a summary of the tools that need to be considered:
More emphasis on income statement line item trends compared to known issues in the economy will be required.
Price volume variances need to be expanded to include sales categories, input, or expense categories, and working capital components, specifically inventory.
Inventory valuation methods need to be reviewed in the current environment. Standard costs may need to be re-evaluated more frequently. Inventory on the balance sheet could be over or under stated depending on methodologies used.
Adequacy of cash on hand and access to ABL structures, coupled with rising interest rates, will need to be considered. Interest expense will increase. Debt service will be stressed.
There are tremendous head winds when considering forecasts and financial performance. But that means working with companies to evaluate and analyze performance is key, and can help businesses improve their performance even in difficult times.