Inflation: Why it is important to companies and investors

Inflation may drive significant changes in value, but those changes are generally not felt equally across the board.

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A big storm tends to move through with strong winds. But when the storm clears, it can be obvious that those winds didn't affect everywhere equally. The same is true for inflation's impact on a company's finances. Inflation may drive significant changes in value, but those changes are generally not felt equally across the board. An investment analysis should identify each impact in order to account for the influence of inflation most effectively.

Start with the basics

In common conversation, inflation is a broad increase in the prices associated with a constant amount of goods and services and it is typically spoken of as a negative factor. But like wind, price changes are always present. They become financially significant only when they become abnormally large, fast, or widespread.

Meanwhile, images of consumers toting wheelbarrows full of currency in places such as Germany in the 1920s and Argentina in the 1980s have etched the impact of rapidly rising prices on the public consciousness. But from an investment perspective, disinflation (when the pace of price increases slows down) and deflation (when the overall cost of living actually declines) can cause significant problems too. All such factors should be considered.

How price changes can impact the balance of assets and liabilities

Inventory and similar assets are typically valued according to either the company's cost of purchasing the asset or the current cost of replacing the asset, whichever is less. This lower of cost or market principle means that in an era of rapidly rising prices, these assets could have a higher value in practice than that which appears on the balance sheet. However, if the price level is declining, those assets could become overvalued. In either case, the changes in effective value may be obscured and reported only as part of their contribution to operating results.

For less liquid assets such as property, plant, and equipment, the impact of inflation may take longer to be felt. Depreciation schedules are typically based on the actual cost of the asset and applied as long as the asset is used. If inflation drives up the cost of replacing that asset, the impact is likely to be realized only when a replacement asset is put into service. The reverse would be true in the event of deflation.

For current assets such as cash and accounts receivable, there is generally little that could be obscured or deferred, and the impact of a change in purchasing power can be assessed immediately. Keep in mind that inflation (and inflation fears) can have a significant impact on foreign exchange rates. In some cases, the resulting currency translation gains or losses could counter the impact of inflation-driven purchasing power gains or losses. In other cases, the translation issues could amplify inflation's effects.

How inflation can change the flows of income and expense

The impact of changes in price level on revenue depends on factors such as pricing flexibility, sales turnover, and pricing power. A company that relies mostly on large deals with multi-year revenue streams may have reduced opportunity to compensate for losses in its revenue purchasing power during the period of a contract. Conversely, it can reap unanticipated gains if the purchasing power of its future revenue were to increase.

A company that continually brings in new sales may be able to adjust its pricing more readily to respond to its customers' purchasing power changes. Of course, while raising prices can promise increased revenue, any such discussion assumes that the company has the market power to increase its prices even if one or more of its competitors do not adjust their prices.

On the expense side of the ledger, the impact of changes in price level depends on factors such as the proportions of cash and accrual expenses and the amounts of inventory and work-in-process that may be carried from year to year.

A business that constantly buys raw materials at current prices could see its costs of goods sold respond relatively quickly to changes in the economy's price level. A business that accrues large fractions of its costs by depreciating prior investments could see less immediate cost effects as older investments are consumed.

Products with short production cycles may see relatively little impact on the cost of any given unit. However, those with a multi-year production cycle may carry accrued costs that lag behind current price levels.

Interest costs could be a special case. A company with a large proportion of fixed-rate interest costs could see the impact of those costs diminish as price levels rise but increase if price levels fall. Conversely, companies with significant variable-rate costs could see their interest costs rise due to inflation and fall due to deflation.

How inflation changes the market

At the broadest level, inflation may tend to increase focus on immediate consumption rather than deferred rewards. This is particularly evident in the consumer sectors of the economy, where the value of buying something before prices rise could outweigh any impulse to save for the future. On the opposite side, the impulse to spend quickly can be diminished when consumers believe that the same item will be materially cheaper in the near future.

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