Small and medium-sized companies (SMEs) often have limited resources and must decide how to use them most effectively. The biggest advantage of hedging may come not just from removing financial risks, but from improving the accuracy of financial results. SME owners will be able to make the correct strategic decisions for projects in foreign currencies. Below is an illustration of how FX rates can muddy the waters for international entrepreneurs and how this can be overcome.
Mike is a successful businessman with a growing list of happy clients in the UK and increasingly around the world. A visionary architect, Mike built his practice from a tiny studio, but as his business expanded he faced the problem many aspiring entrepreneurs wish– deciding which projects accept. He managed the international projects himself, prudently factoring greater uncertainty into his budgeting calculations. His prudence paid off and his team learned from his leadership how to deal in international markets; they gained confidence and an outstanding reputation from satisfied customers.
However, in early 2016, two years into their international expansion, Mike struggled to understand why projects in continental Europe were regularly less profitable than anticipated. The European Union was in the middle of a slowdown, but it had not had much effect on the projects and the problems faced were not dramatically different from those in the US. Yet all the European projects, barring one short assignment, had margins substantially lower than his budgeting had predicted. This built tension in his small and usually united international sales team. Sales managers in the US and Dubai were frustrated to see resources wasted in Europe. They lobbied hard for Mike to allocate more towards their projects, where margins were even greater than those in the UK.
Ready to yield to their demands, it dawned on Mike that the lower margins were not due to the projects or how they were managed, but currency rates.
Even as his international portfolio expanded, Mike’s design team and the majority of his costs remained in London. Thanks to above-average margins, Mike’s company did not usually face existential risks from foreign exchange. However, the foreign exchange impact was enough to distort the regional profitability picture.
As was to be expected, Mike bid for the international projects in euros and dollars. Assignments took 6 to 12 months, with clients settling invoices weeks later. Since his international business had begun, the euro had weakened against the pound sterling by 6-8% over the duration of an average project. Contrastingly, the US dollar had strengthened on average by more than 5%. Converted into pounds, these European payments led to lower than planned proceeds whilst the US payments translated into higher proceeds, even though costs for both regions were similar. Having understood the drivers, Mike implemented a simple and affordable FX risk management policy and avoided an early exit from what later turned out to be a large market for his firm in continental Europe.
Businesses daily make decisions charting the course of their ventures. Each time, factors outside their control influence the outcome and ultimately the profits of their ventures. However, foreign exchange risks can be measured, and more analytically minded entrepreneurs choose this control to give them better visibility.