What are Constant Currencies: Benefits and Challenges

Introduction

Exchange rates significantly influence a business’s financial position and cash flows. A stronger foreign currency inflates values, creating paper profits, while a weaker foreign currency tightens margins. This currency volatility complicates accurate financial reporting to investors and stakeholders. 

This is where constant currency reporting comes into play. It helps businesses with overseas operations offset the impact of exchange rate fluctuations when calculating figures for financial performance. By showcasing their revenues and income in constant currency terms, businesses can reveal their true financial performance, unaffected by exchange rates fluctuations.

This blog will dive into constant currency meaning, how it works, how to calculate constant currency, benefits, challenges, and limitations. 

What Is Constant Currency? 

Constant currencies refers to fixed exchange rates that help eliminate currency fluctuation impact when analyzing financial performance. It helps businesses correct the differences in foreign and home currency values in financial reports, ensuring a transparent picture of their financial position.

 Constant currency shows what a business’s financial figures would look like if it didn’t experience fluctuations. It also enables businesses to make year-on-year comparisons of fluctuations more accurately. While many companies choose constant currency analysis for financial reporting, some financial leaders do not prefer this method, as it can cause inaccuracies in assessing foreign exchange risks and regulatory challenges. 

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How Does Constant Currency Work?

Businesses selling products overseas usually receive revenues in foreign currencies. When these currencies strengthen against the home currency, revenues and income translate into higher reserves. Conversely, when the foreign currency weakens, revenues convert to lower numbers. This fluctuation directly affects the cash flow of the business. 

To navigate this negative impact, businesses disclose numbers in their financial reporting after assuming exchange rates remained constant during the period. This way, investors and stakeholders can evaluate the true picture of a financial performance that is unaffected by currency fluctuations.

Constant currency calculation

For constant currency calculation, businesses can either take the previous year’s average exchange rate or adjust financials based on the current year’s exchange rate. The goal is to determine business performance while facilitating direct comparisons and eliminating currency fluctuations’ impact. 

• Select a base period. Businesses have to choose a specific period whose exchange rate is to be considered for reference. 

• Convert the current period figures. Businesses have to convert the current year’s financial figures into the base year’s exchange rate. It will include converting revenues, expenses, and any other financial numbers that are originally recorded in foreign currencies. 

• Calculate the constant currency figures. Businesses have to recalculate financial numbers by using the base period’s exchange rates. The result will show what the numbers would have been if the exchange rates had remained constant. This step removes the distortions due to currency fluctuations. 

• Compare the financial results Next, businesses will have to compare the constant currency figures to those of their base period to get a clear picture of the business performance. These comparisons will be free of any impact due to currency exchange rate changes. 

Constant Currency Example

Let’s take a real world example of Walmart Global’s constant currency. 

Source

In this example, the net sales of Walmart are expected to rise by 4.5% to 5.0% respectively. Moreover, consolidated operating income will also surge by 3.5% at constant currency rates, with adjusted earnings per share (EPS) expected to stay between $1.25 to $1.30. However, the negative impact of 235 basis points (bps) will offset the growth trajectory. 

The Benefits of Reporting on a Constant Currency Basis 

Constant currency reporting allows businesses to show actual operating performance, where figures are not impacted by any currency fluctuations. It helps businesses gain detailed insights into growth or change while mitigating financial risks associated with foreign exchange rate fluctuations.

• Improved operational performance

Constant currency analysis helps businesses present their true operational performance to stakeholders by removing the effects of currency fluctuations. This will further help finance teams make informed decisions about the business’s operational efficiency and strategic direction. 

• Managing cash flow volatility 

Currency exchange rates often impact actual cash flows. For instance, if a company earns revenue in foreign currencies, changes in exchange rates will change the home currency value of those cash flows, creating volatility. 

• Managing foreign exchange risks

By assessing financial performance in constant currency terms, businesses can make informed decisions and navigate foreign exchange risks. They can then implement strategies like currency hedging to manage the impact of foreign exchange risks and stabilize cash flows. 

• Better budgeting and planning 

Constant currency analysis helps businesses create more accurate cash flow forecasts and budgets by isolating operating factors from currency effects. It provides a clear picture of a company’s liquidity by eliminating frequent changes in cash flows due to exchange rate fluctuations.

Challenges And Limitations of Constant Currency

Despite removing currency fluctuation-related ambiguity and distortions, many finance leaders don’t approve of this reporting method. Here are a few reasons why.

• Non-compliance with regulatory guidelinesThe Generally Acceptable Accounting Principles (GAAP) do not approve of constant currency analysis. GAAP requires companies to report financial numbers without adjusting anything. Moreover, the US Securities and Exchange Commission (SEC) reporting says any non-GAAP measures like constant currencies can violate Rule 100(b) of Regulation G and become misleading. However, investors or stakeholders should not entirely disregard the potential of constant currency analysis, as it shows business performance in a better light.

• Ignoring the significance of exchange rates Exchange rates do play an important role in preparing financial reports. When constant currency is calculated using exchange rates that were not used in preparing accounting results, it gives room for rate impacts that don’t accurately reflect a business’s true performance. To ensure reliable year-on-year (YoY) reporting, businesses should go for only those exchange rates that have been used in prior and current year reporting. Otherwise, they will end up providing more insights about market fluctuations than their actual performance. 

• The problem of seasonality Seasonality often impacts transactions, making them unevenly distributed throughout the year and creating timing differences. When calculating constant currency comparisons, using a simple average exchange rate of the prior year can distort the rate impact on the current year’s results. For more accurate comparisons and to mitigate the skewed effect of timing differences, businesses must apply an appropriately weighted average prior period rate to the current period’s financials. 

• Disconnect with hedging measures. Oftentimes, treasurers and finance teams manage currency risks by reducing the currency impact on margins through hedging. However, the management prefers reporting YoY changes in revenues and expenses using constant currency analysis. This not only creates a discrepancy between financial reporting and currency hedging measures but also leads to internal misalignment. While treasurers protect margins through hedging, management adjusts for currency changes in financial reporting to provide accurate numbers.

How Can Cash Forecasting Help Improve Constant Currency Analysis

An advanced cash forecasting system not only helps businesses with accurate constant currency reporting but also gives better visibility into future overseas transactions. 

• Improved accuracy 

Automated cash forecasting will help businesses forecast cash flows for all categories by leveraging out-of-the-box AI-ML models. Every time the forecasting process runs, the system reviews and picks the best-fit model with the highest accuracy automatically from hundreds of permutations and parameters. It also integrates with all major banks and gathers financial data across accounts, currencies, regions, etc., identifies the impact of currency fluctuations, and detects near-term changes. 

• Dynamic hedging

Cash forecasting provides insights into future currency needs, allowing businesses to adjust their hedging strategies based on anticipated cash flows. This flexibility helps optimize hedging effectiveness and reduce the impact of unfavorable currency changes. 

• Scenario analysis

Businesses can also use scenario analysis to forecast near-term changes in foreign currencies and predict their potential impact. They can create what-if scenarios on top of a base forecast and can change amounts, percentages, or timing of cash inflows, outflows, or foreign exchange rate shocks. They can then analyze the impact each scenario has on various transactions and how it will impact constant currency reporting. 

For instance, an MNC reporting in USD but operating globally decides to use scenario analysis to identify the impact of currency fluctuations. In scenario 1, the business anticipates foreign currency value to increase relative to the USD but revenues and assets decrease due to translation effects. However, its local operations may benefit from stronger currencies, boosting competitiveness and profitability locally. 

Conversely, in scenario 2, the business anticipates currency depreciation, which will significantly increase expenses and liabilities. However the MNC will gain competitiveness in international markets. Through constant currency reporting, the MNC can isolate operational performance from currency fluctuations, enabling better risk management and strategic decision-making.

Use HighRadius’ Advanced, Automated Cash Forecasting To Improve Analysis with Constant Currency

The key to accurate constant currency accounting is to have robust cash forecasting in place that gives complete visibility of currency fluctuations and helps get a holistic view of their impact. HighRadius brings you a cutting-edge, automated Cash Forecasting software from its Treasury Management software that helps reduce challenges with constant currency reporting. 

It offers bank integration with all major banks, such as BofA, Citi, PNC, Chase, Wells Fargo, HSBC, etc., to automatically import bank statements. It also helps businesses identify the type of each transaction in the bank statement and classify them correctly as inflows and outflows, which further helps study the patterns and impact of currency changes on transactions. The solution also helps with consolidated forecasts based on different dimensions such as legal entities, regions, cash flow categories, countries, and currencies. 

In addition to this, the cash forecasting solution also offers features for historical forecast trends that help businesses track changes in foreign exchange rates, identify how they have affected previous forecasts, and compare the impact to that of actual cash flows. Also, businesses can use scenario analysis to predict near-term changes in foreign currencies, create what-if scenarios on top of a base forecast, and identify the FX rate’s impact on business performance. 

With 100% bank automated bank integration, businesses can initiate global net cash forecasting and minimize the ambiguity and discrepancies that currency fluctuations bring to financial reporting, increasing forecast accuracy by a staggering 70%. 

FAQs

1) How is constant currency calculated?

There are many ways to calculate constant currencies. Businesses can either convert current financial numbers using the previous year’s average exchange rate or adjust their previous numbers to align with the current year’s exchange rate. Both of these will help investors make direct comparisons. 

2) What is constant currency growth?

Constant currency growth helps measure a business’s performance by using consistent foreign currency exchange rates to translate financial information from one period to another, usually into US dollars. It reveals the true growth or decline of a company’s operations, allowing for a YoY comparison. 

3) What is a constant currency basis?

A constant currency basis means applying a fixed exchange rate to offset the negative impact of currency fluctuations. This enables businesses to adjust their effects of changing foreign currency exchange rates when sending performance data to investors. It also helps businesses compare YoY results.