FX: A Hidden Reason for Missing the Mark in Cash Flow Forecasting

Ever thought about how you should “convert” certain cash flows or, when you’re hedged, how that might impact the cash flow forecast?

Cash flow forecasting is as much an art as it is a science, but there are some tangible hidden factors that you may not be contemplating in your current cash flow forecasting process. A little background in both ASC 830 (FAS 52 for you seasoned professionals) and hedge accounting (ASC 815/FAS 133) can improve your cash forecasting results.

Cash flow is the life blood of any viable business and companies typically forecast their cash balances at the end of a fiscal period. Whether it’s a top-down or bottom-up approach, you can’t forget the currency impact upon the forecast. A simplistic approach is to assume cash at your local functional subsidiaries will translate at the then-current spot rate into USD. Yes, this approach will work for the “translation” process of converting local balances to the USD reporting currency, but a forecast is more than converting and aggregating foreign balances. It must take into account the actual sources and uses of cash and the rates at which those flows are made vis-à-vis the reporting currency.

A Real-World Example

Let’s assume we have cost-plus legal entities that must be paid each period by the parent to cover the subs’ marketing support costs in foreign currency plus a markup for transfer pricing purposes. To forecast the company’s cash flows, we first have to determine a rate at which the foreign costs will be paid by the subsidiaries. Often, these types of expenses are incurred at the income statement rate, which might be a derived from a current or prior month’s average rate, a beginning of the month rate (Prior Balance Sheet Rate) or a variety of other mechanisms – most of which do not use a current “spot price” but rather a method of approximation.

So what happens when we record 10M EUR of expense at the income statement rate of 1.05 and then pay those expenses during the period at a bank conversion rate of 1.15? If we use the income statement rate vs. the actual spend rate we just “over-forecasted” cash by $1M. In this day and age, a 10% move in 30 days (or longer for some income statement methodologies) is completely reasonable, if not expected. The impact of the change in value between the accounting rate and the cash rate ends up below the line in FX gain or loss, which companies spend little time really thinking about except when trying to hedge it away to avoid income statement volatility. Have you contemplated the implications on the FX gain/loss line as it relates to your company’s business processes and cash flows?

Now let’s assume the company hedges its foreign expenses with a cash flow hedge program to protect the USD value for its foreign denominated costs and operating margin. What then? To begin with, expenses that are hedged have cash flows that are also hedged. The whole concept of hedging your risk is based on providing predictable results, and that includes company cash flows. If a company hedges 10M EUR at 1.05 12 months out, then the USD cash flow is fixed today at $10,500,000 for an outflow occurring up to 12 months in the future. If the EUR rate in 12 months is 1.35 and the hedge is not accounted for in the cash forecast, then the forecast would be off by $3M or more than 25%. You can see how the actual cash flow and the forecast thereof can differ depending on the payment (or receipt) mechanism vs. the foreign currency accounting process.

To put the pieces together, both the impact of hedging and the impact of translation must be contemplated. The more international the company the more these activities will impact the cash flow forecast. So whether one is hedging revenues or expenses, payables or receivables, the cash flow forecast must contemplate the “rate” at which cash will be received or paid out. A weighted average hedge rate for contracts maturing in the period might suffice to approximate the cash in/outflows when forecasting if most or all cash conversions are hedged. A nuance to hedged cash flows is the fact that the hedge typically protects cash (fixes/converts cash) to the functional currency. This means the cash flow forecast must first be contemplated in the functional currency of the subsidiary and then those flows would be converted at the most recent spot rate to arrive at a USD cash flow forecast that contemplates currency risk.

We leave you with this: To accurately forecast cash flows when foreign currency is involved it takes contemplating the rate at which currency is converted. This includes both the actual conversion rate (hedge rate, bank rate) and the accounting “translation” rate.

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