Now is the time to implement a budgeting and planning process that embraces, rather than ignores, uncertainty and volatility.
In December 2015, when most companies were finishing their 2016 budgets, the pound (GBP) was worth $1.52. With the precipitous drop after Brexit in July, the pound is ending the third quarter around $1.26, a decline few could have predicted. As the 2017 budget season draws to a close, companies doing business outside the US are taking lessons from Brexit and asking what the dollar price will be in 2017. The answer is really anybody’s guess, and that’s the point — we live in a world of uncertainty and unpredictability.
The chart below shows that one pound could be converted to 1.52 US dollars at the beginning of 2016. At the close of the year, that amount had dropped to 1.26 US dollars per one British Pound, a decline of 17%.
Similarly, CFOs have experienced volatility in their earnings forecasts in years past. As they prepare for 2017, the level of uncertainty will be on the rise again and perhaps more so than ever. Companies are not only dealing with unusually low oil prices, a tumultuous transition to a new governing administration, and an uncertain U.S. interest rate environment. They’re also coping with continued exchange-rate volatility, which is becoming a much more significant factor as companies increasingly globalize their operations. So how should CFOs approach the challenge of budgeting for 2017? Here are four suggestions to put a solid foundation in place:
1. Understand Your Company’s Risk Tolerance
CFOs have known for years that very detailed annual budgets, predicated on a static set of assumptions, are useless at predicting future business performance — never mind serving as a rational basis for allocating resources. Now more than ever before is the time to acknowledge this reality and move to implement a set planning and budgeting process that embraces, rather than ignores, uncertainty and volatility. By acknowledging that uncertainty and volatility in today’s business environment is the “norm,” you can plan accordingly.
One way to uncover your company’s risk tolerance is to ask, “How much of an adverse effect is your company willing to tolerate?”
The two most common ways to quantify the answer are 1) pennies per share of earnings or 2) dollars of net income.
Consider, for example, ABC Company. At the beginning of 2016 they forecasted a steady-state of $500 million in revenue and $100 million in net income, a 20% net margin. Based in the US, ABC expected to generate 40% of its revenue in British Pound. As the chart above shows, the GBPUSD exchange rate moved 17% in 2016. In that period, currency movement caused ABC’s revenue to decline by USD 34 million from its forecast, even though its pricing and volume were forecasted accurately. Further, net income declined by USD 22.1 million or 22 percent, despite expenses staying steady as forecasted.
An unexpected decline of that magnitude affects every stakeholder: Employees, management, and the Board. At a minimum, cash flow for bonuses, dividends, and investment are diminished. If ABC Company is like most, the Board and senior management would be quite concerned by a decline of that magnitude. In order to protect against a repeat poor performance going forward, ABC Company’s Risk Committee would likely recommend that the Board adopt a currency risk limit somewhere in the conservative realm of 10%. Senior management would then implement a framework to manage currency risk proactively. If ABC’s measured earnings at risk exceeded 10% due to currency exchange rate movement, senior management could then take action to manage its currency exposure within the organization’s agreed upon currency risk limit of 10%.
2. Measure Potential Impact
Companies must look at the impact of the previous year’s currency exchange rate movement to explain current financial performance. But the company’s business activities in the coming year may be entirely different. Furthermore, the relative movement of exchange rates may be quite different going forward. It is not enough, therefore, to assess risk tolerances “post-mortem.”
A full description of the best potential impact measurement techniques is outside the scope of this discussion, but outlined below is a short list of metrics. In each case, a path of exchange rates is simulated. Using forecasted pricing, volume, and costs, the company’s financial performance is calculated and compared to the results, assuming a “static” simulation in which exchange rates stay constant.
- Forward Curve – Exchange rates track the forecast implied by currency forward rate contracts.
- Single Historical Period – Exchange rates mimic the relative movement in a single historical period.
- Exchange Rate Shocks – Paths of exchange rates are generated that represent instantaneous shocks of 10%, 20%, 30%, 40% up and down.
- Exchange Rate Cones – Paths of exchange rates are generated that represent movements within designated standard deviation cones (ranging from +/- 0.5 to +/- 2.5 standard deviation movements).
- Monte Carlo simulation – Multiple random paths (usually 10,000 or more) of simulated exchange rates.
- Historical Monte Carlo simulation – Exchange rates mimic the relative movement during every historical period.
By measuring the potential impact of currency exchange rates and comparing this to the company’s agreed upon risk limits, senior management can assess how much currency risk must be mitigated. Having a framework for measuring potential impact gives a company greater control over performance, thereby reducing risk and saving money.
3. Assess Alternatives and Implement a Strategy
Armed with clearly-defined and articulated risk tolerances and an assessment of a company’s current risk posture, CFOs can evaluate the plethora of risk management or hedging alternatives. Some of the alternative solutions may involve financial derivatives like forward exchange rate agreements, currency options, or swaps.
A risk management framework that uses derivatives to hedge can employ a variety of hedging strategies that include:
- Static Hedging – Hedging once at the start of a forecasting period (e.g. once a year in January).
- Rolling Strategy – Hedging periodically throughout the period (e.g. each month, extending the hedge as the period progresses).
- Layering Strategy – Hedging varying proportions of forecasts based on visibility (e.g. hedging 100% of amounts forecast to occur in one month and 75% of amounts forecasted to occur in six months.
Other alternative solutions may require operational changes. By combining alternative solutions, often very little expenditure is required in order to make substantial reductions in a company’s exposure.
4. Monitor and Report Key Performance Indicators
This fourth step brings the first three steps together for the stakeholders. It involves a “report card” on past performance and a look into the future. With an understanding of the company’s ability to tolerate the impact of currency movements, consistent measurement of the company’s current exposure, and thoughtful implementation of the right strategy, senior management and the Board need simple performance indicators that will tell the story of currency risk management within approved limits.
Exchange-rate volatility is not a new phenomenon. But its impact is increasing as companies make, sell, and serve global markets. As CFOs lock down plans for what could prove to be a turbulent 2017, the only certainty is that their hypotheses about the direction of currency exchange rates may prove to be merely guesses. A willingness to accept this reality, plan for it, identify when their planning assumptions no longer make sense, and then act rapidly and with confidence will distinguish the winners from the losers. The good news is that CFOs have better data and more sophisticated tools than ever before to effectively manage uncertainty.