Disruptions in a Modern World
The term ‘Unprecedented’ has been widely associated with Covid-19 since the start of the pandemic. Just as the world toils to recover from the catastrophic event, the ever-changing geo-political and economic environment continues to pose challenges to the global supply chain and inflation pressures.
On-going tensions between major powers as well as the conflict between Ukraine and Russia have put further strains on the global supply chain, resulting in uncertainties surrounding growth forecasts. Russia is a major supplier of oil, gas, and metals, whilst Ukraine is of wheat and corn. The reduced supply of these commodities have driven prices up, resulting in a domino effect across the supply chain. Inflation especially from agribusinesses, energy and supply chains are on the rise – triggering a host of consequences.
The increase in demand triggered by fiscal stimulus measures, put in place due to COVID-19, coupled with the slow pace of adjustment in production has contributed to the current imbalance in the goods markets, causing the depletion of inventories, bottlenecks and ultimately inflation.
To manage inflation, one of the primary tools used by Central Banks has been to increase interest rates. According to the Monetary Authority of Singapore, inflation is expected to remain high next year despite global prices waning off their recent peaks.
Let us take a look at how supply chain disruptions, increasing inflation and higher interest rates impact the value of businesses.
A quick look at the years preceding the pandemic will show supply chains transforming with the rise of globalisation and “borderless” continents across the world. The entire science of SCM (Supply Chain Management) had been prepped for building efficiencies and reducing delivery time. Globalisation also presented newer possibilities for businesses and higher degrees of achievability in financial projections.
The sudden hit of Covid-19 left businesses grappling to react and tackle major disruptions stemming from safe distancing measures and border closures. Without a tapering demand for goods, supply chains across the world faced severe pressure which continues even today, inducing a demand-supply deficit, higher wait times and soaring prices. Coupled with continuing tensions and conflicts around the world, how do uncertainties surrounding the supply chain affect businesses in their revenue projections and value?
- Achievability of projected revenue: Given the risk of delays in the supply chain, companies should gain a deeper understanding of the risks to its manufacturing and sales process, and put in place robust mitigating factors, for example, an appropriate level of inventory, to reasonably alleviate risks of late delivery of goods/services. Delays caused by supply chain disruptions will have an impact to the achievability of the projected revenue which in turn impacts the value of the business.
- Projecting recovery: Due considerations should be given when reconciling financial projections to historical performance, the expected performance of the industry as well as the business outlook. Subject to the recovery curve, a poorly-timed recovery may result in a significant fluctuation in value.
- Sustainable revenue and growth: Given the transformation brought about by Covid-19, one should also consider how the “new normal” has affected the market’s consumption of its goods and services. Companies should explore how changing consumer needs affect its current business and revenue model.
Company valuations are often based on performance indicators such as EBITDA or EBIT. Higher inflation that affects key expenses such as raw materials, supplies, utilities, wages and salaries puts pressure on these margins. If the increased costs cannot be passed on to customers through higher selling prices, this would have a negative effect on the value of the company.
There are two major pressure points that impact business valuations as a result of inflation:
- The first relate to macroeconomic risks such as rising cost of interest rates, labour scarcity, input costs and supply chain issues.
- The second is the company’s ability to pass off the increased costs of goods and services to their customers.
Since 2021, inflation has been on a rising trend. Prices are surging largely because of the shortages in both goods and labour across supply chains. Higher prices create the need for businesses to mitigate inflation risks and pass the increased costs to its customers.
From a valuation standpoint, one should analyse the business based on expected forecasts and examine key assumptions/inputs that are linked to the economic factors and conditions, including the potential impact from inflation during such times. Outlook and forecasts of the respective supply chains should also be considered when formulating one’s own projected costs and expenses.
Given cost pressures from raw materials and manpower, how will inflation impact the profitability, cash flows and value of businesses?
- Pricing Power: Companies that are able to transfer the increased cost to customers will have less pressure from the rising inflation. Companies should track and scrutinise its profit margins and consider how the decreasing margin affects its pricing strategy. Those companies that have low gross margins will generally be more affected due to the uncertainties caused by inflation.
- Cost Structure: Companies that have substantial exposure to inflation-sensitive expenses (commodities, skilled labour) and low cost flexibility will have a greater impact on their company value. Higher risk companies should re-look cost structures and explore viable alternatives.
- Working capital: Given the rising costs and supply chain disruptions, companies should perform robust assessments on the recoverability and expected credit losses of debtors, as bad debts affects profitability and hence valuation of one’s business. On the supply side, creditors may seek advance payments to mitigate cash flow pressures which would in turn affect the business’s cash flow requirement.
- Long-term growth rate: Long-term growth rates often take into consideration the long term inflation rates of an economy. Countries with higher than normal inflation rate may be perceived to generate higher long-term growth. Companies with operations in high-inflation countries may need to consider the level of adjustments required to normalise such long-term growth rates.
As one of the primary tools used by Central Banks to manage inflation, interest rates usually move in tandem with the inflation of an economy. Any changes in interest rates potentially impacts the value of companies as it affects the required rate of return by investors.
During times of high inflation, rising interest rates affect companies in the following areas:
- Cost of debt: The collateral impact from rising interest rates affect the banks’ borrowing and lending rates. With banks increasing their lending rates, companies need to consider what the appropriate long-term cost of debt is. The higher cost of debt also affects profitability and the ability to generate sufficient cash flows to service the loan. This inevitably increases the default risk and interest rate spreads and drives down the value of the business.
- Cost of equity: Cost of equity is affected by elements such as risk of the business, required return on the market and country risk. Higher inflation brings about uncertainty that increases the equity risk premium. Risk free rate which is part of the cost of equity under the CAPM model will also affect the cost of equity. Similarly, a higher cost of equity will drive down the value of the business.
- Failure risk: Coupled with the higher and more uncertain inflation, there will also be more business failures. This may result in a higher risk of default by customers if the corresponding receivables are credit impaired. Companies should pay close attention to the risk of impairment as the collectability may have an adverse impact on cash flow projections.
The above will affect a company’s weighted average cost of capital (“WACC”) which is one of the factors in valuing a company.
These issues will also pose a concern to companies in their upcoming year end reporting. Potentially, the carrying amount of an asset or cash generating unit (CGU) may not be recoverable and be impaired due to lower value in use (VIU) or fair value less costs of disposal (FVLCD). The impairment loss in turn lowers the company’s bottom line. Financial and non-financial assets would be similarly impacted as the Fair Value of investment portfolios will need to be conducted annually.
In conclusion, the close relationship between supply chain, inflation and interest rates creates a triple threat to the intrinsic value of companies, especially when the world is full of uncertainties. As such, due consideration has to be given so as to account for all possible risks when valuing the business.
For more information, please contact:
Partner & Industry Lead, Technology, Private Equity Group
T: +65 6594 7862
Director, Corporate Advisory (Valuation)
T: +65 6594 7622
Director, Corporate Advisory (Valuation)
T: +65 6715 1399