If you think
currencies and exchange rates are things that only bankers and traders need to
worry about, think again. Many small businesses are subject to exchange rate
risk, whether they realize it or not.
Take last year’s Brexit vote in the UK, for example. The pound dropped sharply against the euro after the UK’s vote to leave the European Union, with severe consequences for any small businesses trading across borders.
“As we have a lot of costs in Euros and most of our income is in pounds, we’ve been impacted by the near 20% decline in the value of sterling this year,” said Ian Baxter, chairman of Baxter Freight in the UK.
It’s not just British firms that were affected. The fallout of Brexit led to sharp swings in other global currencies, too. And that’s just one example among many others in history, from the dramatic single-day plummeting of the Swiss franc to the slower decline of the Japanese yen. And sometimes, just a few words from the president can lead to volatility in the value of the U.S. dollar.
Bottom line: If your small business either incurs costs in other countries or earns revenue from other countries, you probably have some exposure to currency risk. You could see your revenue suddenly decreasing or your costs spiralling due to global political events outside your control.
So in this tutorial, you’ll learn how to manage your currency and exchange rate risk. First, we’ll define a few terms and get clear on what these risks are. Then, you’ll learn how to quantify the risk for your business and how to look at a few different scenarios. Finally, we’ll look at some strategies for reducing your currency risk.
By the end of the tutorial, you’ll be much clearer about how foreign exchange movements could affect your small business, and you’ll have some practical strategies for reducing your exposure.
1. What Is Currency and Exchange Rate Risk?
So first, let’s define what we mean by currency and exchange rate risk.
Basically, what we’re talking about is the risk of changes in the relative values of different currencies, which in turn can affect your business’s revenue, costs, cash flow, and profits. You might see this referred to as currency risk, exchange rate risk, or foreign exchange risk—they’re all essentially the same thing.
Let’s look at a few examples, to make it clearer:
The Purely Local Business
Let’s say that you do all your business in one country—say the USA. You source all your products in the USA, all your offices and employees are in the USA, and you have no international customers. You don’t have any overseas investments either.
In that case, you probably have no currency risk. All of your revenue is earned in U.S. dollars, and all of your costs are incurred in U.S. dollars. So the volatility of global currencies will have little or no impact on your business.
Now let’s say that you have a business based in the U.S., and you still sell only to customers within the U.S., so all your revenue is earned in dollars. But this time, the products you manufacture are assembled in Mexico, so a lot of your costs are denominated in Mexican pesos.
In this case, a 10% drop in the value of the U.S. dollar against the peso could make the cost of your goods go up by 10%, while your revenue remains the same. For a business with tight margins, this could easily make the difference between making a profit and making a loss.
In this example, you manufacture products in the U.S. based entirely on U.S. raw materials and labour, but you sell many of those products to customers in Canada, who buy in Canadian stores using Canadian dollars.
This time, your costs are incurred in U.S. dollars, but some of your revenue is earned in Canadian dollars. If the U.S. dollar strengthens against the Canadian dollar, your Canadian revenues are going to be worth that much less. Meanwhile, your costs remain the same. Again, a major bout of exchange rate volatility could quickly take you from profit to loss.
The Complicated Case
These days, more and more businesses fall into this final category. You have some costs in different foreign currencies, and some revenue in different currencies too. Maybe you’re based in the U.S., but you employ freelancers in Europe and Canada, and you import products from China, which you then sell to clients all over the world.
In this case, there are a lot of moving parts, and you’ll have to do some analysis to figure out what your exposure to different currencies really is. Don’t worry—we’ll look at how to do that in the next section:
2. How to Quantify Your Exchange Rate Risk
Whenever you’re faced with a potential risk, the first step is to quantify it. How much exposure do you have to swings in global currencies? In a worst-case scenario, how much could you end up losing? In this section, we’ll look at how to quantify your currency risk.
Take an Inventory
Start by listing everything you do that involves foreign currency. Your “base” or home currency is the one that’s used in the country where your business is located, and it will probably be the one in which you produce financial statements, pay business taxes, and so on. Make a list of everything you do that’s not in your home currency.
This could be revenue earned overseas. It could be employees who are based overseas and get paid in their own currencies. It could be raw materials or equipment that you have to import as part of your production process. It could be investments in global stocks, bonds, or funds. Or it could be large one-off expenses, like a particular project you’re working on abroad, an overseas office you’re setting up, or a major piece of equipment you need to buy.
Now go through your accounts and come up with some total amounts to assign to each category. For example, you might discover that your exposure looks something like this (using the U.S. dollar as the home currency, and rounding the numbers for simplicity):
- £50,000 annual sales in the UK ($65,000 at current exchange rates)
- €100,000 annual sales in Europe ($110,000 at current exchange rates)
- €100,000 in salaries for sales staff in Europe ($110,000 at current exchange rates)
- 5,000,000 Mexican pesos in production costs ($250,000 at current exchange rates)
Run Some Scenarios
There are different ways of assessing risk. Some of the most effective are also very complicated—see, for example, this paper in which the Canadian Department of National Defence quantifies its foreign exchange risk using a complex Value-at-Risk model.
If you can follow the methodology and implement it for your business, that’s great. But typically, methods like this are the preserve of large businesses and governments, which have whole departments devoted to risk management and can employ trained experts to draw up the formulas and crunch the numbers. For the average small business, a simpler approach is probably more appropriate.
One simple approach that can be effective is to run through some different scenarios and calculate the effect on your business.
Imagine that your home currency suddenly drops by 25% against the other currencies to which you have some exposure. How would that affect your revenue and costs? And what effect would that have on your overall profits? What if it dropped 50%, or strengthened by the same amounts?
Let’s see how that works with the example figures I laid out above:
- If the EUR/USD rate changes from 1.10 to 0.80, the company’s annual sales in Europe will be worth just $80,000, instead of $110,000—a $30,000 hit to the bottom line. But, on the other hand, its European staffing costs will also be reduced by the same amount, so the net effect is zero. Good news!
- A change in the dollar against the pound, on the other hand, would have a greater effect. If the rate goes from 1.3 to 1.8, those £50,000 in sales would be worth $90,000 instead of $65,000—a nice $25,000 windfall. But if it went from 1.3 to 1.0, the same sales would be worth just $50,000, a $15,000 loss. And in this case, there’s no corresponding cost item to offset that.
You can continue going through the process with different currencies, seeing what the effect would be. Use past currency data to see what kind of swings are likely, but also keep in mind that unexpected political events can lead to much greater volatility than you may have seen before. So don't rely too much on the past to predict the future!
Assess the Bottom-Line Impact
When you’ve got an idea of how much the changes in various different currencies could affect your revenue and sales, the final step is to put this in the context of your overall company profitability.
So look at your financial statements for the year, and see how the numbers change with different exchange rates plugged in. Would a major decline or strengthening of your home currency put you at risk of making a loss? How might it affect your cash flow?
When you have all of this information at your fingertips, you’ll be in a good position to know which risks you need to reduce, and which are small enough to be acceptable. We’ll look at some actions to take based on that information in the next section.
In the meantime, if you want more information on quantifying risks, you can read our series on managing risk in your business, particularly this tutorial:
3. How to Reduce Your Currency Risk
Now that you’ve got some clarity around your currency exposure, it’s time to look at what you can do about it. Here are some strategies you can use:
Match Up Costs and Revenue
As we’ve seen, one of the main sources of foreign exchange risk is having costs and revenue being earned and incurred in different currencies. So one way of reducing that risk is to change your business practices so that the difference no longer exists.
For example, a European business that does its manufacturing in the UK but sells the products within Europe is subject to swings in the exchange rate between the pound and the euro. By moving its manufacturing to a country within the euro zone, that company could have both its costs and revenue denominated in euros, greatly reducing or even removing the exchange rate risk.
This is a simple example, but in most cases, businesses won’t be able to eliminate risk altogether. The goal is simply to have a better balance, so that when currencies move, you make gains in one area to offset losses in another (as we saw in the example above, where the company's exposure to euros was effectively balanced between costs and revenue).
This strategy can be very effective, and it’s easier to grasp conceptually than some of the financial strategies we’ll look at next. But it may be difficult in practice to make such changes to your business structure without having other adverse consequences.
After all, there were good reasons why you chose to set up your business the way you have done. Maybe you wanted to take advantage of cheaper manufacturing costs in another country, or a large customer market overseas. It wouldn’t make sense to give up major competitive advantages because you’re worried about currency risk.
Hedge the Risk With Derivatives
If you want to keep doing business internationally in the same way as you always have done, but with reduced exchange rate risk, you can consider using derivatives to hedge your exposure.
Financial derivatives have a reputation for complexity—and sometimes that reputation can be justified. But there are also simple strategies that you can use even if you don’t have a head for trading.
For example, let’s say you have a major expense coming due a month from now, and you’ll have to pay it in a foreign currency. You’ve budgeted for it to be $50,000, but you’re worried that if the exchange rate changes in the next few weeks, it could end up costing you much more.
With a simple “forward” contract, you can effectively lock in today’s exchange rate, ensuring that no matter where rates move between now and then, the amount you pay will still be $50,000.
It’s also possible to use derivatives to manage much more complex situations than this, and if it’s done right, you can reduce your risk. But be very careful, and make sure that you understand what you’re buying and what your risks are. In the wake of Brexit and the extreme currency movements, some UK small businesses got burnt by complex derivative strategies that were supposed to manage their exchange rate risk but ended up increasing it.
As with most financial transactions, it’s best to follow Warren Buffett’s advice not to invest in anything you don't understand. But if you proceed with caution and understand what you’re getting into, derivatives can be an effective strategy.
Pass It On to Your Customers
This option is simple. If currency swings make your goods 10% more expensive, you raise your prices by 10% so that your profit margin remains the same.
If you haven’t used any of the other methods to reduce your exposure, this may be the best option—or perhaps the only way of staying profitable. It’s what the UK small business owner we met at the beginning of this tutorial did after Brexit:
“These extra costs have to be passed on to our customers. Where goods are being imported into the UK, this will of course lead to price increases here.”
But simple is not necessarily effective. There are major downsides to this strategy. Your customers may not be very happy about the price increase, and it may make your product uncompetitive. If you get it wrong, you could end up losing customers, so that your revenue doesn’t increase as much as you’d hoped. And remember that if you pass on cost increases to your customers, they’ll expect you to reduce your prices when the currency moves in the opposite direction.
If you do decide to use this strategy, understand that there are still risks involved. And check out the following pricing tutorial:
In this tutorial, you’ve taken a plunge into the international currency markets. You’ve seen how changes in foreign exchange rates can have a profound impact on your business. But more than that, you’ve learned how to quantify that impact, and you’ve learned some steps you can take to reduce or mitigate your foreign exchange risk.
As a small business owner, you may not know much about international currency movements, and you may not want to know much. But if you have any international exposure, your business will be affected by those movements, whether you like it or not. At least you’re now in a better position to understand those effects and take action to manage them.