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Rising Inflation and Its Impacts on Capital Budgeting
India’s Consumer Price Index (CPI) growth was measured at 5.0% year-on-year in June 2018, up from 4.9% in May.
The CPI qualitatively measures the extent to which prices for certain items have risen, meaning that this will affect consumer purchasing power.
All such indicators conclude in the direction of rising inflation, general price growth and a reduction in the purchasing power of money. Inflation rate in India rose to 5 percent in June 2018 from 4.87 percent in May, below market expectations of 5.3 percent. Still, this is the highest rate since January and the eighth consecutive month in which inflation has been above the central bank’s medium-term target of 4 percent.
When it comes to small businesses, the ever-increasing inflation can have really dramatic effects. I’m sure most entrepreneurs are aware that higher inflation can lead to higher prices, but let’s take a closer look at the effects of this.
Let’s look at how inflation could potentially affect your business and how you can prepare to mitigate the potential risks it poses:
Direct/indirect impact on goods, services and equipment
The rate of inflation is determined by the cost of common essentials and goods purchased by most households, as well as price fluctuations. The recent increase in inflation in India is due to rising prices of petrol, healthcare, garment industry etc.
While your business may not need the same items as the average household purchase, a general increase in the rate of inflation is likely to mean that your start-up will eventually have to pay higher costs
produce the same goods or provide services.
According to economic forecasters, inflation will continue to rise steadily, and one way to deal with this issue for business owners could be a well-thought-out plan for future prices. The safest and most recommended option is to build a financial cushion with periodic business savings. This would help with any price fluctuations. You can also enter into long-term contracts with vendors with whom you regularly do business, so you can depend on today’s prices for the duration of the contract.
Inflation will result in more expenses in the form of equipment and inventory costs, which will significantly affect your profit margin. So you could resort to raising your selling prices to a
a healthy profit margin.
If you feel that you need to raise your prices to remain profitable, you may really want to consider offering your loyal customers contracts with the ability to adjust their prices economically. It is defined as a fixed-price contract with an economic price adjustment that allows upward and downward revision
the stated contract price upon the occurrence of certain unforeseen events. With this technique, you can make adjustments based on pre-agreed criteria, such as your labor or material costs or expenses
labor or material indices and will not suffer losses.
As the prices of finished products rise, your employees may find it difficult to survive on the current money they receive and may look outside for better opportunities to increase their salary. Well, you as an employer can also offer them hikes, but in an inflationary environment it becomes challenging for you as well.
Instead, look for alternative options to increase employee retention by offering flexible hours, extra vacation or extra transportation/meals, etc.
According to the International Monetary Fund – while rising inflation may seem negative, it’s actually good for the economy if growth is small, stable and predictable. While some strategic adjustments may need to be made now to prepare for announced price increases, it is also imperative that if your customers already know that prices will gradually increase later, they will be more interested in buying now. Flat inflation indicates a growing economy, which is always a good sign
business in the long run.
The impact of inflation on the capital budget
Capital budgeting is a process that predicts asset-related costs and future cash flows. It also takes into account various factors that can affect expenses in the long run. One such factor is inflation, which affects both expenditure and income.
Inflation and capital budgeting go hand in hand and are linked in such a way that capital budgeting cannot be completed without taking inflation into account. As we all know that inflation causes a decline in our purchasing power, meaning we are buying an asset for Rs 50,000 today, we must be ready to buy
the same asset for 80,000 after a few years. However, project costs and net revenues are assumed to increase in proportion to inflation. Because of this, inflation rates are not really taken into account. However, this is not always true, inflation affects the capital budget. Inflation and capital budgeting will certainly affect cash flows.
Simply use the average inflation rate for that year in your annual budget.
With cash budgets, however, this is often done on a monthly or quarterly basis, making it more difficult.
How to include inflation in the monthly cash budget?
To incorporate inflation into your budget, you must have a plan to estimate costs or prices
1. Salaries – You need to estimate the annual increase and include it in the month-end budget
after the implementation of the salary increase.
2. For monthly utility bills, you must estimate the increase in costs from the relevant payment month.
3. The sales budget should increase from the moment of the sales price review.
4. Other expenses – You must have a monthly inflation estimate. Like for example – 4% every month or more for the last few months if you expect inflation to rise.
Inflation can be incorporated into monetary budgets and forecasts if assumptions are made wisely and carefully.
What are the effects of inflation on cash flows and profits?
Impact on cash flows:
Cash flows (inflows) tend to decrease as costs increase, leading to higher costs for both inventory and labor. Both lead to higher costs of finished products.
Now, as sales prices increase over time, this has consequences on accounts receivable and they begin to rise, and as a result, current assets (inventory + accounts receivable – liabilities) increase. In general, inflation acts as a fuel in reducing the liquidity of money and helps in creating cash flow shortfalls…
Impact on profit:
Inflation has a direct impact on a company’s costs, which obviously affects a company’s ability to make a profit – especially during that period when costs rose before you could raise your price.
However, price competition also means that it is difficult to set prices so that you can cover the inflated
costs, further reducing your profitability.
Assume that Company A has stocks worth Rs. 60,000, liabilities to suppliers in the value of 40,000 din and receivables 50,000 din.
Now, due to inflation, the cost has increased by 5%, which includes material and labor costs. Selling prices are constant and have not yet been raised.
Now, what do you think will be the impact on the company’s working capital and cash flows? (For now we are only talking about the short term)
In the short run, inventories will increase by 5% (Rs. 3,000) and accounts payable by Rs.2,000. Receivables from customers remain unchanged until sales prices are increased.
The net increase in working capital – and decrease in liquidity – is Rs. 1,000.
With interest rates this low, it will take a long time for rates to rise enough to even reach the historical average. Still, there has been much debate about how higher interest rates affect consumers. It is important to understand that higher rates can affect small businesses as well.
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