Imagine a UK company which does business with customers and
suppliers in continental Europe. Suppose the company has bought an
item of machinery from a German manufacturer for €100,000. At
the date when the invoice is received, €100,000 is worth
£64,500. The invoice is payable in 30 days, and is paid on
time. But in the interim, sterling weakens against the euro, and at
the date of payment, €100,000 is worth £64,800. The
company has had to find an extra £300 to fund the purchase,
solely because of currency fluctuations.
Similarly, if the company had borrowed in euros, and sterling
weakened, it would have to find more – in sterling terms
– to repay the borrowing.
There is, of course, likely to be an upside to the movement
in exchange rates. If the company has invoiced a customer
€100,000 at a time when €100,000 was worth
£64,500, and received payment 30 days later when the same sum
was worth £64,800, it would have made an exchange profit of
£300. And what is true of trade debts is also true of other
assets: if the company had, for example, a euro bank deposit, it
would be worth more in sterling terms.
There is more about exchange gains and losses at
CFM7010+.
FOREX movements are largely unpredictable. This is true of
the world’s major currencies. And even with currencies which,
historically, have moved in one direction for a length of time
– for example, Turkish lira has continued to depreciate
against sterling for several years – there may be short-term
reversals of the trend. So without hedging, a company’s
profits could vary unpredictably from year to year just because of
exchange fluctuations: it might make exchange gains, but equally it
is exposed to the risk of exchange losses.
For this reason, most companies with a significant foreign
currency exposure will hedge the risk – see
CFM7041.
