Protecting Profits when Currencies Fluctuate
Source: Economist Intelligence Unit
Protecting foreign earnings against adverse currency fluctuations once the money is repatriated is among the knottiest issues facing small and mid-sized enterprises (SMEs).
It helps to quantify the gains and losses from currency movements and to assess what strategy may be appropriate in future.
While variations in exchange rates between the home and foreign currencies can work in a company’s favour, they can also wipe out the entire profit from a transaction. An estimated eight out of ten UK SMEs that export see gains or losses as a result of exchange rate fluctuations.1
While large corporations have entire teams to help them manage these risks, smaller companies tend to rely on one or two individuals, who may also have other duties. Larger companies are also more likely to have subsidiaries in the destination country which both make and receive payments in the local currency, thereby reducing the amount of revenue subject to currency risk when repatriated.2
To deal with this risk, SMEs can choose among a range of options, which include: doing nothing and hoping for the best; opening a bank account in the host country to make and receive payments in the local currency; hedging the risk by using financial instruments; or selling accounts receivable at a discount to a factoring company, which then takes on the risk of currency fluctuation as well as the risk of non-payment by the buyer.
How do SMEs decide among the many options available? Finding objective advice on managing foreign exchange risk is not always easy. The UK Government’s Department of Trade and Investment, for example, does not provide specific guidance on the issue, despite making substantial information on other export-related topics available to SMEs. UK trade bodies, such as the British Chambers of Commerce, tend to rely on commercial foreign exchange agencies to provide advice.
Finding a way through the maze begins with understanding an SMEs appetite for risk. “Each business has to understand what percentage of its profits it is willing to risk, and for how long, in its overseas ventures,” says Kevin Grant, managing director of international payments at Moneycorp, a foreign currency exchange company. If the business understands what level of loss from currency fluctuations it considers acceptable, it has a baseline target for the risks it wants to manage.
When an SME is new in a foreign market and expects only minor initial revenues, the “do nothing” option may make the most sense. Currency losses should, however, be transparent. Most accounting software packages have multi-currency functions that can automatically calculate foreign exchange gains and losses by comparing the amount invoiced in one currency with the amount received once it is converted into another currency. While this information is not sufficient for planning a firm’s future currency needs—most often the figures include bank charges which are not listed separately—it helps to quantify the gains and losses from currency movements and to assess what strategy may be appropriate in future.
Doing nothing—essentially deciding not to hedge—is unwise when dealing with large income flows, says Isabel Hahn a managing director of the Frankfurt, Germany-based glass cabinets and windows company Glasbau Hahn. “We had some big UK contracts at a time when the value of sterling fell sharply against the euro, and we lost a lot of money because we did not hedge,” she says. “That was our learning curve.”
To manage its currency risks more effectively, Glasbau took three measures. First, it opened a dollar-denominated account in the US, where it has a legal presence via a New York-based subsidiary. The account enables Glasbau to price and deliver smaller contracts (under $100,000) in dollars. The business denominates its operating costs in the US in dollars as well, subtracting those costs from the dollar-denominated revenues, thereby creating a natural hedge against part of the currency risk. Second, the firm buys future exchange instruments for larger contracts from its bank, which fix the exchange rate—and therefore the level of expected revenue in euros—at a point when a project is expected to end. Finally, the company offers a discount if a buyer pays upfront in euros, a strategy that has worked particularly well in Japan.
While these three approaches have reduced Glasbau’s currency risks, some challenges remain. Ms. Hahn says that while she makes price quotes valid for a relatively short period, or includes a specific currency exchange rate as a condition of the offer, some public tenders require price estimates that are valid for up to a year. This long time horizon makes it difficult to hedge currency risks. “I have to decide on a case-by-case basis whether to participate,” she says. A further risk arises when projects take longer than expected to complete, thereby outliving a future option that was intended to cover the currency risk. The firm can make a further hedge against currency fluctuation, but only at additional cost.
Where cash flow is tight, an exporter may decide to sell its foreign currency invoices (receivables) at a discount to a factoring company. This provides the selling company with cash up-front, and eliminates its currency exposure. But for an SME, this option creates another type of risk, warns Mr. Grant of Moneycorp. “People buy from an SME because they get a personal service,” he says. “If you put a third party between the seller and the buyer, and the buyer is invoiced by this other entity which is faceless, it could devalue the relationship between the SME and its customer.”
1 Hedging FX Risk: Taking stock of the challenge for mid-caps and SMEs, 2014, by the accountancy body Association of Chartered Certified Accountants and Kantox, the foreign exchange provider.
2 “Importers, Exporters, and Exchange Rate Disconnect,” Mary Amiti, Itskhoki Oleg, and Jozef Konings. 2014. American Economic Review, 104(7): 1942-78.