Small businesses across Britain are warning that the cost of living squeeze is holding back economic growth, after two in five company bosses reported a drop in sales at the start of the year.

The Federation of Small Businesses said that although business confidence was rising among bosses before the summer, soaring costs and weakness in consumer demand were still weighing on activity.

According to the latest snapshot from its small business index, a record 92% of companies said costs were higher in the first quarter compared with the same period last year. After a challenging start to the year, two in five small firms expected their sales to increase in the next quarter.

The FSB said business confidence was being restored after plummeting at the end of last year, but warned there were still “dark clouds” on the horizon.

Further interest rate increases from the Bank of England could dampen the recovery of small business, while firms are also under pressure from the high costs of energy, raw materials and transport, and rising staff wage bills.

Economists widely expect the Bank to increase rates from the current level of 4.25% in response to inflation sticking above 10% in March, more than five times the central bank’s 2% target rate.

The FSB, which represents more than 150,000 business owners and self-employed workers, surveyed nearly 700 people. The reading on its small business index rose to -2.8 in the first quarter, up 43 points from the final three months of 2022, but still about 18 points below the same period a year ago.

Martin McTague, the FSB’s national chair, said: “Small firms may be about to turn the corner and rebound after the pandemic and the energy crisis, with confidence recovering alongside improved optimism for the second quarter.

“However, there are still plenty of dark clouds on the horizon that could dampen small business recovery. The prospect of further interest rate rises is causing significant disquiet, at the same time that costs remain at serious highs.”