Corporate currency risk: Be aware before it hits you

Businesses that conduct trades domestically and internationally are often faced with various risks when trading currencies other than their domestic currency.

Typically, companies gain capital by issuing equity or borrowing seed money and then using it to invest in some form of assets and work their way to generate a profitable return of their investments.

Domestic companies that sell products and/or services to domestic customers might still face the repercussions of currency risks because the raw materials that they used in their productions are priced using a foreign currency. Those companies that trade in using only their domestic currency can still face the effects of currency risks if their competitors are trading in a different currency.

There are three types of Corporate Currency Risks. They are:

1. Transaction Risk
Transaction risk arises whenever a company had a cash flow to be received or paid in a foreign currency. The risk often happens when a company sells its services or products on credit and the payment for such will come after 90 or 120 days delay. It is a huge risk to the company because the period between the sale and the time the company will receive payment can pave way for losses for the company, especially when the exchange rate of the foreign currency falls. The reduced value of the payment to be received by the company can greatly affect its profits.

2. Translation Risk
A company that has international operations will have to translate the foreign currency values of its assets and liabilities to the domestic currency. Then, the company will have to consolidate its assets and liabilities before it can make and publish its consolidated financial account, the balance sheet, and profit and loss account. Because of the translation process, it can result to unfavorable values of the assets and liabilities when converted to the domestic currencies.

3. Economic Risk
Just like in transaction risk, the economic risk affects the cash flow of a company. But the difference with the transaction risk, the economic risk affects the uncommitted cash flows, meaning, those cash flows that are expected by the company but not yet committed for future product sales. These future cash flows from future product sales might be reduced, and affect significantly the profit of the company. This happens when the future sales are converted to domestic currency and the foreign competitor that sells to the same customer of the company using the competitor’s currency sees its exchange rate moves favorably as compared to the customer’s, while the company’s exchange rate against that of the customer moves unfavorably. A company would still be exposed to economic risk if the customer resides in the same country as the company, and is using the domestic currency.

Currency risks have various effects on the financial stability of a company, whether it does its business internationally or domestically. To simplify things, transaction and economic risks have effects on the company’s cash flows. The transaction risk affects the known and future cash flows while the economic risk affects the future but unknown cash flows. Translation risk does not affect cash flow although it can be transformed into economic or transaction risk if the company will determine the value of its assets and liabilities in foreign currency.

Risks can be difficult to comprehend but by understanding these categories, it will be easier for you to know how a certain risk can affect the business and its profits.