How Does a Company Prepare for Inflation Risk?
It is nearly impossible to read or listen to news channels today without hearing about inflation and commodity price changes. While no one has the crystal ball that tells what the future holds, it is clear that all businesses will be impacted in some way by inflationary trends or commodity price changes.
The Current Environment
There are three typical measures of inflation – the Consumer Price Index (“CPI”), the Producer Price Index (“PPI”) and the Personal Consumption Expenditure (“CPE”) Index. These measures are prepared in different ways.
Consumer Price Index (“CPI”): The US Bureau of Labor Statistics (“BLS”) publishes the CPI on a monthly basis. This index measures the average change over time in the prices paid by urban consumers for a market basket of consumer goods and services. The CPI also reports on individual components of that market basket of goods such as food, energy, electricity, or medical care.
Producer Price Index (“PPI”): This index is also published by the BLS on a monthly basis. The PPI reports the average change over time in the selling prices received by domestic producers for their output. Individual components such as food, energy, transportation and warehousing are tracked independently.
Personal Consumption Expenditure (“PCE”): The Fed uses the PCE as its inflation indicator. The PCE includes a broader range of goods and services than the CPI, and the PCE uses a broader range of buyers. The Fed believes this measure of inflation leads to a smoother and typically lower level of inflation.
As shown in the next graph, the July 2021 CPI was 5.4% and the August 2021 CPE was 5.3%. Inflation measured by the CPI is at levels not seen since 2008 – or thirteen years ago.
Individual components of the CPI showed more inflationary risk. While used cars were down 1.5% and air travel was down 9.1% on a month over month basis, other CPI categories such as energy and new vehicles continued to show month over month and year over year inflationary growth. People are now beginning to view the concept of transitory inflation with more hesitancy.
The August PPI for July was 7.8%, and August was at 8.3%.
This PPI growth is higher than at any period during the ten years shown in the graph, and may show troubling head winds for the PPI. Several categories within the PPI are increasing faster than others. The next graph shows the pricing changes of cold rolled steel and strip. This production input has tripled in price since the fourth quarter of 2020.
These types of changes in one category can have devastating impacts on a company that relies heavily on the product for an input in its manufacturing process. Commodity price fluctuations are an important component of the analysis of inflationary risks for each company.
The Fed prefers the use of the PCE, which is shown next.
The PCE is published monthly in the Personal Income and Outlays report. The graph above shows the value of a basket of goods from 1960 to July of 2021. The July 2021 PCE (compared to prices one year ago) was reported at 4.2%, compared to 3.6% in April and 4.0% in May and June.
An Example of the Impact on a Company’s Performance
Inflation and changing commodity prices both impact the cost structure of a business.
Inflation will increase costs overall. Consider the impact of a 1% cost increase, a 3% cost increase and a 5% cost increase. Individual line items may increase more or less than the CPI or PPI changes.
Let’s consider an example of a company that has been operating profitably. This company has $50 million of revenues, and has been producing an EBITDA of $2.5 million. Its FCCR has been 1.25.
In the first variation on performance, a key input increased 50% and there was a 1% increase in non-payroll operating expenses. This pushed the company to a slightly negative EBITDA and FCCR was reduce to 0. In the next variations, the key input increases by 50% and there is a 3% or 5% increase in non-payroll expenses. Without a price increase, the company is now operating with a negative EBITDA and will not meet its debt obligations.
Many business owners and bankers have not lived through an inflationary cycle and do not know what to expect and how to prepare.
How does a business deal with this uncertainty and risk?
Dealing with uncertainty requires a level head and a clear understanding of risks and alternative strategies that can be used to improve performance, if needed. This is a time when the use of best practices becomes critical to success. These best practices involve client management, vendor management, the bid process and working capital management. Best practices also include managing the line of credit and implementing evaluation tools such as price volume variance analysis, sensitivity analysis and matrix performance analysis.
The outline below summarizes the questions each company’s management team should be challenged to respond.
Manage client relationships.
Profitability by customer.
Profitability by product.
Profitability by division or by location.
Contracts with customers.
Ability to increase prices?
Auto renewal of contracts?
Contracts with suppliers.
Ability to lock in prices?
Auto renewal of contracts?
Are key input pricings updated frequently?
What is the bid lock period?
What is the escalation wording during the bid period?
What is the escalation wording for the period between bid acceptance and project start?
What is the proposed escalation wording for the contract?
How are deposits reported on the balance sheet and income statement?
Where are customer deposits reported in AR? In one line item? Netted against each customer's accounts?
What deposits are provided to vendors and where are they reported on the balance sheet?
How are deposits treated in the BBC structure?
Working capital management.
Operating Cycle Management.
Line of Credit
Asset relationship limits?
Temporary increases in the line of credit tied to commodity prices?
Price Volume Variance
Each company will need a change agent or disruptor who will take on the task of evaluating performance from the perspective of uncertainty from inflationary trends. This person can hold any role at the company, but needs to be given the authority and responsibility to direct this use of best practices and evaluation of trends.
As a starting point for developing alternative strategies, sensitivity analysis will need to be employed. This means the business needs to consider the following:
How does a $1.00 per unit change in key inputs affect financial performance? For example, a $1.00 per bushel change in corn, a $1.00 change in lumber prices, a $1.00 change in flour prices.
How does a 1% change in all nonlabor costs impact performance?
Will cost structures be impacted by escalation clauses in contracts, such as lease or rental agreements? Are those clauses tied to CPI or PPI and when do they reset?
Each business should start with a review of all CPI and PPI categories that have increased at a faster rate. For example, impact of fuel costs on transportation costs.
It is also important to consider a matrix analysis. This type of analysis considers the number of combinations of events that result in break even performance or adequate FCCR performance. Most importantly, this analysis results in a better understanding of the number of combinations of sale prices and input costs, coupled with company size, that result in break even operations.
It seems that companies are taking one of two approaches. In one approach the company puts its head in the sand, and ignores the impact of inflation because it cannot control inflation. In the second approach, the company understands it cannot impact inflation but works to employ best practices, analyze alternative strategies, and manage its risk profile.
What tools does a lender have available?
It is rare that a company is employing all the best practices identified, and that a risk manager or change agent has been identified. Therefore, what tools does a lender have available?
The lender should:
Identify MONTHLY and QUARTERLY changing trends in:
Cost of inputs
Question the company to determine what they have developed to respond to the inflationary risk?
Working capital management strategies
Rough out an understanding of a $1.00 per unit change in:
Per unit revenue
Per unit input costs
Overall cost inflation of 1%
Consider working capital impacts such as:
Higher per unit revenues mean higher AR levels.
Stress on the AR collection process.
Higher levels of inventory due to supply chain concerns further impacts inventory unit size levels.
Higher investment in inventory.
Higher levels of payables due to supply chain issues.
Are supplier lines of credit keeping pace with the increased costs or are they stagnate at pre-inflationary levels?
Line of Credit Concerns
Overall size limits.
Relationship between asset categories.
Changes impacting ineligible levels.
Evaluation of risk based on inflationary changes or commodity price changes is key to the success of a business. A successful business must have a commitment to the best practices, and a change agent or disruptor who leads the efforts to develop alternative plans and strategies.