Measuring Inflation’s Impact On Small Businesses (2023)

It’s no secret that the pandemic took its toll on small business owners, but until now the true economic impact had not been measured. Biz2Credit recently published the results of its Small Business Inflation Study that analyzed the revenues and expenditures of more than 140,000 U.S. small businesses from January 2019 to October 2022.

The Biz2Credit Small Business Inflation Study identified three distinct phases:

1. The pre-pandemic phase up to Q1 2020.

2. The initial waves of the COVID pandemic before mass vaccination in the first quarter of 2021, when both small business revenues and expenditures fell sharply.

3. The period of gradual, partial recovery of small businesses after revenues had bottomed out in Q1 2021 and extending to 2Q 2022. Inflation persisted through the third phase.

The analysis found that before COVID, the expenses of small businesses were pretty much in control compared to the revenue. However, in the post vaccine recovery and inflationary period, especially in 2021 and 2022, margins were significantly eroded. Small businesses have to work harder have to sell more to attain the same level of wealth. This is complicated by the reality that expenses have gone up significantly over the last year and a half.

The reasons are well documented: soaring gas prices, supply chain issues, and labor costs. Many companies are not able to find labor, and when they do, the cost is greater than it was in 2019. All of that leads to small businesses having lower margin on each sale. Complicating the issue is that if a business owner needs working capital, they have to pay much higher interest rates than they did before the pandemic, as the Federal Reserve continues to increase rates in an attempt to curtail inflation.

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The Fed has now increased interest rates several times over the last year. During most of the past decade, they have been near zero. Financing now costs more than it has in a long time, and business owners must manage for that reality. For the first time since 2008, business owners are encountering interest rates above 10%, depending on the lender.

“I think there's no doubt that this has been hurting small businesses and not just by decreasing consumer demand for products and services, but also by increasing interest rates,” said U.S. Senator John Hickenlooper (D, CO) serves on the Senate Committee on Small Business and Entrepreneurship.

“The lending that could tide you through the slow periods has become something more expensive,” added Hickenlooper, a supporter of expanding access to capital for women- and minority-owned businesses and businesses in underserved areas by having fintechs play a greater role in SBA lending.

Hickenlooper said that for its part, the Senate has focused on the issues around inflation and what can be done to restrain it, since inflation is a hindrance to the growth of small businesses.

Key Findings of the Small Business Inflation Study

· In the pre-vaccination COVID phase, average monthly expenditure by small businesses fell by 21%, from nearly $14,000 in 2020-Q1 to just under $11,000 in 2020-Q3.

· Economic behavior of small businesses in the post-vaccination inflationary phase was very different from the pre-vaccination phase. In the pre-vaccination phase (Q1 through Q3 2020), small businesses conducted severe cost-cutting in the face of falling revenue, with both dollars per expenditure transaction and the number of transactions falling by 14% and 8% respectively.

· In the post-vaccination recovery (Q1 through Q3 2022), a period of high inflation, small business encountered severe cash flow pressures while trying to maintain business activity at higher post-vaccination recovery levels. Thus, dollars per expenditure fell 12%, while the number of transactions rose by 9%, offsetting the fall in the former. This change in behavior reflected the need to control cash outflows by restraining individual cash outflows during a high inflation period.

· During the period of highest inflation, the average monthly expenditure of small businesses fell by 5%, from $11,401 in Q1 2022 to $10,884 in Q3 2022.

· As inflation accelerated, consumers were also increasingly stressed by rising prices. In the post-vaccination recovery, revenue increases outpaced inflation, but by Q2 2022, revenue growth fell below the rate of quarterly inflation.

· This may reflect a reduced capacity for small business to pass on cost increases to their customers (“pricing power”) with important implications for 2023.

The inflationary period is evaluated in the context of the unique circumstances created by the COVID pandemic. Following mass vaccination in Q1 2021, the economy began to recover through a combination of a strong labor market and the spending of accumulated savings by consumers and businesses. However, the economy also faced pandemic-related global supply chain constraints.

This first-of-its kind study was based upon transactional cash flow data comprising nearly 105 million cash inflow and cash outflow transactions from small businesses on Biz2Credit’s online marketplace. Unfortunately, the spike in prices came just as the economy was recovering from the initial waves of the pandemic and created a new set of challenges for small businesses. Many of them are still hurting.

U.S. prices experienced a persistent rise that began in the summer of 2021, and inflation accelerated by the middle of 2022. The Producer Price Index (PPI) which gauges prices paid by businesses, grew at a peak rate of nearly 3% month-over-month by May 2022, and over 20% from the prior year.

“The rise in prices continues to impact us. It is hard to raise our prices. It is mac & cheese; there is only so much you sell a plate for,” said Sarita Ekya, from S'MAC, the first New York City restaurant devoted exclusively to mac & cheese.

Inflation’s impact on individual expenditure items

The study also looked at how inflation impacted small business behavior for individual expenditure items, namely energy prices (gasoline and utility rates). Rapidly increasing gasoline prices in 2022 significantly hurt the Transportation and Warehousing industry, for which fuel is an essential input. Between Q1 2022 and Q2 2022 — when quarterly average gas prices rose from $3.78 per gallon to $4.60 per gallon — average expenditure rose from $325 to $345 and then later subsequently fell to $333 in Q3 2022, when average gas prices had subsided slightly to $4.19.

Despite the higher expenditure, gasoline volume fell from 87 gallons to 75 gallons as gas prices rose in 2Q 2022 and later subsequently climbed back to 80 gallons in 3Q 2022 as gas prices retreated. Transportation firms had little choice other than to fulfil customer orders without much leeway to respond to changing gasoline prices.

"Inflation is the biggest challenge facing small businesses in 2023, and Biz2credit's research shows the impact it is having on small business. Entrepreneurs are struggling to prioritize costs and manage cash,” said Charles "Tee" Rowe, President and CEO, America's SBDC. “With the current volatile economy, we encourage small businesses to visit their local Small Business Development Center (SBDC) for guidance on creating a manageable path forward."

Implications for Small Business in 2023

Inflation during the post-vaccination COVID period led to significant changes in small business activity. In 2023, there is considerable uncertainty remains related to continued inflation, additional spikes in gasoline prices, further increases in interest rates by the Federal Reserve, and weaker economic growth.

Everything is not gloom and doom, however. There have been signals that when the Federal Reserve’s Federal Open Market Committee (FOMC) meets for the first time this year on Jan. 31 and Feb. 1, the next interest rate hike might be smaller. After four consecutive 75 bps hikes, the Fed raised interest rates by a half point in December. Some analysts are predicting, the central bank may hike rates by 25 bps this time around.

Regardless of the size of the next rate hike, the current economic environment underscores the need for careful cash flow management. Cash outflows must be well-timed to match cash inflows from customer revenues. On the revenue side, small businesses must carefully gauge when they have ‘pricing power,’ the capacity to pass on cost increases to the customers without excessively hurting demand.”

Small businesses need to carefully assess whether their operations require additional financing to manage cash flows better and whether their projected cash flows can support borrowing. A disciplined historical track record in prudent cash flow management can be very helpful for companies looking to obtaining financing from banks and online marketplaces, should they choose to apply for it.

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