Why are margins and EBITDA heavily impacted by inflation?
2020 and 2021 were the Pandemic problem years. 2021 and 2022 were the problem supply chain years. 2022 was the year of oversupply of inventory and weakening working capital. What will the 2023 performance theme be? The impacts consistently being heard in 2023 are working through excess inventory and weak EBITDA performance caused by increased costs.
The May 2023 CPI and PPI were published by the Bureau of Labor Statistics on June 13 and June 14, respectively. Politicians and pundits spoke about lessening inflation, with the CPI at 4.0% and the PPI at 1.1%. If inflation has eased, why are businesses continuing to feel stress in financial performance?
The key to answering that question is the change in costs from 2020 to 2023, coupled with the influx of stimulus money to mask concerns in 2020 and 2021, lingering in to 2022. Considering the inflation levels from 2021 to 2023, it is clear costs have increased approximately 20% from the 2020 base level.
A $100 million company experiencing 20% increases in costs of goods sold and operating expenses would experience an $18 million decrease in operating income if it was unable to pass along price increases to customers or impact its cost structure. Also considering the increase in SOFR from 0.04% in May 2020 to 5.08% in May 2023, assuming $50 million of debt at SOFR + 3%, the company would have had its $8.5 million EBITDA decrease to a $12.0 million EBITDA LOSS.
Most companies had some ability to increase prices, but all companies had labor cost and input cost increases. As interest rates increased, reliance on debt increased for many companies.
With these head winds, financial performance of companies has been negatively impacted and all stakeholders are trying to find ways to deal with weakened cash flow situations.
The previous table shows what inaction would mean to a company with a respectable $8.5 million of EBITDA on revenue of $100 million, an EBITDA of 8.5%. The company that has no plan to respond to increased costs and interest rates could reduce performance to a negative $12 million of EBITDA, a $20.5 million performance change.
How to deal with the current business environment?
Every business management team is struggling to respond to the current environment. Convening a task force to deal with every line item on the income statement and all components of working capital is going to be the key to success.
The first step should be an objective financial analysis beginning with financial performance from 2019 to the current period. In this analysis consider:
Realistic impacts of stimulus money in 2020, 2021, and 2022 – evaluate EBITDA and operating performance without those funds.
Realistic evaluation of the impact of the pandemic in 2020. An adjusted EBITDA and operating profit should be prepared considering items such as:
Sales lost during a shutdown period, if applicable.
Labor and other operating costs incurred during the shutdown period.
Labor raises required to bring people back to work after receiving stimulus funding.
Additional labor required to keep necessary staffing in place.
Additional costs to comply with any restrictions to coming back to work.
Any other costs associated the pandemic.
Also consider additional revenue that may have occurred, and the costs related to that additional revenue.
Contract review and evaluation. Maturity dates, repricing opportunities, automatic renewals, etc. need to be clearly laid out for discussion. Prices paid to vendors and prices received from customers need to be evaluated against market intelligence related to the competitive environment. This contract review should include:
Operating costs by line item need to be compared from 2019 to 2023 to evaluate costs against inflation. Some line items may have increased faster than inflation, while others have increased slower than inflation. Consider alternative suppliers and contract renegotiation.
Opportunities to decrease footprint should be considered. Consider number of offices, number of locations, number of warehouses, etc.
Opportunities to increase automation should be evaluated.
Customer profitability must be prepared.
Product profitability must be prepared.
Profitability by supply channel from company to customer should be prepared.
Profitability by location.
Working Capital roll forwards must be prepared.
Payments against terms.
Turnover by larger customers.
Opportunities to reduce the investment in accounts receivable should be considered. Enforcing terms, changing terms, increasing discounts, etc.
Evaluate customer profitability including the cost to carry the accounts receivable for a customer.
Open purchase orders.
Turnover by SKU.
Turnover by customer and supplier.
Aged inventory. Consider obsolete styles and products.
Opportunities to reduce inventory must be considered. Should inventory be sold at a discount to move old or obsolete inventory? Could payment terms or prices be changed to move excess inventory?
Will inventory become ineligible based on current ABL or BBC terms?
Are values of inventory inclusive of transportation costs or other one-time costs that will not be repeated and may result in write downs.
If inventory levels are required by customer contracts, consider interest costs to carry that inventory level.
Payments according to terms.
Turnover by larger vendors.
Hidden tariffs in Free Trade Zones.
Are credit lines sufficient?
When will debt be repriced?
What is the impact of an additional 0.25%? Consider two more 0.25% rate increased in 2023.
The second step is to evaluate forecasts for the remainder of 2023 and 2024 with this increased performance intelligence. Evaluating each line item using the information gathered in the first step – the objective financial analysis – will allow a management team to go through each line item of the income statement to consider changes needed to improve the 2023 and 2024 forecast accuracy and achievability.
The outcome of evaluating the forecast with the data from the objective financial analysis would result in a performance risk analysis to identify the target performance levels, and the range of performance possibilities.
How does a company do this?
Not taking action is a bigger risk that taking the time to perform this type of analysis. The analysis described in this article should take no more than three to four weeks to perform, and should require time from multiple disciplines, with emphasis on the finance and accounting staff.
If the finance and accounting staff is stretched too thin, bringing in an additional resource to augment the process should result in an effective analysis at a reasonable cost.
FMG is able to help companies perform this analysis and help management teams develop plans to improve performance. Give us a call to discuss questions and comments. We look forward to hearing from you.