A beginner’s guide to understanding foreign currency when you trade overseas
When a business starts to trade internationally, one of the first difficulties it encounters is foreign currency. This blog explains in simple terms the most common foreign currency issues for a business trading overseas. It will assume a low level of knowledge of the terms and jargon involved. In this follow up blog I will help you understand how to manage the risks and issues which foreign currency causes.
What is the local currency of a business?
Every business is incorporated in a home country. Usually its local currency will be the currency of that country. So a UK company will typically have a main bank account in £ sterling and its financial accounts will be prepared and presented in £ sterling.
What is foreign currency for a business?
Each country in the world uses its own currency, with some exceptions. Many countries in Europe have a shared currency, the Euro, and countries whose currency is not widely traded often use the US$ or another hard currency in practice for business transactions. For a business, foreign currency is any currency other than its local currency.
The exchange of one currency for another, or the conversion of one currency into another currency, is called foreign exchange. This is commonly abbreviated as “FX” or Forex”. Foreign exchange also refers to the global finance market where currencies are traded. Some currencies have fixed exchange rates e.g. the Hong Kong $ to US$, so these rates will fluctuate less or not at all.
Why is foreign currency important?
When a business trades internationally, it can have exposure to foreign currencies in many different ways. Each of these exposures has different implications and risks for the business. In this article I will focus on four common issues that affect businesses trading internationally:
- Paying international suppliers
- Billing foreign customers
- Currency mismatches
- Hard vs soft currencies
Paying international suppliers
If a business is importing goods or services from overseas, it will need to purchase these from international suppliers. It is likely that these purchases will be denominated in the currency of the supplier, in other words the business will need to pay the supplier in foreign currency.
What does it mean for cash….
As soon as the business has a commitment to pay the overseas supplier, it has a foreign currency liability. While this liability remains unpaid, the foreign exchange rate will continue to fluctuate. That means that when the business pays the supplier, the debt will either be larger or smaller than expected in local currency. In practical terms this means that cash costs will be higher or lower than predicted. This will make the profit margin worse or better, and the business won’t be able to predict in advance which way it will go.
..and the P&L?
If this liability is on the books and unpaid at the end of the accounting period, it will usually be translated back into local currency using the exchange rate at the period end date. So if at year end the business has an outstanding foreign currency debt, it will likely have a currency gain or loss in the P&L due to the currency fluctuations. This may be taxable depending on local country rules.
Watch out for payment fees
Another practical consideration is that payment fees on foreign currency are typically much higher than a local currency. These fees come in two forms, namely transaction charges and buy/sell margins on exchange rates. Make sure you budget for these fees when you are pricing a deal involving overseas goods or services.
Billing foreign customers
If a business is making sales overseas to its customers or distributors, then it may need to invoice these sales in foreign currency. If so there are a number of consequences which are typically the reverse of supplier payments
Consequences for cash….
As with supplier payments, customer invoices can remain open for some time. During that time the exchange rate will fluctuate, so the value of the customer receivable will rise and fall in local currency terms depending on the exchange rate. This means that the business can receive more or less cash than it expected, which has an impact on its profit margin.
…and the P&L
If the invoice is open and unpaid at the end of the accounting period, it will typically be translated back into local currency using the exchange rate at the period end date. So if at year end the business has an outstanding foreign currency receivable, it will likely have a currency gain or loss in the P&L due to the currency fluctuations.
One of the most difficult issues for an international business to manage are foreign currency mismatches. These happen when a business receives income in different currencies from its cost base. For example if a business receives all its income in US$ while paying all its costs in £, then any change in the US$ to £ exchange rate will have a major impact upon its margins and profitability. If the US$ weakens against £, then the business will have much lower profit margins.
This can have a major impact upon pricing and competitiveness. The business may need to increase its US$ pricing to remain profitable. It will then be at a competitive disadvantage to competitors from other countries who can keep their prices stable. If this currency shift holds for the long term, the business will have to reduce its £ costs by becoming more efficient if it is to stay competitive.
Hard vs soft currency
World currencies are classed as hard or soft. This distinction is very important for businesses.
What is a hard currency?
A hard currency is widely accepted around the world as a form of payment for goods and services. A hard currency is expected to remain fairly stable over a short period of time. It is also highly liquid, i.e. easily tradeable in the foreign exchange market. A hard currency is usually associated with a highly industrialised or wealthy economy.
…and a soft currency?
Soft currencies are the opposite of hard currencies. They are less commonly accepted as a form of payment. They are more likely to fluctuate in value in the short-term. It is also more difficult to buy, and in particular sell, soft currencies.
Why is this relevant for business?
If a business is in a hard currency economy, then its local currency will be easily tradeable. However if it is selling to or buying from 3rd party with a soft currency, the risks are much greater. These include:
- the value of any soft currency it will receive could decline significantly in a short period of time
- if it is receiving hard currency, its business partner may struggle to obtain the necessary hard currency to settle the transaction. Soft currencies are prone to capital controls which make it harder to trade them for hard currencies.
- It will be more expensive to buy protection against soft currency risks
Our award-winning team offer a great range of services to meet your foreign currency needs:
- you can read more about managing FX risks here in our free download
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