How to manage working capital during period of inflation

While the World economy and our local economy in Kosovo has been witnessing price index increases for some time then came the Russia-Ukraine war with high increases in energy prices and logistics costs. It makes us feel like meeting someone who we used to know and is antipathetic. It is time to learn to live with inflation for companies in every scale and also for MSMEs indeed.

The first effect of the inflation in the economies with some degree of inflation is perceived in costs and prices. Actually, this is the tip of the iceberg. There are larger causes and results underneath the iceberg. The subject of this article is confined within the working capital needs and management for MSMEs under inflation pressure. Small enterprises are likely to start to experience problems by time on working capital in inflation periods because of not having a professional approach on financial management. The most significant reason for this fact is the fast cost and price increases which is not followed up by MSMEs. The additional working capital need is not noticed until it becomes a substantial problem for most of the small companies.

We need to start to list out and recall the main components of working capital need for an ordinary MSME in order to understand the effects of inflation on working capital need. They are given with brief explanations below:

  1. Stocks: There are always some amount of (low or high in amount) raw material, semi-products, products/goods and consumable materials in the warehouse or anywhere in a small enterprise. For the sake of working capital calculations, it is even simpler in trading companies. In this case only the goods in warehouse is counted in the calculation of stocks. Some part of the stock’s value is acquired by not cash but by owing some debt to suppliers. Only the remaining part of the stocks is paid by own cash. Part of the stocks paid by own sources of the company is taken into consideration of working capital need and it is the first component of the working capital.
  2. Customer Receivables: Credit sales or sales on account are actually allocated credits for the clients. Another way of expressing this activity is reserving some of the capital of the company on behalf of the clients. There must be a cash allowance in the company for it and it constitutes another part of the working capital need of the business. In the simple approach to the working capital need; the average gap between terms of purchases and sales is taken into consideration for the calculation. That’s why a detailed stocks analysis is not needed in this case.
  3. Overhead Expenses Pool: Any business is liable to pay some fixed and overhead costs during the time gap between the collection and payment terms as explained above. i.e. Some amount of capital is to be reserved for the payroll, rent, electricity and other utility bills. And this is the third component of the working capital.
  4. Contingency reserve: There is a need for some contingency reserve for unaccounted risks and crises for a sound and enduring business. This is to increase the endurance of the business for the unexpected.

 It is obvious that there is an effect of raising on the components simplified by 4 items and given above by the increases in costs in economies with increasing inflation. And this turns into an increase in working capital need. For example, cost increases in the stocks will increase the total value of the stocks and the cash to be reserved for it. There will be an increase in receivables in the clients correspondingly. Increases in overall price levels will lead to an increase in overhead expenses pool need due to increases in energy, payroll and other expenses. While each and every component of the working capital is increasing, the need for contingency reserve increases either. Actually, this is a snowball effect and it results in an increase in the working capital need. Working capital need of MSMEs in our country is also increasing, as the same need is experienced in the remaining part of the world in these days.

There is another effect of inflation at the entrance period of price increases; it is the increase in profitability by transferring the current stocks (whose value is increased by the effect of inflation) into cash. This profitability is an illusion in fact and it is the result of overall price index increase.  The business may be perceived to make high profit at the first loop. But the business most probably will not be able replace higher amounts of supply or goods to the stocks then the previous level.

It is an important issue how the increases in costs are reflected to the prices by MSMEs. If any MSME is able to reflect the increases in costs to the prices, then the increase in the working capital need may be covered by the margins in sales and purchases. But it may not be possible to cover the need for additional working capital by the existing profit margin. Then there will be a problem to be resolved either by injecting some cash into the business or increasing the payables of the company. The worst scenario happens if any MSME is not able to reflect the cost increases to prices. The horizon is not bright for those.

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