This is part two of our series on exchange-rate risks for businesses. In part one, we covered transactional risk and how businesses can prepare for changes in exchange rates knowing they have to make international transactions.
Businesses with an international presence, or those that buy or sell overseas, can be prone to exchange-rate risk, but the types of foreign exchange exposure can come in many different forms and may not impact all international businesses.
Identifying those risks and keeping tabs on the ever-moving foreign exchange rates can be a tough job for treasury or accounting departments that are responsible for company financials, but knowing the different types of risks is a good first line of defense.
We’ve already discussed transactional risk, but a more nuanced exchange-rate risk is translational exposure. Translational exposure can have some similarities to transactional, but there are some important differences.
The biggest difference is that transactional is more focused on an international business transaction, like paying a supplier overseas, while translational risk is referring to changes in the exchange rates and how foreign assets and liabilities can impact a company’s financial reporting.
If a company is based in the United States but has assets, like real estate, in another county then they could run into translational risk when determining financial results. This is because assets and liabilities, such as a loan, in foreign countries are in that country’s currency. However, reporting must be done in the home country currency.
This is where the exposure comes into play. Foreign exchange rates change throughout the day and, therefore, so can the value of foreign asset or liability. When it comes to a quarterly financial report, a company might show a financial loss when compared to the previous quarter if the value of a foreign asset is converted at a different exchange rate even though the value of that foreign asset hasn’t changed in that country.
For example, if a company based in the U.S. has a factory in Germany that is worth €4 million and the hypothetical EUR/USD exchange rate is 1.23 then it would be reported as worth $3,252,032.52 million for the company’s financial report. The factory is still valued at roughly €4 million next quarter, but the exchange rate is now 1.33. The asset would be listed at $3,007,518.80 – roughly $240,000 less.
These types of losses are usually listed our in a company balance sheet and can impact company net worth. Many investors understand that the exchange rates change constantly and that rates could even be different from the time the reporting was done to the time the financials are published, but they are still something companies must account for. Perceived financial losses could impact the share price of the company.
Balancing assets and liabilities
Even though exchange-rate changes can increase or decrease the value of a foreign asset, it will also change the value of a liability when translated back to local currency.
In many cases, changes in assets and liabilities cancel each other out. This is why many corporations try to match assets to liabilities in order to avoid having to list a loss or gain on a balance sheet from the foreign business.
A company’s level of translational exposure is the difference in foreign assets and liabilities. If the company has more liabilities than assets, this is considered negative exposure. If the foreign currency loses value, it would result in a translational loss because the amount of money owed on a liability is more than the last time reported in the home currency. If the foreign currency gains value, then there would be a translational gain.
The opposite applies when a company has more assets than liabilities. This is positive exposure. When the foreign currency devalues, the company would have to report a translational loss. If the foreign currency gains value, the company would report a financial gain.
When there is an imbalance in assets and liabilities, positive or negative, there will either be a gain or a loss when exchange rates fluctuate, up or down. With all of those possibilities, it can be worth trying to keep them balanced to avoid constantly having a perceived loss or gain on a financial report.
Some ways companies match them when they have positive exposure in a foreign country is to reduce cash levels, increase local borrowing or delay accounts payable. However, matching liabilities and assets can be tricky, especially if a company has restrictions on its level of borrowing.
When it comes to borrowing, there is an overlap between transactional risk and translational risk. The value of the loan changing due to exchange rates is translational, but the interest payment is transactional. An easy identifier between these two is that transactional exposure usually impacts cash flow, while translational impacts financial statements and could have an impact on share price.
Other ways to manage translational risk
In addition to balancing assets and liabilities, some companies can try to forecast or speculate the foreign exchange markets and adjust forecasting holdings in anticipations. This can be a very risky and hard to predict.
Instead of trying to alter business objectives to follow the foreign exchange markets, some companies simply ignore translational exposure in the short run. Savvy investors understand that these types of gains and losses are common with multinational companies and will look past them on financial statements.
The key here is to not worry about altering business plans, but still keep tabs on the foreign exchange rates for the countries where the company has foreign currency. This allows treasury departments to know about potential translational gains or losses when it comes time for reporting and accounting departments to understand what’s going on in the markets when it comes time to make inter-company transfers or payments abroad.
Many companies do this with the help of an international payments specialist like WorldFirst. WorldFirst offers insightful FX news and dedicated account managers to its clients. Companies can set up rate alerts and even forward contracts to make a payment when an exchange rate hits a desired rate. This can be more helpful for transactional exposure, such as paying suppliers abroad.
The foreign exchange markets are always changing, so it’s smart for companies not to get wrapped up worrying about exposure day-to-day. Being conscious of market movements and how they will impact foreign holdings is a key to tackling translational exposure.