The CFO View: How Does Inflation Affect Small Business?

In our first CFO view of the year, our Head of Finance, Adam Brown, gives his expert view on the current state of the economy and how your business can beat the worst effects of inflation. Adam is a chartered accountant, a chartered financial analyst, and has twelve years of professional experience in the corporate finance world.

 

What is causing inflation right now?

You may have heard the term “inflation” used frequently in the news but it’s rarely defined in explicit terms. Put simply, inflation is a decrease in the purchasing power of money. When inflation is high, goods and services cost more since the currency is worth less.

Both consumers and businesses suffer during inflation: Businesses need to pay more for raw materials and inventory, which forces them to increase their own prices, which in turn forces the consumers to pay more.

Identifying the causes of inflation is rarely simple, as many factors can contribute to an increase in prices. Inflation is generally either demand-pull inflation or cost-push inflation, but in this case we’re experiencing both. COVID-19 is a huge part of the issue because so many sectors stopped trading entirely for a time, cutting much of their supply chains and staff. When the lockdown started to lift, those businesses weren’t in a place to be able to serve the demand that was there, which led to significant inflationary pressure (i.e. increased prices).

In terms of the cost-push side of the issue, the war in Ukraine and its influence on energy prices are key factors. The disruption caused by the conflict has had a significant impact on suppliers and supply chains across Europe, so all sectors will see prices inflate as time goes on. This rise in the cost of gas and electricity is just one way inflation affects small businesses.

 

How does inflation affect small businesses?

Increased Costs

The primary impact of inflation is an increase in the cost of goods and services. Business owners can sometimes overlook the fact that these increased prices appear across multiple sectors. If a company does not immediately feel the effects of inflation, they may get the impression that they’re safe for the foreseeable future.

However, since inflation increases costs throughout the supply chain (raw materials, transport, and wages) it’s impossible for a business to avoid the effects of inflation entirely.

Business owners also need to look at ongoing costs they have, such as subscriptions to digital solutions or contracts with external partners and suppliers. These contracts will likely have clauses in them related to inflation that will alter the amount you pay.

 

Debt

Small businesses with debts need to be aware of how it can affect their financial situation, particularly in times of inflation.

If any of your company’s debts come with variable interest rates, you are exposed to inflation because the usual governmental reaction to inflation is to increase interest rates, which in turn leads to a very high cost of debt.

On the 4th of August 2022, the Bank of England did exactly that, raising the interest rate from 1.25% to 1.75%. Doing so may help alleviate inflation in the UK economy and prevent prices from staying high in the long term. That said, increased interest rates mean small businesses with debt will need to be very careful with their finances until rates decrease again.

 

Increased Wages

Consumers and businesses alike will be dealing with increased costs, which means that times of inflation also usually come with pressure to increase staff wages. Even SMEs with few employees may struggle to offer more pay when high expenses will be cutting into company revenue.

The wage pressures at the moment are coming from two different angles. The first is a lack of staff, which is certainly a problem within the UK. A lack of employees for particular roles creates a supply issue, which gives employees a lot of bargaining power when it comes to salary.

There’s also pressure coming from headlines and news stories. People will often see inflation as a news story, or even the need for wage increases as a news story and will bake that into their salary expectations.

For SMEs, the best decision most often comes down to what your competitor is doing, the market insights you’re able to find on what people are being paid. This is generally what SMEs will be reacting to. Currently, a lot of companies are looking to increase salary packages outside of salaries through benefits and perks instead of direct salary increases. It remains to be seen if that works though, as it’s relatively new.

 

How can I beat the effects of inflation on small businesses?

It’s entirely possible to guide your company through tough economic times without feeling too much of the impact. However, keep in mind that inflation is an entirely external force. While the advice we provide can help support your business, reducing inflation takes government action (such as the interest rate increase mentioned above). As such, prepare to make long-term adjustments to your business plan if inflation doesn’t look to be disappearing quickly.

 

Cut costs where possible

As the primary effect of inflation is increased costs, an SME’s first step should be to evaluate their expenses and work out where costs can be cut. Two pieces of information that business owners need to work out during this evaluation are:

1. Which costs are discretionary (i.e. costs that are not essential to the survival of the business).
2. Which costs are within the business’ power to change (for instance, a supplier cannot be forced to lower their prices, and a bank cannot be forced to reduce loan repayments.)

The importance of cash flow management cannot be understated. In the current economic circumstances, it’s essential that a business is not left in long periods where their outgoing expenses are unmanageably high. Costs should be managed wherever possible to ensure incoming and outgoing cash are relatively equal.

Companies should examine any planned projects or expansions to determine if they can be postponed. If a particular project has the potential for significant return on investment, it’s likely that continuing with it despite the inflation is a good idea. However, expansion plans like building a new branch of your retail store are both expensive and very high risk, so shelving them temporarily may be wise.

The costs you eliminate within your business will depend entirely on the industry in which you operate and the unique needs of your company. However, here are a few general steps that almost any company can take to reduce their expenses:

• Find different suppliers or use alternative materials: If your supplier has increased their prices by an unreasonable amount, it may be wise to seek a new supplier, or (in the case of an SME that manufactures their goods) look into changing your production methods. However, it’s vital to balance low costs with quality, as poor quality products can harm the customer experience.
• Renegotiate contracts: Re-examine your contracts to determine your level of exposure. By contracts, we mean everything from your agreements with suppliers to your rent payments on any leased company property. Contracts with clients may also need to be evaluated — if it’s possible to pass increased costs onto clients by raising prices, do so.
• Eliminate bonuses temporarily: While it may be unpopular with your staff, employee bonuses like staff entertainment or discretionary spending can be temporarily suspended with very little effect on company income.

When cutting costs, always look at the link between the expense and your revenue. If the money you’re paying does not somehow funnel back into your business, consider cutting the cost in question.

 

Look into automation and digital solutions

Automation is a popular cost-saving tool for many modern businesses. Instead of having employees complete time-consuming, repetitive tasks like data entry, you can use a digital solution or software tool to do the job instead. Doing so helps reduce errors and increase efficiency, as well as freeing up employees to deal with more complex issues.

There are so many different products now that provide solutions to reduce manual input, and a lot of them don’t require a large investment of either time or money. Many options are so advanced you can implement them almost as soon as you’ve selected them.

If you can reduce the workload of manual staff by automating back office functions and processes, it’s certainly something that can significantly reduce your cost base.

 

Look for alternate means of funding

While costs can be eliminated, and pricing can be adjusted to help increase revenue, it may be that your small business needs a significant cash injection in order to continue operating. However, in times of inflation, many traditional finance options are simply too slow to be of any assistance. They might also have repayment terms that could leave your SME in a worse financial situation than they were originally.

Less traditional forms of funding can be a more suitable alternative for small businesses dealing with the effects of inflation. A couple of examples are to refinance debt, or seek funding like the revenue-based financing option offered by 365 finance.

One of the key benefits of revenue-based financing is the freedom it gives your business. Spending doesn’t need to be limited to a particular project or department; you can invest in anything from marketing to sales and logistics.

 

Fight Small Business Inflation with 365 finance

At 365 finance, the continued success of our clients is our top priority. That’s why we offer revenue-based financing options with manageable payment terms — your payments are based on your monthly income, so you don’t need to worry about falling behind if you have a month of low sales.

We can offer revenue-based funding of £10,000 to £400,000 in capital, so your business can thrive all year round. Apply for funding today without affecting your credit score. Or speak to our team to find out how we can help your business. Click here to find our more.