Brexit strategy: Managing financial risk through uncertainty

16 Nov 2017

From left: John Power and Barry Doyle of Strategic Growth Leaders. Image: Enterprise Ireland

John Power and Barry Doyle of Strategic Growth Leaders examine some of the key considerations for the finance function of SMEs to consider in relation to Brexit.

The finance function must take an integral role in overall strategic and operational planning for SMEs.

Finance, very often, has been seen as a cost to the organisation as it focuses on historical reporting and compliance, rather than a crucial, strategic, future-focused, commercially minded element of the business. As a result, some Irish SMEs are now experiencing latent issues in areas of their finance function, such as managing multi-currency budgets, cash flows and projections; cash, currency and treasury management; optimising their own capital structure; and ensuring that appropriate types of funding are utilised.

Being Brexit-ready

Brexit uncertainty and related challenges have served to highlight many latent finance considerations for businesses. Many companies have now begun to evaluate whether or not they have the sufficient resources and capabilities in place to meet these new challenges.

Recognising the need for planning to mitigate some of the risks ahead, Enterprise Ireland has created the Brexit SME Scorecard, an interactive online questionnaire that can be used by all Irish businesses to assess their exposure to the departure of our main trading partner, the UK, from the EU.

The Brexit SME Scorecard helps companies assess their business readiness under six pillars: strategy, operations, innovation, sales and marketing, finance, and people and management. Of these six pillars, finance is the one that focuses on understanding how and where margin is delivered for the business, and provides the key quantitative inputs into the strategic direction of a company.

Continuing currency volatility

One immediate concern relating to Brexit has been currency volatility. However, we must be mindful that currency fluctuations are not something new. The narrow trading band of euro/sterling in the past has been manageable. A realisation is now emerging that companies need to actively manage their exposure.

The volatility in exchange rates is such that businesses have experienced significant margin erosion without having protective mechanisms in place. Furthermore, volatility is expected to continue. To manage these uncertainties, it is crucial that companies therefore first assess and understand the impact of their exposure.

Assessing and quantifying such exposures should be a prerequisite for every company. Clearly understanding critical factors – such as the cost base, market/product breakdown and margin, pricing strategy, cash-to-cash cycles, currency exposures, and currency break-even FX rates – will become increasingly essential.

If a business can accurately quantify the financial risk of trading in foreign markets – whether those risks relate to costs, currency, working capital etc – they can then stay competitive by mitigating against them, for an extent and duration that makes sense to their business.

Practical steps

Strategic Growth Leaders (SGL) has been working with a large number of Enterprise Ireland clients concerned about the implications of Brexit. Through our work with these clients, it is evident that those who have finance capability, resources and a clear financial model that quantifies exposure, combined with a documented policy that explicitly states how these are to be managed, are both less panicked and well prepared for the challenges ahead.

Brexit is here, is real, and has created an impetus for companies to better structure and integrate their finance function as a strategic member of the management team, and not just as a back-office operational unit.

There are a number of practical considerations that companies exposed to the UK market’s exit from the European Union should review and implement.

1. Draft and implement a currency and cash management policy (also known as a treasury policy)

Every company, from micro-companies to large corporates, should design and draft a treasury policy. Essentially, that means documenting how you manage your finance.

It doesn’t need to be a complicated document, but should detail how all monies and transactions are managed by the company, including how currency risk is managed. It should also describe the relationships required between the finance function and other internal departments in the company, as well as with external providers such as banks. It is ideally approved by the board of directors and clearly identifies the person (or persons) responsible for managing and applying the component elements.

2. Multi-currency cash flow forecast

Determining your company’s foreign currency exchange risk can only be done by determining net receipts and payments for each currency in which you do business. Recognising that ‘cash is king’ for every business, cash flow forecasting is critical to ensuring that there is active management of funds flow.

This is particularly relevant for identifying net currency exposures. Forecasting monthly surplus or required foreign currency is the starting point for mitigating the impact of foreign currency movements on business margin.

Identifying receipts and payments that can be converted to domestic currency, through negotiation with customers and suppliers to create a natural hedge position, is a crucial first step. Depending on the outcome of this exercise, it may be advisable to enter into FX contracts with a financial institution to buy or sell exposed amounts.

Ultimately, it is important to bring certainty to the value or cost of your foreign currency exposure and avoid ‘playing’ the exchange rate market.

3. Break-even analysis

Break-even (B/E) is a measure of the level of sales required to cover fixed costs. In its basic form, B/E is defined as the point at which your income equals your costs (ie your profit is zero).

As foreign exchange movements can directly impact on each of the component elements of the sales receipts, cost of sales (materials, tariffs etc) and overheads denominated in foreign currencies, modelling future B/E sales levels at different exchange rates will provide key management information for deciding if and when price increases may be required to protect business margin and ensure business profitability.

B/E analysis of different business units or sales territories provides management with a simple but effective comparison measure.

4. Understanding cash cycle

Determining the working capital for each territory or market your business is operating in is critical to ensuring effective cash management. Tracking timelines for payments of overheads (including labour and indirect costs), supply of materials and conversion of sales to cash is critical to understanding the additional permanent working capital needed as a business grows.

Brexit may add significant requirements for investment in stockholding, new costs such as tariffs, reintroduction of VAT at point of entry, delayed payment terms with UK customers due to banking arrangements, and accelerated payment terms to suppliers.

Understanding current cash cycles and modelling potential or likely future cycles will identify funding needed to maintain or grow your business in the UK. Businesses can fund any additional investment required from a lengthening of cash cycle through a combination of methods:

  • renegotiate terms at both ends of the cash cycle – with suppliers and customers
  • review of in-house procedures for managing debtor collections and supplier payments
  • use of alternative financing methods, such as supplier finance or invoice discounting
  • scaling businesses should consider it as part of fundraising
  • loan finance from traditional lenders and new entrants

There are more and more options available for businesses to reduce cash cycle timelines or cover additional requirements through a funding mechanism.

Stay on track

Brexit is by nature uncertain, with implications only being clear in stages, yet companies can still create a solid financial plan to mitigate against known, and as yet unknown, risks.

While Brexit is real and already creating difficulties for businesses buying or selling in the UK, it is not a strategic problem. Continue to drive your strategic plan and determine if modifications are needed to stay on track. Consider accelerating a diversification plan; implement a strategic procurement approach to protecting critical supply and protecting margin; prioritise resources to a digital channel.

Once you’ve established the strategic plan, set and monitor critical success factors and key performance indicators to ensure you stay on a strategic path.

By John Power and Barry Doyle

John Power and Barry Doyle are directors of Strategic Growth Leaders, a finance consultancy that provides strategic CFO and corporate finance services to SMEs on a flexible basis that meets their requirements.