Managing a successful company can be difficult even when during periods of stable prices, but managing a company that survives and even succeeds in periods of high inflation is an extraordinary feat.  The problem with relying completely on GAAP accounting ( matching earnings to expenses and using historical costs) is that you find out that inflation is damaging your company after the damage is done.  Use ROA/ROI and Financial Analysis to forecast when your business will be in danger from inflation. There is one key financial indicator that predicts your success: Return on Assets (ROA) or Return on Investment (ROI). A breakdown of ROI, called the Dupont Formula or Equation, helps with the decision-making process. Note: There is no debt in this example, so ROA=ROI.

 Use ROA/ROI and Financial Analysis to forecast when your business will be in danger from inflation. There is one key financial indicator that predicts your success: Return on Assets (ROA) or Return on Investment (ROI). A breakdown of ROI, called the Dupont Formula or Equation, helps with the decision-making process. Note: There is no debt in this example, so ROA=ROI.

While it is not complicated, a surprisingly large number of small businesses do not understand that if inflation is 15% a year, then you must make about 15% ROA just to have the funds to purchase the same amount of inventory in the next production cycle. Using the Dupont Formula, we can break down the ROA into the various contributions from items on the income statement and the balance sheet. With the Dupont Formula, we can see how to earn 15% or more a year.

I constructed an example of a wooden box company to illustrate this concept. The examples compare high-margin and low-margin balance sheets for a theoretical company that makes boxes – 4 pieces of wood the same size and 20 nails.    I use this simple example company to show that ROA is an excellent predictor of a company’s ability to handle inflation.  Second, we will look at the breakdown of ROA as a tool for managing through the inflation maze and as the foundation for understanding the strategies that can be adopted to improve your company’s success and generate “high quality” ROA.  High-quality ROA means that the earnings are primarily composed of cash flow and not large amounts of non-cash items or deferred sales.

In this example, the company buys 100% of the inventory that it will need for the year at the beginning of the year and the Box Company starts with the following Balance Sheet:

Lumber Initial Costs: 

            Boards             $10.00  each

            Nails                $  0.06  each

4 Boards and 20 nails to make each box

Saw: Life 3 years and $40,000 salvage value

Time: 160 hours a month to make 1,000 boxes at $20 per hour

Cost of Goods Sold in First Year: $41.20

High Margin Example:

Box Sales Price:                           $60.00

Profit per Box in the First Year:   $15.60

Low Margin Example:

Box Sales Price:                           $50.00

Profit per Box in the First Year:   $  5.60

Inflation for Lumber:                    17% annually

Inflation for Nails:                      12% annually

Inflation for Saw:                        12% annually

Finally, Box Company only raises prices on its products in line with inflation on the day it buys inventory for the next year. 

We would expect Box Company to handle the inflation easily in the High-Profit Margin Example, but struggle in the Low-Profit Margin Example.  Looking at this graph, that is what happens.  In fact, based on this example, Box Company has just enough cash to repurchase lumber in the first year in the Low Margin Inflation scenario and does not have enough cash to replace the saw at the end of the third year. Even more worrisome, it appears that the Low-Profit Margin Example is operating in the “safety zone” in the first year when it is in fact close to failing. This is because GAAP accounting relies on historic costs to match expenses to revenues.

Conclusion

In review, Step 1 examined the shortcomings of GAAP accounting; Step 2 was to accept the fact that inflation is here for a while and that we must react now to save our companies.

In this article, we look at GAAP accounting’s inability to warn that your company is in danger. We analyzed the need for business owners to have their financial statements in top shape to fight inflation so that they can easily calculate ROA/ROI and other Financial Ratios to manage their operations effectively.  Employing Financial Analysis Tools such as the Dupont Formula gives us the knowledge to manage operations and earn the necessary ROA/ROI to maintain a healthy balance sheet.

One key to surviving inflation is to focus on the operations and the Income Statement to adjust operating costs to reach your return objectives. This example focused on pricing, however, we could have also looked at adjusting our material costs or labor costs to achieve a higher ROA/ROI and use a more detailed financial ratio analysis to dig further into operating options.

In the next step, we are going to look at financial strategies for adjusting the Balance Sheet to increase ROA/ROI.  In fact, debt is one of the most useful tools for improving a business's finances during inflation.