Managing business finances in an inflationary environment
With accelerating inflation, global political uncertainties increasing and economic growth forecasts dropping, business leaders are facing a perfect storm as they seek to recover from the pandemic.
A significant challenge for Finance Directors is the uncertainty of the economic and political environment and the speed of change in an inflationary environment.
The last time inflation reached high levels was in the 1980s-90s. ICAS Business Policy Panel hosted a discussion with senior members in business to share experiences of those who had been there.
What a Finance Director should be looking at - key messages
The inflationary world is an opportunity for good finance leaders to shine and boards will expect this. Finance directors play a crucial leadership role in persuading commercial colleagues and the rest of the board to look at the business through an inflation lens, to understand the business and how it will respond to different pressures, and how to value assets in that context.
1. Understanding your business through an inflationary lens
- Define what success means for your organisation and then focus on it
- Change the way you think about the business and communicate the need for changed working
- Inflation is a fast-paced environment - you will need to think and act fast and decisively.
Inflation brings opportunities as well as risks. Businesses must identify these and how they will adapt existing working methods to succeed. This includes:
- Understanding your terms of business and adapting them to match changing circumstances
In a rapidly changing environment, a greater degree of certainty on prices may be obtained through shorter-term contracts and agreeing exits which are easier for the business to manage. Know your exit terms and try to build in inflationary margins or caps. If you are reliant on long term contracts, understand your options and limitations. Ultimately the ability to walk away from a longer-term contract that becomes unprofitable may be something that businesses will have to consider.
Think ahead – try to build in certainty for customers by planning for one rather than multiple consecutive prices increases which can discourage buyers. Some industries routinely use derivatives to offer a smoothing effect on their input prices if dealing with a volatile commodity e.g. fuel. However, others avoid using swaps or derivatives in volatile times as the unpredictability can be costly if locked into a deal and the market moves in the opposite direction. Whether you use swaps and derivatives for hedging will depend on how relevant it is for your business and how experienced your team is at managing these given the risks involved.
- Getting control of key pricing decisions – engage with your commercial colleagues
Check sales volumes, procurement and commercial terms are right for the business. If you have inflation on your inputs but no pricing power the viability of retaining that business line may be questionable.
2. Cash and how you manage it is king
- Stay on top of cash levels through more frequent reporting of cashflows.
- Make sure you understand your cash flows and how your working capital behaves in a changing and volatile environment.
- Find your balance between having sufficient cash to meet payments and profit targets whilst avoiding large cash balances which will depreciate with inflation.
- Business funding – how heavily leveraged is your business, stress test the impact on your cash levels and evaluate how sustainable this is.
- Equity funding – this may be more difficult. Dividend policies need to be well thought out.
Interest rates may be rising but holding assets that convert to cash in the future may be better value to benefit from price rises. In manufacturing (not foodstuffs), holding higher stock levels may make financial sense.
Similarly, borrowers may gain an inflationary advantage as their repayment rates may not keep pace with increasing inflation whereas lenders need to build in inflationary margins to keep pace with interest rate rises. If you have debtors, review your charges for non-payment and consider getting a credit controller to speed up collection times.
If borrowing levels are high, look closely at bank covenants and limits as these can creep up quickly. Check your cashflows regularly and compare with the bank covenants. Ensure you have sufficient warning on potential breaches and fluctuations in costs and income.
Are gearing levels sustainable? Leverage can be a useful source of finance in good times when interest rates are low, but it can become costly when rates start to rise. If your business has become accustomed to an interest margin and fixed rates are about to expire you will need to renegotiate at a higher rate.
Scenario planning helps you to stay well ahead and assess the impact on your bank borrowing.
Equity raising may become more difficult as market uncertainty grows. The cost of equity finance may shift as risk and growth prospects change. Dividend policies should be well thought out over the next couple of years.
3. Adapt your reporting to reflect the new reality
Pressures have changed so existing reporting arrangements are unlikely to be sufficient. Identify your reporting requirements, be numerate but do not overanalyse - get enough information to support effective decision making. You will get some things wrong, but you just need to get most decisions right to succeed.
Understanding how your business is affected by inflation and what reporting you will need to inform timely decisions is key.” Paul Hally, chair Business Policy Panel
Key elements include:
- Scenario reporting and modelling of different outcomes.
- Understand your economic costs.
Robust scenario planning showing the impacts on cash flows is an important tool to support boards during times of inflation.” Norman Murray CA
Scenario planning: This is a critical tool to try to stay ahead of reality and reduce surprises during uncertain and volatile times. Modelling the impact of changes to your cashflows across pricing, income and costs help to get the board thinking to anticipate and facilitate decision-making to make sure the business is not getting into trouble.
As well as changing inflation forecasts, interest rates, supply chain disruptions and staffing changes, there are currency fluctuations to manage which will impact businesses differently depending on whether you import or export. Stress testing should include some extreme scenarios – ‘think the unthinkable’ to see how it would impact your business and if it could survive.
Getting a clear understanding of the economic costs in a business is essential to identify any unsustainable business lines.” Mike McKeon CA
Understanding the economic costs: It becomes increasingly important for business decision-making to understand your finances in terms of fixed and variable costs, and contribution margin for items (sales income less variable costs). This is distinct from the historic accounting view of costs. Contribution margin helps evaluate variable production costs and profitability. This helps you analyse your profitability, the impact of changes in activity, whether a rethink on production capacity is needed and how it affects your profit objective.
It will be needed to inform decisions such as which business lines contribute sufficiently to cover your fixed costs. If the business is unable to cover fixed costs this may trigger a shut-down decision (permanent or temporary). Although you can take out fixed costs over the longer term, it is not the only option. Cutting fixed costs can be expensive, you may also need these resources in the future to drive your business. You need to manage, not just cut, these costs to succeed.
4. An experienced board
Newer businesses tend to have a younger average age with less practical experience of managing in a higher interest or inflationary environment. A well-balanced board includes some longevity of experience, even if inflation proves to be a temporary situation. You may need to consider alternatives such as what external help or advice is available in the meantime while you work towards a balanced board.
Overall, whilst inflation offers challenges, there are also opportunities for your business and to exercise leadership. In an inflationary world, you do not have the luxury of time as events can take over quickly. Even if all you do is get more decisions right than those you get wrong, your business may be better placed to survive.