Definitive Guide to Inflation for Small Business Owners
April 5, 2022 | Last Updated on: July 27, 2022
April 5, 2022 | Last Updated on: July 27, 2022
Long before the Ukraine became a global flashpoint — with Russia’s invasion impacting everything from gasoline prices to supply chains and the cost of goods in the United States — the specter of inflation loomed in recent years as a threat that could well eventually pose a major challenge to business concerns in the U.S.
Small businesses can be acutely impacted by inflation in ways that many entrepreneurs probably never even considered. Growing a small business is a challenging enough endeavor on a daily basis for most owners of small companies, without even considering how the damaging effects of inflation can compound that pain.
Let’s first define exactly what “inflation” is. Many consumers, let alone small business owners, have a cursory idea of what it is, especially if they came of age in the early-mid 1970s and heard the term constantly to describe the state of the post-Watergate American economy.
But not all economic woes are linked to inflation. Indeed, the aftermath of the 2008 financial meltdown, a fateful Monday morning in September when Lehman Brothers went bankrupt and an international banking crisis followed, was not accompanied by inflation. That was the year the price of gas, which had soared well above $4.00 per gallon nationwide in the summer, nosedived all the way below $2.00/gallon on a matter of mere months following the September global financial collapse.
When the price of goods and services rises over a period of time, eating away at the purchasing power of the currency, that is inflation. A rise in inflation rates that soars north of 5 percent can be crushing to everyday consumers, and a death blow to some small businesses. A sustained rise in overall price level for goods and services is a simplified definition of what inflation is.
The rate of inflation is the increase in prices during a specified period. If inflation is at an annualized rate of 3%, a product, good or service that costs $1,000 now would, in theory, cost $1,030 the following year. Inflation reduces the value of every dollar in your pocket or your bank account.
The domino effect of inflation on a small business owner is that not only does everything cost more, but hiring more employees or sustaining the growth of a company becomes much more difficult, if not unattainable. An entrepreneur financing his or her company with their own personal savings are especially exposed to risk if inflation reaches unsustainable levels.
Understanding the causes of inflation might not be enough to save a business that’s suffering because of it, but it at least might provide some perspective.
When the demand for a product or service is greater than the actual supply of that entity, inflation can ensue. It’s also the result of what happens if supply is restricted but demand is not. This is exemplified by the rise in gas and energy prices when oil refineries are shut down or drilling ceases.
According to morningconsult.com, supply chain disruptions have been a contributing factor to rising inflation: Nations with more dire shortages and more numerous supply chain issues are where price growth was expedited the most.
Another cause of inflation is when central banks print extra money and circulate that currency in an effort to prop up a flagging economy. An increase in money supply causes a devaluation of the dollar, and the result is that a dollar won’t go nearly as far in its purchasing power than it would otherwise.
A small business will almost always be more vulnerable to the effects of inflation than a larger company. The larger the corporation, the more extensive its financial reserves are. The converse, of course, is that the smaller a company is, the more profound the potential damage from inflation could be.
A small business just doesn’t have the luxury of abundant access to financial liquidity that a larger company does. The salaries of an owner or partner in a small business eat up a bigger percentage of the company’s overall revenue, which in turn affects the business’ ability to expand under these circumstances.
Inflationary forces can greatly impact the cash flow in a small business. If your company is affected by inflation, it means that so are your clients, creating a chain reaction where they might not be paying you what your company is owed in a timely manner. If enough of your clients are slow to pay you on time, then your business may not have enough cash flow to pay your expenses or your employees.
Inflation also affects inventory. The higher the cost of inventory, the more difficult it will be for your business to carry as many products as it previously was able to. If the result of all this means that your business has no other recourse but to raise prices, then your customers might become more reticent to pay those prices, or they may simply not be able to afford to. If your solution to this is to market a marked-up product or service in a more creative way in an effort to drum up increased interest in what you’re selling, then that modified packaging/marketing might cost you more money, as well.
Raising prices could raise your profits and your revenue. But it’s a fine line to walk, because higher consumer prices could also chase off customers or consumers unwilling to pay those higher prices. If you are hesitant to raise your prices for this reason, and you want to accommodate your customers, you could keep prices the same. But doing that means paring away at your own profit margins.
If you want to maintain reasonable profit margins as well as retain existing customers by not raising prices, you could also consider reducing expenses by switching to a vender who charges you less or lowering the quality grade of the product or service you are offering. But then you risk acquiring the reputation for offering a substandard product or service, and a bad reputation could ultimately be a detriment to your small business, too.
Another effect of inflation on a small business is the inability to offer wages to employees or higher rates to freelance workers. That might cause an increase in employee turnover, or a need to go out and search for other freelancers willing to work for what you’re able to offer them.
Rising costs in a wide swath of the economy can affect every aspect of a small business. The entrepreneur of a small company could see rises in the cost of labor, raw materials, and interest.
The more that small business depends on loans to finance itself, the more damaging inflationary pressures can be. High interest rates are anathema to a small business, especially because they pose a problem that can be far from just temporary. If a business owner takes out a 20-year term loan for $250,000 at a rate of 7 percent, the cost per month would be $1,938.25. An interest rate of 11 percent, however, would increase that monthly payment to $2,580.47â€”thatâ€™s $642.22 more every month, and more than $7,700 more per year. Multiply that payment by 20 and itâ€™s more than $154,000.
While all small companies should certainly keep a certain amount of cash in their bank accounts, keeping too much cash on hand could decrease oneâ€™s buying power because of the effects of inflation. A very general rule of thumb according to many economists is that a small business should keep somewhere between three- and six-monthsâ€™ worth of cash on hand.
Thereâ€™s no pat answer and no simple solution to a small businessâ€™ ability to counter the effects of inflation.
But a few principles could be helpful to the entrepreneur struggling against the tide of rising costs.
Study your businessâ€™ profit margins. How much have your own profit margins dwindled during an inflationary period? Once youâ€™ve come up with a figure, study ways that you might be able to boost those margins once again.
Cut your expenses. Are there services your business pays for on a regular basis that it does not use on a regular basis? Is it a fundamentally necessary cost, or something that can be reduced or eliminated entirely?
Whatâ€™s your overhead? Is your business housed in a facility thatâ€™s larger than the amount of space you really need? Moving to a smaller facility or to a less expensive location would reduce your overhead costs.
Do you depend on one supplier? Alternating suppliers, or finding a domestic supplier to replace a supplier whose goods come from abroad might be a partial remedy to supply chain issues. Stocking up in on inventory and attempting to lock in a long-term price now might save your business some costs if prices continue to go up.
Raise your prices. Your customers wonâ€™t like it, but there are incremental methods of effecting a price hike that will reduce the amount of â€śsticker shockâ€ť your customers will experience.
Types of loans that small businesses might be able to secure quickly include:
When a lender provides pre-approved funding with a maximum credit limit, that is known as a business line of credit. If the borrower is approved for this line of credit, funds can be accessed whenever they are needed until the established credit limit has been reached.
Because the borrower is only paying interest on the amount that he or she withdraws, a business line of credit can be advantageous for business owners who are uncertain of the amount of funding they will actually require, or when they might need it.
A loan with a fairly short repayment period, a short-term loan is one in which the borrower receives his cash in a lump sum up front, then repays the loan, often with some pretty sizable financing rates. Some short term loans allow the borrower to make extra payments to pay it off sooner. However, some short term loans actually come with penalties for early repayment. Short-term loans generally have a term of 12 months or less.
Payments on short-term loans are required frequently â€” sometimes once a week, or, in some cases, every day.
Although the credit requirements are not as strict for short-term loans as they are for regular term loans, the frequent payment schedule may be burdensome for someone in a new business without a lot of cash flow at that moment. But a businessperson who needs a loan in a hurry still might opt for a short-term loan because it may be easier to secure than other forms of financing.
For companies that have unpaid invoices. Invoice factoring is a financing method where you sell your accounts receivable at a discount for a lump sum cash amount.
A method of securing working capital that is a little different than applying for a loan, invoice factoring is the process of selling invoices at a discounted rate to a factoring company and receiving in return a lump sum of cash that can be used as working capital.
After assessing the risk of financing the business ownerâ€™s invoice, the factoring company collects payments from the businessâ€™ customers over a span of between one and three months. If a company sells something to a customer, but that customer cannot pay off the invoice right away, thereâ€™s a gap of time that could create a shortfall for the business owner. The lump sum that the business would receive by undertaking the process of invoice factoring would cover the shortfall and solve the problem of cash on hand.
The U.S. Small Business Administration (SBA) offers commercial financing backed by the SBA through its SBA 7(a) loan program. The most common type of SBA loans, an SBA 7(a) loan assists businesses in the purchase or refinance of owner-occupied commercial properties up to $5 million. This loan also gives the business owner a chance to borrow funds for working capital.
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