Foreign Exchange Gains and Losses: More Than a Working Capital Signal
Foreign Exchange Gains and Losses: More Than a Working Capital Signal
Admittedly, foreign exchange salespeople aren’t the most compelling people to speak with. Maybe that’s why I often hear financial executives handwave the impact of foreign exchange gains and losses as simply ‘earnings noise.’
That said, dismissing FX gains and losses on earnings misses a key point. The earnings impact of FX gains and losses, both realized and unrealized, are downstream of very real economic changes in working capital, and working capital is the most fungible asset a business has.
When Finance Teams Should Care About FX Gain or Loss
The simplest decision lens is this: finance teams can ignore FX gain or loss when exposures are small, short-term, or naturally hedged through operations. They should start to care when foreign currency balances are material and sit inside working capital accounts like receivables, cash, or payables, because that is where FX becomes a liquidity, solvency, and capital issue, not just an accounting one.
Back To Accrual Accounting and Foreign Currency Remeasurement
To understand why reported foreign exchange gains and losses are more than ‘earnings noise,’ we need to dig into how these gains and losses are generated.
Ultimately, FX gain/loss accounting reflects valuation changes of working capital items denominated in a currency different from the functional or reporting currency.
In the example above, we have a small US-based manufacturer that sells in euros. Upon revenue recognition, a working capital item is created: cash, accounts receivable. In this instance, it is accounts receivable.
The Accounts Receivable balance is recorded in USD, the reporting or functional currency of the entity, at the EURUSD spot rate on recognition. This balance is then re-measured for every reporting period to account for changes in spot FX rates. This balance sheet remeasurement is what generates the FX gains or losses that are recorded on the income statement. The key point is this remeasurement reflects a real valuation change in a highly fungible asset.
It’s more than just accounting.
Why FX Gain / Loss is a Working Capital Signal, Not Earnings Noise
This process is often automatic.
A business’s Chart of Accounts indicates which accounts are eligible for remeasurement, and ERP/accounting systems automatically revalue balance sheet items to reflect fresh FX rates as one reporting period moves into the next.
Cool. We have the accounting down, but that’s not what matters.
Corporate finance types know that working capital is the lifeblood of a company. It is the first thing any credit analyst or lender is going to look at. Oftentimes working capital is margined or securitized as part of lending; variations from FX on working capital items directly impact the value of this security.
More importantly, if businesses don’t manage working capital effectively, it not only can impact the cost and availability of capital but it may also impact the business’s ability to pay their bills as they come due.
This is where FX gain loss stops being earnings noise and becomes a working capital signal.
FX risk can easily turn into credit risk, for businesses as well as for brokers.
FX Gains and Losses, Runway, Credit Risk, and Capital Access
There is a stereotypical view that balance sheet hedging programs are largely the domain of mature businesses. This is predicated on the idea that balance sheet FX hedging is primarily a tool for minimizing earnings volatility. With many public companies obsessed with hitting earnings guidance, you can see why that assumption would be made.
In fact, this is something I often encounter. Within the tech space in Canada and Europe, it is common for fast-growing venture or scale-up stage businesses to receive the majority of their financing in USD, even if they report in a different currency, or if the majority of their operating expenses are in a different currency.
In these cases, the large cash balances that sit on their balance sheet are generating more than FX gain / loss noise. Each loss from FX reflects a real loss in purchasing power, a shortened runway, and potentially reduced access to additional capital on favourable terms.
In other words: FX gain/loss accounting is not just about financial reporting. It reflects valuation changes due to FX movements that directly impact working capital, which then impact liquidity, access to capital as well as earnings.
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