Inflation is an economic concept that refers to the increase in prices of goods or services over a set period of time, resulting in a decline in the purchasing power of money. It means the same amount of money today can buy less a year after. This trend is influenced by several factors including the increase in production costs and a surge in demand for products and services.
Why You Should Account For Inflation
In financial forecasting, it is necessary to include inflation in calculating projections to cover the future increase in the costs of goods. This method is referred to as inflation accounting or price level accounting, wherein the financial statements are adjusted based on price indexes instead of solely on a cost accounting basis to understand the financial standing of a business in inflationary environments.
Below are the areas where you should take inflation into account.
It’s essential to account for inflation when you’re calculating the amount of money required to fund your business. This much is true if your working capital cycle—the time it takes to convert your net assets and liabilities into cash—is longer. Otherwise, you could end up in a shortage of working capital to finance the business until you earn enough revenue to sustain your daily activities.
Prices of Goods & Services
You should regularly assess your pricing and adjust it based on inflation to cope up with the rise of production costs—raw materials, labour, and administrative expenses included. You risk suffering from business losses if you will not take inflation rate into account to your prices as the earnings will be short of covering future costs.
Additionally, you should also consider the inflation in forecasting your cash flow. It should provide more accurate projections of the required amount of resources to finance your day-to-day operations as well as big-ticket purchases in the foreseeable future. For the same reason as above, it can ensure that you have enough working capital to cover the cash outflow.
Because inflation influences the prices of products, services, and overhead expenses, including it into your book of accounts will allow you to pay the right amount of tax. Otherwise, you could either be understating or overstating your taxable income.
How to Calculate Inflation Rates
Inflation rates are generally calculated by monitoring the changes in price indices. In many cases, changes in the Consumer Price Index (CPI) serve as the basis for inflation.
For example, the CPI in Australia was at 114.1 in 2018. At the end of 2019, the CPI was 116.2. You can calculate the percent change to see the inflation over the time period. Subtract the starting date CPI from the later date CPI and divide the answer by the starting date CPI. Multiply the result by 100 and the answer is the inflation rate in percentage.
Inflation Rate = 116.2 – 114.1 / 114.1 x 100 = 1.84%
You can look at the calculation above to see how inflation can affect your business. It illustrates how your money has to keep up and increase by at least 1.84% to stay equal to the economy.
When your business operates in a hyperinflationary environment, historical information on financial statements is no longer relevant. This is where inflation accounting comes in. It allows you to update your statements periodically to reflect the current financial and economic conditions.
As we cover how inflation rates can significantly influence your business, one cannot understate the value of accounting for it in your financial modelling.
To make things easier and less complicated, you can always ask help from a consultancy and data solutions provider or from financial modelling experts who understand the importance of including the inflation rate in your projection. They can provide you with a wide range of data solutions that helps businesses turn challenges into gains.