How to deal with foreign exchange risk when selling abroad
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If you’re doing business internationally, currency fluctuations are an inherent business risk. This is true for Canadian companies that source materials from international suppliers. But for Canadian exporters selling abroad, foreign exchange (FX) risk can have a significant impact on their profitability, and even their competitiveness.
“From the moment you start to think about doing business internationally, even setting a price for your product or service, foreign exchange risk becomes a business reality,” says Phil Turi, Director of Export Advisory Services at Export Development Canada. “Understanding FX risk can help put your business in a more competitive position by mitigating against macroeconomic changes that impact your bottom line.”
Determine your business exposure to FX risk
Your level of exposure to foreign exchange risk depends on many factors, including volume of sales, the length of your sales cycle, where you’re selling, how many international customers you have and your level of integration in global supply chains.
If you’re just starting out internationally, you may decide to hold off putting a formal hedging instrument in place. Your commercial banker and a foreign exchange broker can help determine your exposure to currency risk, based on where and what you’re selling, and how much of your revenues comes from sales outside of Canada.
Once your international sales start creeping over 5% of your total revenues, it’s time to talk to your bank or a foreign exchange broker about solutions to protect your business against negative currency swings.
Use financial instruments to mitigate currency risk
Your banker or a foreign exchange broker are best positioned to help you identify the precise tools to protect your revenues against FX volatility.
The two main products are forward contracts and currency options.
Forward contracts are agreements to buy or sell a given amount of a currency at a set exchange rate on a specific future date. Ideally, you can lock in a contract at a time when the exchange rate is in your favour. This provides some stability in your business plan, allowing you to forecast sales and revenues with a relative certainty, and to create a competitive pricing strategy.
Currency options give you the right, but not the obligation, to buy a certain amount of currency at a particular date in future when the exchange rate is in your favour. These are also a contractual arrangement with your bank. One downside to this instrument is that if the currency never shifts in your favour, you may use up your cash to secure the contract and never use the option.
“In both cases, your bank will expect you to post collateral,” says Turi. “This effectively ties up your working capital, which you may need to fulfill the terms of your international contracts.”
Canadian exporters that use financial tools to mitigate FX risk should look at EDC’s Foreign Exchange Facility Guarantee (FXG), which could help them free up some of their working capital.
“EDC’s FXG allows companies to avoid posting collateral as payment assurance for a foreign exchange contract, keeping their cash free for operations,” says Turi. “This can help businesses better predict their cashflow and profitability and put them in a more competitive position.”
3 natural hedging strategies businesses can employ
If you’re just starting out internationally, also consider using natural hedging techniques to protect your revenues from currency fluctuations, providing you’re aware of their limitations.
There are three main strategies your business can employ.
1. Invoice in Canadian dollars
“Paying your invoices and collecting revenue in the same currency is a natural hedge against currency fluctuations,” says Turi. “But you give up a lot of control by using this strategy.”
First, buying and selling in Canadian dollars puts your business at a competitive disadvantage if your customers or suppliers are non-Canadian. Customers expect to buy goods and services in their local currency and they’re far more likely to “abandon cart” if they discover they must pay in foreign dollars.
It’s not always practical if you have numerous suppliers and buyers in foreign countries.
2. Transfer FX risk to the buyer
This is done through a contractual arrangement with your buyers, where you set a price based on the exchange rate of the day. A clause in the contract states that if exchange risk isn’t in favour of the seller the price will be adjusted to reflect the change.
“In some cases, there could be an agreement between the buyer and the seller to split the difference,” says Turi. “But these terms can be very hard to negotiate in sales contracts.”
3. Raise your export selling price
“If you feel you have a local competitive advantage, or that your product has value otherwise unseen in the market, you may have more pricing power,” says Turi. “You can increase your international selling price and use that increase in margin to protect against foreign exchange risk.”
Turi warns that companies using this strategy may not be maximizing sales opportunities.
“There are companies that have been doing this for years, but it relies on high margins,” says Turi. “Odds are companies are more likely to generate higher sales using a competitive pricing strategy.”
FX risk using e-commerce platforms
Many Canadian businesses sell internationally using e-commerce platforms, which is a cost-efficient way to break into new markets. Amazon and Shopify make it fairly easy to conduct foreign transactions in local currencies. But keep in mind that although these platforms facilitate payments, they don’t protect cash flow certainty.
“At one point or another you still have to repatriate your currency,” says Turi. “You will have to convert those sales in foreign currency to Canadian dollars so you can pay salaries and other costs here. Exporters need to be mindful of this business reality.”
Include FX risk in your export plan
Turi advises companies to start thinking about FX risk as soon as you start planning to sell outside of Canada. Especially as sales volumes grow, the effect on margins, your price and your available cash becomes a strategic business consideration.
Foreign exchange risk can affect your price competitiveness, especially.
“There are many things that go into pricing, from the size of the local market, your competition, costs of sales, taxes, tariff and non-tariff barriers to trade, and of course, product distribution,” says Turi.
To set a competitive selling price abroad, you need to have a clear idea of how currency fluctuations will affect your costs and projected revenues.
“Any time you plan to have a sustained presence in international markets, you need to assess your company’s level of risk to FX exposure,” says Turi.
At the end of the day, how your business decides to deal with that risk depends on the level of exposure and how much certainty you need.
“Your approach to FX risk, or policy requires managers to determine what kind of year-end results they’re comfortable with,” says Turi. “If you’re the kind of manager that prefers more predictable and positive year-end outcomes, which I believe most are, your best bet is working with practical FX risk mitigation tools.”