Introduction

At the time of publishing, the US inflation rate stands at 8.52% (down slightly from June’s rate of 9.06% earlier this summer).  In economics, inflation is a general increase in the prices of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduction in the purchasing power of money.

As consumers, we have all experienced the impact of inflation and have likely discussed the day-to-day challenges it has presented for us- whether it be commuting costs, price of groceries, rent and other living expenses- the list goes on. 

Yet what is not as actively talked about, is the impact the current inflationary period is having on small business owners and their businesses- And if you work with business owner clients, it’s likely they’ve come to you with questions about how to mitigate the impact of our current environment on their businesses.When researchers asked more than 1,500 small business owners about their single most important problem, a clear majority said that inflation is their biggest problem. A total of 34% chose inflation, compared to 23% who said labor quality and 11% who said taxes.

Addressing your client’s concerns around inflation and what is to come in the coming months may seem daunting. However, it’s important to remember this is not the first time we have experienced inflation to this degree. What makes the current inflationary period unique is not just the overseas war in Ukraine, but the additional recovery from a pandemic and the stop-start of COVID-containment policies in China’s manufacturing hubs.

What is inflation now?

In addition to two consecutive quarters of negative GDP growth, during the month of June alone, the Consumer Price Index (CPI) for all items rose 1.3%. Over the 12-month period ending in June 2022, consumer prices are up 9.1% (the largest annual increase in 40 years). This increase varies for certain goods; for example, select fuel and oils are up 70.4% over the last 12 months.

Today’s inflation is multi-faceted, i.e. we have both “supply side” and “demand side” forces combining to create the worst inflation in four decades.

Supply Side = Cost Push Inflation, e.g. reduced oil supply, higher oil and gas prices, leads to higher prices across the board (groceries/household items, etc.)

Inflation can start with scarcity of certain goods or raw materials such as energy or computer chips for vehicles or fertilizers for crops, etc.. That rings true in 2022, when we’ve seen massive disruptions in normal business due to COVID-19 and ongoing disruptions to the supply chains we depend on to deliver raw materials and finished goods.

Demand Side = Demand Pull Inflation, e.g. too many dollars (facilitated by the Fed who accommodates record level deficit spending through direct government security purchases) chasing too few goods leads to higher prices

Worst Case Scenario – when inflationary expectations become entrenched as an economy is shrinking.  Due to inflation, workers demand higher wages – then the higher wages lead to higher prices and more inflation, etc., etc.

Generally speaking, inflation is not good for business. The primary effects of inflation on a business are that you’re likely to sell less, see lower profits, and pay higher costs.

While some mega-corporations and sellers of high-priced, luxury goods with more established pricing power may not feel the impact on their bottom line, the majority of smaller, privately-owned businesses are likely to raise the price of their goods and services, and in turn sell less or lose customers. These same companies are also under pressure from employees to raise wages to keep up with a higher cost of living.

Speaking with Business Owner Clients on the topic of Inflation

Every business is unique in how they are affected by the combination of 40 years of high inflation. However, there are common pain points all businesses are facing. 

Challenges your small business owner clients are likely experiencing:

  • Goods and materials become harder to find
  • Dollars buy less and materials cost more
  • Consumers redirect spending
  • Labor costs increase 
  • Rising interest rates lead to shifts in investment portfolios

With inflation, BOTH revenues and operating expenses may rise with the relative change of each determining the impact on total profits. 

Big picture, there are three major factors you and your clients should focus on:

What is their industry, or more specifically, their NAICS code?

The price of raw materials and production, and the amount of money customers have to spend. When it costs more to buy the eggs and flour or get the lumber or nails you need, profits will go down. Raw materials often become difficult to find as well as more expensive to have delivered. 

Consider customers’ purchasing power. If they’re paying more for groceries and electricity and other necessities, they have less money left over to spend on other more discretionary items.

The ultimate impact of this current bout of inflation on the US economy is still uncertain, with the following key questions likely to determine future developments: 

  • How long will supply chain disruptions last? 
  • How do inflation expectations affect wage negotiations? 
  • How do consumer spending habits evolve? 
  • What is the nature of monetary policy? 
  • How will the 2022 election affect future policy-making in Congress?

Other questions advisors should prepare themselves for:

How do the current economic forces impact the profitability of the company in the next few years? 

Can price increases on raw materials be passed on to customers? (i.e. is it “bad business” to increase prices because overhead costs are an increasing expense?)

When the government spending stops/slows and security prices drop, will there be a drop in demand for goods/services?

 

Check back next Thursday for part two of Inflation and It's Impact on Business Valuation in the US Economy