Foreign exchange risk – a hidden cost for manufacturers

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INDUSTRY INSIGHTS: FOREIGN EXCHANGE RISK – A HIDDEN COST FOR MANUFACTURERS

Manufacturers, by their very nature, have to be good at managing things. They have to manage production lines, inventory, sales teams, finances, procurement, logistics - and the list goes on. They must also think about managing the risks associated with these areas and deal with the ‘what if?’ scenarios if things do not go to plan. With so many variables, it’s no wonder that some risks can often be overlooked.

Exchange rate fluctuations

A common risk for manufacturers is the continual fluctuation of currency exchange rates and the impact this can have on underlying profitability. The globalisation of supply chains means many manufacturers source their components/raw materials from overseas or export the products they produce. Invariably, they will have to undertake foreign currency conversions to pay supplier invoices and/or collect payments from their customers. But how many consider that currency movements can put their profits at risk?

This problem is often made worse for manufacturers due to the existence of long production cycles. Typically, a supply contract is calculated using a current exchange rate, but it could be many weeks or months before the order is completed and payment is made. Over this time, exchange rates could move significantly and, if not addressed, this could threaten profit margins. For example, a UK manufacturer that agrees a EUR 250k capital investment in new equipment could find the GBP/EUR exchange rate has fallen by 5% when payment is due to their supplier 3 months later. This would add an unwelcome £11,000 to the contract cost in GBP terms.

Identifying currency exposure

To tackle this issue, the first step is to quantify exactly how much exposure the business has to any one currency. It could be that a business has some inflows and outflows in the same currency and so to some degree the risk of exchange rate movements will be reduced. This is called ‘natural hedging’ and the business needs to have sufficient cashflow to cover the timing differences between receipts and payments without converting to its domestic currency. Any foreign currency requirement exceeding natural hedging represents an exposure which should be assessed and continually monitored.

Protecting profit margins

Jamie Holmes is a director of foreign exchange company CurrencyWave and helps manufacturers who would otherwise have little or no help from their bank when it comes to dealing with FX and international payments. Says Jamie: “Whilst large manufacturers may have internal resources and expertise to deal with currency risk, this is often not the case with mid-sized and smaller companies. Either they leave exchange rates completely to chance, hoping that things will even out in the end, or they try and ‘play’ the market hoping to buy/sell at the right time. Either way, both strategies are flawed and can end up with catastrophic results, especially in today’s volatile currency market. Instead, what they should be doing is protecting their margins by using forward currency contracts, removing the risk and giving them certainty over their future cashflows”.

Forward currency contracts are a simple, yet effective way to bridge the timing gap that occurs when invoices are issued to when payments are received or paid. They allow the holder to buy or sell a specific amount of currency at a fixed exchange rate and then settle the conversion at a pre-determined future date. No matter what happens to the exchange rate in this period, the holder is protected, and the currency risk is removed.

Get expert help

For manufacturers looking to reduce currency risk, the good news is that this need not be a complicated exercise. First and foremost, it is important that the risks are fully identified and then a cohesive strategy to deal with them should be agreed upon. There is no one size fits all solution as this will be determined by several factors including cashflow, attitude to risk and practical considerations. If in doubt it is wise to get expert help from a specialist foreign exchange broker but, above all else, ignore currency risk at your peril.

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