What are 'Constant Currencies'

Constant currencies are exchange rates that eliminate the effects of exchange rate fluctuations when calculating financial performance numbers for various financial statements. Companies with major foreign operations often use constant currencies when calculating their yearly performance measures. Since currency fluctuations can mask the true financial performance of a company, many firms use constant currencies to make their financial statements clearer or more meaningful.

BREAKING DOWN 'Constant Currencies'

For example, consider a Japanese company that sells primarily abroad and sets its prices according to U.S. dollars. If sales increase 10% in dollar terms, but the dollar fell 5% against the yen during the year, only a 5% increase in sales will be reported in the accounts, unless a constant currency is applied in the calculation. In other words, the use of constant currencies allows companies to show performance unaffected by currency fluctuations.

Comparing Results With and Without Constant Currencies

As a simple example showing the effects of using constant currencies versus not using constant currencies, consider the following. Company X is based in Australia and does business in the United States, earning revenue in U.S. dollars. In year one, the company earns $500,000 and has a net profit of 10%. At the end of year one, the AUD/USD exchange rate is 0.8. In the second year, the company earns $600,000 and has a net profit of 10%. The AUD/USD exchange rate is 1.1 at the end of the second year. Bases on this, the financial results, translated to AUD, would be:

USD Revenue (year one; year two) = $500,000; $600,000

USD Net Profit = $50,000; $60,000

AUD/USD Exchange Rate = 0.8; 1.1

AUD Revenue = $625,000; $545,455

AUD Net Profit = $62,500; $54,545

These results do not use constant currency. They show that USD revenue of net profit both increased by 20% year over year and that the exchange rate increased by 37.5%. Due to the exchange rate fluctuation, the AUD revenue and net profit numbers actually decreased by 12.7% each. This may not be a fair number to report due to the fact that the declines were solely due to currency exchange rates. To eliminate this phenomenon, the company can use constant currency methodology. A company can either keep the currency rate constant using the beginning year currency number, or the company can use the latest year's exchange rate and adjust prior year numbers. Both methods are valid, but by adjusting prior year numbers, a company isn't producing artificial results for the current year. Here is how the latter method would look:

USD Revenue (year one; year two) = $500,000; $600,000

USD Net Profit = $50,000; $60,000

AUD/USD Exchange Rate = 1.1; 1.1

AUD Revenue = $454,545; $545,455

AUD Net Profit = $45,455; $54,545

In this scenario, the AUD revenue and net profit numbers now show growth of 20%, eliminating the currency fluctuation's effects.

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