The Impact of Inflation on the Division of Assets for Small Business Owners
The United States has hit the heights. That's not a good thing.
In 2022, the annual inflation rate in the U.S. accelerated to 7.9%— the highest since February of 1982. (Keep in mind that in developed countries, including the U.S., anything above 4% is considered "high.") And inflation is predicted to increase in coming months as we start to feel the impact of the war in Ukraine and the world's sanctions against Russia.
Inflation is the rate at which the value of the dollar falls at the same time that the price of goods and services is rising. This reduces purchasing power. The math is pretty straightforward. Higher costs for businesses lead to increased prices, which raise the cost of living. This in turn may lead to demand for higher wages, which results in worker shortages if employees leave for better pay from a competitor. These shortages can force businesses to offer higher wages to entice workers to return—which means higher costs. And the cycle begins again.
From a macro-economic standpoint, as prices rise, the value of a country's currency begins to decrease. But inflation also can quickly filter down to individual households, where the largest assets are the marital residence, retirement accounts and businesses—all of which must be properly valuated during a divorce settlement.
To gauge the impact of inflation on a personal level, just check your retirement account balance; if it's lower than it was three months ago, inflation is most likely the cause. Inflation also can reduce the value of the marital estate; the future cost of consumer spending; the value of spousal maintenance; and especially the value of the small business that has supported the home and purchases over the years. (All of these factor into the division of assets.)
For a small business, inflation's effects may not immediately be obvious.
- Inventory Costs. Inflation causes businesses to pay more for inventory as well as materials. If these costs cannot be met, it can lead to an inventory shortage.
- Employee Wages. When the price of goods increase, employees will want a higher wage. If a company is unwilling or unable to increase wages, talented employees may leave.
- Consumer Purchasing. Another consequence of rising prices: the number of consumers buying those goods decrease.
- Investment. To correct inflation, the Federal Reserve hiked interest rates in mid-March, for the first time in three years. Higher interest rates often deter business owners from borrowing money for investments in equipment and facilities.
To achieve an equitable appraisal, business owners should strongly consider employing a business valuation expert, who will typically choose one of three methods: the Asset Approach, the Market Approach or the Income Approach. Most of these experts, when valuating a small business for a divorce settlement, will choose the Income Approach. It includes an analysis of the business’s cash flow over the last five years, as well as projections of future cash flow. Notably, the business valuation expert also will determine the impact of inflation, along with other factors, on that cash flow.
Inflation impacts the value of a business primarily in three areas.
- It can alter the risk-free rate, which is used in calculating the cost of equity. As the name suggests, the risk-free rate is the rate of return an investor would expect on an investment that has no risk. It is determined by using the interest rate on a Treasury Bill, a very safe investment since these are backed by the government. As interest rates rise, the risk-free rate will also rise—which, all other things being equal, would decrease the value of the business.
- Inflation may also affect the after-tax cash flow of a business. If a business incurs additional costs due to inflation—and if revenue does not rise accordingly—a business’s after-tax cash flow will decrease. Again, all other things being equal, this can decrease the value of the business.
- Finally, inflation can change the effective tax rate paid by a company. Take the example of a company that deducts depreciation expenses related to newly purchased equipment. If decreased cash flow (or lack of funds) prevents the business from making such purchases, it will have no new assets to depreciate; the company then loses the opportunity for pre-tax depreciation. Inflation is the root cause, and this too will reduce the business’s value.
Inflation not only afflicts individual consumers faced with higher prices at the grocery store, the gas pump and the mall. It also affects small businesses that already are walking the tightrope between increased costs and maintaining profitability. If the business owner is in the process of obtaining a divorce, inflation must be considered in calculating the value of the business—and, correspondingly, the value of the marital estate—to arrive at a fair and equitable conclusion.