- As a result of the COVID-19 pandemic
that played havoc with world trade and economies,
inflation is once again rearing its head above the parapet
as concerns of rising inflation are becoming noisier.
But what are the effects of higher than normal inflation
on your business?
And most importantly,
what can you do to protect your SME business
from the possibility of higher than normal inflation?
In this part two of this series,
we will cover the relationship
between your business and inflation,
the relationship between taxation and inflation,
and finally four actionable ways
that you can protect your business against inflation.
And if you have not already done so,
it is advisable to watch part one of this series first
by clicking here
so you can get foundational knowledge and context
for this episode.
Before I get into today's video,
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In your small or medium sized business,
there are essentially three sides of your balance sheet,
that is assets, liabilities and equity.
There is also the income statement
or profit and loss account too,
which is a primary statement,
but inflation has more of an effect
on your balance sheet items,
which is where I'm going to focus.
Now, the most common types of assets
your SME business probably holds
are cash money in the business bank account,
plant and equipment such as laptops,
hardware, machinery and other equipment.
Stocks for goods for resale,
and debtors, essentially people or other businesses,
entities who owe your business money.
Now, I accept there are more types of assets
such as fixed assets like property or investments,
but for the purpose
of keeping this episode as simple as possible,
I'm only going to focus on the most common types of assets
in my experience at large.
And then the other side of your balance sheet
is the liabilities.
That's creditors, essentially people or entities
your business owes money to,
including the tax man for PAYE taxes,
VAT and corporation tax for a limited company,
income taxes for sole traders.
And loans or short-term borrowings.
Now, for your assets,
if you hold these for a prolonged period of time,
then inflation at higher than normal rates
can have the effect of eroding the value of these assets.
Remember from part one,
the purchasing power.
Higher than normal inflation rates
can perhaps be defined as inflation
above the Bank of England's target rate,
which is 2% for the consumer prices index, CPI.
The Bank of England also makes a very good case
for soft inflation.
That is the 2% target as the opposite of inflation,
which is deflation,
has its consequences too.
However, you, the business owner,
needs to determine your own materiality,
what rate of inflation starts to become an issue
that makes you think about taking action
to protect your assets against this inflation?
So for example, if your business is micro small,
has say only £10,000 of cash on your balance sheet,
and inflation is running at 2% per annum,
then perhaps the maths does not worry you too much.
And a £200 erosion of purchasing power over a year
of the cash in bank
is not too concerning and quite absorbable.
On the other hand,
if your business has £100,000 of cash on its balance sheet
and inflation is hitting 5% per annum,
then perhaps a £5000 pound per annum erosion
in the purchasing power of your cash assets
is material and worth your attention
to take action to protect against.
The flip side to assets is of course liabilities.
And this is where perversely
inflation can actually work in your business's favor.
How, you may be asking?
Well, let me show you with a simplified example.
Let's say your business took a loan of £100,000
at a fixed rate of interest of 4%.
That's £5000 pounds of interest payments per annum.
Let's suppose inflation went up to 5%,
and as a result,
you raised your prices and did everything you could
to protect your business against inflation.
As a result, the true value of the £100,000 liability
starts to erode in your business's favor.
And what's more, the nominal rate of inflation
in this example,
that is the 5% exceeds the nominal rate of interest
your business is paying, that's the 4%.
So in real terms,
that debt is eroding by 1% per annum.
Or another way to look at it
is that your business is benefiting
from a minus 1% real interest rate.
Not great for your lender,
but perfectly fine for your business.
Now, a small caveat here
for you economists and analysts out there.
I accept there are more variables and factors at play,
but my objective in this episode
is to simplify explanations as far as possible
without compromising the true facts and principles.
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So how does inflation interact with taxation?
Well, from an economic point of view,
a rise in taxes by the government
should have a dampening effect on inflation
as your business and the population at large should,
in theory at least,
have less money to spend due to the tax rises.
And less money circulated and transacted
in theory leads to a slowdown or reduction
in the rate of inflation.
However, if the government then goes
and takes this additional tax revenue
and spends it on public spending, for example,
well, then all they've done
is really channel the money into something of their choosing
rather than yours.
So with regards to your business,
the main taxes you will be liable to are PAYE income tax,
VAT, corporation tax and income tax.
For VAT, this is linked to general prices
of standard rated goods and services.
So inflation will cause a VAT element of the price
to actually rise too.
PAYE, that is pay as you earn income tax
linked to your employees,
or even your own director salary payments.
Quite often, if inflation starts ramping up,
you will get demands from the employees
for a salary increase
as their household fuel and other expenses
increase due to inflation.
And if this is the case,
the of PAYE tax in absolute terms goes up too.
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So here are four suggestions you can action
to help you manage the effects
of higher than normal inflation
or levels above your own determined materiality.
So number one, and this is the main one,
and that is to place excess cash
into either an interest bearing business bank account
or exchange it for assets that will provide a return.
Now, you should only keep as a benchmark
three months of working capital requirements
to meet your average monthly expenses.
And you should be able to work out
your average working capital requirements
from your numbers and financial statements.
If you're not sure,
then certainly speak to your accountant
or speak to an accountant.
So let's say your business has total expenses
of £10,000 per month on average.
And if you're holding anything more than £30,000
in liquid non-interest bearing cash
in your business bank account,
then it is potentially too much.
This will of course vary from business to business,
dependent upon the type and nature of your business.
And quite importantly,
how long it takes your debtors to pay you
and you to pay your creditors.
Furthermore, you're probably thinking,
but exchanging any excess cash for assets
that will provide a return carries a risk.
And generally, yes, it will.
You'd seldom get an absolute risk free return.
So for example,
if you exchange your excess cash for cryptocurrency
in your business,
well, we all know that's a high risk asset at present.
Very volatile, but if you get it right,
with some luck too,
it could provide exceptional returns
that more than protects your excess cash
from the erosion in value caused by inflation.
So you should assess your own risk appetite too.
And remember, the objective here
is to protect the excess cash against inflation.
And at the current CPI rate,
which is on screen,
you'll only need a return that exceeds this.
Number two is to make sure you have an effective system
to get paid from your debtors.
That is people or entities that owe your business money
for goods and services provided.
Often see credit terms drift
and debtor balances become stubborn
due to their lack
of the business owner having a robust system
to chase up and collect money owed.
And as a result,
if inflation starts to kick in at higher rates,
well, this is not particularly ideal for your business.
Number three is to do the reverse
for creditors and the taxman.
Now, I am not suggesting in any way, shape or form
you don't pay your creditors or the tax man.
What I am suggesting
is to pay as close to or pretty much at the deadline.
For example, you have nine months
to pay your corporation tax bill
as a limited company business.
So take the full nine months to pay HMRC,
should your business allow this.
Remember, money has a time value,
and the longer you can delay payment,
the more opportunity your business has
to make those funds work in your business's favor.
And finally, raise your prices annually.
Now, this is a big one,
and I often encounter so many business owners
who are crippled with fear
as soon as raise your prices is even mentioned.
I accept that inflation alone
should not be the reason to raise your prices
and other factors such as your competitors,
market demand and so on should be considered.
But these other factors should be used
in how much you should raise your prices,
as opposed to actually raising your prices
on at least an annual basis.
Even a 1% raise in prices can go some way,
if not all the way and more,
to hedging your business against inflation
and helping your bottom line.
This is Tony Dhanial for the Accounting and Tax Academy.
Thanks for tuning in.
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