This article is the first in a series about currency risk management in an enterprise. This subject should be of interest to all those whose company’s turnover is realized in foreign currencies. How to create the right currency risk management policy? Can losses on currency transactions be eliminated? I will answer these and other questions below.
Let’s go back to 2009, when many exporters were observing growing Euro prices with concern (I wrote about this in one of the previous articles). The total losses in businesses linked to that situation can be counted in the millions. Such situations should never happen, and they could have been avoided thanks to the methods I am presenting here.
But managing currency risk is not an issue relevant only to times of economic turmoil. It is also, and maybe even above all, a current topic that’s worth talking about here and now. Why? Because the number of domestic business owners who perceive the potential of foreign markets is growing. But swimming in deeper waters has its price: the aforementioned currency risk. No company should take it lightly, because a lack of awareness and knowledge about how to manage this factor is the shortest path to severe losses. In such a climate, it is difficult to think about further expansion and entry into new markets. There’s no reason to clip one’s own wings.
Currency risk – does it concern you too?
You don’t have to be an importer or exporter. You can just as well operate only on the domestic market, but if you are settling an accounts with a client or contractor in a foreign currency, you always take the risk related to fluctuations of its value. Depending on the complexity of a given company’s business model, this risk is either small (has a nearly unnoticeable influence on the financial result) or is a permanent part of the business “game”, and profits are dependent on it. In both cases, methods of action (risk management) and their goal are identical: it’s about unburdening the company and eliminating the risk of working with foreign currencies. In the ideal scenario, thanks to the right tools and methods, it is possible to completely “clean” the balance of profits and losses from the negative influence of changes in currency exchange rates. How can this be done in practice, and where to begin?
Before you take the first step
Business starts and ends with people. That’s why they can’t be absent when building the ideal system for currency risk management. Such a model always requires the awareness and support of decision-makers at a given company, such as the owner or board. They must feel good about their decision, because then and only then will implementation of the strategy end with success. If they lack awareness of the benefits of reducing currency risk, then specific examples from other businesses should convince them. Some honest arguments are:
– a much better picture of the company’s financial situation (undisrupted by currency exchange rates);
– a transparent account of results reflecting the actual margins on sales;
– “easier” financial audits;
– elimination of the risk of losses linked to fluctuations in currency exchange rates;
– improvement of control over applied business models;
– and application of the best practice approach at the business.
When the board is convinced and gives its blessing, it’s time to develop a detailed plan. Here are its successive stages.
Exposure to currency risk: identification and scaling
First of all, all of the types of currency businesses must be located. This will be the foundation on which the strategy of hedging currency risk will be built. It may also be necessary to renegotiate current contracts with the company’s contractors and clients.
Depending on the company’s size, identification can be more or less tedious, but regardless of everything, this step must be taken scrupulously. Talks will need to be held with the owner and the person in charge of the financial department, but meetings with people from the purchases and sales departments may also prove critical. They are the ones who best know the specifics of a given currency business. We analyze, above all: purchase currencies, sale currencies, information about potential warehousing of goods, payment deadlines, the method of calculating the price of sale, margin, VAT rate, monthly sales value, contract or arrangements with suppliers/consumers concerning currency exchange rates (if they exist), current methods of hedging exchange-rate risk for the given business (if they exist).
In various guides to currency risk management, it is often advised to investigate, above all, the balance and account of profits and losses (assets vs. liabilities) in order to determine which elements at the company (receivables, commitments, future cash flows, etc.) create exposure to currency risk for us. This is the wrong approach, and I can’t warn you about it enough! By choosing this approach, the company will not achieved the intended results in the long run, and conclusions and decisions made based on analysis of solely assets and liabilities will be imprecise or incorrect. The company’s finances will not be cured, and the additional discouragement to risk management will block changes for a longer period of time.
Negotiations with clients and contractors
In this step, the aim is to, above all: identify the goals of the new currency risk policy and enter into renegotiations that will tame this risk. If existing contracts are unfavorable for the company (make it impossible to achieve our goals), talks with clients and contractors must be held. It happens that the method of determining the sales price of goods is so complicated, that an enterprise has limited capabilities of implementing the right strategy for hedging currency risk. But very often, only a small change of contractual terms (not necessarily less beneficial for our business partner!) is necessary to reduce currency risk. Let’s look at this in an example!
EXAMPLE 1. A company imports machines from Germany in Euro and sells them in Poland in Polish Zlotys. According to the contract with the domestic client, the price of machines in PLN will be calculated based on the Euro exchange rate and the average exchange rate of the National Bank of Poland from the previous half-year, for example, the price during the period of July – December is dictated by the situation of the currency during the period of January – June. A contract worded in this manner is not favorable to either party, although at first glance, the currency risk is under control thanks to averaging of the exchange rate over a longer period of time (half a year, in this case). For the importer to hedge effectively, they would have to finalize a transaction calculated according to amounts in July – December at the beginning of January. For many reasons, this may not be possible (no information about the volume of future sales, greater cost related to hedging currency risk over a longer period of time, etc.). In such a case, both parties will benefit if they change the terms of the previously signed contract.
Strategy: a course to security
After identifying currency businesses and renegotiating contracts with clients and contractors, the time has come to develop a strategy of action: how to get a hold on currency risk? In practice this means that methods of reacting are planned for every currency business separately, and so, for example, who will transfer information inside companies, how and in what direction. Here, tools such as the following may provide assistance: natural hedging, hedging by means of derivatives, deposits, currency loans, etc. The provider of these tools should be the bank with which the company collaborates. Here, it is also worth holding a series of separate talks concerning not just the instruments that we have at our disposal, but also their prices. Moreover, specific people from the company’s staff must be designated to transfer reliable information about the given currency business on time. Here again, the human factor is inestimable: training employees is a critical part of an effective currency risk management policy.
Calculating and closing the currency position
To calculate the current currency position in the company, one must first account for all the components that affect its value. These include, among others: currency commitments and receivables, loans and deposits in foreign currencies, signed purchase/sale contracts. But the currency position is also affected by less obvious elements such as future sales of owned goods, orders, forecasts of purchases/sales, tax obligations and receivables, currency exchange transactions (forward contracts, currency options). In a word, all operations in the company that are performed in currencies other than the zloty.
It is best to calculate the currency position at least once a month (after the month has been closed) and to close a potential, open currency position. When implementing the currency risk hedging strategy, it is worth closing the currency position gradually, in order to be certain that there are no errors.
Implementation and control of the strategy
Calculation and closing of the currency position as well as implementation of the security strategy should take place in parallel. In simple terms, implementation of the strategy is based on applying the methods you have thought of earlier in an ongoing fashion: when risk appears in a given currency business, we react in real time. Maintaining this tempo of action is the key to “maintaining” the currency position at the same level. At this stage, the purchases and sales departments play a large role, because they transfer the required information to the financial department on time. The currency risk hedging department is at the end of this chain. It’s like the rapid reaction force of any army: it takes steps according to the assumptions of the adopted strategy.
One last ally: hedge accounting
After taking the first five steps, the goal seems to have been achieved from a financial point of view. The currency position is eliminated, and the company is not exposed to losses as a result of exchange rate changes. Properly set up currency businesses effectively hedge currency risk in the company. In turn, thanks to their training, every employee at the company knows what to do and how so as not to expose the company to exchange-rate risk. There is, however, a certain critical “but”: from an accounting point of view, the situation in the enterprise may appear worse than before the start of the entire project. Results in the company’s financial statements (in the profit and loss balance) may not reflect implementation of the strategy at all, because sales will still continue to change depending on the current exchange rate. For the entire investment of time and energy to pay off, one missing element is necessary, and it is: hedge accounting. It helps to put two different perspectives on the same level: accounting and finances. Let’s see how it works in an example.
EXAMPLE 2. A Polish company imports products from Germany in Euro. Next, it sells them after a month to a Polish buyer, also in Euro. To simplify things, let’s assume that the company is selling the products without a margin and at a zero VAT rate, meaning that it sells them for the same price for which it bought them, EUR 1,000. The company’s accounting is conducted in Zlotys. So how would the accounting of operations in such an enterprise work?
April 2015 – purchase of goods for EUR 1,000. EUR/PLN accounting rate 4.1000
Goods/Liabilities EUR 1,000 = PLN 4,100
May 2015 – sale of goods for EUR 1,000. EUR/PLN accounting rate 4.0000
Receivables/Sales EUR 1,000 = PLN 4,000
Cost of sold goods / Goods in stock PLN 4,100
Since the amount of purchase and sale, in Euro, is the same, but the currency exchange rate had changed in the meantime, the company recorded a loss on a single product in the amount of PLN 100. Of course, in the final settlement, the company will not incur a loss, but such a distorted picture of finances looks awful on statements, introduces misinformation and disquiets business owners – understandably so. In such a situation, hedge accounting is the answer, since it helps to even out irregularities when data is presented in this manner. And now, I will limit myself to assuring you, Dear Reader, that it is possible to implement such hedge accounting that the above situations will not occur in accounting. Further articles in this series will discuss this subject in greater detail.
The finish line: just a few more steps
Every system, even the most well-tailored, needs fine-tuning in practice. At the last stage of activities in the company, it is worth conducting an evaluation and introducing potential improvements. The effect we are looking for is the absence of a currency position (no currency profits/losses) as well as to eliminate fluctuations in financial statements (the accounting situation is a mirror image of the financial situation).
At this stage, each department at the company is in a winning position. The owner and board are satisfied with stable results, auditors have an easier task when preparing financial audits, and inspectors from government bodies have a transparent situation when analyzing the profit and loss balance.
I hope that together, we will be able to create such methods in every interested company operating on the Polish market. I am aware that currency risk management may seem like a lot of information to take in at first glance. Each step has a certain number of sub-steps, which in turn, require the cooperation and training of many people. But the game is worth playing – healthy and secure finances are the first step to company growth.
Meanwhile, I await your comments! Do you think your company needs currency risk management? Or maybe you have already taken part in implementing such management?
If you have any questions on the subject of hedging currency exchange risk or there are specific examples you would like us to discuss – don’t hesitate and respond in the comments below or use the contact form.