How To Factor Inflation Into Your Financial Model and Forecasts

Inflation. It’s a big deal in the world of finance, and it affects all types of businesses, from huge enterprises to budding startups. If you’re on the small side of that spectrum, overlooking inflation can mess up your financial projections and plans, and even put your profitability at risk.

Let’s dive in and see why you might need to consider inflation in your financial model and how to do it correctly.

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• Understanding Inflation
• The Impact of Inflation on Startups
• Factoring Inflation into Your Financial Model
• Tools and Resources for Managing Inflation

Understanding Inflation

Inflation is all about prices. It’s the rate at which the general level of prices for goods and services is rising, and subsequently, causing purchasing power to fall. In simpler terms, your money is worth less over time.

Central banks attempt to control inflation - and avoid deflation - to keep economies running smoothly.

However, inflation rates can fluctuate because of government policies, supply and demand dynamics, and global events. For startups, these fluctuations can mess with your operational costs, pricing strategies, and profitability.

The Impact of Inflation on Startups

Understanding how inflation can impact your startup is the first step towards building it into your financial model. Here are a few things you should watch out for: 

Operational costs
When inflation goes up, the cost of goods and services increases. That means more cash for raw materials, rent, utilities, and wages.

Pricing strategies
Inflation can push you to adjust the prices you charge for your products or services. If your costs are climbing due to inflation, you might have to pass them on to your customers to maintain profitability.

Investment and funding
Inflation can play tricks on investment returns. If inflation outpaces the rate of return on an investment, the investment loses its value. This can scare off potential backers. High inflation can also jack up interest rates, making debt-based financing more expensive.

Factoring Inflation into Your Financial Model

Now that we’ve covered how inflation can mess with your money, let’s see how you can fit it into your financial model and forecasts.

1. Add inflation rate assumptions: The first step is to make some assumptions about future inflation rates. While no one can predict future inflation rates with absolute certainty, you can use historical data and expert analysis as a starting point. Be sure to document your assumptions and the reasoning and sources behind them so you can adjust them as necessary as conditions change.
2. Adjust cost and revenue projections: Apply the inflation rate to your costs and revenues. If you expect a 2% annual inflation rate, for example, you would increase your costs incrementally to a total of 2% for each future year in your model. Observe how rising prices impact your revenue over time.
3. Create alternate scenarios: Because it’s impossible to predict exactly what inflation will do, it’s a good idea to plan for a few different scenarios. One strategy is to create a ‘best case’ scenario with low inflation, a ‘worst case’ scenario with high inflation, and a ‘most likely’ scenario with moderate inflation.
4. Clarify real vs. nominal values: It’s important to clearly differentiate between real and nominal values in your financial model. Nominal values are not adjusted for inflation, while real values are. When you share your forecasts, make sure it’s clear whether you’re using real or nominal values.
5. Review and adjust regularly: Economic conditions and inflation rates can change quickly. You need to keep an eye on your plan and update it when things shift. This not only keeps your forecasts accurate but also helps you stay prepared for whatever the economy throws at you.

To sum it up, it’s a great idea to include inflation in your startup’s financial model. It makes your forecasts more accurate, helps you prepare for future challenges, and lets you monitor your profitability over time.

It might seem tricky at first, but with consistent updates, handling inflation will become a natural part of your financial planning process.

Tools and Resources for Managing Inflation

The good news is that startups today have access to many tools and resources that can simplify the task of dealing with inflation in financial models.

Financial planning software
There are many financial planning and analysis (FP&A) software options on the market today that can help you build sophisticated financial models, add inflation into the mix, and create different scenarios. Software makes things simpler and more accurate.

Government and economic data
Governments and international organizations share lots of data about inflation, including forecasts. You can probably get what you need online through the U.S. Bureau of Labor Statistics or the International Monetary Fund. They’re both valuable resources with helpful information.

Financial advisors and consultants
If you have the resources, hiring a financial advisor or a fractional CFO is a smart move. An expert can take this off your plate and provide solid guidance on managing inflation and other financial risks.

Inflation-Proof Your Startup Strategy

Inflation is just one puzzle piece in your financial planning, and it’s not something to freak out about. When you factor inflation into your financial plans, you set yourself up for a stronger strategy, better readiness, and reliable profitability forecasts.

Remember, your financial model isn’t supposed to be perfect. But it does need to be adaptable so that you can shift your plans when things change.

Inflation rates, and economic conditions in general, are guaranteed to change. Stay informed, know your numbers, and use the tools and resources available to you. If you do these things, you’ll be in good shape to guide your startup through every challenge the economy sends at you.