Rising Inflation and its impacts on capital budgeting

India’s Consumer Price Index ( CPI ) growth was measured at 5.0 % YoY in Jun 2018 which when compared to that of May was 4.9 %.

The CPI measures in qualitative terms the extent to which prices for certain items are increased which means that the consumer’s purchasing power will get impacted.

All such indicators conclude towards a rising inflation, a general increase in prices and a decrease in the purchasing value of money. The inflation rate in India reached up to 5 percent in June of 2018 from 4.87 percent in May, below market expectations of 5.3 percent. Still, it is the highest rate since January and marks the eighth straight month in which inflation is above the central bank medium-term target of 4 percent.

If we talk about small businesses, constantly rising inflation could have really dramatic effects. I am sure most of the entrepreneurs are aware that higher inflation can lead to higher prices, but let’s look into the impacts of that in detail.
Let’s see how inflation could potentially have an impact on your business and how you can prepare to mitigate any risks posed by this:

Direct/Indirect impact on goods, services, and equipment

The inflation rate is determined by the cost of common essential items and goods purchased by most households and the fluctuations in prices. The recent increase in inflation in India is due to rising prices of gasoline, health care services, apparel industries etc.

While your business might not require the same items that an average household purchase, a general increase in the inflation rate likely means that your start-up will eventually have to pay a higher cost to
produce the same goods or provide services.

According to economic forecasters, inflation will continue to increase steadily, one way out to tackle this issue for business owners could be a well –thought plan ahead for future prices. The safest and most recommended option is by building up a financial cushion by having business savings in place from time to time. That would help with any price fluctuations. You could also lock-in long-term contracts with vendors you deal with regularly so that you can depend on today’s prices for the duration of the contract.

Less Profits

More expenditure in form of equipment and supplies cost will arise due to inflation and that will impact your profit margin significantly. So, a resort to it could be to increase your selling prices to reach up to a
healthy profit margin.

If you believe you are required to raise your prices in order to stay profitable, you may indeed consider offering your loyal customers contracts with an economic price adjustment option. It is defined as a fixed- price contract with economic price adjustment provides for upward and downward revision of the
stated contract price upon the occurrence of specified contingencies. Using this technique, you can make adjustments based on criteria agreed upon in advance, such as your costs for labor or material or cost
indexes of labor or material and won’t suffer losses.

Higher Employee Attrition

As prices increase on end products, your employees may find it difficult to make ends meet with the current money they are getting and they may look for better opportunities outside to get a salary hike. Well, you also as an employer can offer them hikes, but it becomes challenging for you as well in an inflationary environment.

Instead, look for alternate options to increase employee retention by offering flexible scheduling, extra time off or complementary commute/food etc.

According to the International Monetary Fund – while increasing inflation may seem negative, it’s actually good for the economy if the increase is minor, stable and predictable. Although it may be necessary to make some strategic adjustments now to be prepared for forecasted price increases, it’s also imperative that if your customers are already aware that prices will gradually rise later, they may be more interested to buy now. A steady inflation indicated towards a growing economy which is always a good sign for
business over the long term.

Impact of Inflation on Capital Budgeting

Capital budgeting is a process which anticipates expenses pertaining to assets as well as cash flows in the future. It also takes into account the various factors which may impact expenditures in the long run. One such factor is inflation which impacts both expenditures and incomes.

Inflation and capital budgeting go hand in hand and are related in such a way that at capital budgeting cannot be completed without taking inflation into account. As we all know that inflation causes our purchasing power to decline which means buying an asset for Rs.50,000 today, we must be ready to buy
the same asset for 80,000 after a couple of years. However, it is assumed that the project cost, as well as net revenues, increase in a proportionate manner with inflation. For this reason, in reality, rates of inflation are not taken into account. But this is not true always, inflation does affect capital budgeting. Inflation and capital budgeting are bound to affect cash flows.

In the annual budget simply use an average rate of inflation for the year.

For cash budgets though, these are often done monthly or quarterly – making it trickier.

How to include inflation in a monthly cash budget?

To have inflation onboard as a part of your budget, one must have a plan to estimate when costs or prices
may rise.

1. Wages – You need to estimate the annual increase and include in the budget for the end of the month
after the pay rise takes effect.

2. For monthly utility bills, you need to estimate the increase in costs from the relevant payment month.

3. Sales budget should increase from the time of the sales price review.

4. Other costs – You need to have a monthly inflationary estimate in place. Like for example- 4% each a month or higher in last few months in case you are expecting inflation to rise.

Inflation can be included within cash budgets and forecasts if the assumptions are made wisely and carefully.

What are the impacts of inflation on cash flows and profits?

Impact on Cash-Flows:
Cash flows (inflows) tend to reduce as the costs increase which leads to more expenses in both inventories and labor. Both lead to higher costs of finished goods.
Now as the sales prices are eventually increased, that leaves an impact on trade receivables and they begin to rise, and as a result, the Working capital (Inventory + Receivables – Payables) increases. All in all, Inflation acts as a fuel in decreasing liquidity of cash and aids in the generation of cash flow deficiencies…

Impact on Profits:
Inflation impacts the costs of the business directly which obviously hits the profit earning capacity of the business -particularly in that period when the costs have risen before you could put up your price.

However, price competition also means it’s challenging to decide prices so that you can cover the inflated
costs hence reducing your profitability even more.

Illustration
Let’s assume, company A has inventory worth Rs. 60,000, trade payables worth Rs.40,000 and receivables of Rs.50,000.

Now because of inflation, the costs increased by 5 % which includes costs of materials and labor. The sales prices are constant and have not been raised yet.

Now, what do you think will be an impact on working capital and on cash flows of the business? (Let’s talk about short-term only for now)

Analysis:
In the short term, the inventory will increase by 5% (Rs.3,000) and trade payables will increase by Rs.2,000. Until sales prices are increased, trade receivables remain unaffected.

The net increase in working capital – and reduction in liquidity – is Rs. 1,000.
With rates so low, it will take a long time before interest rates rise enough to even reach historical averages. Even so, there has been much discussion about how higher interest rates impact consumers. It’s important to understand that higher rates also can have an impact on small businesses.

Why is budgeting a key to small business success?

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