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From Volatility to Value: 3 Reasons to Minimise FX Gains & Losses
Most practitioners in the field of corporate finance agree that, when making investment, financing and dividend decisions, the ultimate objective of the finance team is to maximise the value of the business. But what is the role of currency management in this process?
One way to enhance the value of the business with currency management is to remove FX gains and losses from financial statements. In this blog, we will walk you through the basics of FX gains and losses and give you 3 reasons to remove them from your financials.
What are FX Gains and Losses?
In the context of a firm’s transactional accounting exposure, FX gains and losses reflect changes in exchange rates during the time lapse between the moment a foreign currency-denominated account receivable or payable is recognised in the firm’s balance sheet, and the settlement of the corresponding transaction.
Finance teams can implement balance sheet hedging to achieve a clean, zero-line in terms of removing the impact of FX gains and losses. As we will see in this series of blogs, achieving this is easier said than done. Before discussing these hedging programs, however, it may be worthwhile to ask ourselves:
Why is it so important to achieve a clean, zero-line in terms of FX gains and losses?
And most importantly, how does that relate to the value of the firm? CFOs and treasurers can point to a number of reasons, the most important being:
- Reducing net income variability to lower the cost of equity capital
- Smoothing out earnings when higher earnings are taxed at higher rates
- Allowing the firm to grow by using more currencies in business operations
Let us consider these reasons in more detail.
1. Reducing net income variability: Merck's success
In 1990, Merck CFO Judy Lewent made history as she co-authored a paper detailing the firm’s approach to FX risk management. Back then, the finance team reasoned that equity market participants failed to differentiate between earnings drops that could be attributed to the managers of the firm, and earnings drops that were the result of currency fluctuations.
A decline in earnings caused by an adverse exchange rate movement would cause the stock price to fall, impairing Merck’s ability to invest in R&D and grow its drug pipeline. This observation provided the rationale for balance sheet hedging programs to remove the accounting impact of FX gains and losses, a practice which continues till this day.
As we can infer from the Management of financial risks guidelines, Merck hedges FX-denominated "receivables from and liabilities to third parties". Balance sheet items are "hedged in full" in order to remove the accounting impact of FX gains and losses.
As the company tells investors, this practice is carried out in a systematic way, strictly eschewing any type of speculation regarding the path of exchange rates.
The hidden benefits of balance sheet hedging: stock prices
Lower earnings variability resulting from balance sheet hedging can bring down the discount rate and boost the stock price—ultimately enhancing the company’s ability to invest. Merck now boasts of a market capitalisation north of $330 billion—a fitting testimony to the success of a currency management policy envisaged more than 30 years ago.
Merck’s stock price
2. Smoothing out earnings
Another reason to tame earnings variability is often made in the context of corporate taxation. To the extent that higher levels of corporate income are taxed at higher rates (convex tax rates), there will be tax savings over time to firms that use currency hedging to effectively remove FX gains and losses.
The hidden benefits of balance sheet hedging: taxation
Here’s a hypothetical example from Prof. Aswath Damodaran. Consider a tax schedule where income below €1 billion is taxed at 30%, while income beyond the €1bn level is taxed at 50%. Since removing FX gains and losses smooths out earnings, it is possible for a firm with volatile income to pay less in taxes over time, as shown in Tables 1 and 2.
Comparing the two situations, it appears that hedging to remove FX gains and losses can help reduce the taxes paid over 4 years by €140 million. In other words: the firm can afford to spend up to €140 million to manage currency risk and still come out with a value increase.
3. Using more currencies in the business
The rationale for removing the impact of FX gains and losses may vary from firm to firm. Listed companies with robust profit margins are more likely than not to implement balance sheet hedging.
Companies that operate on thin profit margins may have other primary objectives, including:
- Protecting profit margins on every transaction
- Protecting a budget rate during a particular campaign/budget
- Achieving a smooth hedge rate over time
Some companies, including Merck, use the full gamut of hedging programs at their disposal. They hedge the FX exposure from both “forecast transactions and transactions recognized in the balance sheet” [see]. They can do so with the help of combinations of hedging programs.
Whatever the goal of your hedging program, here’s the important thing to keep in mind: removing currency risk not only reduces the variability of performance — it also allows the business to use more currencies in its commercial operations. With FX risk out of the way, companies can confidently buy and sell in the currencies of their suppliers and clients.
They are in a position to scale their operations by tackling new markets. And while they do so, they can reduce contracting costs and lower the credit risk in their accounts receivables. This is the third key reason for achieving a clear, zero-line in terms of FX gains and losses.
