For finance directors making overseas payments, managing currency volatility can be a real challenge. A sudden shift in exchange rates can lead to a profitable deal or international payment suddenly losing value, increasing a business’s costs.
Take the first six months of 2014 as an example; the pound has fluctuated by 5.22 per cent against the euro, despite the past few months seeing historically low levels of overall currency volatility. Whilst this may not seem like a lot, for a business making a payment of £100,000, this would equate to a difference of over €6,000 over the period – potentially a significant sum for a small or medium-sized business.
This is why is it essential for those in charge of a company’s overseas payments to be financially savvy and become well-informed about the strategies that can maximize cash flow despite constantly moving markets.
For many larger UK businesses and especially those with a physical offshore presence, managing foreign exchange risk takes on increased complexity and importance. Foreign assets and liabilities need to be re-valued at financial year end, leading to potentially significant translation gains and losses on the balance sheet. While these may be considered paper entries, this type of FX risk, commonly referred to as “translation” risk, can impact equity balances and therefore the firm’s capacity to source funding.
Translation risk is of growing concern for CFOs in Britain as the improving UK growth outlook could lead to higher interest rates and the potential for further Sterling strength. Whilst the impact of translation risk is often reluctantly accepted, it can be managed through implementing a process called hedging.
Hedging is also a way of managing transaction risk, which is the most common type of risk associated with foreign exchange. What hedging does is allow a company to manage their foreign exchange exposures and cash flow in a number of ways. One method is by adopting a "Protection" strategy using products such as a forward contract that allow finance directors to lock-in an international payment at a fixed exchange rate for a trade they will conduct at some point in the future. By fixing the exchange rates of at least some of their international payments, businesses will be in a better position to manage their outgoings and will be better equipped to cope with unforeseeable market disruption and other external variables.
With no absolute way of predicting what markets will do in the future, businesses should identify how much of their expected incoming and outgoing funds need to be protected. That way they can protect the cash flow that needs to be safeguarded and still retain a level of flexibility if that is something that works for their business.
Many UK treasurers have started to move away from protection-only strategies that rely exclusively on products such as a forward contract to strategies better described as "Protect and Participate". These strategies use a balance of products such as forwards and options that allow for a greater level of flexibility in case a market movement allows a company to secure more favourable rates. When implemented in a simple, clearly defined strategy, products that offer such flexibility enable improved cash flow whilst maintaining bottom line protection.
The key element to the above is to find and work with the right financial services provider. A good partner will take the time to understand a company’s holistic cash flow needs and then work with that company to come up with an overall payments and hedging programme that meets them. Foreign exchange markets are notoriously unpredictable, but finance directors and treasurers that implement a good risk management strategy can provide budget certainty and gain increased visibility into their cash flow.
Furthermore, by not having to worry about the impact of continual currency fluctuation, businesses can concentrate on what they do best; selling a product or providing a service. Businesses that put in place the right cash management strategy will not only be well placed to survive, but thrive in the global marketplace.