What it means
A currency performs three jobs at once. It settles transactions, it provides a common yardstick for prices, and it holds value between the moment you earn money and the moment you spend it.
When any one of those jobs breaks down, as it does in periods of very high inflation, commerce becomes difficult in ways that go well beyond finance. Modern currencies are fiat money, meaning they are not backed by gold or any physical commodity but by confidence in the issuing government and central bank.
Their value comes from the fact that taxes must be paid in them and that people accept them, which is why credibility of the issuing institution matters so much. For a business, the practical questions are which currency you report in and which currencies you actually transact in.
Your functional currency is the one of the main economic environment you operate in, and it drives how foreign transactions are translated in your accounts under standards such as IFRS. The moment those differ, currency risk appears.
A company reporting in dollars that sells in euros and buys components in yen has three currencies moving independently, and its reported margin can change without a single price or volume changing. Currencies are also grouped by how freely they trade.
Major currencies are highly liquid with narrow spreads, while some emerging market currencies are restricted, expensive to convert and occasionally trapped by capital controls, which is a cash flow issue rather than a theoretical one.
In practice
Real-world examples.
Example
A UK-based consultancy invoices an American client in dollars for convenience, then finds that a 5% fall in the dollar over the payment period reduces the sterling it eventually banks. It switches to invoicing in pounds and lets the client carry the conversion.
Example
A retailer sourcing from three Asian suppliers negotiates all its contracts in dollars even though none of the suppliers is American, because the dollar is widely accepted for trade and quotes are easier to compare in a single currency.
Example
A software company with a subscription base across twelve countries reports in euros. Each quarter it discloses revenue growth both as reported and in constant currency, so investors can see how much of the change was genuine growth rather than exchange rate movement.
Formula
Calculation
Converting an amount from one currency to another uses the exchange rate:
Amount in home currency = Amount in foreign currency x Exchange rate (home currency units per foreign currency unit)
Kestrel Instruments, a US firm, has issued an invoice to a Canadian customer for 180,000 Canadian dollars. At the time of the sale the rate is $0.75 per Canadian dollar.
Value recorded = 180,000 x $0.75 = $135,000
The customer pays 90 days later, by which time the rate has moved to $0.72 per Canadian dollar.
Cash received = 180,000 x $0.72 = $129,600
The difference of $135,000 - $129,600 = $5,400 is an exchange loss, equal to 4% of the original invoice value. On a product with a 12% net margin, that single currency move has wiped out a third of the profit on the sale, which is the reason exporters either price in their own currency or hedge the exposure.Case study
Seen in the real world.
This is an illustrative and fictional example. Vantia Kitchens, an invented mid-sized appliance importer, reported in dollars, bought its stock in euros and sold entirely at home. For three years the exchange rate drifted gently and nobody paid much attention to it.
Then the euro strengthened by roughly 11% across two quarters. Vantia had ninety days of stock in transit and a price list printed for the season, so it absorbed the increase on everything already committed. Gross margin fell from 34% to 27% on a revenue base of about $46,000,000, and the finance director had to explain a profit shortfall that had nothing to do with sales performance.
The response was structural rather than clever. Vantia began buying forward contracts covering about 70% of its expected euro purchases six months ahead, moved to twice-yearly price reviews, and added a currency assumption line to its budget so that the board could see what rate the plan depended on. The next currency move was larger, and the profit impact was a small fraction of the first.
Watch out
Common mistakes.
- Treating exchange gains and losses as one-off items outside real performance. For a business that regularly trades abroad they are a recurring cost of doing business and belong in the margin discussion.
- Assuming that invoicing in your own currency removes currency risk. It moves the risk to the customer, who may respond by demanding a discount or buying less when their currency weakens.
- Confusing the reporting currency with the functional currency. The functional currency reflects the economics of where a business actually operates, while the reporting currency is simply the one chosen for presenting the accounts.
Questions
People also ask.
What makes one currency stronger than another?
Relative interest rates, inflation, trade flows, government debt levels and investor confidence all feed in, and no single factor reliably predicts short-term movement.
Should a small exporter hedge its currency exposure?
If foreign sales are a small share of revenue, careful pricing and prompt invoicing often suffice, but once exposure is large enough that a 10% move would change the year's result, hedging is worth costing.
Is a digital currency the same thing as a currency?
Some are used as a means of payment, but most cryptocurrencies are too volatile to serve as a stable unit of account, which is one of the three core jobs a currency is meant to do.
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