Once upon a time, in May 2010, John and his team at EngCo Ltd were competing to win an order from a firm in the US. John knew they could deliver a high quality job and it was a company they’d wanted to work with for some time. They’d also done their due diligence and knew the company had plenty of cash reserves, so payment shouldn’t be an issue.
Together, the team at EngCo worked out a price that included a 10% profit margin on the work and sent the US firm a quote for £244,000. However, the company shortly came back to them and asked for the quote in US dollars (USD) instead of pounds (GBP). John readily agreed and his sales manager duly converted their fee. Using a currency converter, she moved everything into dollars with a conversion rate of 1.4334 on 20 May 2010, rounded the figure up to $350,000, and sent the quote off again. The US company quickly accepted and John and his team were thrilled to have been selected!
EngCo got started on the work straight away, spent a couple of months completing the order and invoiced the client in early August. The client was delighted and paid almost immediately.
Great news…or not so much!
The trouble was that, having converted their original quote to US dollars, EngCo only received £219,485 instead of the £244,000 they’d accounted for! In the process, they effectively lost £24,515 and just over 50% of their profit margin.
So what went wrong?
When the US client paid EngCo Ltd, the exchange rate for USD to GBP was 0.6271. This meant that although the US company still paid $350,000 at their end, EngCo received much less than anticipated as they had converted their quote when the exchange rate was more favourable.
What could John have done differently?
There are a number of things that John could, and should, have done to protect EngCo from the risk of exchange rate fluctuations.
Quote in EngCo’s own currency
To be fair to John and his team, this is what they did initially and all would have been fine had the US firm not asked for a quote in US dollars. The team could however have been smarter when dealing with the request for a new quote.
For example, John could have quoted in dollars but negotiated with the client over who had exposure to exchange rate fluctuations and within what limits, thereby triggering a re-calculation mechanism should exchange rates become unfavourable.
He may also have been able to negotiate phased payment for the project (including an upfront deposit), again reducing EngCo’s currency exposure and significantly smoothing their cashflow.
Foreign currency account (or local bank account)
Another simple solution would have been to set up a US dollar account with EngCo’s bank and ask the US company to pay into this (John would simply have needed to provide the client with the IBAN and BIC numbers for the currency account). While this wouldn’t have protected EngCo from currency fluctuations at the point of conversion, John would have been in control of when the monies were converted to GBP (unless, of course, he needed the cash to cover overheads, in which case this option would have offered less benefit).
Setting up a foreign currency account would have also meant that if John had further expenses in the US (such as setting up an international office), he would have been able to pay in US dollars directly from this account, thereby entirely removing any exchange rate risk from these transactions.
Alternatively, if John was committed to the US market, he could even have set up a local US bank account through his existing UK bank. This option would have been particularly attractive if EngCo ever wished to give the impression of being a local US company.
Forward foreign exchange contracts
If John had been completely certain of when his team would invoice and when EngCo would be paid, he could have set up a forward foreign exchange contract. This would have meant that John was committing to converting $350,000 to GBP at a fixed point in time and at a pre-agreed exchange rate—a great solution for removing exchange rate uncertainty in a predictable transaction.
That said, a forward contract would also have had the potential to expose John to significant risk if he had not been paid on time. A forward foreign exchange contract requires that, whether payment has been received from the client or not, the exchange must be actioned regardless. Had John not been paid, he therefore would have had to find $350,000 from somewhere else in EngCo!
Similarly, if the August exchange rate had instead gone in EngCo’s favour, John would still have had to convert at the agreed forward contract rate, thereby missing out on any additional profit.
Currency options are in some ways similar to forward foreign exchange contracts in that they enable you to buy or sell currency at a specified exchange rate at a given time. As the name suggests however, the key difference between currency options and forward contracts is that options are optional!
If John had pursued this path, he could have bought an option to sell EngCo’s US dollars at a pre-determined exchange rate but later decided whether or not to use the option. John could even have purchased an option before he knew he had won the contract, giving him the security that, whatever happened, EngCo’s margins would have been protected. If EngCo hadn’t won the contract, if the client had failed to pay when expected, or if the August exchange rate had gone in EngCo’s favour, John could then have simply chosen not to use the option, only taking the hit on the option premium.
Don’t leave your foreign transactions to chance
As John’s story illustrates, currency can have a significant impact on your profit margins and you can incur huge losses if you’re not careful! We tell the story here with two fairly stable currencies but the risks and effects are magnified further when dealing with countries in which currencies are more unpredictable.
For those of you who are looking at internationalising or are dealing with international clients, take heed! The uncertain financial environment that we find ourselves in at present only increases the likelihood of uncertain and extreme currency fluctuations, so don’t leave your transactions to chance.
Similarly, in our story, John was certain of the buyer’s ability and willingness to pay and he was able to cover his working capital requirements through EngCo’s reserves: if a relationship with a client is less certain for any reason or you are unable to fund the cashflow requirements of the project yourself, you should also look at reducing risk through various export finance and insurance options.