Quantify your exposure
The first step in managing currency risk is to understand and quantify the actual and potential exposures that your business is running.
This involves examining both your costs (the supplies or inputs that your business purchases) and your revenues (what you receive for selling goods or services) to establish the extent to which you have an exposure to a change in currency other than your home currency.
For example, you may routinely import a large quantity of raw material from the UK and are invoiced in Sterling for the supply of that material. If the Euro weakens against Sterling – each Euro buys you less and less Sterling – then you will end up paying more in Euro terms for the supply of that raw material.
If you are exporting finished goods to the UK market and are receiving Sterling in return, than you have a natural offset or “hedge” against deterioration in the Euro v Sterling exchange rate, as your UK costs can be matched against your Sterling receipts. If, however, you receive payment for your UK sales in Euro, and are paying for production inputs in Sterling, then you run the risk that a change in the exchange rates could substantially reduce, or indeed, wipe out your profit from sales.
Take the following example, which we will refer to again in this guide:
- You are a manufacturer selling goods to the UK. The currency exchange rate is: €1 =£0.75 (one Euro will purchase 75 pence Sterling.).
- You purchase £10,000 worth of raw material from the UK at this exchange rate, and thus will have to pay €13,333 for the materials.
- You sell the finished goods in the UK, for €20,000, receiving payment in Euro.
- Your profit in euro is €6,666. In Sterling your profit is €6,666 * (0.75) = £5,000.
If the Euro falls in value against sterling by 15%, which means that a Euro is now worth only £0.6375, what is the impact on your business profitability?
- Your costs increase to €15,686 in Euro terms (i.e. £10,000/£0.6375)) from €13,333, an increase of €2,353.
- Your Euro profit falls from €6,666 to €4,313, a reduction of around 35%.
Decide on the risks that you wish to run
There is no legal or accounting requirement for you to protect your business against currency risk. However, it would be prudent not to ignore this risk, and to put in place a robust risk management policy for the business. Once the business has decided on how it is going to manage the risk, it should document this by establishing a risk management framework/policy.
The policy should be:
- Clear and understood by all relevant employees
- Not to be deviated from without a formal process
- Reviewed regularly
Use the right tools for your business
The typical ways of managing currency risk within a small to medium sized business include:
1. Asking for a dual invoice
Dual invoicing, simply put, is getting two prices for anything purchased from abroad – one in Euro and one in the supplier’s domestic currency and paying the cheaper. By getting two prices you can now clearly see the change in cost based on exchange rate differences. You should then choose the cheaper and use that method of payment.
There may be times when it would be more favourable for a business to pay in Euro (usually for once-off small amounts), but by using dual invoicing, it will be clear to the business which payment method is cheaper and you can then make a more informed decision.
The benefits of dual invoicing are:
- It can reduce currency conversion costs, offering potential savings.
- It provides you with more information to choose the best payment option.
- By knowing the true value of your payment, it can strengthen your buying power when dealing with suppliers.
2. Consider forward contracts
A forward contract is an agreement with the bank to exchange a specified amount of foreign currency at a specified date in the future, with the exchange rate fixed at the time the contract is entered into. It is by far the most widely used hedging instrument for business.
The benefits of forward contracts include:
- You know your cashflow in Euro terms, making budgeting and forecasting easier.
- There is an opportunity to avail of attractive foreign exchange rates prevailing in the market for delivery at a date in the future.
- Foreign exchange risk is eliminated
Note that with a forward contract, you cannot benefit from a favourable move in the exchange rate which happens after the date on which you entered into the contract. Therefore, it is important to talk to your bank’s treasury specialist to understand fully the benefits and risks associated with a forward contract.
3. Foreign currency accounts
If you have receipts and payments in the same (non-Euro) currency, then currency accounts may be worth considering. Your bank should be able to offer you a full range of currency deposit and current accounts in all major currencies.
The benefits of currency accounts include:
- Offering you the ability to “net off” foreign currency payables and receivables – pay your suppliers from the money that you have received for sales in that currency.
- They can help minimise and manage exchange risk and maximise cash flows efficiently.
However, if used incorrectly, you could be exposed to foreign currency translation risk. For example, at the end of the year, the foreign currency in your account may be worth a lot less in Euro terms than it was worth during the year, depending on exchange rate movements. Therefore, you should talk to your bank’s treasury specialists to understand fully the benefits and risks associated with currency accounts and the various ways in which this may be managed sensibly.