Inflation and High Interest Rates are Current Risks 

Business valuation is a dynamic process that is sensitive to economic and market conditions. But the impact of market forces may vary considerably depending on the size of your business and its location. 

While national economic forces such as the inflation rate, gross domestic product growth and decisions by policymakers exert a greater impact on large multinational corporations, smaller companies in areas like the Midwest are affected more by local and regional forces such as supply and demand, workforce availability, the cost of resources and logistical expenses. 

Moreover, when it comes to obtaining a business valuation during volatile economic times, different sectors fare better than others. Generally, the technology sector is more volatile in terms of risk factors since their technology products and services can rapidly become obsolete and competition is high. However, companies in more traditional manufacturing or service sectors with established markets generally have a lower risk profile.  

Current Risk Factors 

To be sure, both macro and micro economic factors affect all businesses. Over the past two years, inflation exceeding 8% in 2022 and 6% in 2023 has pressured businesses in all industries to cut costs and raise prices. As such, inflation also has impacted cash flows and introduced a heightened element of risk that must be taken into account by a business valuation analyst. 

Several successive interest rate hikes by the Federal Reserve have boosted the cost of borrowing to heights not seen for many years. Growing companies that rely on bank lending for working capital requirements and to finance capital assets have a higher risk profile. Overall, this additional risk factors into the valuation analyst’s conclusion. 

Inflationary pressures and higher interest rates place economic stress on workers as well as businesses and are fueling demands for higher wages in nearly every industry. High-profile strikes by workers in the automotive, entertainment, healthcare and retail sectors this year have highlighted the concerns of wage earners in those industries, but businesses are also feeling wage pressure from non-union workers. 

Since wage costs are typically the largest expense, the prospect of paying more to recruit, train and retain workers is yet another risk factor that must be built into a business valuation. 

These factors taken together impact companies in nearly all sectors, but some feel the pressure more than others, and some actually benefit from government programs designed to blunt the impact of a volatile economy. 

There is typically a lag in the effect that economic volatility has on private business valuations. The manufacturing industry experienced this when price pressure increased costs for producing goods, but by the time the products were ready to go to market, conditions had changed, and manufacturers couldn’t raise prices without seriously affecting sales. So, manufacturing companies absorbed some of their cost increases as the inflationary period began in 2021.  

For companies in the clean energy field, however, government spending and tax incentives contained in the Inflation Reduction Act of 2022 will help buoy their sales in the next couple of years. 

As a consequence, the impact of economic volatility on business valuations varies considerably from one industry to another, and if you are planning to obtain a business valuation in the next two years it’s important to understand how your industry is faring, and to take certain steps to prepare. 

Preparing for a Business Valuation 

Some strategies for preparing for a business valuation can benefit companies in any industry, including: 

  • Be intentional about capital expenditures. Budgeting for variable costs can help in terms of cash flow. 
  • Try not to add debt during a high interest rate period. Keep your spending low so you can keep your debt low.  
  • Manage the risks you can control and lower risk wherever you can, especially those that affect valuation. 
  • If you are planning to sell your company and you’re thinking about a transition period, make sure your cash flow is sound and your earnings quality is good. 
  • Many companies are currently experiencing higher earnings. There will come a time, though, when they hit a ceiling. Prepare for that. There are no crystal balls. 
  • Remove non-operating assets from the balance sheet and distribute those to shareholders unless you’re planning an acquisition, and you need that cash to fund it. 
  • Manage your working capital, which is current assets minus current liabilities. Look at your industry standards for working capital levels. If you’re in line with industry levels, stay there, but if not, bring it in line. 

If you would like to discuss the best strategies to prepare for your business valuation, contact an Adams Brown business valuation advisor.