Foreign Exchange Ratios Formula

A company that engages in trade with business partners in other countries will expose itself to foreign exchange fluctuations, unless it can convince its partners to only transact business in U.S. dollars or engages in hedging operations. The two ratios shown in this section can be used to determine the proportion of foreign currency gains and losses that a company is incurring in relation to overall net income and sales. These ratios can be used to make a case for foreign exchange hedging operations, which will mitigate the risk of foreign exchange losses“.

 

Foreign Exchange Ratio Formula: Divide both recognized and unrecognized foreign currency gains and losses by net income. The formula is:

Foreign currency gains and losses
——————————————
Net income

 

A variation is to divide both recognized and unrecognized foreign currency gains and losses by total sales. This approach gives one a perspective on the size of such gains and losses in relation to total revenue generating activity. The formula is:

Foreign currency gains and losses
——————————————
Total sales

 

Foreign Exchange Ratio Example: The Lie Dharma Trading Company, which imports goods from Thailand, is reporting a net loss for the first time in its history. Its controller wants to find out how much of the loss was caused by foreign currency losses. The company experienced a loss of $178,000 as opposed to a budgeted profit of $242,000 for the year. Foreign currency losses were $113,000. The controller chooses to use the budgeted profit figure as the denominator for the calculation, which is:

Foreign currency gains and losses
—————————————— =
Budgeted net income

$113,000 Foreign currency losses
—————————————— = 47% Foreign currency loss ratio
$242,000 Budgeted net income

 

Revealed: Though the calculation shows that 47% of the budgeted profit was lost to foreign exchange losses, the actual reduction from the budgeted profit level was $420,000 (actual loss of $178,000 + budgeted profit of $242,000). Consequently, the controller will have to continue searching to find additional causes of the loss.

 

Problems with Foreign Exchange Ratio (Word of Cautions): The foreign exchange ratio that uses net income as the denominator is the recommended approach, since it gives one a clear idea of the impact of these activities on a company’s profits. In particular, if a large proportion of company profits comprise exchange gains, an investor should inquire as to why the company is not making more money from its core operating activities. If such a high proportion of exchange gains continues for several periods, this can be a sign that the company is relying too heavily on its foreign currency trading expertise to generate profits.

Author: Lie Dharma Putra

Putra is a CPA. His last position, in the corporate world, was a controller for a corporation in Costa Mesa, CA. After spending 15 years as a nine-to-five employee, he decided to serve more companies, families and even individuals, as a trusted business advisor. He blogs about accounting, finance and tax, during his spare time, and helps accounting students (around the globe) to understand the subject matter easier , faster. Follow him on twitter @LieDharmaPutra or add him to your circle at Google Plus Lie+

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