Managing business debt during periods of high inflation

Pros and Cons

Inflation is the general increase in the prices of goods and services over time. It reduces the purchasing power of money and erodes the value of savings. High inflation is usually associated with economic instability and uncertainty.

Borrowing during periods of high inflation can have both advantages and disadvantages, depending on the situation and the expectations of the borrower and the lender.

One possible advantage of borrowing during high inflation is that the real value of the debt decreases over time, as the nominal amount of the debt remains fixed while the prices rise. This means that the borrower can repay the debt with less valuable money in the future. This can be beneficial for businesses that have contractual terms with customers which includes inflation income grows faster than inflation.

Another possible advantage of borrowing during high inflation is that it can stimulate economic activity and growth, as borrowing can increase the demand for goods and services and create more jobs and income. This can be beneficial for any business that is involved in productive activities that generate returns higher than the interest rate and inflation rate.

However, borrowing during high inflation also has some drawbacks and risks. One possible drawback is that the interest rate on loans tends to increase during high inflation, as lenders demand higher compensation for lending their money. This means that the cost of borrowing increases and the borrower has to pay more interest on the debt. This can be detrimental for borrowers who have a variable income or whose income grows slower than inflation.

Another possible drawback is that borrowing during high inflation can exacerbate inflationary pressures and create a vicious cycle, as borrowing can increase the money supply and fuel more demand and price increases. This can be detrimental for borrowers who are not able to adjust their prices or wages to keep up with inflation.

What is a safe level of business debt to have?

There are several metrics that businesses can use to assess their debt levels and determine a suitable amount of debt. Here are a few:

1. Debt-to-equity ratio: This metric compares a company's total debt to its total equity (or shareholders' equity) and indicates the proportion of a company's financing that comes from debt. A lower debt-to-equity ratio generally indicates that a company is using less debt relative to equity to finance its operations and is therefore considered less risky. A higher ratio may indicate a higher risk of default. As a general rule, a debt-to-equity ratio of 1 or less is considered safe, but this can vary by industry.

2. Interest coverage ratio: This metric compares a company's earnings before interest and taxes (EBIT) to its interest expense and indicates how easily a company can meet its interest payments. A higher interest coverage ratio indicates that a company is generating enough earnings to cover its interest payments and is therefore considered less risky. As a general rule, an interest coverage ratio of 2 or higher is considered safe.

3. Debt service coverage ratio: This metric compares a company's net operating income to its debt service obligations (i.e., principal and interest payments) and indicates how easily a company can repay its debts. A higher debt service coverage ratio indicates that a company is generating enough income to cover its debt service obligations and is therefore considered less risky. As a general rule, a debt service coverage ratio of 1.25 or higher is considered safe.

4. Industry benchmarks: It can be helpful to compare a company's debt levels to industry benchmarks to assess its relative risk. Industry benchmarks can be obtained from sources such as trade associations, industry reports, or financial analysts.

Remember a safe level of debt is one that allows a business to meet its financial obligations without excessive risk of default or financial distress.

How to prepare your business for inflation

1. Increase Prices: One way that you can prepare for high inflation is by increasing the prices of your products or services. This allows you to maintain your profit margins and offset the higher costs of raw materials, labor, and other expenses.

2. Hedging: Another way to prepare for high inflation is by using financial instruments such as futures, options, and swaps to hedge against price volatility. By hedging, you can protect yourself from sudden increases in the prices of commodities or other inputs.

3. Cost Reductions: Reducing costs in various areas, such as trimming non-essential expenses, optimizing supply chains, and improving operational efficiency. This can help to maintain profitability and offset the impact of inflation.

4. Long-Term Planning: If your business has responsible levels of debt and diversification you could consider for example purchasing new equipment that would lower your overall cost of operations using debt borrowed at a reasonable interest rate. This will allow you to reap the benefits of reduced costs while reducing the real value of your debt through inflation.

5. Diversification: Finally, companies can prepare for high inflation by diversifying their operations and revenue streams. This can help reduce the impact of inflation on any one area of their business and provide a buffer against economic volatility.