How to identify foreign exchange risk: a 5 step guide for SMEs
In the first of our series on currency risk management, we discovered how currency volatility affects businesses trading overseas. In the second of our series on currency risk management we will explore how your business can identify foreign exchange risk and how you can manage that risk.
In recent years, Brexit, COVID and the Russia-Ukraine war have all generated unprecedented volatility in international markets.
Just look at the recent example of EUR/USD, which has swung a total of 13%+ in the first half of 2022 alone. As political chaos engulfed the UK throughout the year, GBP/USD had an even bumpier ride.
The pound, which opened the year at $1.35, dropped to a record-low $1.035 on Sept. 26, just days after the disastrous mini budget, leading to the demise of then Prime Minister, Liz Truss.
SMEs need to be more risk aware
Mitigating foreign exchange risk is normally associated with large companies with substantial sales overseas. FX risk can have an impact on business performance regardless of company size.
If currencies fluctuate between the time a product is manufactured and when payment is due, profit margins can be severely impacted. This is especially felt by smaller businesses when factors like low profit margins and international supply chains come into play.
SMEs who import or export should ask themselves “how does currency risk affect my gross profit margin”? Small businesses operating on thin margins will feel the effect of even a 1% movement on the gross profit.
When it comes to currency risk mitigation, awareness amongst SMEs is still low and so too is the execution of FX strategies. A recent report showed that multinational corporations in the U.S. and Europe reported a loss of $9.5bn in Q1 2021 due to currency volatility.
If larger businesses with some hedging strategies in place are experiencing these losses, how are SMEs with less staff and smaller budgets expected to fare?
Identifying your currency risk
For SMEs trading in foreign currency i.e., payables and receivables, there will always be an element of risk. To identify foreign exchange risk in your business, consider the following factors.
1. Determine your currency exposure
The first step is to identify the areas of the business where the company is exposed to foreign exchange risk. This may be through international sales, imports, exports, investments, or loans in a foreign currency.
There are three types of foreign exchange exposure that you may face when making transactions in FX. These are transaction, translation, and economic or operating exposure.
- Transaction exposure
This is the effect that exchange rate fluctuations have on a company’s obligations to make or receive payments denominated in foreign currency. Exposure is short to medium-term in nature.
- Translation exposure
When a business has overseas subsidiaries, fluctuation in currency can impact its consolidated financial statements. This type of exposure is usually medium to long term in nature.
- Economic/operating exposure
Economic or operating exposure is not as common as the above mentioned but the risk can still be substantial. Unexpected currency fluctuations may impact a company’s cash flow and market value. This can affect a company’s competitive position and is usually long term in nature.
2. Revenue and costs in foreign currency
If a large portion of your revenue or costs are in a foreign currency, then your business is exposed to foreign exchange risk.
It is important to undertake an analysis of your company’s revenue and cost structure across each currency to determine which areas pose the greatest financial risk.
Management will then be able to determine how currency risk may affect the company’s financial operations.
3. Payment Terms
Always do a full evaluation of payment terms with suppliers or customers to understand the timing and the amount of foreign currency payments.
If you are selling to buyers in markets with traditionally volatile currencies, you should take FX rate fluctuations into account when you offer payment terms.
The longer the term, the longer you are exposed to potentially adverse FX rate changes, and the higher your FX risk becomes as a result.
Keeping that risk to an acceptable level may be achievable with a shorter term if that can be negotiated.
4. Market Dependence
Assess the extent to which your business relies on overseas markets. If a significant portion of your revenue is generated from foreign markets, then your business is exposed to foreign exchange risk.
If your business has subsidiaries or assets in a foreign currency, changes in exchange rates can impact the value of these assets when they are translated into the company’s reporting currency. This can impact your business’s financial statements and overall profitability.
Equally, a company’s dependence on a particular market or region can also impact its competitive position and pricing. If the local currency weakens, your business may need to adjust its prices to remain competitive or risk losing market share.
5. Hedging Strategy
A company’s hedging strategy can reveal its level of risk aversion.
For example, a business that hedges all of its FX exposure may be more risk-averse than a company that only hedges a portion of its FX exposure.
By examining your hedging strategy, you can determine the level of FX exposure that your company is willing to accept.
How Fexco can help
Companies with exposure to foreign currencies are prioritising and developing their hedging strategies, allowing them to respond more effectively to the challenges of an unpredictable landscape.
Whilst large companies have recognised the importance of this issue, many smaller companies are lagging behind.
The first step to ensure your business is protected from FX volatility is to determine your exposure.
Fexco works with businesses of all sizes to determine their level of exposure and provides foreign currency risk management solutions to protect their profits and working capital.
Sign up for a free account today and get expert advice on how to navigate the FX markets. Alternatively, you can contact us with your query.