For many high-growth companies, the top priority is building the business and demonstrating top-line revenue growth. As they progress, the focus often shifts to the bottom line, which includes assessing and managing financial risk. Whether you are building toward an IPO or are currently public and expanding globally, the framework for assessing financial risk can begin with three big questions:
- How do foreign currency fluctuations affect our business?
As your company expands into global markets, your business model may not support maintaining all revenue and costs in U.S. dollars. Each additional currency increases the risk that market fluctuations will affect margins and profitability.
During this growth phase, organizations are often faced with two significant questions:
-- How do we know which currencies are contributing the most risk to our global profile?
-- At what point is this exposure large enough to warrant dedicating our time and attention?
To answer these questions, start by assessing foreign exchange (FX) risk and quantifying its impact. This analysis enables you to decide whether it makes sense to hedge and for which currencies hedging will deliver the biggest benefit. If you choose not to hedge right away, you’ll have an objective basis for that decision and a baseline to revisit periodically as your business grows.
Chatham Financial’s Jason Peterson: Keep an eye on rates.
If you decide that starting an FX hedging program makes sense, you can take an incremental approach, focusing on your most meaningful exposures and expanding over time as your risk profile changes. Addressing your currency risk doesn’t have to mean racing to add headcount or technology. It’s about getting a handle on how much FX is hurting or helping you in the market, and what you can practically do about it.
- How important is predictability in interest payments?
If debt plays a role in your capital structure, it’s important to keep an eye on the interest rate environment. Whether you’re borrowing from a relationship bank or considering a bond issuance, you should understand how rising rates can affect your overall expense. Often, the first stop along a client’s debt journey is through term debt issued from their relationship banks. While this debt provides the liquidity needed to continue the investment in your core business, there are three main questions to answer:
-- How much will interest rate fluctuations impact our interest expense?
-- Should we convert floating-rate bank debt to a mix of floating- and fixed-rate debt by hedging?
-- How can we achieve our economic objectives while still aligning accounting with the desired outcome?
After answering these questions, many organizations determine that hedging is necessary but lack the specific expertise or team capacity to support it internally. In addition to a resource gap, you may have significant questions around the right time to hedge. Addressing these concerns can be straightforward; it starts with understanding the impact of the rate fluctuation, selecting the appropriate hedging products, and aligning the accounting with economic results.
- Is there anything we can do to rein in supplier pricing?
If fuel, metals, or other commodities represent significant input costs for your organization, managing commodity risk is likely on your radar. 2022 has seen an unprecedented increase in commodity prices almost across the board, for anything from fuel and metals to power purchase agreements.
Unlike foreign currency and interest rates, addressing commodity risk may not always sit squarely in the treasury department. Often, the best option is to collaborate with your partners in procurement to determine the best path to managing commodity risk. In some cases, you can accomplish this through purchase agreements. In others, it can be best achieved through financial hedging. Either direction requires thoughtful analysis to quantify risk, determine your best course of action, and operationalize a risk mitigation program. Important questions to address when thinking about this risk include:
-- Are we truly able to manage all our commodity risk through procurement?
-- Is our procurement contract pricing tied to a specified index?
-- Do we have any key supplier price risk?
Taking an Incremental Approach
If your answers to any of the “big three” questions points to financial risks you need to manage, a three-step approach can address risk incrementally without adding burdensome complexity that detracts from your core business:
- Understand your risk
Before you can take steps to reduce risk, you need a holistic view of your existing risk profile with an understanding of the key risk drivers. What is the magnitude and direction of exposures? Is data available with sufficient granularity to support economic and accounting decisions? Are there ways to mitigate the risk within the current business model? How volatile are the markets? Are there correlations we should consider?
Then you can quantify portfolio risk, define risk tolerance levels and priorities, confirm that the stated objectives can be achieved, and decide where to focus risk mitigation efforts for maximum efficiency and effectiveness.
- Select the right hedging strategy
With your exposure profile and desired targets identified, you can evaluate potential hedging strategies (including hedge tenor, ratios, products, and frequency) that will best align with your objectives. As you consider alternatives, keep in mind operational requirements, hedge accounting capacity, and forecast certainty.
- Start small but plan for scale
When taking an incremental approach to hedging, map out your expected growth areas. For example, you might initially rely on a partner to execute hedges and then hire in-house staff or invest in a technology platform when the program becomes more complex.
Selecting a partner that can support that growth trajectory – initially providing hands-on support, training new team members as they onboard, and, later, facilitating technology implementation – can not only smooth the process but also ensure the proper policies, controls, and documentation are in place. It can also avoid potential switching costs as your organization outgrows the capabilities and core competencies of these providers.
Defining your risk tolerance levels and periodically assessing foreign currency, interest rate, and commodity risk can position your organization to make strategic decisions confidently when market changes impact your business.
Jason Peterson is the managing director of the Client Relationship Management team in Chatham Financial’s corporate sector. He brings more than 15 years of experience in assisting corporations with interest rate, foreign currency and commodity risk management challenges, and was previously a strategy consultant at Deloitte.