How the Inflation Rate Affects the Financial Modeling Result?
by Mashum Mollah Finance 04 May 2020
The inflation rate is the increase in prices of the bundle of goods and services that results in the decline in the purchasing power of money. A dollar today would be less than a dollar a year after. In preparing financial modeling, it is empirical to include inflation in making the projections to cover the increase in prices in the future. How does the inflation rate affect the preparation of the financial statement? Let’s take a look at some of its effects.
Here are how the inflation rate affects the financial modeling result:
1. The Needed Funding to Start the Business. It is crucial to account for the inflation when you are computing for the funding needed for your business, especially if your working capital cycle is longer to estimate the changes in prices during that time. You will end up in shortage of working capital if you do not account for inflation since the money you raised at the start of the operation won’t be enough to finance the business until you have enough revenue to sustain your day-to-day activities. It means that you need more significant funding compared to the nominal cost of the present.
2. Prices of Goods and Services. You must do a regular assessment of your pricing if it includes the increase of inflation to cope up with the rise of the production costs and general & administrative expenses of the business operation. You will end up in a losing end if you will not account for the inflation rate to your prices since the earnings will not be enough to cover future costs.
3. The Effect on Your Cash Flows. It is needless to say that you have to consider the inflation in your cash flow forecasting to create accurate projections of the required resources to finance the daily operations of your business and in budgeting for large purchases in the future. In this way, you can avoid the future problem of lacking enough capital to cover up the cash outflows.
4. The Effect of Inflation on Taxes. If you will not include in your book of accounts the cost of inflation, it means that you understated or overstated the taxable income depending on the effect of inflation on the prices of products or services, and the cost of sales and the general & administrative expenses of your business. By accounting for the cost of inflation, you will be able to pay the right amount of tax.
As we cover some of the points in which the inflation rate affects the preparation of financial modeling and how it can jeopardize your business operation if not considered, you cannot understate the importance of incorporating the inflation rate in your financial modeling anymore.
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