Why are you losing foreign customers?
It is not your fault or your employees’ if financial management has become very chaotic. Why is it that the foreign exchange transactions are closed with a loss reducing your company’s margins? Where are the experts who can always predict the future of the financial markets? The good news is that you are not alone as many companies are experiencing the same problems. The Swiss Franc, the Ruble, the Yen and the US Dollar have all been playing tricks on operators throughout the previous months.
The bad news is that the perfect guru does not exist. At the very least, there are no infallible gurus. We must accept that and act accordingly.
Making timely forecasts of financial markets is practically impossible.
Why? The main assumption of traditional financial management is that we need to “guess” the exchange rate. To reach this goal, we try everything: ask all the banks we have relationships with, ask customers, consultants and make super DIY analyses. Good. Whoever comes closest is in the better situation and will win. Earns more, brings home a better income statement, and makes the sales team happier. Everyone is happy.
But what about when the currency prices go in the wrong direction? Everything goes wrong. It becomes hard to regain the trust of the Sales team, the shareholders and management; everything becomes more complicated.
What does all this mean? The answer is simple: do not predict. Relying on forecasts reduces the performance of the income statement of a company. The new rules of financial management apply to the most advanced technologies to financial models to help you manage, control, monitor and achieve your income statement objectives.
How? There are two rules: stop predicting and set realistic goals.
1. NO MORE FORECASTS
Rule No. 1: Try to think of how many times in recent weeks you have been surprised by an unexpected trend in financial markets that altered the foreign currency cash flows. How many times the expected amount was not reached? This question has been asked to several managers, consultants, entrepreneurs and the response is always the same: almost never. If your answer is similar, you should ask yourself what is going wrong.
1.1 Financial markets are unpredictable
Volatility is increasing. The complexity of treasury management is increased accordingly. This means, for companies that use traditional techniques of treasury management, more and more will experience financial losses. Foreign sales translated into domestic currency are reduced when compared with forecasts, and foreign purchases are becoming increasingly expensive. In short, a lot of hard management work without getting the desired results, while the FinTech, conversely, offers us the opportunity to be informed, to choose and compare the best financial strategies. The treasury management processes of today are on the web because this is where companies find what they need, when they need it and with real-time updates.
1.2 The time of price formation
Both in the case of an exporting company collecting foreign currencies or in the case of a company that imports raw materials or semi-finished goods from abroad by paying suppliers in foreign currency, the formation of prices is the time for discussion.
Besides when we decide the price to be offered to customers, we have to take into account the income objectives (the economic margins, also known as the “markup”) to be applied to the total costs to achieve the desired economic result. But it is not enough. We need to also consider the impact of fluctuations in the purchase prices of raw materials and the impact of exchange rates on payments and on receipts.
Let’s look at a quick example
The “IHateRisk” company manufactures machines for the automotive industry. The total costs to produce one product are estimated at around €500,000, moreover other direct and indirect costs (commercial, general, etc.) amounted to €350,000.
If the required markup is 15% of the final price, then the sales price is € 1 million.
The price to be offered to a customer paying in euros is 1 million, a price that includes all costs and gives the desired margin.
But when the Sales team wants to sell our product to a customer paying in US dollars, what is the right price?
At today’s exchange rate (spot) Euro against the dollar (1.11) you get an amount in US dollars equal to 1,110,000, but several weeks or even months might be in between today – the day we fixed the price to the customer – to the day when the customer will pay.
Changes in exchange rates can result in unexpected losses, arising from the unfavorable movements of the financial quotes respect to our situation. In our example, when the customer pays, the exchange rate of the Euro against the US dollar has become 1.15, so instead of cashing 1,000,000 euros, I will cash 3.5% less. An amount which leads to a reduction of the margin remaining in the company account.
A common problem. For example, look at what has happened in recent months with the euro/USD exchange rate in Figure below.
1.3 How to protect profit?
How can I get the expected company results, given that the fluctuations of the financial markets could have an adverse impact?
If I require the customer to pay in euros (my own currency) rather than in foreign currencies, would I get an improvement? No, because in doing so, you completely transfer currency risk to your customer. If we fix a sale price in euros, the customer can pay the same day, or they might pay an amount in US dollars higher than they originally budgeted when considering the purchase of our product. It is also likely that then they may reconsider and replace us with another supplier that is able to keep fixed the prices so long as it is required by the customer.
2. SET REALISTIC GOALS
Rule No. 2: Set realistic goals. When it is necessary to fix the prices for foreign customers (price list for foreign sales), we must consider the financial risks together with the industrial and commercial costs must. Then we have to add the expected loss that results from the fluctuations in exchange rates.
Returning to our example. Today (2 September 2016), the euro/dollar exchange rate is equal to 1.1167. How can I set a price in US dollars for a customer paying at the end of December?
What is the likely scenario at the end of December? It is a question that can be answered using a statistical tool used by the best financial institutions: the probabilistic scenarios. eKuota uses a generation engine of probability scenarios that have been developed internally and which enjoys a high level of trust confirmed by tests published in well-known scientific journals.
The current scenario for the Euro / US dollar exchange rate is shown graphically in the following Figure.
Based on the calculate year-end scenario, there is a 5% of probability that the euro exchange rate against the US Dollar will reach a level lower than 1.178.
And since it is realistic to assume that the exchange rate could reach this threshold, then this should be taken into account when we have to set the foreign exchange prices.
For example, in our case, the selling price may be fixed using the 1.178 exchange that corresponds to a price of $ 1,178,000. In this case, the budget rate becomes 1.178.
By using this scientific procedure for the formation of the prices, it is possible to obtain the following benefits:
- To have a clear understanding which scenario is likely. To have an analysis with scientific validity that can be shared with the company to identify the best trading strategy in foreign markets;
- To set a timescale through which decisions must be taken. If the foreign exchange rate worsens beyond the threshold of the budget rate, margins will reduce. So, if the company cannot afford lower financial results, it will have to hedge (with a forward foreign exchange or with options) to secure future profitability.