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How can you use financial forecasting to analyze inflation's impact on business operations?

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Inflation is the general increase in the prices of goods and services over time, which reduces the purchasing power of money. Inflation can affect your business operations in various ways, such as increasing your costs, reducing your profits, and changing your customers' behavior. Therefore, it is important to use financial forecasting to analyze inflation's impact on your business operations and plan accordingly. Financial forecasting is the process of estimating future financial outcomes based on historical data, trends, assumptions, and scenarios. In this article, you will learn how to use financial forecasting to analyze inflation's impact on your business operations in four steps.

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1 Step 1: Identify the inflation rate

The first step is to identify the inflation rate that affects your business operations. The inflation rate is the percentage change in the average price level of a basket of goods and services over a period of time. You can use official sources, such as the Consumer Price Index (CPI) or the Producer Price Index (PPI), to find the inflation rate for your country, industry, or product category. Alternatively, you can use your own data, such as your historical prices, costs, and sales, to calculate the inflation rate for your specific business.

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Muhammad Ilyas, ACA

AGM Finance at Qarshi | ex-EY | SAP S4 Hana | FP&A | Financial Modeling | Power BI
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In my experience, understanding and monitoring the inflation rate is crucial for any business. I've seen how a seemingly modest inflation rate can significantly impact costs and pricing strategies. Using official sources like CPI or PPI or analyzing our own data allowed us to make informed decisions, adjust pricing, and manage expenses effectively. It's an essential step in maintaining financial stability and ensuring the sustainability of our operations in an ever-changing economic environment.

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Oliver Loutsenko

Head of Asset Allocation Research | Founder & CEO | Financial Markets Strategy
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Right, identifying the inflation rate today is basically as easy as typing it into Google. But to calculate CPI inflation, we look at the YoY price change of a basket of goods & services. PPI is effectively producer inflation; CPI for consumer inflation.

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2 Step 2: Adjust your financial statements

The second step is to adjust your financial statements to reflect the inflation rate. Financial statements are the records of your business's financial performance and position, such as the income statement, the balance sheet, and the cash flow statement. You can adjust your financial statements by using either the nominal method or the real method. The nominal method uses the current prices of goods and services, which include the inflation effect. The real method uses the constant prices of goods and services, which exclude the inflation effect. By adjusting your financial statements, you can compare your financial results over time and across different scenarios.

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Oliver Loutsenko

Head of Asset Allocation Research | Founder & CEO | Financial Markets Strategy
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This is the challenging part. To properly budget for costs ahead of plan in advance for inflation, you really should be looking at inflation expectations rather than focused on real-time inflation necessarily. There’s a lot of commonly accepted economic theory supporting why that’s the case.

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3 Step 3: Project your future cash flows

The third step is to project your future cash flows based on your adjusted financial statements and your assumptions. Cash flow is the amount of money that flows in and out of your business over a period of time. You can project your future cash flows by using either the discounted cash flow (DCF) method or the pro forma method. The DCF method discounts your future cash flows by using a discount rate that reflects the inflation rate and the risk of your business. The pro forma method multiplies your current cash flows by a growth rate that reflects the inflation rate and the expected changes in your business.

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Oliver Loutsenko

Head of Asset Allocation Research | Founder & CEO | Financial Markets Strategy
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Projecting cash flows when inflation is not known is difficult. With the DCF valuation method mentioned, if you aren’t sure what inflation is going to be, finding the appropriate discount rate to calculate the NPV becomes more difficult.

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4 Step 4: Evaluate your financial performance

The fourth step is to evaluate your financial performance based on your projected cash flows and your financial goals. Financial performance is the measure of how well your business achieves its financial objectives, such as profitability, liquidity, solvency, and efficiency. You can evaluate your financial performance by using various financial ratios, such as the return on investment (ROI), the net profit margin, the current ratio, and the debt-to-equity ratio. By evaluating your financial performance, you can identify your strengths and weaknesses, and make informed decisions to improve your business operations.

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Oliver Loutsenko

Head of Asset Allocation Research | Founder & CEO | Financial Markets Strategy
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I think this is probably always a good idea, inflation or no inflation. But especially when you aren’t certain what the changes to your costs will be - if you’re uncertain about inflation - staying on top of that is definitely essential.

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5 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you use financial forecasting to analyze inflation's impact on business operations?

1

2

3

4

5

1 Step 1: Identify the inflation rate

2 Step 2: Adjust your financial statements

3 Step 3: Project your future cash flows

4 Step 4: Evaluate your financial performance

5 Here’s what else to consider

Economics

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How can you use financial forecasting to analyze inflation's impact on business operations?

1

2

3

4

5

1 Step 1: Identify the inflation rate

2 Step 2: Adjust your financial statements

3 Step 3: Project your future cash flows

4 Step 4: Evaluate your financial performance

5 Here’s what else to consider

Economics

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