SMEs are small businesses, in their early stage of growth. They exercise little or less control over markets. They, during initial years, have to struggle with cash flow management leading to squeezed reserves and labor shortages which implies high wage costs. A rise in inflation can impact their growth and competitiveness such that in times of hyper-inflation many may not even be able to survive.

Demand and Input Cost

Inflation causes uncertainity, forces consumers to tighten their belts leading to shrinking demand and market size. Huge pressures created by input price rise lead to rising output costs. While big businesses can easily pass the pinch to their customers, small businesses may not always enjoy this privilege. The result is declining margins, unhealthy financial statements, at times leading to closing down.

Nominal Exchange Rate and International Markets

Input quality and price determine comparative advantage. High input costs wipe off this advantage and also hurt the producer’s position in international market. Studies show that inflation leads to depreciation of the domestic currency which affects international position and cash flows (receivables and payments). If the increase in output price is relatively more than the depreciation of domestic currency, the profitability and sales are adversely affected.

Capital Budgeting and Credit Costs

Rate at which credit is made available to SMEs is also impacted by inflation. Central banks may have to increase interest rates to control inflation which may lead to high credit costs.

Minimizing the effects of inflation

• Manage cash flows efficiently so that cash reserves can be built to fight short-term crunch and high cost borrowing can be avoided.
• Maintain overheads at lower levels.
• Whenever a price rise is noticed, it is important to start raising the output price by small amounts so as to pass on the burden to the consumer step by step which makes it a smoother process, rather than passing it in one go.
• Avoid locking into long-term contracts where margins may be narrow as they will further be squeezed in times of inflation. Also, avoid huge lags between delivery and receipt of payments as that will help manage cash flows better, reducing uncertainity and probability of loss.
• If possible create a treasury department which can hedge against such uncertainities. There are securities that cater specifically to the needs of inflation hedgers. For example:
  • TIPS – Treasury Inflation Protection Securities, issued by the government that compensate for the erosion in value of fixed income assets (like bonds, annuities).
  • Corporate IPS
  • Gold is one investment that can always help offset losses incured due to inflation.
• Managing currency risks – I believe hedging forex risk is the primary thing an exporter should do as that also helps safeguard profits.
• To manage cost of capital, try and pay away floating rate loans because these payments increase with rise in inflation, eating up the profits.