The Financial Impact of Consolidation; Why Is It So Hard on Smaller Companies?

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It’s conventional wisdom that smaller companies are having an especially tough time meeting their financial needs, or even surviving, in the snowboard industry shakeout. It’s so conventional it’s taken for granted; even chanted like a mantra at times.

And it’s true. But why exactly? What are the specific changes in the financial operating environment of smaller companies that’s made life so difficult for them?
 
It’s 1993. The glory days when a snowboard company could sell all the decks it could get at full price if they could only find a competent manufacturer who would deliver on time (well, at least not too late) a quality (okay, reasonably decent) product. The mythical Burp Snowboard Company is on a role. The company did US$4 million in sales this year and its income statement looks like this for the 12 months ending 31 December 1993:
 
Net Sales                                  $4,000,000
Cost of Goods Sold                  $2,400,000
Gross Profit                              $1,600,000
 
Expenses:
Sales and Marketing                  $    400,000
Commissions                            $    280,000
General and Administrative        $    500,000
Interest and Miscellaneous         $    100,000
Total Expenses:                                    $ 1,280,000
 
Pretax Profit                             $    320,000
 
In 1993, snowboarding is a nice clean business. The balance sheet at the same date is a thing of beauty. There’s cash in the bank. Receivables are pretty low because a big chunk of sales were COD and terms, when offered, didn’t extend past 60 days. Product is flying off the retailers’ shelves, so retailers have paid you as agreed and bad debts are minimal.
 
Inventory? Not much more than what you think you need for warranty and some stickers and T-shirts. If you’re lucky, some samples for next season have already arrived.
 
Cash flow wasn’t great at the beginning of the season. But half of sales are to Japan and they paid for at least half their $1,200,000 order in advance. The rest showed up in the company’s bank account a few days after shipment. Your creditors (excluding some of your suppliers) are giving you terms of 30 to 60 days and retailers are paying you before you have to pay them. Snowboarding is so hot that raising a little money from some wealthy friends of friends was pretty easy. That and the money from Japan allowed you fund your operating expenses from January through July and to make required supplier payments.
 
Burp’s employees and you, the owner, are all thrilled to be in the snowboard business and are working your asses off for not too much money. Customer service, sales management and warranty are all pretty minimal expenses. Retailers and customers are just happy to get product and aren’t demanding much in return. You increased your prices 10% over last year and nobody so much as raised an eyebrow.
 
Ain’t life grand?
 
Fast forward to 31 December 1996.   Who knows what happened to Burp, but the New Guy snowboard company has also done US$4 million in the calendar year that has just ended. Their income statement looks like this:
 
Net Sales                                  $4,000,000
Cost of Goods Sold                  $2,720,000
Gross Profit                              $1,280,000
 
Expenses:
Sales and Marketing                  $    400,000
Commissions                            $    280,000
General and Administrative        $    500,000
Interest and Miscellaneous         $    100,000
Total Expenses:                                    $ 1,280,000
 
Pretax Profit                             $               0
 
The only change shown above is that the gross profit margin has been reduced by 8 percent from 40 to 32, reflecting competitive pressures and the resulting product pricing. In fact, as discussed below, you can also expect some increases in operating expenses.
 
Your balance sheet has changed from a thing of beauty to a nightmare. Cash is kind of scarce. Inventory isn’t. You’ve got a bunch of it left and it’s worth less by the day. If you sell it at all, you’ll be lucky to get your cost out of it. This is the result of order cancellations and over supply that has allowed retailers to buy product in season at great discounts (great for them anyway).
 
Your receivables look about as good as your inventory. Retailers have demanded terms with the result that, as of 31 December, a bunch of your receivables aren’t even due yet. Those that are due aren’t exactly coming in right on time, and some significant bad debt seems inevitable. Unless you’ve built up a hell of a bad debt reserve over the last couple of years, your pretax profit of $0.00 is going to be a loss if only because of collection problems.
 
Japanese orders were only a quarter of your total sales this year. The market there, and in the rest of the world, is moving towards more recognized and reliable brands from larger companies. There was no cash up front from the Japanese distributor and you felt fortunate to receive a letter of credit that got you paid within a week or two of shipment.
 
You had to sell more product units to achieve the same net sales due to price competition and as a result had to finance an additional $320,000 in cost of goods sold. Because of collection problems, you have to finance it for longer. Your suppliers, feeling some of the same competitive pressures you are feeling, helped out some by offering some better terms, but the net result of higher cost of goods sold and slower collections is more interest expense.
 
Administrative and selling costs have increased as retailers have demanded better warranty and customer service and reliable, timely delivery. You had to add a customer service person, offer point of purchase displays, and upgrade your computer hardware and software. You had to front your reps some more money so they could be every where they needed to be and look good being there. Shipping expenses increased as you worked hard to make sure everything got to the retailers on time.
 
You can’t just be an order taker anymore. Sales have to be earned and that means time and expense.
 
All these changes didn’t catch you completely by surprise. In order to adjust to them, you actually reduced your sales and marketing expenses by 25% during the season. Unfortunately, you did it at exactly the time you needed to spend more to establish your brand name. Your move made good tactical, short-term sense, but was a strategic error that will only make things more difficult in the future.
 
The net affect of all these changes, then, leaves you with an income statement for 1996 that probably looks something like what’s shown below.
 
Net Sales                                  $3,850,000
Cost of Goods Sold                  $2,720,000
Gross Profit                              $1,130,000
 
Expenses:
Sales and Marketing                  $    300,000
Commissions                            $    269,500
General and Administrative        $    600,000
Interest and Miscellaneous         $    150,000
Total Expenses:                                    $ 1,319,000
 
Pretax Profit (Loss)                   $(   189,000)
 
Not a pretty picture. I’ve assumed a five percent bad debt on the non-Japanese part of sales. Your cost of goods doesn’t decline because you don’t typically get that product back. Sales and marketing expenses are reduced by $100,000 though you really ought to be increasing them. Commissions are down a little to the extent net sales have declined. General and administrative expenses are up $100,000 to reflect the increased costs of doing business and an extra $50,000 in interest expense has been added.
 
A company similar to one that made $320,000 in 1993 has lost $189,000 in 1996. That’s a decline of 159 percent. Cash flow is critical as well and investors who were so accommodating in 1993 are reluctant to provide any additional financing in 1997 because they can’t see that the risk they would be taking is justified by the potential return. Prospects for orders for the 1997-98 season look bleak because retailers are turning to larger, more established suppliers.
 
What did the management of New Guy do wrong? Operationally, nothing. This is the result they would have achieved, and the position they would be in, if they did literally everything right. Their problem is that they didn’t have a well functioning crystal ball. They didn’t look into the future and see that industry maturity was inevitable and would require either that their company achieve critical mass before the consolidation began or have a distinctive competitive advantage.
 
It’s hard to be too tough on them for that, since most of our crystal balls don’t work to perfection either.
 
The industry shakeout isn’t going to reward only operating well. Of course you have to do that, but success under the new market conditions will ultimately depend on the strength of your balance sheet and having a clear competitive advantage and market position.

 

 

Selling Your Business How to Get Ready and What to Expect

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At some point, every business owner considers selling their company. Most that don’t go out of business are sold at some time in their history. But between considering it and selling are a host of issues, surprises, conundrums, and general confusions for the business owner who has never been through the process before. I have spoken with or heard of sellers who are minimizing the chances of making a good deal by

·         Requiring that the buyer make an offer before seeing the seller’s financial statements
·         Stating prices that are so unrealistic as to make any further discussion futile
·         Hoping to close a sale without using appropriate professional advisors.
 
If you’re going to sell your business, let’s make sure you do it right and for the right reasons. You can maximize your chances of success, and minimize wasted time, by focusing on what I call the five “Gets.” Get real, get a goal, get ready, get agreement, get help. 
 
Get Real
 
It’s as predictable as the sun coming up in the morning. The owner believes in his business. He believes in it so much that his perception of what it is worth to a buyer is, in my experience, almost always out of line. 
A sophisticated buyer won’t ignore your projections, but he will discount them very heavily. He will recognize the growth potential of your business, but balance that with a realistic assessment of the competition. He will want to know very specifically why you have been or will be successful. He will base his offer to you on the potential return he objectively thinks he can earn compared with other investment opportunities he has. In determining his maximum purchase price, he will value your business in ways that are standard for valuing companies in this or similar industries.
 
He will recognize that your growth depends on increasing working capital investment in the business and that he, not you, is the one who is going to have to take that risk. He will admit that there are some synergies in combining the two companies, but will believe (probably correctly) that his organization will be more responsible for achieving them than yours. Accordingly, he will be reluctant to pay you for them. He will understand that the business is dependent on you and perhaps a few key managers, and will be concerned with your motivation once the deal is closed. So if you expect to receive the value you perceive in your business you should expect to do it in an earn out.
 
He will look closely at your historical financial statements. They will frequently be the single most important (though not the only) factor in determining the price he is willing to offer and no amount of explaining, rationalizing, projecting or shucking and jiving will change that.
 
So, to begin, make a realistic estimate of the value of your company. There are many ways to value a company. None of them give a right or wrong answer. But when you are done, and you may need help to do it, you will have a reasonable range of value for your company. You may also want to value it under different scenarios. For example, your company may be worth more as part of a larger organization because your sales will no longer have to support, on a stand alone basis, all the overhead expense you currently have.   Value it, in other words, as the potential buyer would to get insight into his thought process.
 
This knowledge is a powerful negotiating tool. Make sure you have it.
 
Get A Goal
 
What do you want to accomplish by selling (besides get money)? What do you want to sell; assets or equity? How do you want to get paid? Will you take stock? Cash at closing only? Is an earn out acceptable? What will be your role be in the business after the deal closes? For how long? How hard do you want to work following the sale? What is the minimum price you will accept? 
 
There is no way to know if an offer is a good one or a bad one unless you know what you are trying to accomplish by selling the business. You always want the other side to put the first offer on the table, but you never want them to be able to control the negotiating process because you haven’t thought long and hard about what a good offer looks like. You can be successful in your negotiations if you know specifically what you want to accomplish and why.
 
The converse is that you must also know when to walk away. If you are desperate for a deal, you’ll get a bad one.
 
Get Ready
 
From the time the first contact with a serious purchaser begin, it you can generally expect it to take six months or longer to close a deal. But preparations may begin literally years earlier, when the owner concludes, based on the kind of valuation and goal setting described above, that her best long term strategy is a sale of the business.
 
Try and increase awareness of your company among potential buyers. You can do this, for example, by being active in the appropriate professional associations. Get articles about your company published in trade journals. You may be better positioned to negotiate if the buyer comes to you. 
 
Have systems that prepare consistent, accurate financial statements and information that can be easily verified or audited. It’s a critical element in determining a purchase price and an important indication that you are a competent business person the buyer can rely on to operate the acquired business.
 
Clean up your balance sheet. Get rid of old inventory and write off uncollectable receivables. It’s never a good idea to fool yourself about the value of assets, and you won’t fool a potential buyer. But by not making these adjustments you may find your own competence and credibility questioned during the acquisition process. “What other surprises are hidden here?” wonders the potential buyer.
 
Have a current business plan that validates your strategy. Make sure the warehouse is brightly lit and painted. If there’s any tax issues, litigation or disputes with employees out there, settle them.
You can’t put your best foot forward if it’s stuck in the mud.
 
Get Agreement
 
This may seem a little obvious, but it’s a good idea if all the shareholders agree with the decision to sell the business and have a common understanding of what constitutes an acceptable deal before the negotiations begin. Legally, it’s possible to sell a business with the approval of less than 100% of the ownership. But in a private company, with only a few shareholders, it can be difficult. A buyer may be concerned about litigation by a minority shareholder. If a dissenting shareholder is expected to continue to work for the acquired company, an uncomfortable operating situation can result.
 
While you can’t please all of the people all of the time, it’s usually a good idea to try and get acceptance (enthusiasm would be nice) from other key stakeholders. These may include customers, suppliers and key employees. At the very least, make sure they have good information about what is going on as negotiations reach their final stages.   They will all be asking “How is this going to affect my relationship with this company?” and you need to have an honest and accurate answer.
 
Get Help
 
Sale of a company demands an accelerating time commitment from the owner. My experience is that as the deal gains momentum, you can either manage your business or work on the deal. There’s often not enough hours in the day to do both well.
 
Let’s look at a typical scenario. You’re selling the business you built. It’s your baby. You’re proud of it, and are far from objective. To make it more interesting, you’re entering into a process with which you have little or no experience. And this deal is potentially the most important and lucrative transaction you have ever entered into.
 
Let’s say that on the other side of the table is the representative of a larger company. He’s been through this before and knows what to expect. At the end of the day, whether or not there’s a deal, he gets paid the same and goes on to work on the next deal. He’s completely dispassionate and may not have any stake in the outcome.
 
Somewhere in the course of the negotiations he looks at you and says, “I assume you’re willing to warrant that there are no outstanding disputes with any federal, state or local tax authorities except as disclosed in appendix A of the agreement?”
 
Now, a good response, assuming it’s true, is something like “I’m willing to warrant it to the best of my knowledge,” but if you’ve never done this before, you might not know that. Happily, you’ve got an attorney sitting by your side to handle those kind of issues.
 
But if he’s the attorney who drafted your will, helps you collect from delinquent creditors, or kept you out of jail after the IRS audit, he may be waiting for you to speak up. Your attorney must be experienced in representing sellers of business.
 
The same is true of the other professionals who may work with you; your financial advisor, tax accountant, business valuation advisor and possibly others. Get help. Do it right. You may only get one chance.

 

 

Big Air; Initial Public Offerings in the US

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Open on the table next to me I have the preliminary and actual prospectus for, respectively, Morrow and Ride Snowboards initial public offerings. As of December 13th, 1995, my broker assures me, Morrow is not public yet.  Ride’s prospectus is dated May 6, 1994 and those of you who bought their stock at the time of the offering are patting yourselves on the back. Those of you who didn’t, aren’t.

Ride’s prospectus estimates expenses of the offering at $361,500. Morrow’s estimate is $900,000. They pay these expenses for the privilege of filing quarterly and annual statements with the Security and Exchange Commission (SEC), dealing with shareholders, revealing information they’d rather keep confidential, paying for audited financial statements and legal fees and holding annual meetings.
I can tell you from experience that to prepare their company to do all this, they went through a process which, besides being expensive, distracted senior management from running the business, was stressful and involved a high level of uncertainty. Why would they do it?
For the money, dude. But it’s not quite that simple. Basically, there are five financial benefits to going public.
First, the company receives cash from the sale of shares. In the case of Ride, the net proceeds were $4,138,500. Morrow hopes to raise something like $19,000,000. The company has great flexibility in how it uses the money. The Use of Proceeds section of the Ride prospectus says they expect to use $175,000 for office and warehouse equipment and the remainder for “working capital and general corporate purposes.” As non specific as that is, they then go on to reserve the right to use it differently “…if market conditions or unexpected changes in operating conditions or results occur.”
Basically, they can use it for any reasonable business purpose.
Second, it’s typical that the value of a public company is higher than a private company. As recently as April of 1995, Morrow sold convertible debentures with a conversion price of $3.67 per share. Remember they are hoping to go public at “between $11.00 and $13.00 per share.” If the offering price was $12.00, the company’s apparent valuation would have increased over 225% since April. Going public creates wealth.
Third, the company gains liquidity, and this in part explains the higher valuation. Shares in the company can now be bought or sold easily and efficiently.  The price is determined daily by the actions of (hopefully) objective third parties.
Fourth, the owners reduce their risk and can diversify their portfolios. Also, they make a lot of money. Morrow expects to sell 1,600,000 shares to the public but current shareholders will sell an additional 530,000 shares personally. The net proceeds from sale of those shares (around $6 million) will go directly to those individuals.
Finally, the company creates an asset that doesn’t show up on its balance sheet; the ability to sell stock. There are restrictions to how much you can sell, when, and at what price.  Some restrictions are legal one, and some the result of how the financial markets view the sale of new shares. But in general the public company has easier access to capital.
In August of this year, Ride did a secondary stock offering. The company sold an additional 1,165,400 shares and existing shareholders (directors and officers of the company) sold 834,600 shares they held at a price of $17.00 a share, succinctly demonstrating the value to the owners of a public offering and a successful company’s ability to raise cash after it is public.
The process of doing a public offering starts when a company goes into registration, submitting a registration statement and a draft of the prospectus (known as a “red herring”) to the SEC. Depending on how recently the company has done an offering, and how well known the company may be, the SEC may decide to have no review, limited review, or full review. A review will typically take about a month. It results in the company receiving comments from the SEC that require changes and/or additions to the registration statement and prospectus.
If there is no review, or when it is complete, the road show can begin. The road show is a series of meetings and presentations with interested investors and institutions in different cities. These meetings allow the company and its investment bankers to create interest in the offering and to evaluate how it should be priced.
Following the road show, the stock is priced in one or more meetings between the company and its investment bankers. The price depends on a variety of factors including market conditions and the reception during the road show. Once the deal is priced, the prospectus can be printed with complete information and become effective. The prospectus and stock are distributed to interested institutions for sale to investors and the stock begins to trade.
The draft I have of Morrow’s prospectus runs to 66 pages. Ride’s was 48. Both have sections entitled “Additional Information” which makes the reader aware that the prospectus does not contain all the information in the Registration Statement filed with the SEC. It notes that “Statements contained in this Prospectus as to the contents of any contract or other document are not necessarily complete…” and informs the reader that they can get copies of these documents (which, including exhibits, can run to hundreds of additional pages) from the SEC.
The form and content of a prospectus is clearly defined by the SEC. It is a carefully choreographed document that results from a certain level of creative tension between the company executives, the lawyers and the investment bankers. They all share the goal of getting the company public. The executives and investment bankers want the prospectus to be as positive a document as possible to improve the prospects of selling the shares at the best price. The lawyers are more cautious. Their job is to make sure that all the relevant information is disclosed completely and accurately, whether it is negative or positive. Lawsuits by investors claiming inadequate or inaccurate disclosure in the prospectus are not unusual.
My favorite example of how language gets crafted is in the Morrow prospectus when they talk about manufacturing risks. When discussing the company’s ability to get the materials it requires for manufacturing, they say “In addition, the Company has experienced limited delays in the delivery of certain raw materials due to delay in payment for such materials.” Those of us who are less eloquent than attorneys might have said “Their suppliers wouldn’t ship any more until they paid for what they’d already received.”
Obviously Morrow is far from the only snowboard company to have a tight cash flow, and one purpose of the offering is to prevent that from happening again, but you can see how it can pay to read some of the fine print carefully.
The Table of Contents to Ride’s prospectus dated May 6, 1994 is reproduced in the box below. Morrow’s is the same except for a few words and the order of presentation. We’ll talk briefly about some of the sections.
Table of Contents                                  Page
Prospectus Summary                            3
Risk Factors                                         6
Use of Proceeds                                   12
Dividend Policy                                     12
Dilution                                                 13
Capitalization                                        14
Selected Financial Data                         15
Management’s Discussion and Analysis
  of Financial Condition and Results of
  Operations                                          16
Business                                               18
Management                                         22
Executive Compensation                       24
Principal Shareholders                           27
Certain Transactions                              28
Description of Securities                       31
Underwriting                                          33
Shares Eligible for Future Sale               36
Legal Matters                                        36
Experts                                                 36
Additional Information                           37
Index to Financial Statements                F-1
The prospectus begin with a summary and moves on to “Risk Factors.” Morrow and Ride take six pages to talk about what could go wrong; foreign exchange, seasonality, ability to sustain growth, weather, dependence on key individuals, product liability. The list goes on. It gives the potential investor insight into the business risks, but is also important in protecting the company from lawsuits for inadequate disclosure.
“Selected Financial Data” is summarized historical income statement and balance sheet data. I always ignore this and proceed directly to the detailed, audited financial statements. The “Management Discussion” puts into words the financial relationships you’ll note yourself in reviewing the financial statements and explains the conditions that led to those results. The “Business” section talks about the industry, the company’s strategy, and its basis for competing.
Now it starts to get really interesting. “Management” describes the age, position and background of the company’s executives and directors. “Executive Compensation” tells you who is paid how much in salary, bonus and “other.” “Principal Shareholders” lets you know who owns how many shares, and what percent they own before and after the offering.
Now comes my favorite section: “Certain Transactions.”   This is where you can hope to  learn how the company really got financed before its public offering. You learn about stock issued for services, loans from family members of officers, private placements to officers and directors and their families and other interesting transactions. I always smile when I read about them, but it’s partly in admiration for people who figured out how to get the job done.
“Shares Eligible For Future Sale” gives you some idea what the “float” (number of shares actively available to trade) will be. Morrow’s prospectus indicates that after completion of the offering, but assuming no exercise of outstanding options or warrants, there will be 5,061,045 shares of common stock outstanding, but that only 2,130,000 will be eligible for sale to the public without restriction. The others are restricted either for legal reasons or be agreement with the investment bankers doing the public offering. They will become eligible to be sold as described in this section of the prospectus. As and if they appear on the market, the supply of Morrow common stock will increase. All other things being equal, increased supply reduces demand and, therefore, price.
Now you know a little about what it means to go public in the US and what’s to be found in a prospectus. Only the substantial financial rewards to the company and the shareholders can justify the expenses, distractions and continuing obligations the process inflicts.

 

 

Foreign Exchange Management; What’s All This Brouhaha?

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Actually, there’s nothing to it. The differential in rates of inflation between the economies of two countries equals the percentage change in the exchange rate over the same period. This is known as the Purchasing Power Parity theorem.

There. That should be clear. Of course, government intervention in the markets can also affect exchange rates and everybody knows that in the short term currencies with higher interest rates tend to be stronger, but of course the dollar has plummeted recently following a series of short term interest rate increases by the Federal Reserve, and various tariffs and trade barriers affect rates, so I guess that’s not always right.
 
What we really ought to do is read the 78 pages of fine type in Financial Accounting Standards Board pronouncement 52 that deals with accounting for foreign exchange transactions. Then this wouldn’t be so confusing.
 
On the other hand, we could say screw it. Unless we’re buying or selling in a foreign currency or, as a retailer, have a lot of time, effort and money invested in establishing and promoting a brand you’d like to see survive and offer better prices. Or unless you’re making boards (or other products) in the U.S. and exchange rates affect how your competitors price their products. Or unless you’re exporting boards and getting paid in a currency besides dollars.
 
The hypothetical U.S. based company BFD Snowboards is buying boards from that European snowboard manufacturing behemoth EPS. BFD is only buying 5,000 boards and EPS’s capacity is sold out, so they can insist that BFD pay for the boards in their currency. Let’s let our imaginations run wild and assume it’s the German Mark.
 
In spring, BFD opens a letter of credit (LC) through their bank in favor of EPS. Let’s say all 5,000 boards are the same and each costs 200 Deutsche Marks (DM 200). This board is hot. All 5,000 are committed to dealers (must be a signature board). BFD’s letter of credit is for DM 1,000,000 (5,000 times 200).
 
That’s as complicated as we’ll let this example get. In practice, partial shipments up to the total of the LC may be permitted, EPS may be allowed be over or under the DM 1,000,000 by maybe 10%, and some of the boards shipped may be second quality boards that carry a lower price. In addition, assuming BFD is buying ex factory (that is, they are responsible for all the costs after the boards leave the factory door) they will spend six to seven percent of the purchase price in freight (more if it’s air freight) and customs duty to get the boards to the U.S.
 
What these variables mean is that the actual DM amount you have to pay may be higher or lower than 1,100,000 and there may be more than one payment date.
 
The LC is opened in April. An LC, for those of you who have had the good fortune not to have to deal with them, is a promise made by a bank to pay a certain amount of money upon receipt of specific documents indicating shipment of the correct merchandise the right way, by the time required. Note that the bank pays based on the documents. There’s no protection against fraud. If the boxes get to BFD and are full of P-tex scraps, the bank has no liability if the documents they paid against were as required.
 
In April, then, BFD has a potential liability for DM 1,000,000. It doesn’t become an actual liability until EPS ships the product. If the exchange rate at the shipment date is, say, 1.60 DM to the Dollar, BFD will have to come up with $625,000 (DM 1,000,000 divided by 1.60) to pay for the merchandise. That payment date depends on the terms of their agreement with EPS.
 
Assuming it costs them about DM 12 for freight and duty, BFD’s landed cost for each snowboard is DM 212, or $132.50 at the exchange rate in effect when the LC was opened. Now BFD wants to earn a little money itself to pay for lift tickets, so it marks the product up and sell it to retailers for $172.25, giving BFD a gross profit of $39.75, or 30 percent.
 
Ah, but we forgot about that moving exchange rate. BFD had to price their boards before the letter of credit was ever opened so retailers could show up at the shows and know what they were going to pay for it. If, at the time BFD set their prices, the exchange rate was 1.70 DM to the Dollar, BFD is bummed. As the Mark has strengthened from 1.70 to 1.60 (strengthened because you get fewer Marks for each Dollar) BFD’s dollar cost per board has risen from $124.71 (DM 212 divided by 1.70) to $132.50 (DM 212 divided by 1.60). If, on the other and, the Mark was at 1.50 when BFD set its prices, it is mighty happy, because its dollar price per board has declined from $141.33 (DM 212 divided by 1.50) to $132.50 (DM 212 divided by 1.60).
 
The difference between a cost of $141.33 and $132.50 is 6.25%. To put that in perspective, it’s enough to be the difference between a profit and a loss for the year. For BFD, it’s a swing in gross profit of $44,150 on the sale of the 5,000 boards.
 
Exchange rates move every day. A lot, a little, up, down; there’s no way to tell. If BFD just waits until they have to pay EPS marks, it will have to pay whatever number of dollars the market dictates at that moment. That’s one possible strategy. There a couple of others.
 
At any time you can buy the marks you need and put them in a bank account in Germany earning interest. The marks will be available to pay EPS as required, and you will know your exchange rate and, therefore, your cost.
 
Choice two is to buy a forward contract. A forward contract is an agreement entered into with a third party, usually using a financial institution as an intermediary, to buy or sell a given amount of foreign currency at an agreed upon exchange rate on a specified date. Forward markets for major currencies are broad and deep. You can generally buy or sell whatever amount you need for delivery at the date required. The forward rate (that is, the exchange rate at which you buy or sell a currency for future delivery) is determined by market expectations.
 
BFD is buying DM 1,000,000 of boards from EPS. Let’s say EPS ships the boards May 15. The documents from the shipment go to EPS’s bank and then to BFD’s bank to be “negotiated.” The letter of credit calls for terms of “sight 60.” That is, BFD’s bank, and therefore BFD is required to pay DM 1,000,000 60 days after documents receipt. If the documents are received May 23, payment date would be July 23rd.
 
BFD decides the dollar is as strong as it’s going to get before payment is due and that, in any event, it doesn’t like it’s profitability to depend on the whims of an unpredictable market. It instructs its bank to purchase forward DM 1,000,000 for delivery on July 23rd. The bank enters into the contract and BFD now knows exactly what those boards will cost it. It no longer cares how the Mark moves against the Dollar between now and July 23rd. It’s cost in dollars will be the same.
 
On July 23rd, BFD receives the marks, paying dollars for them at the contracted exchange rate, and orders its bank to transfer the marks to EPS’s bank account to satisfy its liability to EPS. Depending on how the dollar and mark have moved against each other in the period between the date the forward contract was purchased and the date it matured, BFD’s financial manager may feel like a hero or an idiot. But a major source of financial risk will have been removed.
 
The third option involves what’s called asset liability management. Let’s assume BFD doesn’t really know anything about the U.S. market, but has convinced some Japanese distributor that it is a cool brand and that Japan really needs another snowboard (obviously, this is a hypothetical situation.). The Japanese distributor agrees to buy 4,000 of the boards, to pay for them in German Marks at a price of DM 250 per board, and that payment is due July 23, the same date BFD must pay EPS.
 
Suddenly, BFD has a perfect balance sheet hedge. They have an asset of DM 1,000,000 they will receive from the Japanese distributor and a liability, due the same day, to EPS. They no longer care how the dollar moves against the mark because they will not have to convert one currency into the other.
 
If you’re exporting and getting paid in a foreign currency, the problem is the mirror image of paying for imports in foreign currency. Most companies I know of solve this problem by insisting on payment in dollars.
 
Now you know a little about how foreign exchange risk arises and how it can be managed. You may also have realized that even if you don’t deal in foreign currencies, your suppliers and/or competitors probably are. That affects the prices you pay and the profit you can make and is worth a few minutes of thought.