Exchange Rate Risk: What CFOs Should Know

In this post commercial interim CFO Garry Hirth looks at the impact of exchange rate fluctuations on sales in overseas markets and offers to solutions for managing this risk.

When Falling Sales Can Mean Growth 

I wonder how many times in 2015 and in particular in the last two quarters of 2015, businesses would report that like for like sales in European markets were down on the prior year. This was often explained by a series of factors which had affected this market, although none could be quantified.

For one company that I was working with, the European market, which in previous years had grown by between 12%-18% showed a decline in 2015 of around 2%. Detailed analysis confirmed that discounts were at similar levels to prior years. Further analysis revealed that average order values also had fallen by 2.4%. Overall, a picture of doom and gloom was painted.

Two anomalies could not be adequately explained:

1. Outbound logistics costs had not fallen and had increased by 4.4%. This was attributed to the higher unit cost of dispatching smaller packages.
2. Gross profit margins had shown a gradual decline in Europe but not in other territories attributed to a change of product mix within Europe.

To understand what was happening it is necessary to understand how the company priced its products. In October of each year it produces its master sales price list for the forthcoming year and then converts these into US dollars and Euros prices using an exchange rate supplied by the CFO. Glossy brochures incorporating the price lists are printed and sent to all customers in time for the New Year. When the 2015 price lists were prepared, the Euro prices were based on an exchange rate of 1.24 and these prices remained unchanged for the whole of 2015.

I began by re-evaluating the sales performance to better understand these anomalies and to explain in my first board pack why gross margins on EU sales had gradually deteriorated through the year with no appreciable change to the product mix.

Assessing sales in local currency, rather than in base currency, revealed a completely different picture as the graph shows. Other than August, sales to the EU had improved on the prior year. Overall, sales had not declined but actually improved by 10.4% over the previous year.

Furthermore, average order values had actually increased by €86.53 i.e. by 8.1%.

When reviewing sales in sterling, the business clearly performed worse than the prior year for almost half of 2015. However, when the results are viewed in Euros, the picture is completely the reverse. For 2015, the business reported a drop in like for like sales of £870k whilst in reality sales were €972k higher. With costs being broadly unchanged, profitability was reduced by this lost income. The true cost was probably higher as management took steps to reverse the trend including personnel changes and increased discounting to generate sales.

How To Identify Currency Impact On Sales

How could the company have spotted this problem earlier? In practice, there are four main tools companies should be using:

1. Monitor exchange rates against the base used
2. Incorporate within the MIS reports:
   1. gross margins achieved by territory
   2. sales in local currency or percentage variance against prior year in local currency
3. Analyse gross margins as part of the monthly pack

Monitoring of exchange rates

Whilst fairly obvious and common sense, it is surprising how many companies do not track exchange rates especially when their business is reliant on maintaining a stable rate. A simple chart showing the spot rate against the holding rate will alert most management to issues.

For a company selling in Euros, when the exchange is above the holding rate (the rate used to price goods), less sterling will be received for a given amount of Euros. The above chart clearly highlights that any businesses reliant on Easter and Christmas sales would have been particularly badly hit in 2015.

With this company, all sales were translated at the spot rate, rather using a holding rate, which was updated on say, a quarterly basis. The resulting exchange losses when either the balances were revalued at the month end or settled would therefore be low and immaterial and consequently not spotted.

Amend the MIS reporting

Companies which solely rely on sales statistics to manage their business will often miss key trends. At a minimum, reports should not only show sales statistics compared to various metrics but show the gross margin achieved. These days, most ERP systems capture either the cost of sale or gross profit which makes it relatively straight forward to report on the margin achieved. Of course, reporting on margins may not immediately highlight exchange rate issues as there are other factors which impact on the margin including:

• Sales/product mix
• Sales Channel mix
• Territory mix

However, with little extra effort it is possible to eliminate these impacts and understand the underlying trends as is shown below.

Most multi-currency ERP systems now hold both base and foreign currency sales data which means that reports can be produced in any currency. However, mixing currencies in a single report is more likely to create confusion than solve problems. But with this information to hand, the business can now assess the impact of foreign currency movements.

Review Gross Margins Achieved

I remain surprised at how many monthly management packs devote so little thought to the gross profit being achieved and give so much space to sales analyses or overheads which exceed budget. To quote the old saying “turnover is vanity, profit is sanity” and so an understanding of the margins achieved is vital in managing the business.

Above is shown an extract of a Board Pack seen last year. The margin analysis (which was not provided in this pack) revealed that the GP% earned in the UK and Europe was 60.1% and 57.8% respectively.

The margin waterfall below is a simplified way of reconciling the budgeted margin to that actually achieved. This immediately shows that the profit on the extra sales generated and reduced buying costs were more than outweighed by the £43k exchange losses.

Rather than castigating the sales teams for poor sales, they should have been praised for actually increasing sales.

How To Manage The Risk Of Exchange Rate Fluctuations

Companies that price their products in sterling pass all the risk for currency movements to their customer; any movement in the exchange rate will impact on the buyer’s cost of purchase. In this instance, the seller assumes no risk. Where, however, the customer buys in their local currency, then the seller assumes all the exchange risk and must therefore take steps to minimise their exposure to currency fluctuations.

Unfortunately, there is no single panacea to completely eradicate all risk and businesses need to manage a number of solutions, in combination, to minimise the risk to their business.

Doing nothing is one option. If the business believes strongly that sterling will depreciate then doing nothing is a valid plan. Most businesses do not have sufficient expertise or knowledge of currency trading to make such a decision in which case the business is merely gambling.

So what should the business do? Below are listed some of the more common actions, although these are not necessarily mutually exclusive, nor is this list exhaustive:

1. Price and sell in sterling
2. Revise local currency price lists more frequently and for longer term contracts fix contractual rates
3. Retain foreign currency to pay for goods and services in the same currency (“natural hedge”)
4. Hedge future foreign currency sales i.e. sell forward.

Price And Sell In Sterling

Clearly the most risk free solution is to set prices in home currency. There will be many situations where this is not possible, for example:

1. Retailing and e-tailing overseas; customers buying from a British shop or website in Europe will expect to pay in Euros
2. A large customer may be sufficiently important to insist on having contracts denominated in their preferred currency
3. Smaller customers, where certainty of price is essential, may rather pay slightly more with a competitor for that benefit as this provides them with a stable cost base
4. Better prices can be obtained when pricing in local currency

Revise The Local Currency Price More Frequently

A fairly obvious solution would be to revise prices on a more periodic basis. If the company issues an annual price list then it should consider issuing bi-annual or quarterly price lists. One common argument against this is that prices are set and issued to coincide with major launches or trade shows. This should not however prevent a business from issuing updates throughout the year and can even be made to coincide with minor shows or product launches.

Hold Foreign Currency To Pay For Goods And Services In That Currency (“Natural Hedging”)

Natural hedging is frequently used to minimise the impact of currency fluctuations and often forms part of an overall strategy, so long as the business buys and sells in the same currency. The rationale being that exchange rate movements will impact on both purchases and sales equally. However, the amount of foreign currency received usually exceeds the expenditure in that currency. A company achieving a 60% gross margin will find that 40% of its currency can be applied against purchases, but will still have a surplus of currency which needs to be converted to sterling to pay its own overheads.

There is also a cashflow impact as purchases are paid in advance of sales receipts, although there are ways of dealing with these issues albeit at a cost e.g. borrowing to cover the shortfall.

Hedge future foreign currency sales

Most companies today understand the impact of currency on supply chain and will often buy currency forward to protect their cost base. The value of purchases is known and the payment dates can be reasonably determined. Far less common, is forward selling of currency simply because business cannot be sure that they will physically have the currency to sell and at the specified date.

To overcome this uncertainty, banks have devised a number of products ranging from:

• Forward sales options; these give the seller the option to sell at a predetermined rate although there is a low cost associated with options. If this rate is unfavourable, then the option need not be exercised and the company will only lose the cost of the option
• “Collar and cuff” contracts; the bank will offer an upper and lower rate to cover sales over a pre-agreed time. This type of contract fixes maximum and minimum exposure of rate movement.

The critical decisions to be made are how much cover is needed and over what length of time? Unfortunately, there is no right or wrong answer. A company signing a two year fixed price contract where prices are in foreign currency will want to cover a substantial portion of that contract over the full term.

However, businesses which sell from stock face more difficult decisions and need to produce good financial forecasts which highlights both the expenditure and income by currency. A proportion of the ‘gap’ (the difference between costs and income) can be covered. The percentage of that gap will depend on the reliability of the forecast but typically, companies will cover between 60% and 80% of the exposure. Where certainty of income is more doubtful, then the use of options, which will cost more, should be considered.

With long supply lead time, the business can easily quantify the amount of foreign currency it needs to sell forward and when it this should occur. In this type of situation, it is relatively straight forward to set up a number of forward contracts to account for this.

In Conclusion

Companies today are having to look to overseas markets if they want to grow and with that comes new challenges. One of the more important and often least understood is the impact of doing business in different currencies can have on decision making, cashflow and profitability. Businesses need to understand the impact of currency fluctuations, how to assess the impact and what measures need to be put into place to reduce risk.

Ultimately, businesses need to understand:

1. The risks associated with trading overseas
2. The measures they need to adopt to identify, sooner rather than later, the impact of currency movements in order to make sound business decisions
3. The actions needed to be taken to minimise the impact of large swings in foreign currency rates

This article has provided some solutions to this problem but others exist and the solutions will always be tailored to each individual situation.

Have you experience in cross-border trade? What measures have you implemented to lessen the impact of currency fluctuations and reduce risk? Garry Hirth would be delighted to answer any questions you may have on the above post, please leave your comment or share your experience in the box below.

Tags: Chief Financial Officer, overseas markets