LGT's Profit Sense

The impact of inflation on a company's financial statements can vary depending on the specific circumstances of the company and the industry in which it operates. It is important for companies to monitor inflation trends and adjust their operational strategies accordingly.

With inflation at its highest in 40 years, business owners are reasonably concerned about how this will impact their business operations. The volatility in the Consumer Price Index (CPI), which looks at shelter, food, clothing, transportation, medical, dental, medication and similar goods and services that people need for living on a daily basis, also has many people worried. According to the United States Bureau of Labor Statistics CPI Inflation Calculator, a dollar in January 2020 has the same buying power as $1.18 in April 2023, representing an 18% increase in CPI since pre-pandemic levels. This significant increase has business owners questioning just how much of a price increase can the consumer market withstand.

Similarly, the producer price index has risen by 11% over last year, barely decreasing from March's 11.2%, which was the highest increase for wholesale inflation on record, gauging the rate of inflation prior to hitting consumers. But what impact will these inflation rates have on your company's finances?

As inflation continues, there are several major impacts that you may see in your company. Overall, inflation often increases your direct costs of production while lowering consumer demand for your discretionary services and goods. In many cases, unless you can pass these cost increases to your customers, they may spread past your gross margin. Here's how several other factors in your financial statements can be affected by the high rate of inflation we're seeing:

1. Debts: Does your business have loans? If they have variable interest rates, your interest rate may fluctuate, as the Federal Reserve threatens to raise interest rates at the fastest rate in 40 years to reduce inflation. The federal rate has been increasing, with the current federal funds rate currently at 5% to 5.25% at the end of April 2023. Inflation can impact a company's debt and interest expense. If a company has debt with a fixed interest rate, inflation may reduce the real cost of that debt over time; however, companies with variable-rate loans should switch to fixed-rate loans or apply for additional credit to lock in lower rates before the rate is increased again, while others reduce debt. Depending on the restructuring approach, it can be reported as modification, extinguishment of debt, or troubled debt restructuring.
   
   
2. Inventory: Companies use a wide range of methodology to determine the cost of inventory, which can include first-in first-out (FIFO), last-in first-out (LIFO), and average overall cost. Given that United States Generally Accepted Accounting Principles, or GAAP, measures inventory at the lower of cost or market value or the lower of cost and net realizable value, inflation can have an impact on the inventory costing method that you choose, which can impact your company’s profits as inventory becomes cost of goods sold, as well as your ending valuation of inventory. This process also causes a range of trickle-down impacts on tax liability.
   
   
3. Investments: Inflation makes public markets more volatile. As market values change the value of a company’s investments, realized or unrealized losses or gains may result. This will impact a corporation’s deferred tax liabilities and assets under GAAP practices. Because there are greater concerns about how inflation can impact the market, companies may wish to revisit their investments and overall investment strategy. This shift may require a change to a new method of accounting or even specific or special disclosures in the financial statements.
   
   
4. Overhead Expense: When was the last time you went over your long-term contracts? From lease agreements to service provider contracts, many company contracts may feature escalation clauses which have been tied to the CPI or similar inflationary measurements. If it does, you may see increases in lease, contract, or service payments. In a similar approach, other vendors or service providers may implement a rate increase during these already difficult times to protect their own profits, as their own overhead expenses increase during the inflationary periods.
   
   
5. Going Concern Disclosure: Is the ongoing inflation creating a higher risk that your company will be able to continue in the future? During each reporting period, your company's management will need to consider if there are doubts about your company’s ability to continue operating successfully. If there are problems emerging that create substantial doubt that your company will be able to meet its obligations on time over the next year, it’s time to revise your existing budgets and look to cost mitigating strategies. As inflation soars, companies that are unprepared to deal with the impact may fail. From the investor point of view, inflation can impact investor and stakeholder perception of a company's financial health and performance. Higher inflation rates may lead to concerns about the company's ability to maintain profitability, manage costs, and generate consistent cash flows. This perception can affect stock prices, credit ratings, and investor confidence over time.
   
   
6. Goodwill: To estimate the fair value of goodwill that you acquire during a period of inflation, businesses using GAAP processes should be consistently applying the same valuation technique every period. However, assumptions underlying the fair value estimates can change with inflation. For example, market participants often use higher discount rates when in an inflationary period, due to expected revised cash flows as expenses rise, customer behavior changes, and modified product pricing, which can impact goodwill estimates.
   
   
7. Cash Flows: Inflation can impact a company's cash flows in various ways. Higher inflation may result in higher costs for raw materials, labor, and other inputs, which can reduce a company's cash flow since the company is paying more for the same materials from previous years. Conversely, if a company is able to pass on higher costs to its customers, it may benefit from higher cash flows.
   
   
8. Revenue and Sales Reporting: Inflation can affect a company's revenue and sales reporting by increasing the prices of goods and services which are then passed on to the customer through sales price increases. As sales prices rise, the nominal value of sales may increase, but it may not necessarily reflect an increase in the volume of sales made. It becomes important to distinguish between inflation-driven price increases and actual growth in sales volume to assess the company's true performance in order to make good business decisions for the future. To put things in perspective, a company may want to not only assess the dollar change in sales revenue, but also the change in number of units sold and the change in the number of customers those sales were made to.

As costs increase, the level of monitoring and analysis that a company has over its financial reporting process and business strategies should also increase. Although inflation can have a significant impact on a company, close monitoring and efficient responses can help a business come out on top.

Want to read more on this topic? Learn 3 ways not-for-profits can save money in the face of inflation.