Preface: The Consumer Price Index for All Urban Consumers (CPI-U) increased 0.6 percent in January on a seasonally adjusted basis, the U.S. Bureau of Labor Statistics reported today. Over the last 12 months, the all items index increased 7.5 percent before seasonal adjustment. – USBLS News February 10, 2022
If Inflation Conditions Where Will Your Business Be? (Segment IV)
Working capital in entrepreneurship should be given paramount attention during inflationary economic expansions. Historically, during gradual or more rapid inflation, prices rise as too much money chases too few goods. This is the current experience on Main Street American, from grocery store aisles to auto dealerships. But, more importantly, inflationary trend impacts are not solely financial but also extend into the social fabric of daily life. More so, astute observers realize that in prior decades, inflationary gauges monitored changes in packaging sizes and unit costs as changes to inflation rates. In 2022, times are a ‘changing.
Working capital management during an inflationary business environment bestows the clear expectation that as the inflation rate climbs, so too does the cost of capital. As a result, capitalists require a higher rate of return on their investments, i.e., as the present value of the investors liquid capital decreases from inflationary effects, capitalists have a necessary incentive to be fully invested, leading to a shortage of reserve capital for future needs, say particularly for those financing outside of the banking system.
For example, any top hat investor who had $1.0m of cash in the bank in March of 2020 could still have $1.0m of money in the bank. Yet pricing that $1.0m investment is in dollars, say. If that same investor compares the number of pickup trucks, houses, steaks, or boxes of cereal that the $1.0m could purchase in 2020 to just two years later, we soon realize that most investors desire a higher rate of return on such an investment continent on prescient projected trends. Correspondingly, the present value of money changes substantially and rapidly. Hence, any business that requires a 40% to 50% capital build to keep their inventory stocked, such as an auto dealership, has two options for financing – debt or equity.
Again, looking forward, any business financing growing working capital builds in inventory or scaling overhead costs with equity will want and need a higher rate of return on their assets to compensate for the additional balance sheet risks. This flywheel of too much money chasing too few goods leads to the trending expectation of higher net income for entrepreneurs so the entrepreneur can obtain a higher rate of return on working capital to compensate for the higher risks, resulting in higher costs customers. On that track, the customers paying the higher costs will either obtain their working capital from higher wages or more passive income? Or may it also include a shortage in the household budget?
When a business cannot raise prices during inflation, it will need to accept a lower rate of return on working capital and, therefore, lower net profitability. For an asset-intensive business with substantial debt, that scenario is most challenging. However, a company can also manage working capital costs by reducing the level or amount of capital required for activities, reducing its financial risk in the marketplace.
Inflation often leads to reduced capital expenditures in the long term because the economic costs of those capital expenditures multiply based on the elevated cost of capital. As capital expenditures decrease, so will the activity in the associated economic food chains. Businesses who enter an inflationary cycle with a working capital structure of mostly debt, based on leveraging a higher rate of return or asset building plan, will discover that if they don’t score above an A on inflationary trend projections, they have little room for error, and perhaps none. Businesses with higher levels of equity working capital are not guaranteed worry-free navigation, but reducing a cash conversion cycle is a starting point to manage financial risks during inflationary periods.
Quoting Fed Chairman Alan Greenspan from 1996 – Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the past inflation rate. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade? Summarized = we may not know what asset euphoria looks like, but the above quote counsels it as a sign of the peak on an economic sine wave.
Inflationary theories or facts, perhaps exemplified in Venezuela, show that interest rates trend with inflation rates. This leads to a high cost of capital in times of higher inflation. Recent reports for Venezuela detail that the country runs on the confidence of US Dollars, and money exchanges are vital, as the inflation rate in its currency was 686.4% for 2021 and interest rates were above 50%. Is that a currency meltdown in terms of conserving denominated wealth? Without mentioning taxes on the capital gains appreciation in such an economic environment, simply losing least is winning? The world is powered with dollars, and while a bastion as the world’s reserve currency, if usurped, would seem to perhaps resemble an H.G. Wells 1897 The War of the Worlds state, but I’ve only glanced at those works, so I should refrain from further comment.
Finally, one generally concerning factor of the inflationary flywheel is any passive quasi-government subsidy or fixed income supplement recipients, if not to be left behind, will also need additional funds. Perhaps this is to be afforded? It will require additional debt or higher taxes, or both. Either option presents substantial risks to maintaining stable working capital rates and a stable pricing environment for an affable entrepreneurial marketplace that more than a few have genuinely credited as a status quo.