Inflation – it’s a word that’s been on everyone’s lips recently. Rates are on the rise, and our small business community is feeling it the most. Increased supply costs, a lack of workforce, and dwindling profits are among the challenges faced. 

Let’s demystify inflation and delve into its impact on small businesses.

Grasping Inflation

In essence, inflation is the uptick in the cost of goods and services. Whether it’s a can of beans or a property, prices creep up. This fluctuation is driven by numerous factors including supply and demand, production costs, staff shortages, monetary expansion, and wage increases.

While it may seem counterintuitive, a certain degree of inflation is intentional. Economists broadly concur that a 2% annual inflation rate is optimal, striking a balance in the economy while fostering growth. This modest rate enables central banks to decrease interest rates, stimulating the economy without burdening consumers excessively. 

Despite this consensus, the intricate nature of inflation and its implications often spark spirited discussions. Though we can’t control inflation as individuals, understanding its implications for our personal finances is critical.

Inflation isn’t just about higher prices; it affects the broader economy and, indirectly, our daily lives. For example, when inflation rises unexpectedly, central banks may raise interest rates to curb it. This, in turn, increases borrowing costs for businesses and individuals alike, impacting everything from mortgages to business loans. Rising interest rates slow down consumer spending and investment, leading to an economic slowdown. Hence, while a low level of inflation can indicate healthy economic activity, high inflation can signal underlying issues, from supply chain disruptions to excess demand.

How does inflation affect small businesses?

Small businesses, with their limited financial buffers, are especially susceptible to inflation. As inflation pushes up the cost of goods and services, small businesses must grapple with these increased expenses with fewer resources at their disposal. Picture this: a small business sells a product for $10. Suddenly, production costs rise to $12 due to inflation. The business is then faced with a tough decision – absorb this extra cost or pass it onto customers, potentially harming sales.

One of the key features of inflation is the erosion of consumers’ buying power. When your savings grow at a slower rate than inflation, you’re effectively losing money. The interest earned on your savings account needs to outpace the inflation rate to preserve its value. With global inflation currently outstripping the average savings account interest rate, you might find your money doesn’t go as far as it once did, even though the dollar amount remains the same.

Small businesses often face unique challenges when inflation rises because they don’t always have the leverage to negotiate better pricing with suppliers. Larger corporations may be able to absorb higher costs or negotiate bulk discounts, but small businesses have limited purchasing power and may struggle to adjust prices without losing customers. Additionally, inflation impacts hiring costs: if wages increase to keep up with inflation, small businesses may find it difficult to attract or retain employees without cutting into their profits. Navigating these challenges requires strategic planning and, often, creative problem-solving, such as identifying local suppliers to reduce shipping costs or diversifying product lines to attract new market segments.

Navigating with the Rule of 72

To get a rough idea of what this loss of buying power looks like, let’s turn to the Rule of 72. Though it’s a rough estimate and doesn’t account for varying inflation rates over time, it’s a useful tool to envision what might happen to your money if the current rates persist.

To estimate how long it’ll take for your savings to double, divide 72 by your annual interest rate. Let’s say you have $100 in a savings account with a 2.5% interest rate. According to the Rule of 72, it’d take about 28.8 years for your savings to reach $200.

The Rule can also help you gauge how quickly inflation might eat into your savings. Divide 72 by the annual rate of inflation. If the inflation rate is 6.5%, for example, it’d take just a little over 11 years for your $100 to be worth half its value.

This illustrates why an inflation rate exceeding the interest rate earned by your customers can be a challenge. As prices go up, consumers become more hesitant to buy goods and services. If small businesses have to raise prices to cope with inflation, it could further affect consumer purchasing power. Therefore, it’s crucial for small businesses to adjust to inflation to stay afloat.

Using the Rule of 72 is also valuable in long-term financial planning. For instance, business owners saving for future investments, such as equipment or expansion, can use this rule to understand how much inflation could erode their savings. By comparing the inflation rate with potential investment returns, business owners can make more informed decisions about whether to reinvest their money or hold onto cash reserves. Additionally, applying the Rule of 72 to debt can offer insight into how quickly interest expenses can accumulate, helping businesses strategize more effective debt management.

Strategies to Combat Inflation’s Impact on Small Businesses

While inflation poses challenges, small businesses can take proactive steps to mitigate its impact. Here are a few practical strategies:

1. Reevaluate Pricing Strategies: Increasing prices may seem risky, but gradual, small adjustments over time can help cover rising costs without shocking customers. Consider offering value-added services or bundles to justify price increases, allowing customers to perceive added value even as prices rise.
2. Streamline Operations: Evaluate internal processes to identify areas where efficiency can be improved. For example, automating routine tasks, reducing waste, or optimizing supply chains can help cut costs. Even small adjustments, like reducing energy usage or finding alternative packaging, can accumulate into significant savings over time.
3. Diversify Suppliers: Relying on a single supplier can be risky, especially during inflationary periods. Consider working with multiple suppliers to improve your bargaining position and avoid supply chain disruptions. Having alternative suppliers also gives you options if one vendor raises prices.
4. Focus on Cash Flow Management: During inflation, strong cash flow management is crucial. Try to shorten your accounts receivable cycle, encouraging customers to pay faster through discounts for early payment. Extending payment terms with suppliers can also help manage short-term liquidity, giving you more time to cover expenses.
5. Invest in Technology: Leveraging technology, such as cloud-based accounting software or inventory management tools, can streamline your operations and provide real-time financial insights. These tools make it easier to forecast cash flow, track expenses, and manage inventory, all of which contribute to more efficient operations in a high-cost environment.
6. Evaluate Financing Options: Rising inflation often leads to higher interest rates, making borrowing more expensive. However, securing a fixed-rate loan now could protect you from potential rate hikes in the future. If debt is necessary, consider exploring financing options like business lines of credit or working with lenders who offer favorable terms for small businesses.

Implementing these strategies not only helps small businesses withstand the pressures of inflation but can also lead to greater operational resilience and efficiency. By staying adaptable and proactive, small businesses can navigate inflationary periods while protecting profitability and supporting long-term growth.

If you’d like to talk about steps you should take in your business, get in touch with us.