Businesses involved in the manufacturing of goods in one country to be sold in another are highly exposed to the risks associated with fluctuations in the exchange rate. This could be detrimental to the day to day running of your business, cause problems with cash flow and ultimately leave your profits at risk.
Many factors outside of our control can influence exchange rates such, political developments, financial data, and environmental factors, all of which could reduce the value of the Pound against other currencies. For most businesses, a 5% increase in costs would put them under much more financial pressure and a significant shift in the market could easily cause an increase of this magnitude.
Particular industries are more at risk of currency swings due to their reliance on buying materials from overseas. The automotive industry, for example, relies heavily on buying parts abroad and assembling them in the UK. Ultimately, the more of your business relies on import and export, the more at risk you are and the greater need to have a tailored FX strategy in place.
A UK business buys electrical goods from the US. Once ordered, the electrical devices are built and shipped over to the UK. The lead time on these electrical goods can vary and can be anywhere between 1 to 6 months, therefore 30% of the cost of the order is paid upfront and 70% once the delivery has been received. Problems occur however when the exchange rate moves in an unfavourable resulting in the business having to pay the remaining 70% of the order at a worse rate than the initial 30%.
For example, if the total cost of the order is $1,000,000 and the GBPUSD rate is 1.25 at the point of order the goods would cost the UK business £800,000. Based on the agreement $300,000 is paid upfront and $700,000 will be paid once the items have been delivered. If the build and delivery of the goods take 5 months the likelihood is that the exchange rate will have moved. In this scenario, the GBPUSD exchange rate has moved to 1.21 by the time the order has arrived. This means that the outstanding $700,000 will now cost the UK business roughly £578,500 rather than the £560,000 it would have cost once the order was made. This may not seem like a huge difference but as exchange rates are constantly changing due to both economic and geopolitical events a large shift is never out of the question.
This can lead to uneasy times for business owners and finance teams who are left continually watching the market, hoping that it shifts in their favour. We have also seen it be the case that businesses end up losing their entire profit margin due to a change in the FX market and have to turn down new business opportunities due to cash flow concerns as the rate has dropped away from them.
While these factors, that could risk your profits and increase your costs are out of our control, the good news is there are things you can do to protect your business against movements in the currency market. The important thing to do is to act when the exchange rate is in your favour and secure the amount of currency you know you will require. This can be done through the use of a forward contract which allows you to secure an exchange rate when it is in your favour. Using the previous example, if the electrical goods company had secured the $100,000 that they needed when the exchange rate was 1.25 they would have saved £18,500 on the order.
By using hedging strategies, such as forward contracts, businesses can eliminate the risk of exchange rate fluctuations and by locking in a rate they can give themselves certainty over costs and profits on each order.
To find out how a forward contract could benefit your business and begin reducing the risk of exchange rate fluctuations speak to one of our FX experts by calling +44 (0) 20 7738 0777 or request a call back via our website.
Posted in Business Resources on Nov 8 2019