If you do some or most of your business outside of Canada, currency volatility is something to keep in mind. The more international transactions you make, the higher your financial risk. In fact, any time you buy supplies, sell products or work with manufacturers in other countries, you expose your company to currency fluctuations. But by taking steps to manage that risk, you can reduce the likelihood of potentially disastrous changes to your company’s cash flow.
Understand Your Costs and Revenue
For small businesses like yours, the biggest currency risks happen when your costs are in one currency, and your revenue is in another. This sort of imbalance exposes you to a great deal of financial risk. For example, say your business has a factory in Europe, but you sell products in Canada. If the value of the euro rises suddenly compared to the Canadian dollar, you now have higher costs without an increase in revenue. In this case, you might decide to move manufacturing to Canada to eliminate the currency risk.
How to Mitigate Transaction Risk
Transaction risk happens when you agree on a price with an international party on one day, but you don’t make or receive a payment until a later date. If the exchange rate changes between the two dates, it naturally affects your cash flow. Although these risks usually even out over time, they can have a big impact on your company in the short term, which is particularly dangerous if your small businesses has a tight budget.
Say you make a deal to export a $100,000 shipment of products to the United States in March, but do not require payment until delivery in June. When you sign the contract, the currency exchange rate is $1 CAD to $1 USD. When you ship in June, the U.S. dollar is stronger, and the exchange rate is $1 CAD to $1.2 USD. You still receive $100,000 USD for the sale, but when you convert it to CAD, the value is now just $83,333 CAD.
To protect your business, you could require payment immediately after the contract is signed. That way, you receive $100,000 USD in March, convert it at the 1:1 exchange rate, and have $100,000 CAD in the bank.
Or, you could allow payment on delivery, but quote your price in CAD rather than USD. This strategy transfers the currency fluctuation risk to the U.S. buyer, and you receive the same amount of CAD regardless of the market.
Hedging With Forward Contracts
When you make investments that help offset your currency risk, this is called hedging. A hedge is like an insurance policy because it fills in the gaps of currency fluctuations. For small businesses, forward contracts are one possible hedging option.
A forward contract is an agreement between you and your bank to buy foreign currency in the future at a set exchange rate. Imagine you agree to buy a machine from China at a price of 500,000 yuan, payable upon delivery in six months. At that point, you could go to your bank and enter into a forward agreement to purchase 500,000 yuan in six months at the current exchange rate. That way, your costs are fixed, and you don’t need to worry about changes to the exchange rate.
It’s important to note that hedging comes with drawbacks. The currency rate could change in your favor during the forward contract and then you would lose out on the potential savings. What’s more, if the Chinese manufacturer fails to deliver your order, you’re still required to purchase the 500,000 yuan from the bank.
Depending on the way your small business is structured, you may use one or many of these strategies to protect your company from currency fluctuations. By anticipating potential risks and adjusting your financial practices as needed, you can operate internationally and maintain a stable cash flow.