The past months have been eventful, to say the least. Various significant topics, such as Brexit and the on-going trade war, have claimed their spot in the papers’ headlines. For you as an entrepreneur it is definitely not always clear what this means for your business. Some consequences may be obvious, others are more concealed. But it definitely will cause feelings of discomfort. We have drafted some guidelines to help you make up your mind and identify risks. Furthermore we share some of our insights into how you may address these issues.
Identifying risk: understand the business
The key to understanding what events may impact your business is very straightforward: you should understand how your business works. And we understand; there is no-one who understands your business better then yourself. However, reflecting on your business model and simply plotting your business cycle on a piece of paper may spark remarkable insights. Where do you buy your raw materials? How are these economies performing financially, politically? What fiscal policies are about to be adopted? Is there technology in your business cycle that is rapidly developing? Where do you originate new talent?
The second step is to identify any assumptions which may affect critical economic events. Suppose you are forecasting financial years 2020 and 2021. One of your projects is setting up a new warehouse abroad. This consists of three stages: finding the actual location and (human) resources, running the new operations and finally scaling up the business. However, the success of stage three is conditional to the success of stage one and two. What does this conditionality mean for your forecast? Are your assumptions realistic? Is your financing agreement ready for delays or alterations to these steps?
The lawyer and the politician
It will not come as a surprise that our Visser & Visser Team International Business is often asked about the political situation in The Netherlands. Having a trustworthy and stable political- and legal environment greatly contributes to the likelihood of investments. However, your industry may be susceptible to an increased political risk. From there, you can leave it to fate but alternatively you can actively try to reduce your risk. For example, there are tailormade insurance policies insuring you for import- or export embargoes, violation of ownership rights and even nationalization. Visser & Visser can assist you in assessing how this impacts your project, investments or forecast. We can also act as a trusted advisor and give you a second opinion on your current strategy and the providers that come with it.
Another main risk is currency risk. You may be exposed to foreign currency fluctuations in various ways. It is crucial that you adequately identify how the following three exposure types influence your business.
- Transaction exposure (or contract exposure) can be defined as the sensitivity of realized domestic currency values of your firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes. Due to the fact that the settlement of the contractual cash flows is impacting your business’ domestic currency cash flows, transaction exposure is often classified as a short term economic exposure. So briefly put, transaction risk appears from fixed-price contracting in an environment where exchange rates are constantly moving.
- Economic exposure (or operating exposure) refers to the extend your firm’s value may be affected by unanticipated changes in the exchange rates. Changes in exchange rates can have a large effect on the firm’s competitive position and consequently it’s cash flow and market value. This means you may be operating completely in one currency but the local currency in the country your are working in (of which recently telling examples have occurred) disturbs your purchase- or sales transactions.
- Translation exposure (or accounting exposure) describes the potential that your firm’s consolidated financial statements can be affected by changes in exchange rates. This is a direct result of the consolidation exercise as it involves translation of foreign subsidiaries’ financial statements from local currencies to the firm’s reporting currency.
Now how to deal with it?
While processing the last paragraph, you may already have been asking yourself whether you do enough to address these risks properly. Ironically, empirical evidence suggests that firms generally tend to overestimate their ability to assess the market. The same research also shows that firms taking a neutral position by hedging their foreign exchange risk outperform their peer group who do not or just partially cover particular risks and take a very active position in assessing these positions.
A good next step is to identify your hedging objectives: do you want to reduce volatility in cashflow and earnings? Are you willing to leave certain positions uncovered? How much resources in time and money are you willing to spend on the actual issue? Does your strategy in hedging reflect your overall corporate strategy?
We strongly advise our clients to draft a hedging policy, where the following guidelines are covered:
- An identification of the type of exposure (as described under ‘Currency Risk’);
- A risk netting guideline;
- A directive on the cost-benefit trade-off (since given the costs, it not always makes sense to cover e.g. small contracts);
- Policies on an active or passive approach;
- Guidelines on hedging types (options, futures, forwards);
- Guidelines on product mix (see notes below);
- Accounting policy (depending on your adopted principles such as IFRS, NL GAAP, HGB).
Drafting this centralized policy will improve awareness amongst financial officers and reduce risk.
Consult your advisor
Our Visser & Visser International Business Team is happy to assist you with the actual translation of strategy into a policy and the operational execution of such. Together we can take a look at your various types of exposure, risk-netting, instrument choice (forwards vs options), risk thresholds, fiscal- and reporting matters. Besides that we have a result-driven approach where our aim is that you will translate your theoretical policy into hands-on daily practice. Feel free to reach out to share your thoughts in the comment section or reach out to me or one of our advisors.