Building up from the Balance Sheet
In our past two posts, we discussed the centrality of the balance sheet for many US corporates as a tool to capture their exposure to FX. While the balance sheet is a point-in-time measure, we can use the components of the cash conversion cycle to build to a better understanding of a business’s projected FX exposures. This will give them a yardstick by which to measure their potential margin risk from FX, an insight that a balance sheet alone cannot provide.
Balance-sheet basics
The balance sheet is a good place to start to determine FX risk exposure. This is how it’s done:
The existence of an FX gain/loss in the non-operating income line of the income statement is evidence that there is FX exposure on working capital items and thus FX risk in the business.
To calculate this line item, most ERP (Enterprise Resource Planning) systems automatically flag working capital items like cash, short-term investments, receivables (AR), inventory, and payables (AP) that are held in a different currency from the functional/reporting currency of the entity.
By digging into these items, we can see what currencies they are held in, AND the FX rates at the beginning and end of the reporting period. This helps us build our report.
The size of the corresponding gain or loss taken on the income statement, against the percentage change in the reported rates of that currency, tells us the notional size of the currency exposure, by currency, on net for the period.
Example: AP item flagged for remeasurement at a business with EUR functional currency
After several reporting cycles (over the course of 12 to 18 months, for example), and depending on the seasonality in the business, we get a rough idea of the notional size of the FX exposure carried on the balance sheet with a reasonable level of certainty.
Determining Prospective Exposure & Margin Risk
How do we get an idea of our prospective FX exposure? Well, that’s an industry unto itself, given the centrality of 13-week rolling cash forecasts to treasury and FP&A (Financial Planning and Analysis) planning.
Unless we dig into individual transactions, we can’t get to the level of granularity that most would expect from a 13-week cash forecast. But we can get close enough to get solid insight into the amount and sensitivity to margins of the business’s FX exposure.
The cash conversion cycle below highlights how we determine prospective FX exposure.
In steps #2 and 3 in the Balance-sheet basics section above, we identified which items were impacted by FX revaluation. We can decompose the cash conversion cycle to determine how much prospective FX exposure we have that is not reflected on the balance sheet at a given point in time.
For example, if we see that Accounts Receivable (AR) is impacted by FX movements, we can apply the Days Sales Outstanding (DSO) figure to understand the sensitivity to cash from FX movements. Using this insight, we can also confer with sales leadership to determine their sales cycle and how often prices are adjusted to get a better understanding of FX risk exposure to gross margins.
The same can be done with Days Payable Outstanding (DPO), and comparing it to notional sizes of FX exposures held on AP balances. Combined, this gives us a better understanding of how FX can impact our cash conversion/margins.
In Conclusion
Ultimately, businesses that show FX gains/losses on their income statement have working capital items influenced by FX rate movements. We know from basic corporate finance that effective working capital management is central to financial performance and valuation. Simple exercises like the above can be helpful in giving the insight necessary for finance teams to really move the needle in driving financial performance.
In our next piece, we will elaborate more on hedge accounting and the role of the audit in evaluation and reporting.
Read the previous article in the series: The FX Lifecycle Explained
Read the next article in the series: Ask the Auditor: Cross Country Observations on Hedge Accounting
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