Inflation is currently a global phenomenon due to government responses to COVID-19, supply disruptions, the Russian invasion of Ukraine, and other factors. It’s common to believe that inflation affects everyone similarly, however businesses can be affected quite differently depending on a variety of circumstances such as: their industry, competition, ability to shift price increases to customers, and amount of debt they currently hold.
A business’ industry is a major factor regarding inflation’s effect. Essential goods and services demand remains relatively unchanged when prices rise, this is referred to as Inelastic Demand. These can include gasoline stations, grocery stores, and healthcare. A current example is rising gas prices, we gripe about them but we still fill our tank to get to work. These businesses can more easily shift rising cost burdens to their customers.
Other businesses are insulated from inflation if they operate in a monopoly or have very few competitors. Customers with have few alternatives, will generally have to accept rising prices. For example, Insurance Corporation of British Columbia (ICBC) doesn’t have any competitors, it is a Crown Corporation that does not allow private companies to enter the market. Since customers must buy car insurance they also must accept whatever premium ICBC charges.
Inflation’s Negative Effects
For the businesses that aren’t immune to inflation, there can be a wide range of impacts.
The most obvious impact is as prices rapidly increase, consumer demand decreases. For businesses providing discretionary goods and services like travel or retail, demand may continuously drop as inflation rages on. Consumers are dramatically losing purchasing power and have to re-organize their finances by prioritizing their essential needs.
Inflation affects the direct costs businesses pay for materials and inventory. The inventory your business just sold now costs more to replace. However, all costs do not increase equally at the rate of inflation so simply raising prices isn’t a long-term solution. You also risk pricing out your customers if you continue to raise prices.
Business’ margins are also squeezed by rising overhead costs like rent, utilities, and wages. A certain amount of price increases can be shifted to customers but small businesses will still have limited margins to work with.
As noted in our previous article, “Interest Rates & Inflation,” the Bank of Canada has been steadily increasing interest rates throughout the year to make borrowing more expensive, stifling demand in order to fight inflation. Business’ tight margins are exacerbated by higher interest payments on any debt held. If your business needs to take on more debt during this time, fixed-rate loans will be preferable compared to loans with adjustable rates.
The lack of borrowing power will reduce the liquidity of many businesses that rely on credit to fund inventory or operations. This also limits a business’ ability to invest in its future or expand/improve operations. Not only are margins slim from the above conditions, but the new computer or equipment simply costs more now.
These can be worrying times for small businesses but being prepared to face the changing market can put you ahead of your competitors.
- Raise prices slowly so customers don’t get ‘sticker shock.’
- Streamline your production line and workforce productivity as best you can. This can include removing low-profit-margin products and streamlining employee training.
- Diversify your supply chain.
- Analyze all costs in the business and determine what can be removed or adjusted.
Inflation’s Effect on Business Valuation
The effects of inflation on small businesses can vary widely, not just day to day operations but also the value of the business. All depends how exposed your business is to inflation.
Levers in Determining Value
EBITDA (Earnings before interest, tax, depreciation, and amortization)
Inflation’s effect – Increased or Decreased EBITDA
As explained above, a business will experience rising costs of goods sold due to inflation. If you aren’t able to pass along the rising costs, the EBITDA margin declines. EBITDA gives a figure that clearly reflects the operating profitability of a business that can be directly compared to similar companies. Lower EBITDA yields lower value.
After-tax Cost of Debt (cost of borrowing money)
Inflation’s effect – Increased cost of debt
The Bank of Canada has increased its policy interest rate by 300 basis points since March 2022. This will affect firms who hold higher levels of debt and ones that are at higher risk of defaulting. Higher borrowing costs yields a higher discount rate and lower value.
Cost of Equity (rate of return that equity investors demand)
Inflation’s effect – Increased cost of equity
Inflation will increase the risk free rate and the equity risk premium.
Companies in riskier sectors (i.e. discretionary rather than essential businesses) are more exposed to market/economic shifts. Company specific risk premium will rise on companies with higher default risk, negative cash flows, or country risk. Higher expected equity return rates yields a higher discount rate and lower value.