Often, a company’s gains or losses from foreign exchange swings don’t have a direct or proportionate impact on its financials because of ‘natural hedge’.
With the rupee yo-yoing, foreign-exchange gains or losses have buffeted the numbers of many companies in recent quarters.
Take JSW Steel. It reported a foreign-exchange loss of Rs 821 crore for the year ended March 31. Partly because of this, the company made only Rs 1,626 crore in profits, lower than the Rs 2,010 crore made in 2010-11. The company’s exchange-loss woes continued in the April-June quarter of this year, too.
Such losses sometimes lead to shares nose-diving. If substantial, this can mask a company’s true operational performance. As an investor in the company’s shares, would you not be interested in finding out what these losses are, where they come from and whether they are reversible?
Fortunately, you need not be an accountant to understand all this. A basic knowledge of how companies operate, topped up with a reading of the annual report will suffice.
Who’s impacted by forex
Companies with a substantial export component to their revenues or a big import bill on raw materials are usually the most exposed to foreign exchange fluctuations.
Take Bajaj Auto, a company which derives about 35 per cent of its revenues from exports. The sales made in export markets, which fetched an average of about Rs 46.50 for every dollar during the first quarter last year, moved to over Rs 50 by the fourth quarter. This helped the company’s export revenues for 2011-12 grow by 45 per cent over the previous year to Rs 6,604 crore.
JSW Steel, on the other hand, usually reports hefty forex losses when the rupee depreciates, because it imports about 60 per cent of its total raw material requirements. Fall in the rupee’s value would mean an escalation in raw material costs which would have a direct impact on its margins.
Often though, a company’s gains or losses from foreign exchange swings don’t have a direct or proportionate impact on its financials. This is because of the concept of ‘natural hedge’.
A software exporter such as HCL Technologies or Infosys does incur sizeable expenses incurred in dollars, which will reduce its gains from the rupee’s slide.
Or an oil importing company like Reliance Industries may export petroleum products, too, thus making some gains when the rupee slides.
Income and expenses
Take IT companies, such as Infosys. Infosys receives about 95 per cent of its revenues from exports, implying that a substantial portion of its income is earned in foreign currencies. This exposes the company to exchange-rate risks when the rupee appreciates.
Manufacturing companies such as Maruti Suzuki earn much of their revenues from India. However, the company imports raw materials and components and pays royalty to its parent Suzuki in Japan. This implies that a depreciation of the rupee will increase the company’s payments.
For example, in the October-December quarter of 2011, the company’s profits fell to Rs 205 crore, compared with Rs 565 crore in the same quarter of 2010.
Although slowing auto sales were responsible too, the profits could have been higher by at least Rs 200 crore, if not for the forex loss.
For one, the appreciation of the yen and dollar made raw material imports costlier. Two, the company incurred an exchange loss of Rs 19 crore on royalty payments for the first half of the year, which was made in November. Besides, it had to set aside Rs 75 crore as marked-to-market loss on provision for royalty as well.
Details about the quantum and kind of foreign-currency transactions your company is exposed to can be found in the annual report in the annexures to the Directors’ Report. The details are also found in the notes to accounts.
Hedging and its impact
If the rupee is depreciating and this benefits Infosys, how come the company makes forex losses? A major reason is because it does not leave its entire foreign exchange earnings/expenses to be made at market rates. Considering the uncertainty, it uses derivative instruments like forward contracts, options, futures, etc., to hedge against currency volatility.
Let us take an example. For a portion of its expected forex revenues over next three months, the company enters into an options contract valuing rupee at 55 to a dollar. Now if the company expects the rupee to plunge further in the interim, it could unwind its position originally taken and book a loss on it.
This is disclosed as forex loss in the profit and loss (P&L) account. Take a look at Infosys’ annual report. You will see that even as the company made a forex gain of Rs 344 crore on some items for the year ended March, it made an option/forward contract loss of Rs 263 crore.
Usually, most companies show forex losses/gains under the ‘other income’ head in the P&L account (losses could be netted off the gains). Hedging losses, too, are adjusted against other income.
When the forex losses/gains are huge, they may be shown as ‘exceptional items’ in the P&L account. Details of items covered by derivative contracts and various hedges that are open as on the balance-sheet date are given in the annual report in the notes to accounts section.
Not all the losses are ‘realised’, meaning that they can reverse later.
For example, if a derivative contract remains open at the end of a quarter or a year, accounting rules require that it be valued by marking to market.
To take out such notional fluctuations from the P&L account, some companies create a hedging reserve in the balance sheet. When the transaction which is hedged actually happens, the loss or gain will come to the P&L account.