Managing international cash flow properly, to avoid as much risk as possible and retain as much profit as possible, requires a conscious development of a foreign exchange policy and procedure.

Establishing a foreign exchange policy will do more than improve cash flow and profits. Whether you're importing a component for your manufacturing process, establishing a foreign subsidiary, or looking to sell your product overseas, the establishment of a foreign exchange policy and procedure is essential in understanding the risks inherent in doing business internationally. A foreign exchange policy helps to identify, classify and quantify the different types of risk your company may be undertaking, no matter if you do business entirely in U.S. dollars or use foreign currencies in the course of your international dealings.

Many businesses believe their foreign risks aren't large enough to warrant the devotion of valuable time. Unfortunately, most companies find out eventually these risks can't be ignored because they can have a great effect on financial statements. The foreign exchange market is the largest financial market in the world and trades nearly 24 hours a day, seven days a week. Individual currencies can fluctuate wildly over a given time period. As an example, let's take a look at Europe's single currency, the euro, since it birth on January 1, 1999:

As can be seen from the graph at right, at its worst, the euro had lost 26% of its value against the U.S. dollar. If you operate on a tight margin on your overseas sales to Europe, there's a distinct possibility your company could lose money on those sales just through the rate of exchange. The following four steps provide a rough outline on how to begin identifying and managing the risk inherent in doing business internationally:

Step 1: Audit Your Current Business Structure and Determine the Optimal Method to Facilitate Hedging

The first step in determining whether you're biting off more risk than you care to chew is auditing your firm's accounting and multi-currency cash flows to determine their tax treatment, risk and the optimal structure to facilitate hedging the foreign exchange risk. Hedging can be defined simply as implementing a formal method of reducing, by whatever means preferable, a given risk. In this case, our risk is the fluctuation of currency exchange rates.

The process begins by reviewing your company's current international cash management practices and identifying the optimal business structure and method to account for risk exposures. Perhaps you sell your product into European markets and require that your customers pay you in U.S. dollars. Guess what? You're voluntarily putting your sales at risk and have absolute, and quantifiable, foreign exchange exposure. Here's another example: You import sprockets from Taiwan, which you use in your manufacturing process. Your foreign vendors ask that you pay them in Taiwanese dollars. Minimal risk here? Guess again. You have definable foreign exchange exposures, which can be mitigated with a bit of analysis. One more example is valuable: You've just established a factory in Mexico and wire U.S. dollars there each week to meet payroll and expenses. Risky? Yes. Your payroll may end up costing you more than you anticipate.

A plethora of financial tools exists for reducing these risks. The point is to sit down and hammer out which of them are best suited to your company and develop a method in which to use them. This leads us to the next step:

Step 2: Create a Foreign Exchange Policy

A foreign exchange policy stipulates the tenets for dealing with foreign exchange risk; what the risks are, how they may be hedged and accounted for, and the method and personnel responsible for managing the risk mitigation process. The initial step in the development of a foreign exchange policy is clarification of senior management's objectives and determining the company's appropriate level of-and management's appetite for-risk.

What is the appropriate level of risk your company should be comfortable taking on? It varies widely by company size, industry niche or segment, organizational structure, management's understanding of the financial markets as well as the exclusivity of the product or service being sold or manufactured in the foreign country. The point is to gain an understanding of the risks your firm is taking on and then to manage the risks head on-before they impact the bottom line.

By selling your product in overseas markets in dollars, could you potentially be putting it at a competitive disadvantage? Yes. By paying foreign vendors in their local currency and not identifying nor hedging these costs, might profit margins be impacted through potentially increased costs of acquisition? Absolutely. By sending Mexican pesos to fund the payroll in your Mexican factory each week, might you run the risk of increased production costs through the fluctuation in the Mexican peso? Most definitely. The risk in each one of situations can be defined as well as mitigated though the hedging process.

For example, a U.S. company importing Italian marble and paying for it in Italian lira is subject to varying U.S. dollar product costs due to the ever-changing dollar/lira exchange rate. This importer can minimize this fluctuation through the use of carefully selected financial derivatives. The process of identifying the risk and choosing a method to combat it is a classic definition of "hedging."

Once you have determined your risk exposures inherent in your international business and the most efficient ways to mitigate or reduce this risk, it's time to put the hedging plan into action. The roles and responsibilities of deciding when to implement the hedge must be allocated to ensure that the hedge is employed as planned. This encompasses trade approval and confirmation, as well as settlement with a bank of choice.

Step 3: Create Foreign Exchange Management, Accounting and Control Procedures

The federal government has outlined special accounting rules for foreign exchange hedges utilizing currency derivatives. Once the risks and hedges to mitigate these risks have been identified and implemented, the next step is to classify the hedges used for tax and accounting purposes, and determine the correct method, under FASB rules, to account for them.

Step 4: Periodically Evaluate Your Choices and Procedures

Last but not least, after a track record of the hedging strategy is established, it's time to develop an evaluation framework in an effort to compare the expected versus reported foreign exchange gains and losses. The volatility of global trade and financial markets requires that the most tried and true hedging strategy be altered from time to time. A disciplined evaluation framework assures that these changes will be made and implemented.

Once foreign exchange policies and procedures are developed and implemented within the company, your firm can rest assured of its firm grip on the risks it faces as well as the methods in which to mitigate those risks and manage them with confidence.

Links

• Union Bank's Global Markets Group