It’s no secret that inflation has been on the rise lately. According to The Economist, it is currently at a four-decade high! Everyday consumers have raised some valid concerns about inflation, but they are not alone. Managers are also scrambling to learn how to prepare for inflation and make changes to their business models. So, what can CFOs do to plan for the short-term and long-term impacts of growing inflation?or deflation?
What Is Economic Inflation?
Inflation is a persistent increase in the general price level of goods and services in an economy. This means that the prices of everyday items are slowly but surely climbing over time. While a small amount of inflation is considered healthy for an economy, too much inflation can be detrimental.
What Is Economic Deflation?
Economic deflation is a period of sustained falling prices. Several factors can cause this, such as a decrease in the money supply or a reduction in aggregate demand. Long-term deflation can have severe negative consequences for businesses and economies:
- During periods of long term deflation, companies may find it difficult to invest and grow, leading to a decrease in economic growth.
- Long-term deflation can lead to an increase in unemployment.
- Consumers may reduce their spending during periods of deflationary pressure, further decreasing economic activity and leading to higher unemployment.
The Main Challenges CFOs Face When Planning for Today’s Inflation Rates
CFOs must consider a variety of factors when making inflation-related decisions for their company. However, much has changed since the last time CFOs had to battle rising inflation.
- Inexperienced, younger CFOs. The managers battling inflation at this rate 40 years ago have likely retired. While brilliant CFOs remain, they do not have experience with this. However, so much has changed regarding how organizations function, and the role of CFOs, that experience from 40 years ago can only go so far.
- Trading partners’ credit risk. When inflation was last this high, the United States had much more control over world prices because its dollar was the predominant currency used in international transactions. Nowadays, there are a plethora of currencies, and many countries no longer use the dollar as their peg. This lack of uniformity creates credit risks for companies that have to deal with multiple currencies.
- Lack of pricing power. Companies had more control over prices because fewer substitutes and less global competition existed in the past. With the rise of the internet and e-commerce, consumers now have more options. This increased competition put downward pressure on prices, making it difficult for companies to raise prices without losing market share.
- Forecasting difficulties. The current inflation environment is quite different from what it was in the past and is constantly changing. This makes forecasting much more difficult. CFOs need to predict future inflation based on historical and current trends to counter this. They must also account for various factors, including unpredictable changes in the cost of energy, food, and other commodities.
How To Prepare for Inflation
Economies go through periods of boom and decline. However, when inflation climbs to current rates, companies need to think seriously about how they keep goods and services affordable. There are several things businesses can do to prepare for inflation:
- Review your pricing strategy: This is probably the most obvious way to combat inflation. If the cost of your goods or services increases, you will need to raise your prices accordingly. Keep an eye on your competition and make sure you don’t price yourself out of the market.
- Review your supply chain: Inflation often leads to increases in the costs of raw materials and other inputs. Maintain a good handle on your supplier relationships and always look for new, more cost-effective suppliers.
- Review variable interest rates: Inflation can significantly impact your business’s debt. If you have loans with variable interest rates, you will need to prepare for the possibility of higher interest payments in the future.
- Refinance debt. During times of inflation, interest rates tend to be lower than usual. Take advantage of these more favorable borrowing rates by refinancing debt or looking for new borrowing opportunities. Note that while federal and private interest rates are low, lenders will still have more stringent requirements for creditworthiness.
- Buy goods and services early. If the cost of goods and services is on the rise, then the best time to pay for them is sooner rather than later. This may not always be possible, but you can save a significant amount of money if you can plan far ahead and take advantage of early payment discounts.
- Diversify your investments. During the pandemic, companies learned the importance of agility and pivoting. The same can be said for investing during periods of inflation. Diversifying your investments will help you weather the storm and protect your business from the market’s volatility.
What Is the Cost of Capital Inflation?
The cost of capital is the minimum return that a business must earn on its investment projects to satisfy its owners. This concept is closely related to inflation, as companies need to account for the fact that money today is worth less than money in the future. When comparing inflation and cost of capital, note that the company’s cost of capital depends on two things:
- The time value of money. This concept is also known as the “law of one price.” The law of one price states that, over time, all goods and services will cost the same amount of money. In other words, a dollar today is worth less than a dollar in the future.
- The riskiness of its investment projects. This is another critical factor that affects the cost of capital. Riskier projects require a higher return to compensate investors for the additional risk.
The Bottom Line
While inflation can have some negative consequences, inflationary pressure usually occurs when an economy grows rapidly, and businesses struggle to keep up with the demand for their goods and services. Consequently, despite the disruptive nature of inflation, it is often a sign that an economy is healthy and growing. Inevitably, the market will correct itself. In the interim, CFOs must do everything possible to keep their businesses stable and profitable.
