Guest post by David North.
Multinational organizations are continually faced with the risk of currency exchange rate fluctuations impacting financial results. With Mexico and Russia’s currency at all-time lows and double digit declines in Columbia, Brazil, Turkey and South Africa, currency risk management is receiving attention at all levels in global organizations.
Fluctuations in exchange rate pose two risks. First, changes can adversely impact the value of assets and liabilities. Second, currency changes can choke margins and handicap the company’s competitive position.
Asset Value Destruction
For example, a publicly traded multinational manufacturer has negative cash flow in the U.S. where it has corporate office costs to fund and pays a regular dividend to stockholders in dollars. At its Brazilian manufacturing subsidiary positive operating cash flow goes into a bank account and builds to a value of $R 6 million in excess of working capital needs at a date when the BRL/USD exchange rate is R$ 2.00/$US 1.00. Local currency controls prevent the Brazilian subsidiary from transferring the money to a dollar denominated account. The company has no plan to further invest in Brazil and wants to avoid the tax consequences of a dividend from the subsidiary to the parent. Therefore, the money sits in the Brazilian account. Three quarters later, the BRL/USD exchange rate is R$ 4.00/$US 1.00. By holding a commodity called the Brazilian Real during this period, the company lost over $1 million in shareholder value. Account for it as you will, but someone left the cake out in the rain.
A manufacturer has one factory in the U.S. It sells half of its product in the U.S. and exports half to Mexico with a 25% gross margin in both countries. The company’s competitor, with a factory in Mexico, sells half of its product in the U.S. There’s a free flow of goods yet no free flow of labor and the Mexican company has a significant labor cost advantage with a 40% gross margin in both countries. The dollar strengthens by 35% against the Peso. The cost of U.S. manufacturing operations does not change; however, the Mexican sales price relative to those costs drops by 35%. The gross margin on Mexican exports is now a loss of -1% and the overall gross margin drops to only 14%. The lower gross margin fails to cover general and administrative expenses and the American company begins to lose money. The competing Mexican company’s costs in pesos remain the same, but the price for U.S. exports relative to those costs just increased 35%. Now the competitor’s gross margin on exports to the U.S. is 75%.
How should companies address currency risks?
Textbook discussion of exchange rate risk usually focuses on hedging contract derivatives as a solution. While hedging may be a solution for a company with a single foreign currency denominated monetary asset or liability to manage, it tends to be the last resort for a small or mid-sized multinational organization. This method is expensive and, to work well, requires that assets and liabilities be well defined and of finite duration.
It is important to get the accounting right. Once accounting rules have been properly implemented, develop management reports that separate the P&L effects of exchange fluctuations from the effects of on-going operations. For each income statement line, companies should have management reports which calculate variances from the budget, forecast and prior period before and after the change in exchange rate. This allows the company to discuss the currency effects in the MD&A of the 10-Ks and 10-Qs.
Priority on Stockholder Value
The accounting methods described above can sometimes divert attention from danger by implying: “All is well with our operations. The ugliness on the income statement is just due to accounting for temporary currency exchange rate fluctuations beyond anyone’s control.”
For a multi-national organization, the danger of exchange rate fluctuations is not the appearance of financial statements but rather how they might influence stockholder value. A talented CFO will prioritize stockholder value over the accounting presentation.
Develop Tax and Treasury Strategy
The strategy starts by forecasting which countries’ operations will generate and which will consume cash. The company in the first example should have forecasted cash generation in Brazil to cover cash requirements in the U.S. The next step is to forecast trends in the exchange rate. In our example, all macroeconomic and political factors in Brazil and the U.S. predicted continued decline of the Brazilian Real against the U.S. Dollar throughout the period cited. The final step is to use a tax and treasury strategy to restructure balance sheets to reduce risk. In the first example, the company’s tax manager may have calculated that foreign tax credits would offset other tax costs of sending cash to the U.S. parent as a dividend. Cash could not be sent back to the U.S. parent as a loan because U.S. federal tax law would deem it a dividend, resulting in unfavorable tax consequences. However the cash might be transferred as an intercompany loan to another subsidiary, for example the U.K., where it would be exchanged and held in a more stable currency or where local regulations would allow for deposit in a USD denominated bank account.
There is no easy solution for the second example of the U.S. manufacturing company with costs in a strengthening currency for sales in a weakening currency. Hedging for a significant percentage of the revenue stream would be far too expensive and would only prolong the margin problem.
A strategy to reduce the margin risk is to align the revenue streams with the operating costs of the company. Aligning operations is a costly and lengthy alternative requiring a transfer of production to the country of sale. Large multinational organizations can reduce risk by spreading manufacturing across several countries to reduce vulnerability to currency fluctuations. Unfortunately, U.S. exporters currently caught in this bind have no short term solution other than to reduce costs and ride it out.
All three of the above components must work in harmony. Having the right accounting basics and focusing on shareholder value should enable development of a tax and treasury strategy with implications well beyond accounting. Over the long term, companies can integrate the tax and treasury strategy with their overall business strategy to gain competitive advantage in the capital and commercial markets.
David North is the Corporate Controller for L.S. Starrett Company and has 30 years’ financial management leadership experience with a variety of global manufacturing organizations. David’s finance and accounting expertise includes internal controls, SEC reporting, and treasury and risk management.
Trenegy is a management consulting firm advising finance executives on transforming global finance organizations into innovative and high performing teams. Our team of experts help enable efficient financial controls, global treasuring and tax strategies and shared service environments.