The Risk Management Process: Business Strategy and Tactics - Essay Example

? INTERNATIONAL FINANCIAL STRATEGIES Introduction The era of globalisation has seen businesses extend their operations in foreign markets making them be classified as multinational enterprises. In this course, multinational companies face many challenges. Foreign exchange is one of the major challenges that multinational enterprises have to reckon with. Failure to come up with better ways of managing foreign exchange risk might significant lead to foreign exchange losses that will adversely reduce the profitability of the company and affect the company’s financial performance. Foreign exchange risk is the unanticipated changes in the exchange rates that could lead to losses or gains for a firm. Multinational companies face three different types of foreign exchange risk: transaction risk, translation risk and economic risk (Eun & Resnick 2005). Translation risk is the risk that occurs when firms consolidate the financial statements foreign operations with that of the home country. For consolidation purposes, the financial statements of subsidiaries are restated from the foreign currencies to the functional currency. The translation risk is therefore the accounting risk involved when restating the foreign currencies to the functional currency for consolidation purposes (Eun & Resnick 2005). Transaction risk on the other hand is the risk of changes in exchange rates on the value of foreign currency transaction that the firm had entered into. Since multinational companies engage in credit transactions where payment for goods and services are made at a future date, there is a likelihood that the exchange rate at the transaction date will be different from the exchange rate on the date when the financial obligations are settled. The differences in the exchange rates may make multinational enterprises earn different cash amounts to the cash expected on the transaction date. Future cash flows of the enterprises are therefore at risk. Finally, economic risk is the effect of foreign exchange changes on the value of the firm. It is the long term effect of exchange rate fluctuations on the value of firm future expected cash flows. It is important to note that economic risk is difficult to determine because future cash flows are hard to anticipate. In order to clearly demonstrate how the foreign exchange fluctuations affect the contracts, cash flows and market values of a firm, the risk of foreign exchange fluctuation on Unilever has been analysed. Unilever is a leading supplier of fast moving consumer goods in the globe (Unilever 2010). The products are in the line of hygiene, nutrition, personal care and other products which make people feel good and improve the quality of life. The turnover of is generated in emerging markets and in the developing economies (Unilever 2010). This global nature of operations exposes the company to operational, political and economic risks. These risks could adversely affect the cash flows; asset base, turnover and profit margin hence impair the shareholders value maximisation goal. Moreover, because Unilever prepares consolidated financial statements in Euros, it is exposed to translation risk of the subsidiaries net assets (Unilever 2010). Unilever is as well faced with the threat of exchange controls by individual countries that constrains its imports ability paid by foreign currency (Unilever 2010). During the economic recession, the Euro declined significantly in the various countries of operations (Eun & Resnick 2005). This threatened the profitability of Unilever as the economic recession made most regions incur colossal losses from the foreign exchange fluctuation. It thus made Unilever to react swiftly to the risk in foreign exchange exposures by adopting hedging techniques. The report further discusses the hedging techniques that were used by the finance managers to mitigate if not eradicate the adverse impact of the fluctuations on the firms profitability and operations. The paper has also come up with the various recommendations that Unilever can pursue to help curb the phenomena. With increasing needs to globalise, fluctuation in the exchange rates becomes a major challenge that must be looked into by these firms. Analysis Conventional currency hedging techniques To reduce the risk of incurring losses because of foreign currency fluctuations, companies use various hedging strategies. The first strategy is the use forward contracts. A forward contract is a contract entered in today to buy or sell a specified quantity of a foreign currency in the future at a specified exchange rate that is predetermined (Clark & Marois 1996). The parties in the forward contracts can determine with certainty the amount they will receive on the date of the transactions. This strategy will limit the amount of losses or gains that the parties will receive should the exchange rates fluctuate favourably of unfavourably. The second strategy that is the use of currency swaps. Currency swaps are real time transactions in which the transactions in one currency is swapped with another of an equal value in a different currency (Eun & Resnick 2005). For example, a UK firm which intend to borrow in the US market will search for another firm in the US market which want to take a loan in the UK. The two firms will therefore take a loan in their own domestic markets and enter into a currency swap. In addition, multinational companies have employed leading and lagging technique as a way of reducing foreign exchange risk. Leading and lagging involves delaying transactions until the time when foreign exchanges are favourable i.e. a firm may decide to delay purchase of a machine in a foreign market up to the period when the exchange rates are on its favour (Madura 2003). Moreover, foreign currency options have also been used in shielding the company from potential foreign exchange risks. Foreign currency options give the holder a right and not an obligation to sell or purchase a specified foreign currency. The party accorded the right pays a fee in exchange of the right acquired. A company which enters in these contracts can therefore use their rights to execute foreign exchange transactions when favoured by the exchange rates. Another strategy is the use of the money market hedge. In this strategy a company will use the matching concept by creating current asset where there is a current liability to offset the obligation at the date of expiry (Eun & Resnick 2005). For instance, a company with a current asset in US will create a current liability in US which would be settled by the proceeds from the assets on a future date. There is therefore no risk since there will be no foreign exchange transactions on the maturity date. Before settling on which strategy to adopt, multinational companies must evaluate the advantages and disadvantages of each strategy in order to select the most viable. Foreign exchange risks exposure on Unilever Unilever just like any businesses enters into credit transactions whose future payment will be affected by fluctuations in exchange rates. The differences in the exchange rates between the rate at the date of payment and the date of the transaction have exposed Unilever to foreign exchange threat. As a result of the fluctuations in the exchange rates, Unilever contracts will be affected thereby requiring the company to mitigate the likely adverse impact (Unilever 2010). Changes in the prices of products further increase the risk in foreign exchange. Foreign exchange management in Unilever A look at the comprehensive income statement of Unilever for the 2009 and 2010 performance reveal that the company successfully managed their foreign exchange risk and realised positive performance. In the year 2009 the company’s translation gain was 396million and 460million respectively (Unilever 2010). This improvement in translation gain reveals that the company strategy of managing their foreign exchange risk is effective and improved from 2008 to 2010. Considering the cash flow statement, Unilever recorded an adverse impact of 148 million and 173 million Euros in the year 2010 and 2009 respectively (Unilever 2010). This shows that the company cash flows were affected negatively by the alterations in the exchange rates for transactions carried out in the foreign currencies. It is important to realise that the adverse impact on the cash flows declined from the year 2009 to 2010 showing improved management of currency risk (Unilever 2010). The diagram below shows the fluctuation in foreign exchange between the euro and the dollar (Clark & Marois 1996). As can be observed, the euro appreciated against the dollar. This justifies the reason as to why the consolidated income statement of Unilever had a positive foreign exchange gain and a reduction in the adverse fluctuation on the cash flow impacts. From the diagram, more dollars were needed to buy a Euro implying that transactions that were made in the dollar affected the financial statement figures adversely during the consolidation process. Financial management strategies used by Unilever To manage the fluctuations in foreign exchange rates, the management of Unilever developed various strategies. First, Unilever maintains a policy in which operating companies manage trading and financial foreign exchange exposures within a particular limit. This ensures that the amount of foreign exchange transactions that expose Unilever to vast fluctuations in foreign exchange rates remain within a controllable range (Unilever 2010). Operational companies were closely supervised by the regional groups to ensure that the set limits were not exceeded and that the adverse financial impacts in the exchange rates are reduced hence becoming immaterial to the general companies performance. Unilever has widely used forward contracts as a way of shielding it from potential losses against the fluctuations in foreign exchange rates. Forward foreign exchange contracts are the contracts entered in today with exchange rates predetermined to take effect at the future date. These contracts were used in the purchase of materials used in the manufacturing process (Unilever 2010). For instance in making its payment, Unilever will enter into a forward exchange contract in which the exchange rates are determined e.g. 1$=?100. This shields the company from incurring losses should the exchange rates move adversely against the Euro which is the reporting currency. Forward contracts made Unilever determine with certainty that amount it will realise in the future with regard to transactions that had already taken place. Before entering into the forward contract agreements, the company responsible finance managers are mandated to do a cost benefit analysis and ensure that the forward contracts are worth the risks. The third way in which the foreign exchange exposures have been mitigated is by the monitoring of the compliance of operating companies (Unilever 2010). The regional groups closely monitor the operations of the companies within their control to ensure that the company’s policies are implemented accordingly. Monitoring for purposes of compliance will make Unilever operational companies to avoid entering into foreign exchange transactions that are likely to impair their financial performance (Bhat 2000). The close regional groups will also take timely decisions to ensure that they salvage the operational companies that are in financial difficulties because of foreign exchange exposures. This ensured that the operational companies manage their foreign exchange transactions in the best manner. Moreover, the regional groups had a pool of professionals and experts whose advice can be relied on by the operational companies. When there were likely chances that the currencies will fluctuate in an adverse way, the forecast provided by the pundits will be considered to reduce the size of losses. In addition, Unilever allowed its operating companies to make borrowings in the local currencies except in cases where regulations prohibit such borrowing. This financial strategy ensured that there is no foreign exchange risk exposure because currencies are borrowed in the local currencies and therefore require no conversion the domestic currency. Borrowing in the local currency would also ensure that the company benefit from the relatively lower interest rates charged on borrowing (Eun & Resnick 2005). Companies that borrow from foreign markets are usually charged higher interest rates and this increases the interest charge apart from the exchange rate exposure risk (Brealey & Myers 2003). Operating companies can only borrow in the foreign markets when barred by regulations, lack of local liquidity or when the local market conditions are incapable of lending such amounts (Unilever 2010). Besides, Unilever enters into forward foreign exchange contracts in countries with high currency fluctuation. Foreign currency borrowing helps Unilever in these markets. Other strategies that have been adopted by Unilever include the reduction of partnership between 2001 and 2006 to reduce the foreign exchange risks (Wallace 2010). These reduced the potential losses from large suppliers. Unilever also adopted the integrated supply management information system. The company was therefore in a position to closely monitor foreign exchange risks across the different regions. Effects of currency fluctuation on contracts A contract is a binding agreement between two people who have contractual obligation. Just like any other businesses, Unilever entered into several contracts with suppliers and customers. The changing prices and values of materials affected the contracts of Unilever because of the changes in spot exchanges rate (Wallace 2010). The impacts were high during the recession, financial crisis and on periods of political instability. In these contracts, Unilever had financial obligations that required them to make or receive future payments in the foreign currencies. The future cash flows or assets that were received in the foreign denominations have to be converted to the reporting currency thereby impacting on the profitability and performance of Unilever (Jain 2007). Examples of contracts that have to be managed are the creditors and the debtors that are elements in the consolidated balance sheet. The diagram below shows how the fluctuation in the trade receivables and payable affected their percentages to the total assets of Unilever from the year 2001 to 2006 (Wallace 2010). From the above diagram, it can be seen that the management of foreign exchange exposures resulted in the decline in the company’s trade payable. This means that the net worth of the company improved because the effects of foreign exchange on the value of a company were reduced. Effect of exchange rate fluctuation on the Value of a firm The value of a firm is the net present value of the expected future cash flows. Since the cash flows are not certain, present value of the firm will depend on the uncertainties. The fluctuations in the future exchange rates will affect the foreign cash flows which have to be translated to the functional or reporting currency (Jain 2007). Because the exchange rates affect the cash flows, the value of the firm will also be affected. Unilever as a multinational business is also affected by the fluctuations in the exchange rates which influence the firm’s value. Effects on cash flows In making their transaction Unilever, enters in both cash transactions and credit transactions. Credit transactions are those that are made today and the payment obligation is to be incurred in the future. When these credit transactions are made in the foreign currencies, Unilever’s cash flows were affected when the foreign currencies are converted to the functional currencies (Brealey & Myers 2003). Unilever cash flows have been affected by the exchange rates fluctuations. This therefore necessitates finance managers to take hedging actions to avoid adverse effect on the firms operations. Conclusion In going global, companies extend their operations in emerging markets and new regions with the aim of recording better performance. Emerging markets like Brazil, China and South Africa provides multinational companies with the ability to correct poor financial performance realised in the underdeveloped and developed economies (Neave, 1998). It is therefore a way that businesses increase their returns and increase the value of shareholders. However, the actions of multinational operations to start their operations in emerging markets and new regions are met by strong challenges that have to be overcome. Some of the challenges faced by firms in going global include political risk, interest rates risk, foreign exchange risk and economic risks which is portrayed by performance in the financial markets (Neave 1998). Foreign exchange fluctuations therefore remain a major challenge that must be addressed by finance managers of the multinational enterprises for the sake of maximising shareholders wealth. Unilever being a multinational company which has to provide consolidated financial statement by incorporating the performance of their foreign subsidiaries can be said to have performed relatively well in the market. This is portrayed by the gains in the translation that is reported in the consolidated income statement and the reduction in losses of cash flows caused by translation process. Unilever financial management strategies have been effective and were carefully scrutinised before adoption. The pundits ensured that the particular strategy adopted was in line with shareholders wealth maximisation and the general goals of the firm. The large consumer base of Unilever and their product nature supports the growth in revenue and performance (Unilever 2010). Unilever is therefore at a position where good financial performance and high profitability can be sustained if the foreign risk exposures are well managed. In sourcing from suppliers and selling to other businesses, contracts entered into should incorporate the way in which the future unanticipated cash flows will be mitigated. Financial management of Unilever currency fluctuation requires strong financial understanding and continuous analysis. This is because Unilever operated in the developing and emerging markets whose currencies are not very strong and are susceptible to foreign exchange losses. At the same time, the proportion of turnover made by Unilever in these markets is significant to the financial statement. This implies that even small negative changes in exchange rates in the various markets will have a big effect on the consolidated accounts. Recommendations Multinational enterprises in entering contractual agreements and credit transactions should forecast the possible impact of the transactions on the business. If the contracts are not properly checked and regulated the actual benefits of the contracts can be insignificant to the business and the future cash flows will be affected. As a result, the value of the business will be reduced. To enable multinational enterprises survive volatile economic conditions, foreign exchange reserves should be made. This would make the businesses salvage the outlook of the financial statements from the huge losses that could scare potential investors and threaten the customers of the company about the future existence of the business. A cost benefit analysis must also be done for multinational companies to avoid incurring extra cost where potential investments could be made. Finally, management of multinational companies require a better understanding of the international financial markets. Their stocks are traded in various stock exchanges and their foreign transactions are also undertaken in such markets. This would therefore require the companies to adopt and implement policies that would make the company identity is same across the globe. It would also make the consolidation process easy and simple. Unilever in managing their financial performance has to assiduously renew their foreign exchange risk management strategy to mitigate the fluctuation of the euro. References Bhat, P 2000,Cases in financial management, Tata McGraw-Hill. Brealey, RA & Myers SC 2003, Principles of Corporate Finance, McGraw-Hill. Clark, E & Marois B 1996, Managing risk in international business: techniques and applications:International Thomson Business Press, London. Culp, CL 2001, The risk management process: Business strategy and tactics, Wiley, New York. Eun, CS & Resnick, BG 2005, International Financial Management: McGraw-Hill, Irwin . Jain, N 2007, Foreign exchange risk management: New Century Publications, New Delhi. Madura, J 2003, International Financial Management, 7th ed., Thomson - South Western. Neave, EH 1998, Financial systems: Principles and organization, Routledge, London. Unilever, 2010, Unilever financial report 2010, retrieved from http://www.unilever.com.com/images/Unilever_20-F_AR10_tcm13-259486.pdf Wallace,William, Unilever, Retrieved from http://www.coursework4you.co.uk/essays-and-dissertations/sample47.php Read More