subject: How Does Inflation Impact Companies? [print this page] How Does Inflation Impact Companies? How Does Inflation Impact Companies?
Inflation is an economic concept that describes how prices of goods and services rise over time, affecting the amount a dollar can buy. This has real implications for all of us; both in our personal lives and in our businesses. The problem is that we're given mixed messages about what is happening to the value of the dollar. Federal Reserve Chairman Ben Bernanke claimed this week that deflation is possible, while commentators and economists claim the opposite - that inflation is going to be inevitable with so much money being printed by the treasury. JP Morgan claimed this week that these forces will make the dollar the weakest currency in the world.
At the end of the day, whether we are affected by deflation or inflation, we still need to understand the impact of inflation on the key financial ratios within our companies. To understand inflation, it's important to understand the different things that precipitate it. Inflation can happen when a government floods the market with money, and to maintain equilibrium in supply and demand, the price of goods and services are driven up. This is eerily reminiscent of what we are seeing with our current administration, and many analysts believe that inflation will rise in conjunction with the flood of new money. A more natural form of inflation is when production costs rise, thereby increasing the cost of the finished product. This can apply to raw materials, labor or underlying labor burden (like increasing healthcare costs).
Inflation can also be driven by debt, as we borrow more money, the interest must be paid, which forces us to raise prices to pay for the interest expense. Exchange rates can also drive inflation when it affects the amount of goods imported and exported. Between new taxes that are passed on to consumers, wars that require funding and major shifts in the governments' assumed mandate (healthcare, cap and trade, etc), inflation is the end result.
The question remains; how does this economic factor affect a business's financials and the associated financial ratios? Inflation's principal issue is that it makes money worth less, affecting financials by lowering the real value of any realized asset gains or sales. Consider the following four factors and the way they are impacted by increasing inflation:
Return on Assets: ROA is calculated by dividing Net Income by Total Assets, and inflation affects both of these factors. Net Income may be artificially inflated by higher consumer prices, but they are essentially selling assets that were accumulated at pre-inflation prices. This will artificially drive ROA to a higher level. This assumes those inventories were built prior to the inflation and at costs commiserate with that time period.
Inventory Turnover: Calculated by dividing Sales by Inventory, this will provide similar results to ROA. Inflation will tend to drive this ratio higher because sales are made at inflated prices, while inventory is still valued at the pre-inflation rate. One factor that compounds this problem is FIFO, essentially the older the item is the more out of date its value is with inflated pricing. This assumes that sales can actually be adjusted to the new inflated pricing, that there is enough of a time period between assets being valued and being sold to have any effect and that supply/demand are not affected by the new pricing.
Current Ratio: Current is calculated by taking current assets and dividing by current liabilities. In the short term, the current could improve from inflation because cash and A/R might increase, but A/P and short term loans would most likely remain fairly stable. The effects would be minimized if short term liabilities increased along with increases in assets, including an increase in costs from suppliers and increases in other short term obligations. This again assumes that the effects of inflation are severe enough to change the valuation of assets, and that our short term assets, including cash, would actually increase due to higher sales. There is always the possibility of inflation high enough to actually decrease demand for our product, where consumer's resources are diverted to staples rather than whatever it is we are selling.
Debt to Total Assets: Very similar to the current ratio in that there are items that affect both the numerator and denominator. In this ratio, inflation doesn't have a huge affect. Asset values might increase as items are valued higher and assets increase due to higher revenues, but liabilities also increase, with potentially higher interest rates, higher raw production costs, and costs from suppliers going up. If a company is able to maintain its debt structure, there is a possibility that this ratio could improve. Part of the problem in this assumption is that long term items in both columns are slightly isolated from inflation; plant and equipment are purchased with pre-inflation dollars and are valued as such, and long term debt is typically locked in at a certain interest rate.
Both Inflation and deflation are destructive forces for the economy as a whole, but as with all negative forces there are, and will continue to be, opportunities for businesses that are prepared. As a post script, I'm curious if anyone knows how much did a six pack cost back in 1960? That being a few years before I was born, a quick check on the internet determined it was about 98 cents. I can guarantee one thing - the $10 in my pocket is going to be worth a whole lot less in a few years. When I have to spend the whole $10 on a six pack, it might be time to switch from Corona back to Keystone Light.
