- If you have operations outside the US or parked capital abroad, foreign exchange (FX) will impact your results; the impact may be material.
- You can use the factors described in this article to help identify materiality.
- Assessment of materiality for fast growing innovation sector companies is not a one-time exercise, but an integral part of the financial planning & analysis (FP&A) process.
Unexpected FX costs can be a headwindMost companies look at FX costs, as they arise, as a standard business expense. Currency is bought as needed and repatriated as soon as it’s earned. This type of unexamined currency exchange operation may create unexpected losses, increasing over time.
There are many ways to help manage these risks, so there’s no need to accept FX risk as a cost of doing business internationally.
You can identify and quantify FX risks
This article provides guidance on the factors that tend to create material FX risk. If you’re interested in having SVB help you calculate the materiality of your FX exposure, reach out to your FX Advisor or Ivan Asensio.
Simply by examining the FX risk, you have moved beyond passively accepting it – you are actively managing FX risk. That’s good. See our recent FX Risk Advisory article, Why passive FX management falls short. In that article, we recommended that you determine whether your company’s FX exposure is material.
What is materiality?
Materiality is a function of two factors, size and potential impact. The combination of these factors constitutes a company’s currency exposure.
Size corresponds to the amount of currency that must be transacted over a period of time, or the value of assets and liabilities denominated in foreign currencies, or some combination of the two. Impact measures the potential loss that would arise from an adverse move in the foreign currency. This projection can be based on historical patterns, or currency option prices, and is generally associated with a level of probability.
FX exposure is specific to your operating model
Suppose a global life science company receives a quarter of its revenues in Hong Kong dollars. The size of the FX exposure is large relative to the total pie; however, the Hong Kong dollar is a currency that is pegged to the USD (and so does not move vs. the USD) and it has been so for close to four decades. The likelihood that this peg breaks over a fiscal year is remote. Thus, size combined with the potential impact of the currency move would not trigger the materiality threshold.
In contrast, early stage technology companies moving R&D to India will find the value of the rupee vs. the USD exhibits material swings from one period to the next; the longer the period, the larger the swings. The typical swings in the rupee over a year have historically been about 10 percent, but they have been as large as 30 percent. Taken together, even a small annual rupee spend can translate into a material currency exposure for a growing firm.
Where will you need to look to assess FX materiality for your company?
A checklist of factors that create FX materialityFor corporations:
- Where are your customers/vendors? Do you have the ability to price in USD for your customers/vendors outside the US? How sustainable is this arrangement?
- What percentages of operating expenses are denominated in currencies other than the dollar? What is the mix of currencies?
- For early stage and expanding companies, will a rise in foreign currencies adversely impact your cash burn and runway?
- If you cannot price goods or services exclusively in USD, what percent of revenues are denominated in foreign currencies?
- Do you need a foreign entity to operate outside the US? If you are billing and collecting overseas directly for the parent through a third-party payment provider who is doing the conversion to USD for you, are there hidden FX risks to consider?
- Are you operating out of cost-plus or standalone entities? What is the functional currency of these entities? What is your overseas profit repatriation strategy? Do you expect having to hold currency outside the US?
- What percent of fund capital is held in assets denominated in foreign currencies?
- Do you have limited partnerships outside the US?
- Do you build a “5 percent buffer” to allow for the difference in timing between capital call and investment for foreign investments?
- Is the buyer or seller of foreign denominated assets domiciled in the US or overseas?
- Are these credit assets that generate regular non-USD denominated cash flows, or equity assets that have large back end anticipated flows?
Any of these factors indicate that your business has potential exposure to FX risk. To help prevent or mitigate the unexpected costs of unpredictable currency exchange rate fluctuations, the exposures need to be actively tracked and measured and examined and, if warranted, actively mitigated.
FX risk mitigation will take different forms in different companies, as the examples suggest. Choosing the right approach requires that you know the source of the exposure.
One method of determining FX materiality is to look backward. Examine your budgeted FX revenues/expenses against actual revenues/expenses, or your projected sales margin versus the actual. Was the difference material? If so, you should not rely on passive FX management, but should start using active FX management strategies to prevent unwanted expenses in the future.
Ideally, however, the backward looking exercise described should be done in conjunction with a forward looking analysis which involves incorporating FX budget rates into the FP&A process. Statistical techniques then can be used to project a range of outcomes for the business, net of FX, providing an objective framework a global business can use to make informed decisions about whether or not to proceed with hedging and to what extent.
For more info on budget rates, read the FX Risk Advisory article: Setting FX budget rates.
A benchmark for materialityThere are guidelines for levels of materiality that call for risk mitigation.
Generally speaking, if a minimum of 20 percent of top-line revenues, operating expenses (OpEx), or earnings (EBIT) is projected to be realized in foreign currencies, then the “size” threshold is met and it is time to pay attention to FX. SVB can work with you to help gauge whether size coupled with potential impact means your company’s exposure is material.
For material exposures, active management of currency risk makes sense. For more information about active and passive FX management, read our recent FX Risk Advisory: Why passive FX management falls short.
Talk to usIf you’d like to discuss your specific situation to determine FX materiality, or to explore the merits of active FX management, contact your SVB FX Advisor directly, or Ivan Oscar Asensio, SVB FX Risk Advisory at email@example.com.
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- FX Risk Advisory: Why passive FX management falls short
- FX Risk Advisory: How currency movements can affect your global business