Belmont University

What, Me Worry? Inflation and Debt

My post yesterday got a comment questioning why business owners are so worried about inflation and its affect on debt.

During periods of high inflation, many small business cannot keep pace with higher costs. Their profit margins will shrink as costs go up more quickly than they can increase prices. We are already seeing evidence of this.

When margins shrink, businesses may no longer be good credit risks for banks. Their cost of borrowing money goes up. Or in some cases, they may become out of compliance with the profit margins required in the restrictive covenants in their loans. The banks may force them to move their loans to another bank. That will mean the transaction costs for the new loan and typically higher interest rates.

The Fed will soon begin to use higher interest rates to cool off inflation. The cost of debt goes up. During our last period of inflation in the late 1970s mortgage rates hit 16-18%. Higher rates hung around late into the 1980s, when we still were paying 9% for a prime plus a quarter business loan.

Inflation of 2-3% we can handle. We have had a long period of solid economic growth with modest inflation. Younger entrepreneurs have never known anything else. What many of us think is coming is double digit inflation. That changes everything. Profits will be harder to maintain. Debt will cost more and can become much more difficult to secure.

Those who get out ahead of this will have a better chance to be OK. Those who do not will have a higher risk of failure. See this recent post I wrote on steps entrepreneurs should be taking to shore up their income statements and balance sheets to prepare for a period of much higher inflation.


Posted by Jeff Cornwall on July 9, 2008 06:37 AM |

Comments

Thanks for addressing my earlier comment. I though I should throw another 2 cents out here as well though. You said here that "as costs go up more quickly than they can increase prices".

What in the heck are you talking about? If you own a business and have a decision to raise prices or go under, that decision becomes one of the easiest to make. You raise prices. Customers buy gas, they buy things, and know that prices have gone up. If you lose some due to increased prices, it is the lesser of 2 evils, with the alternative being going under.

Not many small businesses are capitol intensive. Most owners borrow money to get established or to expand. If you don't have a profitable model, and the future is uncertain, then you really have to think hard before going the expansion route. Inflation reduces your debt. Not on a $ basis, but on a % basis. Your debt gets easier to pay. Student loans get easier to pay off.

Compliance and covenants on loans? That isn't even worth a reply, and I challenge you to find a single example where a bank "forced" a customer to move their loans to another bank.

Birdied by: Pizzamancer | July 9, 2008 06:15 PM

Pizzamancer,

The reason that expenses go up faster than revenues for many businesses are plentiful. For example, your customers are also feeling the pressure of inflation so lean on you to hold the line on prices. Last night a business owner told me the story of how a big customer was demanding he cut his price by 10%. I experienced this in my businesses and I am seeing it again right now.

I never said that businesses got in trouble because of their business model. People with business models that have been healthy are reporting declining profits because they cannot increase their prices quickly enough. Not all businesses, of course, but many. This is a particilar problem for small companies that supply big companies.

Finally, you said, "Compliance and covenants on loans? That isn't even worth a reply, and I challenge you to find a single example where a bank 'forced' a customer to move their loans to another bank."

I have dozens of examples that I have whitnessed over the years. They are making all payments and many are still profitable, but they fall below the acceptable ratios in their loan docs and cannot improve them in time to hold off the bank from taking action. Any business banker will tell you that this is something they have to do.

Birdied by: Jeff | July 10, 2008 11:16 AM

I am sorry, that just doesn't cut it. I worked in the largest business banking department of Wells Fargo for 2 years before opening my own business, and there was not a single case of a small business owner who had compliance issues and was forced to take out loans at another institution. Not one.

Profits are down all over the place. That is easily verified by buying a gallon of gas, cheese or a pound of flour. Just because cheese and flour goes up by 140% does not mean that all pizza shops need to increase prices, it is the kiss of death not to though, although you would only need to increase your prices by 5% to cover the increased costs of doing business.

If you buddy's company only has one customer and they want a 10% discount, well then they better find a way to cut other expenses if they want to keep the account. pretty black and white there too. Either that or try and increase the value of his product by 10% and keep prices the same. Give him some advice and tell him to tighten his belt for the next 4 years.

Birdied by: Pizzamancer | July 10, 2008 07:53 PM

Pizzamancer,
What type of small business do you own? I think that you both are talking about different types of businesses. Pizzamancer seems to be referring to a small business such as a restaurant that services customers that need a commodity, such as food. In this type of business, yes, prices typically mirror a raise in cost associated with inflation. Jeffrey is more talking about the larger picture of entrepreneurship which is the other 99% of businesses such as those that provide services to large clients. I think what Jeffrey is saying is that those businesses that services larger companies are bound by contracts, whether it be with customers or banks. Inflation hurts those small businesses because large businesses will shop around for the small business that will give them the lowest price for what they need. In this situation the small business cannot raise their price, even though costs increase. In response to your other point about banks forcing a small business to pay their loan and move to another bank, all I can say is of course they can and do. In the loan docs banks put ratios that small businesses must meet. During inflation, some small businesses cannot meet these ratios and therefore have their loans recalled. At this point, yes, they must move banks.

Birdied by: Matthew Higgins | July 21, 2008 05:11 PM

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