The board of directors for a U.S.-based equipment manufacturer, headquartered in the Northeast, found out the hard way how currency exchange rates can impact business, especially in a post-Brexit world.
The company, which generates $1.1 billion in annual revenues, including 340 million pounds through sales in the United Kingdom, saw losses after the dollar strengthening against the British pound. The currency change frustrated the CFO who had to report an average loss of $2 to $22 million each quarter to the board. The losses resulted in lower bonuses and postponement of a long-anticipated company project.
The board grasped the challenge, but only after it was too late.
Currency exchange rates—sometimes called FX or foreign exchange—can move substantially in short periods of time. And those movements often squeeze profit margins and detract from the value of the company.
The management of currency risk is seldom a core competency within the company. Consequently, not every CFO or finance department knows how to diagnose and address the currency risk that could wipe out hard-fought gains in revenue or evaporate achieved reductions in cost.
Board members can help by asking the right questions to encourage senior management to explore solutions to a crucial problem they may not otherwise address.
· What are the sources of currency risk in the business?
· How much exposure is the company willing/able to tolerate?
· How does the company respond when the exposure exceeds the company’s stated limit?
By definition, “dollar strengthening” means the value of the dollar denominated in foreign currency is increasing. The chart below shows the recent history in the exchange rate between the dollar and the pound. The number of pounds per one dollar has increased markedly since the UK vote to leave the European Union in June 2016.
Currency risk can result from singular events like the purchase or sale of property in another country or a one-time dividend from a foreign subsidiary. In those cases, a company may transact in a foreign currency and convert to its home currency after the transaction takes place. Not knowing how exchange rates will move, the company risks a less-beneficial exchange rate between the conception of the transaction and its execution.
Singular events are the most commonly addressed sources of currency risk. They do not represent, however, the greatest risk. By far, the greatest risk comes from the company’s ongoing activities within its annual revenue cycle and supply chain. These activities are also the most overlooked.
The equipment manufacturer, for example, developed accurate forecasts for its revenues denominated in pounds, but the exchange rate became less favorable during each quarter of the subsequent year. After converting pounds to dollars, the company reported a 21% decline in UK revenues, solely related to currency exchange rates.
Risk exposure, tolerance
Identifying the source currency risk is crucial, but what is the right amount of risk to take on? For most companies, currency risk is not part of the core product or service. Consequently, each company must determine how much currency exposure it is willing to tolerate. Those entrusted with managing the financial performance of the company are best equipped to determine the company’s currency risk limits. Examples of “currency risk limits” or “FX tolerances” are:
· The company will not tolerate more than a 5% adverse revenue impact to due currency exchange rates.
· The company will limit the negative impact of currency exchange rates to less than $0.01 EPS each quarter.
When the board identifies currency risk and limits have been defined, the next questions are, "How is management addressing the company’s currency exposure within the stated limits? Furthermore, how will the board hold management accountable on behalf of the shareholders?"
While the nitty-gritty of the measurement and management of currency risk may not be necessary to understand at the board level, management should be able to provide a retrospective of the impact of currency exchange relative to the expressed limit or tolerance. Excellent frameworks for managing currency risk can be applied to any business.
Bottom line, it’s not typically well-understood by most companies, currency risk poses substantial risk; it can be measured and managed; and it always present in companies doing business internationally. Directors and boards have an obligation to raise the issue and exhort management to implement a solution that will achieve consistent, predictable earnings in the midst of the volatile global currency markets.
Mark Henderson is the founder and CEO of Grayline Partners, a risk management firm that helps companies doing business outside the U.S. to achieve consistent, predictable earnings by managing currency exposure.