Hidden Effects of Inflation on Profitability

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Hidden Effects of Inflation on Profitability
Ramon, Member, Consultant, Spain

Inflation might hamper profitability at different levels.

Inflation has positive effects in the liabilities side of the balance sheet, as diminishes the present value of monetary liabilities such as long term loans. Nevertheless, this advantage does not usually fully compensate for the negative effects that inflation has in the assets side, such as the loss of value of cash and receivables or the deviation of calculated depreciation.
To counterweight the effects of inflation companies have to increase earnings at a rate higher than inflation to compensate for lower depreciation. Depreciation during inflationary periods is lower than the cost of replacement and offers less tax shelter. To maintain the generation of cash flow, it is necessary to achieve rates of earnings growth above inflation, and sometimes this can be a daunting task. Furthermore, companies have to achieve to pass the full cost of inflation to customers,
Also, during inflationary periods, the higher cost of capital in real and nominal terms reduce the present value of expected future cash flows and the calculated value of share prices. Financial markets liquidity, which might be present during inflationary periods, might not be enough to increase demand of shares and avoid poor stock market performance unless liquidity is also accompanied with a substantial appetite of investors for risk.

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