Businesses that operate internationally or domestically must deal with various risks when trading in currencies other than their home currency.
Companies typically generate capital by borrowing debt or issuing equity and then use this to invest in assets and try to generate a return on the investment. The investment might be in assets overseas and financed in foreign currencies, or the company's products might be sold to customers overseas who pay in their local currencies.
Domestic companies that sell only to domestic customers might still face currency risk because the raw materials they buy are priced in a foreign currency. Companies that do business in just their home currency can still face currency risk if their competitors operate in a different home currency. So what are a company's various currency risks? (See also: Currency Exchange: Floating Rate Vs. Fixed Rate.)
Transaction risk arises whenever a company has a committed cash flow to be paid or received in a foreign currency. The risk often arises when a company sells its products or services on credit and it receives payment after a delay, such as 90 or 120 days. It is a risk for the company because in the period between the sale and the receipt of funds, the value of the foreign payment when it is exchanged for home currency terms could result in a loss for the company. The reduced home currency value would arise because the exchange rate has moved against the company during the period of credit granted.
The example below illustrates a transaction risk involving U.S. and Australian dollars:
|Spot Rate||AUD Received From Sale||USD Received After Exchange|
|Scenario A (Now)||US$1 = AU$2.00||2 million||1 million|
|Scenario B (After 90 days)||US$1 = AU$2.50||2 million||800,000|
For the sake of the example, let's say a company called USA Printing has a home currency of U.S. dollars, and it sells a printing machine to an Australian customer, Koala Corp., which pays in its home currency of Australian dollars (AU) in the amount of $2 million.
In Scenario A, the sales invoice is paid on delivery of the machine. USA Printing receives AU$2 million, and converts them at the spot rate of 1:2 and so receives $1 million in its home currency.
In Scenario B, the customer is allowed credit by the company, so AU$2 million is paid after 90 days. USA Printing still receives AU$2 million but the spot rate quoted at that time is 1:2.50, so when USA Printing converts the payment, it is worth only $800,000, a difference of $200,000.
If the USA Printing had intended to make a profit of $200,000 from the sale, this would have been totally lost in Scenario B due to the depreciation of the AU during the 90-day period.
A company that has operations overseas will need to translate the foreign currency values of each of these assets and liabilities into its home currency. It will then have to consolidate them with its home currency assets and liabilities before it can publish its consolidated financial accounts—its balance sheet and profit and loss statement. The translation process can result in unfavorable equivalent home currency values of assets and liabilities. A simple balance sheet example of a company whose home (and reporting) currency is in British pounds (£) will illustrate translation risk:
|Pre-Consolidation||Year 1||Year 2|
|£1:$ Exchange Rate||n/a||1.50||3.00|
In year one, with an exchange rate of £1:1.50, the company's foreign assets are worth £200 in home currency terms and total assets and liabilities are each £300. The debt/equity ratio is 2:1. In year two, the dollar has depreciated and is now trading at the exchange rate of £1:$3. When year two's assets and liabilities are consolidated, the foreign asset is worth 100 pounds (a 50% fall in value in pound terms). For the balance sheet to balance, liabilities must equal assets. The adjustment is made to the value of equity, which must decrease by 100 pounds so liabilities also total 200 pounds.
The adverse effect of this equity adjustment is that the D/E, or gearing ratio, is now substantially changed. This would be a serious problem for the company if it had given a covenant (promise) to keep this ratio below an agreed figure. The consequence for the company might be that the bank that provided the 200 pounds of debt demands it back or it applies penal terms for a waiver of the covenant.
Another unpleasant effect caused by translation is that the value of equity is much lower—not a pleasant situation for shareholders whose investment was worth 100 pounds last year and some (not seeing the balance sheet when published) might try to sell their shares. This selling might depress the company's market share price, or make it difficult for the company to attract additional equity investment.
Some companies would argue that the value of the foreign assets has not changed in local currency terms; it is still worth $300 and its operations and profitability might also be as valuable as they were last year. This means that there is no intrinsic deterioration in value to shareholders. All that has happened is an accounting effect of translating foreign currency. Some companies, therefore, take a relatively relaxed view of translation risk since there is no actual cash flow effect. If the company were to sell its assets at the depreciated exchange rate in year two, this would create a cash flow impact and the translation risk would become transaction risk.
Like transaction risk, economic risk has a cash flow effect on a company. Unlike transaction risk, economic risk relates to uncommitted cash flows, or those from expected but not yet committed future product sales. These future sales, and hence future cash flows, might be reduced when they are exchanged for the home currency if a foreign competitor selling to the same customer as the company (but in the competitor's currency) sees its exchange rate move favorably (versus that of the customer) while the company's exchange rate versus that of the customer, moves unfavorably. Note that the customer could be in the same country as the company (and so have the same home currency) and the company would still have an exposure to economic risk.
The company would therefore lose value (in home currency terms) through no direct fault of its own; its product, for example, could be just as good or better than the competitor's product, it just now costs more to the customer in the customer's currency.
The Bottom Line
Currency risks can have various effects on a company, whether it operates domestically or internationally. Transaction and economic risks affect a company's cash flows, while transaction risk represents the future and known cash flows. Economic risk represents the future (but unknown) cash flows. Translation risk has no cash flow effect, although it could be transformed into transaction risk or economic risk if the company were to realize the value of its foreign currency assets or liabilities. Risk can be tricky to understand, but by breaking it up into these categories, it is easier to see how that risk affects a company's balance sheet.