Lower- and middle-market companies are increasingly operating beyond domestic borders. International activity isn’t limited to companies with foreign subsidiaries; it also includes companies with foreign vendors and customers. This international activity presents new challenges for analyzing financial statement trends. Buyers and sellers should consider normalizing operating results affected by foreign exchange rate volatility.
Exchange Rate Volatility
Global currency markets have seen significant volatility in recent years. The chart below illustrates the strengthening of the U.S. dollar (USD) over the British pound (GBP) from November 2014 through October 2017. For purposes of our hypothetical examples, the companies have fiscal years ended October 31. The lines in the chart below represent the average exchange rate for each of the companies’ fiscal years.
Constant Currency Analysis Illustrative Example 1 – Foreign Vendor
Consider a U.S.-based manufacturer with major U.K.-based suppliers. Each of the last three fiscal years, the company purchased and used exactly £1,000 of materials evenly throughout the year. Assume sales and all other costs remained constant in USD. The chart below illustrates the effect of a constant currency normalization of costs. The constant rate chosen for purposes of this example is 0.79 GBP/USD.
As illustrated in the chart, the reported gross margin shows a significant increase each year as a result of lower costs in terms of USD. While management may tout this as an operational improvement, the constant currency analysis reveals exchange rate variance was a main driver. It’s important to understand the reported margins aren’t inaccurate, but in a volatile exchange rate environment, reported financial statement trends can be misleading.
Constant Currency Analysis Illustrative Example 2 – Foreign Subsidiary
For the second example, consider a U.K.-based manufacturer reporting in GBP. The company produces all its inventory in the U.K., but then sells most of the inventory to a U.S.-based subsidiary that makes the final sales to customers in USD. Under the company’s accounting guidance, a weighted average exchange rate was used to present foreign subsidiary operating results in the parent company’s reporting currency.
The chart below displays the company’s reported consolidated sales and gross margins based on results using average foreign exchange rates. Reported sales grew 31.8 percent from £66,000 to £87,000, while gross margin increased from 43.9 percent to 47.1 percent. These trends likely would be appealing to a potential buyer.
The chart also presents consolidated sales and gross margins under a constant currency foreign exchange rate. The rate chosen for this example is 0.79 GBP/USD. The constant currency analysis has a dramatic effect on results, as constant currency sales only grew 13.3 percent, while constant currency gross margin declined from 51.8 percent to 47.1 percent.
As illustrated in the example, changes in foreign exchange rates generated sales and margin growth for the company. The constant currency analysis revealed critical underlying business trends skewed by the changes in foreign exchange rates.
Financial statement trends for companies with foreign subsidiaries and/or foreign currency transactions can’t always be taken at face value, as changes in foreign currency exchange rates can mask trends in financial statements. When these trends influence strategic decisions, it’s crucial to understand their underlying drivers. A constant currency analysis of a company’s operating trends could portray a clearer picture of underlying activity than company-prepared financial statements.
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