The U.S. Bureau of Labor Statistics reported that the Consumer Price Index (CPI) increased by 6.5% in 2022 after rising 7% in 2021. The 2021 CPI increase was the highest year-over-year increase in CPI since June 1982. In addition, the Producer Price Index (PPI) increased by 6.5% in 2022 after rising 9.7% in 2021. The 2021 PPI increase was the highest calendar-year increase since the data were first calculated in 2010.
The inflationary environment presents challenges when analyzing historical financial trends for companies throughout the middle market, and it can impact firms differently depending on industry, business model, and accounting processes. Buyers and sellers should evaluate the impacts inflation has on earnings and working capital, including how to normalize operating results.
Sales Trends
Given the historical high inflation rates in 2021 and 2022, revenue growth should be evaluated in real (inflation-adjusted) terms; otherwise, buyers may unintentionally attribute growth resulting from inflation to an increase in output or performance. Sales trends also should be evaluated in terms of volumes, which would not be directly impacted by inflation.
Expense & Margin Trends
While applying an inflation adjustment factor to a full income statement may provide value in making a comparison across years, it would not necessarily normalize any impacts to margins. Increases in costs typically result in price increases passed along to customers. However, the timing and magnitude of price increases relative to cost increases can lead to fluctuations in margins. These price and cost increases will vary significantly across organizations based on industry, contract types, and cost structure.
Businesses with contractually locked-in prices may experience margin decreases during this inflationary environment, and it will be important to evaluate whether commensurate price increases will be accepted by customers at the end of the current contractual period.
Businesses with the ability to adjust selling prices quickly may have a temporary benefit from inflation. For instance, a manufacturer or distributor with low-cost layers of inventory may be able to sell those items based on current market pricing and generate temporary above-average margins. Similarly, if vendor purchasing agreements are long term and customer pricing can be updated more quickly, a company may have a short-term margin increase.
An analysis of monthly sales and costs at the detailed level (such as by SKU) may provide insight as to how margins have changed over time. This type of data also could allow buyers and sellers to evaluate a baseline for expected go-forward margins at the item level. This baseline could be applied across time to normalize historical margin swings while controlling for changes in sales mix. Buyers and sellers will want to be able to demonstrate either the sustainability of margin growth or the reasons that margins should recover as pricing and costs normalize. The inflation impact should be evaluated both in historical results as well as for any forecasted periods.
Pro forma adjustments are frequently considered in a quality of earnings analysis to capture the potential incremental costs and/or cost savings associated with the proposed transaction. When estimating go-forward costs for items such as employees, business and property insurance, and professional fees, it’s important to use recent market rates as opposed to historical averages.
Inventory Standard Costing Considerations
Standard cost accounting involves setting a predetermined cost for each unit of inventory, which is then used to value the inventory on the balance sheet and calculate the cost of goods sold on the income statement. As inflation increases the cost of raw materials, labor, and other production inputs, this can lead to a situation where the standard cost of inventory does not reflect the actual cost of production, leading to inaccuracies in the company’s financial statements. It’s important for buyers and sellers to assess the frequency of standard cost updates as well as consider how manufacturing variances (actual cost versus the standard cost) are reported within the financials. A company that expenses variances within the month incurred as opposed to capitalizing them may see a decrease in gross profit and corresponding understatement of inventory. Conversely, capitalizing manufacturing variances will result in properly stated inventory; however, for companies with low inventory turnover, it will defer the cost impact of inflation until inventory is sold.
Customer Contracts & Costs to Fulfill Considerations
Many firms seek long-term fixed price customer contracts to secure customer retention. However, inflationary pressures have strained the profitability of these contracts as the price is fixed while costs are variable. When considering targets with long-term customer contracts, it’s important for potential buyers to assess the company’s historical ability to increase pricing either through contract renegotiation or on renewal for key customers.
In addition, companies often receive annual contract payments upfront and report them as deferred revenue. Upon closing, it’s common for a certain amount of cash consideration to be left behind at close by the seller to cover any potential servicing costs of the existing deferred revenue. Typically, costs to fulfill are estimated based on historical gross profit or contribution margin of the services provided. Given cost inflation, we would recommend modeling expected future costs to fulfill factoring in the impact of inflation.
Working Capital Considerations
Buyers and sellers typically establish working capital targets based on historical trends and averages. While working capital needs vary across businesses and industries, in periods of inflation, dealmakers could consider establishing a working capital target closer to the most recent period to help capture the most recent effects of inflation on the company’s current assets and liabilities, such as a three-month average.
Conclusion
Inflation is driving additional conversations in mergers and acquisitions (M&A) transactions. The level of inflation in a year may have no impact on the accuracy of a financial statement under GAAP, but it may have a significant impact on normalized sales, margins, EBITDA, and working capital analyzed during an acquisition. We believe due diligence should be performed to understand the impacts of a rising cost environment on the entity’s financial results.
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