Financial Management
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THE UPS AND DOWNS OF GLOBAL FINANCIAL MANAGEMENT STRATEGIES
Rachel O’Neill, Head Teacher HSIE, Newtown High School of the Performing Arts
The strategic role of Financial Management The strategic role of a Finance Manager is to manage the financial resources of the business, in collaboration with the other Key Business Functions, in order to achieve the business’ long-term objectives .
The key financial objectives of any business include: Profitability: maximising the difference between revenue and costs/expenses, Growth: increasing the size of the business, for example increase sales over time, open new stores/factories, expand globally, Efficiency: using resources in a way that minimises costs/expenses, Liquidity: the ability of the business to meet short-term financial obligations, e.g. energy bills, Solvency: the ability of the business to meet long-term financial obligations, e.g. mortgage.
All businesses will go through ‘ups and downs’ – short term periods of success when sales are rising along with profits, versus periods where sales might be slow and profits not rising or even falling. Financial management is fundamental to achieving the business’ financial objectives over the long term by balancing short- term and long-term objectives. In doing this, financial management is intrinsically linked to the other key business functions of operations, marketing and human resources . In the contemporary globalised world of business, managers not only need to monitor and control the function of their individual department, but to work interdependently with the other KBFs to ensure that the vision and goals of the business are met in the long run .
Global Financial Management Global Financial Management refers to the planning, monitoring and controlling of a business’ financial resources in the international business environment .
Comparing the risks involved in domestic as well as global financial transactions
Running any business involves taking risks - owners and shareholders risk their money when they invest capital into a business . While all businesses face risks, global financial management involves greater complexity including both domestic risks as well as global risks when making decisions and undertaking financial transactions.
Domestic risks for any business include such matters as unexpected financial losses or costs caused by events such as economic downturn, failure of debtors to pay, theft, falling demand in the industry, rising interest rates, rising production costs, increased taxes or other costs related to Government policy decisions, natural disasters or human-made events such as internet outage or hacking, as well as business failure .
Businesses that import, export or operate globally not only face domestic risks, but need to manage a number of global risks as well . These can include: • Many businesses export and/or import goods and
services which need to be paid for in local currency, and so will be affected by fluctuating currency prices,
• Some businesses borrow money from overseas, and some businesses lend money overseas, and so will be affected by changes in global interest rates,
• Businesses that operate globally - Australian businesses with branches overseas and foreign businesses operating in Australia - will be affected by fluctuating exchange rates and changes in global interest rates,
• All businesses with some form of global exposure can also feel the impacts of regional or global economic downturns, government policy decisions (both domestic and foreign governments), as well as global/ foreign natural or human disasters .
Undertaking Global Financial Management Global Financial Management involves attention to a number of factors:
• Exchange rates - businesses need to be aware of the impacts of fluctuating exchange rates and to devise management strategies accordingly;
• Interest rates - businesses can take advantage of lower interest rates in other countries to minimise costs but also need to monitor global financial markets to avoid negative consequences of events such as rising interest rates or a falling Australian dollar;
• Methods of international payment – businesses can choose from a range of methods such as payment in advance, letter of credit, clean payment, bill of
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exchange;
• Hedging - there are a number of strategies a business can adopt to manage the impacts of currency fluctuations;
• Derivatives - businesses can use derivatives such as forward exchange contracts to create certainty and hedge against risk when conducting international transactions .
Exchange Rates An exchange rate is the price of one country’s currency in terms of another country’s currency . Fluctuating exchange rates are a fact of life to be expected by financial managers operating in the global business environment, whether the business exports, imports, or borrows or invests globally .
Exchange rates are determined in the foreign exchange market . The foreign exchange market refers to the buying and selling of foreign currencies between participants who buy and sell currencies for a range of reasons .
Considering the market for Australian dollars, businesses and individuals will buy and sell Australian dollars for different purposes .
Who buys Aussie dollars?
Those wishing to buy Australian dollars include foreign businesses wanting to buy our exports, Australian exporters who have been paid in a foreign currency (e .g . US dollars), tourists and others coming to Australia, businesses/people investing in Australia such as buying shares in Australian businesses plus Australian companies operating overseas who send their profit back home (profit repatriation).
Those wishing to sell Australian dollars include Australian businesses purchasing imports, Australian tourists and others going overseas, Australian businesses/people investing overseas such as buying shares in foreign businesses or setting up companies overseas, as well as Australians repaying interest on foreign loans or repatriating profits overseas to parent companies.
Fluctuations in the value of the Australian dollar
Fluctuations refer to changes (increases or decreases) in the value of a currency and are caused by changes in demand and supply of the currency . The buying and selling of Australian dollars in the foreign exchange (forex) market will lead to an appreciation or depreciation of the Australian dollar . An appreciation means the value of the Australian dollar
increases, such that one Australian dollar will buy more of a foreign currency such as the US dollar . When more people want to buy the Australian dollar (AUD), demand for the AUD increases and the currency appreciates .
Conversely, a depreciation means the value of the Australian dollar decreases, such that one Australian dollar will buy less of a foreign currency such as the US dollar or Chinese Renminbi . When more people want to sell the Australian dollar (AUD), supply of the AUD increases and the currency depreciates .
• Any action that requires someone to buy Australian dollars (e .g . exports) will affect the demand for the AUD, whilst any action that requires someone to sell Australian dollars (e .g . imports) will affect the supply of the AUD .
• If people want to buy more Australian dollars then the demand for AUD increases .
• If people want to sell more Australian dollars then the supply of AUD increases .
Currency fluctuations can benefit a business by reducing import costs or increasing export income; conversely currency fluctuations can cause problems for a business by increasing import costs or reducing export income, as well as by creating uncertainty .
Figure 1: Appreciation and depreciation
Positive impacts of a currency appreciation for a business include a decrease in the price of imported inputs, as well as a decrease in the Australian dollar value of any loan and interest repayments overseas that are denominated in foreign currencies . Conversely, negative impacts of a currency appreciation for a business include increased export prices making Australian exporters less competitive in global markets; also, an appreciation makes Australian domestic businesses less competitive against foreign imports which become cheaper .
Positive impacts of a currency depreciation for a business include cheaper export prices benefitting Australian exporters via increased income, while
Appreciation Depreciation
Exports more expensive
Imports more expensive
Imports cheaper Exports cheaper
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Australian domestic sellers become more competitive against foreign imports whose prices rise due to the depreciation . On the other hand, negative impacts of a currency depreciation include higher costs for businesses importing inputs; also, a depreciation increases the Australian dollar value of any loan and interest repayments overseas that are denominated in foreign currencies .
Figure 2: The a2 Milk Company produce and export dairy products to global markets including China, and benefitted when the Australian dollar depreciated by around 8.8% in 2018. Their EBITDA* for 2018 was up 101% from the previous year at $283m.* Earnings Before Interest, Tax, Depreciation & Amortisation). PIcture: https:// thea2milkcompany.com
Interest Rates Interest rates represent a cost to business when they borrow money to fund investment . Interest rates are also useful for a business to generate income in interest bearing deposits . Just as interest rates affect a business’ financial management in the domestic economy, so they do in the global economy . Businesses need to be aware of interest rate differentials, which mean different interest rates in different countries . High/rising global interest rates increase costs for businesses and indicate reduced availability of funds, and so have negative impacts . Low/ falling global interest rates decrease costs for businesses and indicate increased availability of funds, and so have positive impacts .
Interest rate differentials can be used by businesses as part of their global financial strategies. For example…. • If interest rates are lower in other countries, borrow
from overseas;
• If interest rates are higher in other countries, save money in foreign accounts, or borrow from Australia;
• Businesses also need to consider exchange rates also - if the Australian dollar depreciates, this makes interest repayments in US dollars more expensive
Methods of international payment Ways of paying for imports and getting paid for exports include:
• payment in advance,
• letter of credit,
• clean payment,
• bill of exchange .
Payment in advance
Payment in advance, as the name suggests, occurs when the seller/exporter obtains full payment up front before shipping the product . Using this method eliminates risk for the exporter - If the buyer doesn’t pay, the seller suffers no loss except for any administrative costs or time consumed in organising the transaction . However, buyers are unlikely to agree due to the risk involved for them, unless the exporter can use a strategy to alleviate the buyer’s concern, e .g . using the services of a global payment gateway provider such as PayPal or Stripe . While this type of payment is fairly uncommon in international trade it is increasingly being used for internet transactions .
Figure 3: Picture: www.easyparcel.my
Letter of credit
A letter of credit is a written promise by the buyer’s bank to pay the exporter for the goods received, on the proviso that certain documentation is submitted . Exporters need to be careful that they read the conditions of the Letter of Credit and meet the documentary requirements in order for payment to be guaranteed .
The current policy rate in the US is 2 .5% while Australia’s is 1 .5%, meaning other interest rates are generally higher in the US than Australia - this makes it cheaper to borrow from Australian financial institutions (depending on what happens to the exchange rate of course) .
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Clean payment
Under the clean payment method, the exporter ships the goods directly to the importer before payment is received, and all trade documents are handled directly between the trading partners, with the role of banks limited to facilitating the transaction (transferring the funds) .This makes the transaction relatively cheap (minimal banking charges), but it can be risky for the seller (exporter) as it involves shipping in advance - again, if the two parties use a global payment company such as PayPal the risk is reduced .
Bill of exchange
A bill of exchange is a written order by an exporter asking the buyer to make a money payment for the goods/ services to the exporter’s bank, at a specified time. The buyer’s bank transfers the money to the seller (exporter) when they are satisfied that the goods have been shipped (as evidenced by shipping documents/parcel tracking) .
In addition to the above methods, businesses should conduct a credit check to assess the risk of non- payment from a buyer . This could be done by the business itself or through a credit rating agency such as Dunn & Bradstreet or with the help of the Australian Government’s Export Finance and Insurance Corporation (EFIC) .
Hedging Hedging means the use of financial strategies to reduce the risks associated with commercial transactions . It involves the strategic use of financial instruments to offset the risk of negative price movements, for example a currency appreciation or depreciation, or changes in input costs such energy or raw materials .
Examples of hedging
• Insurance – payments made in case of loss;
• Natural hedge – open a factory in another country instead of exporting to it, to avoid the impact of currency fluctuations;
• Export and import in the same currency;
• Derivatives – contracts based on future transactions.
Derivatives A derivative is a financial instrument (contract) whose value is based on an underlying asset . Underlying assets include commodities (e .g . coffee), shares, currencies, interest rates . Derivatives are often called ‘futures’ as they are based on transactions that occur in the future .
Hedging costs money: Any action that reduces risk to a business will reduce return . So, hedging will lower potential returns to a business but it also lowers potential losses .
We have been requested to advise you the following letter of credit as issued by:
• THIRD HONG KONG BANK
• 1 CENTRAL TOWER
• HONG KONG
Please be guided by its terms and conditions and by the following:
Credit is available by negotiation of your drafts in duplicate at sight for 100% of invoice value drawn on us accompanied by the following documents:
1 . Signed commercial invoice; 1 original and 3 copies
2 . Full set 3/3 ocean bills of lading consigned to the order of THIRD HONG KONG BANK, notify applicant and marked freight to collect
3 . Packing list in 2 copies
Figure 4: Excerpt from a sample letter of Credit sourced at www. export.gov.au
Natural Hedging at Volvo
Swedish car manafacturer Volvo opened a factory in South Carolina USA in June 2018 as part of their ‘build where you sell’ global strategy . By producing and selling cars in the US, Volvo is hedging against short term currency fluctuations between the Euro and the US dollar .
Figure 5: Picture: www.volvocars.com/news
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Some types of derivatives
• Futures contracts
• Forward exchange contracts
• Options (option contract)
• Swaps (swap contract)
Futures contracts
These are legally binding agreements to buy or sell a commodity or financial instrument sometime in the future. They are standardised according to the quality, quantity, delivery time and location for each commodity . Futures contracts can be used by domestic and international traders to protect against unfavourable movements in prices .
Figure 6: Image: www.contract-template.org
Forward contracts
Similar to futures contracts, forward contracts occur where a seller agrees to deliver a specific commodity to a buyer sometime in the future . In contrast to futures contracts, they are privately negotiated and tailor-made between two parties - not standardised - making them more flexible. Forward contracts on currencies are the most commonly used derivative security .
Options An option is a contract giving the holder the right but not the obligation to trade in a commodity, a share, or currency on some future date at a certain price . There are a variety of option types including put options (the right to sell) and call options (the right to buy) .
Hypothetical case study example 1: Forward contract on a currency trade used by an importer
• Ozfleet, a car leasing company, purchases 1000 cars at $US50 000 each to be delivered and paid for in 6 months;
• Ozfleet is exposed to the risk that the AUD will depreciate, and the total of $US50 000 000 will cost more in AUD terms to purchase;
• Ozfleet buys a currency derivative to lock in the existing $A/$US exchange rate – that is, a contract that states that when they need to purchase the $US50 000 000 in the future, they will get them at the earlier rate;
• If Ozfleet is right and the AUD depreciates, they have hedged against the loss they would have made;
• The risk they take is the possibility that the AUD actually appreciates and they lose out .
Hypothetical case study example 2: Fuel price hedging
• An airline company wants to hedge against the possibility that fuel prices will rise in the next 12 months and a barrel of oil currently costs $100;
• The airline buys a futures contract to lock in the $100 price per barrel;
• If the airline is right and the price of oil goes up, they have hedged against the potential loss;
• The risk they take is the possibility that oil prices fall to, say $80, and they lose $20 per barrel (if they were purchasing 1 000 000 barrels this adds up to $20 000 000!) .
So we can see that using derivatives to hedge against loss takes some ‘weighing up’ .
When hedging doesn’t work
Airline companies are typically exposed to the global financial risks of changes to exchange rates, interest rates and oil prices . Airline companies that hedge against rising fuel (oil) prices can experience large hedging losses when the price of oil falls . For example, hedging losses related to the Global Financial Crisis cost Emirates $US428m and Air China $US994m, and hedging losses in 2014 cost Delta Airlines $US1 .2b .
One way an airline company can ‘hedge against hedging’ is to not hedge all of its fuel costs . For example Qantas, who faced a total fuel cost of $4b in 2018/19, hedged 76% of its fuel requirements in 2018/19 but 39% of its fuel needs for 2019/20 in the face of oil prices .
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Weighing the ups and downs in global financial management Financial managers have a complex job of weighing up potential benefits and successes against the downs associated with risk, a slowing economy or rising costs leading to potential losses or even failure . What all managers and owners need to remember is that the global economy will always move in cycles, that the greater risk you take the greater potential there is for loss, and that hedging against risk will cost money . The challenge for strategic financial management is in getting the right balance between taking risks and absorbing short-term costs, and achieving long term business success in maximising profits and ensuring business growth and success .
Student activities
Literacy/vocabulary
Define these terms used throughout the article in their correct business context:
strategic role of financial management; profitability; growth; efficiency; liquidity; solvency; interdependence; importing; exporting; EBITDA; interest; interest rate; exchange rate; depreciation; appreciation; hedging .
1 . Outline why a financial manager should work closely with the managers of the other key business functions in order to achieve strategic goals .
2 . Compare potential risks for a business that operates domestically with a business operating globally .
3 . Create TWO Mindmaps, one for the impacts on businesses of a currency appreciation and one for the impacts on businesses of a currency depreciation .
4 . Create a table summarising key features of each of the methods of international payment (payment in advance, letter of credit, clean payment, bill of exchange) . You could also create study cards with the method on one side and the features on the other .
5 . Explain a potential conflict for Volvo when they decided to use natural hedging to reduce exposure to the risks of currency volatility, and why they ultimately made that decision to open a factory in the US .
6 . Discuss how global markets for currencies, finance and oil can affect the profitability of an airline .
7 . Explain how an airline such as Emirates could hedge against oil price increases .
8 . Why do you think Emirates lost $426m through hedging against oil price increases?
9 . How does Qantas use hedging in balancing the risk of oil price rises versus oil price falls?
10 . The a2 milk company exports milk products to China and uses milk sourced from Australia, New Zealand, the US and UK . Imagine you have been asked to provide advice to the owners regarding global financial management. Write a Business Report for the directors of this business in which you: a) Outline the strategic role of financial management with reference to global financial management b) Recommend methods of international payment c) Outline the various forms of hedging and recommend a hedging strategy
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Editor: Rachel O’Neill
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References and further reading Chapman, S . et al, Business Studies in Action HSC Course, Jacaranda, 5th Edition
https://www .afr .com/markets/currencies/how-to-position- to-capture-a-falling-a-tailwind-20181010-h16fwt
https://www .rba .gov .au/publications/bulletin/2017/dec/ pdf/bu-1217-8-foreign-currency-exposure-and-hedging- in-australia .pdf
https://markets .businessinsider .com/commodities/oil- price?type=wti
https://thea2milkcompany .com/wp-content/uploads/A2M- Annual-Report-FY18 .pdf
https://www .sbs .com .au/news/explainer-fuel-hedging- and-its-impact-on-airlines-and-airfares
https://group .volvocars .com/news/corporate/2018/volvo- cars-first-us-plant-officially-opens
https://www .reuters .com/article/us-europe-companies- currency/battered-by-currency-swings-european-firms- unpick-global-production-model-idUSKBN0MX09W2015 0406?feedType=RSS&feedName=businessNews
http://australianaviation .com .au/2018/10/qantas-says- fuel-bill-to-top-4-billion-in-2018-19/
https://www .austrade .gov .au/Australian/Export/Guide-to- exporting/Getting-paid
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