By Jackie Russell-Green*
Small businesses that import or export goods or services often face additional challenges in dealing with international transactions.
There are two important areas you should consider to help you manage the risk and improve cash flow when undertaking international trade:
- foreign currency payments
- international trade finance.
Foreign currency payments
When importing or exporting goods or services, you may need to pay or receive payment in a foreign currency. Your bank can help arrange payment in foreign currency or can convert foreign currency payments into New Zealand dollars for you.
By hedging your international currency payments you will reduce the risk of negative impact on profitability.
One of the main issues when the business is dealing in foreign currency payments is that currencies move on a daily basis and business can be subject to a fall in revenue (where foreign currency payments are being received) or increased costs (where foreign currency payments are made), and have little control over this impact.
However, various methods can be used to assist business to minimise this impact.
Essentially, the importer or exporter sets off the foreign currency risk by using one or more bank products - this is referred to as foreign currency hedging. Let’s have a look at these various products and how each one can be used.
Forward foreign currency agreement
To minimise the impact of foreign currency movements on your profit, it may be possible to enter into a forward rate agreement with your bank. You first need to discuss with your bank whether your business “qualifies” for the bank to offer this product.
How does this product work?
The agreement between you and your bank allows you to lock in a pre-agreed exchange rate for a set date in the future.
The agreed future exchange rate will be based on the current exchange rate and the financial market’s view on where the exchange rate will be at the time you settle the transaction.
The benefit is that you then know exactly how many New Zealand dollars you will be either paying or receiving.
It important to note that once this transaction has been entered into with your bank you will be required to “settle” the transaction on the agreed date. This means you will need to ensure you either have the New Zealand dollars to buy the foreign currency (importer) or have received the foreign currency to sell for New Zealand dollars (exporter) on the settlement date of the transaction.
Therefore, before entering into this type of transaction with the bank, you should make sure your international trade transaction is confirmed and payment date is accurate.
Foreign currency option
For some organisations, locking in the foreign currency exposure may limit their ability to provide a competitive edge.
How is this so?
If, for example, an importer is importing goods denominated in US dollars for delivery in three months and enters an agreement with their bank for a forward foreign currency agreement, then the importer is contractually bound to accept the US dollars he or she has purchased at the agreed rate (for New Zealand dollars) on the agreed date.
If the New Zealand dollar strengthens, the importer must still honour the contract even if it is less favourable than the current exchange rate.
International trade finance products are specifically designed to assist importers and exporters in managing risk and improving cash flow for their business.
The importer can get around this problem by purchasing a currency option, which is like insurance.
As with insurance, an option requires payment of a premium, which can be relatively expensive. The option will protect the importer from downward movements in the value of the New Zealand dollar, but allow the importer to benefit from favourable movements in the New Zealand dollar.
Often using a combination of hedging products will provide the best protection over movements in foreign currency.
So if the New Zealand dollar increases in value, the importer can abandon the option. If the New Zealand dollar diminishes in value, the importer can rely on the rate in the option. The maximum cost to the importer is the premium.
Seek advice from your bank or accountant on which method of hedging will best suit your business needs.
Alternative methods to manage foreign currency payments
Foreign currency bank accounts/facilities
If your business has both cash inflows and cash outflows, you can match these currency exposures.
The cash flows do not need to match precisely in terms of timing.
With the perfect hedge inflows are received at the same time as outflows are expected. However, this is rarely the case.
Where the timing of the inflows and outflows doesn’t match, timing issues can be managed by depositing surplus foreign currency in a foreign currency bank account for later use, or by borrowing now to pay for foreign currency purchases, and then using the foreign currency receipts to repay the loan.
Foreign currency payments can also be managed by implementing alternative payment methods.
Negotiating to pay/receive in New Zealand dollars
This means the supplier/customer manages the foreign exchange risk.
Be careful in this situation, as the supplier may increase the cost to cover the possibility that the currency may move against them, or the customer may expect a reduced selling price to cover their risk.
Goods paid for at the time the agreement is made
This means the goods will be paid for at the foreign currency rate at the time of order; however, it also means you will have to fund the goods for a longer period of time while waiting for the goods to arrive, and the exchange rate may be more favourable to you at a later date.
Speak to your banker to determine the best option to manage your international trade payments.
International trade finance
Letter of credit (L/C)
A letter of credit is a guarantee by the bank that payment will be made. This helps exporters, as they are guaranteed payment from the date the L/C is entered into.
This type of finance also locks in the protection defined in the export/import documentation, certifying to the importer that the goods received will be in accordance with the terms and conditions set out in the L/C documentation.
Trading internationally can place a real strain on cash flow. If you can negotiate with your supplier or customer to use trade finance products, you can free up cash flow to use in other parts of the business.
A number of fees are attached to L/C facilities. These could include:
• establishment fees
• documentary fees
• presentation fees
• dishonour fees.
Documentary collection differs from an L/C in that there is no guarantee of payment provided by the bank.
Essentially, this facility is used to minimise the risk of inaccurate documents that can impact on the delivery of goods and hence payment. Also, this facility ensures goods are shipped and payment will not be released until documents are confirmed.
A deposit to secure the facility is not required, and it is often a cheaper alternative to an L/C. For international trade transactions, the use of either of these facilities will be a matter of negotiation with your trade partner and bank.
The most favourable method of payment for exporters is prepayment and for importers, open account (paying upon receipt of the goods).
The full Guide is available in the .pdf attachment, or here »
Chapter 1 is about Understanding financial statements and you can read it here »
Chapter 2 is about Assessing your busines's financial health and you can read it here »
Chapter 3 is about the Importance of Budgeting and you can read it here »
Chapter 4 is about the Maintaining Profitability and you can read it here »
Chapter 5 is about the Improving Cashflow and you can read it here »
Chapter 6 is about the Managing Cashflow and you can read it here »
Chapter 7 is about the Debt, equity or internal funds? and you can read it here »
Chapter 8 is about the Transactional banking and you can read it here »
Chapter 10 is about Applying for a loan and will follow next week.