Tight resources. Constant squeezes from bigger competitors. If all this wasn't hard enough, currency exchange rate fluctuations further complicate your business' finances.
Exchange rates—how much of one currency you receive in exchange for another—have an outsized impact on international SME profits.
Just how much of an impact are we talking about?
A famous study by Donald Lessard and John Lightstone, published in the Harvard Business Review, found that an exporter with a nominal profit margin of 15% would have experienced "real" margins from -30% to 35%.
Exporters with a currency risk mitigation strategy would have restricted that band from 8% to 30%.
Why do such swings happen? According to James Gunns, FX expert at iBanFirst, unpredictable macroeconomic events play a substantial role. "Over the last decade, we've witnessed monumental market-moving events such as Brexit, COVID-19, and the war in Ukraine, just to name a few," he highlights.
These events, he asserts, were largely unforeseeable, yet their profound impact on FX markets cannot be ignored.
Here's how fluctuating exchange rates impact your SME and what you can do to mitigate their negative impact.
Exchange rate fluctuations can change how much you owe your suppliers for their services. While these fluctuations have several causes ranging from political volatility to inflation, the bottom line is that currency swings complicate cash flow planning.
Here's a simple example. Let's say you place an order worth EUR 30,000 from China, and your supplier bills you in RMB on January 15:
Your supplier invoices you for 233,579 CNY but this amount is due post-production, three months down the line on April 15.
Let's say the CNY/EUR exchange rate changes to 0.134487 during those days. You owe 233,579 CNY but at the new rate this is equal to EUR 31,413, an additional EUR 1,413 compared to the original amount you budgeted.
James warns that some foreign suppliers may propose solutions that increase costs. “Some Chinese manufacturers, for example, prefer to receive payments in Sterling but add an additional 15% to 25% on invoices to offset currency risks,” he says.
He recommends transacting in local currencies and mitigating risk through FX products instead. “This approach provides greater control and potentially lower costs.”.
While supplier payments are the most obvious cost affected by exchange rates, employee compensation costs experience an effect too. This effect occurs for both domestic and international employees.
If you grant your employees performance and revenue-based bonuses, placing them in the right context is critical. Your employees could have performed well, earning you huge revenues, only for an exchange rate blip to erase profits on your books.
In this case, you should review your compensation schemes to reward high-performing employees while mitigating FX risk.
James stresses that “if you've got an exposure to FX at any level, it should be considered a serious risk that needs to be addressed one way or another.”
With what we’ve seen happening in terms of volatility these last few years, It's no longer just a case of it's a fixed amount of risk, or it's a fixed amount of loss that you could potentially be facing. It is increasing on a regular basis.", he adds.
Collaborating with a currency risk management specialist can help you gain a better understanding of your currency risk exposure and uncover strategies to mitigate the impact of currency market fluctuations on your cash outflows and bottom line.
Picture this: You suddenly begin receiving orders from the UK despite allocating little marketing budget to that region. The demand is big enough for you to realign your production schedules and supply chain.
And once you've done everything, demand falls flat, leaving you with hefty costs. What could possibly explain this scenario?
Currency rate fluctuations play a crucial role in shaping the demand for your goods. A favorable shift can make your products appear more affordable in certain regions, while an unfavorable move can have the opposite effect. Additionally, internal currency transfers within your company's foreign units can skew performance metrics, giving a misleading impression of departmental efficiency.
This was the situation plenty of small businesses faced during Brexit. Wild swings in the EURGBP exchange rate meant products were either cheap or expensive for customers.
Worse, if a business held a portion of its cash reserves in GBP, it was exposed to currency risks even on the revenue it had collected.
While opening a local currency account can be a step in the right direction, it must be complemented by efficient transfer mechanisms to your home currency and a comprehensive currency risk management strategy.
Take Nooz Optics, for example. Opening a local USD account allowed them to reduce conversion costs when selling to American customers. In addition to that, better FX risk management involving forward contracts has boosted their margins by 10%.
Currency risk management is more than just monitoring exchange rates. It's a strategy that mitigates the effect of changing exchange rates and keeps you from acting on the wrong business demand drivers.
Supplier relationships and customer demand are the most apparent effects exchange rate fluctuations have on your business. But they aren't the only effects.
Currency exchange rates also impact the prices of ancillary goods you need to run your business smoothly. You may not pay for them directly, but their prices will factor into your Cost of Goods Sold (COGS.)
Oil prices, for instance, heavily correlate to USD strength. A 2020 study discovered that oil prices track USD levels, and USD strength or weakness can reasonably predict oil price levels.
Given the Dollar's central position as a medium of exchange, you can expect knock-on effects on the Euro and British Pound.
Oil price fluctuations mean transport and logistics prices swing, complicating your budget projections. While there is no way to predict these risks, being aware of currency fluctuations can help you mitigate them.
One way is to use fixed-rate contracts with suppliers. For instance, lock in rates ahead of time with your logistics provider to prevent any wild price swings.
For countless small and medium-sized businesses (SMBs), grappling with currency risk is an unavoidable part of venturing into international markets—a challenge that can feel daunting and uncertain.
Exchange rates are the product of several factors like inflation, geopolitical stability, and global economic trends. Keeping track of all these factors will leave you in a spin.
While you may not have control over the global economy, you can still take proactive steps to mitigate currency risk.
“Begin by thoroughly examining your currency exposure, and then collaborate with your FX partner to assess your choices and develop an FX risk management strategy tailored to your specific needs and objectives," advises James Gunn.
Curious about which FX risk management strategy works best for you? Check out our Hedging Simulator.
Currency exchange rate changes affect international businesses of all sizes in the following ways:
Cross-border payments become risky as a result of these factors.
Exchange rates fluctuate due to a combination of the following reasons:
While figuring out each factor's contribution to an exchange rate's value is challenging, SMEs must focus on mitigating currency exposure risks instead of tracking every variable.
By mitigating risk, you focus on what you can control and safeguard profits.
Every currency's exchange rate is influenced by supply and demand. Exchange rates fall if a currency's supply exceeds demand and rise if demand exceeds supply.
Exchange rates fluctuate 24 hours a day. This happens because the international FX market operates 24 hours worldwide. Individual currencies experience varying activity throughout the day.
For instance, the EURUSD currency pair is highly active when European and American markets are open. The pair is relatively inactive when those markets are closed and the Asian markets are open.