How Small Businesses can use FX Forward Contracts

When dealing with international suppliers, small businesses often find themselves at the mercy of fluctuating exchange rates. One powerful tool that can mitigate this risk is the forward contract, also known as an FX forward. This financial instrument allows businesses to lock in today’s exchange rate for a transaction set to occur at a future date, typically up to 12 months ahead, with a small deposit.

What Are Forward Contracts?

A forward contract is an agreement between a business and a financial institution such as Rutland FX for example to exchange a specified amount of currency at a predetermined rate on a set future date. This means that businesses can plan their finances with more certainty, knowing exactly what exchange rate they will be working with, regardless of market fluctuations.

Why Should Small Businesses Consider Forward Contracts?

Many small businesses mistakenly believe that forward contracts are tools exclusively for large multinational corporations. However, these instruments can be highly beneficial even for smaller enterprises, particularly when dealing with international payments and supplier agreements.

Example Scenario: Paying Suppliers in China

Consider a small business that sources products from suppliers in China on 90-day payment terms. The business pays a 30% deposit upfront to commence the manufacturing process, with the remaining 70% due upon shipment of the goods. Once the initial 30% is paid, the cost of the remaining 70% becomes subject to exchange rate fluctuations.

In a 90-day period, exchange rates can vary significantly, potentially increasing the cost of the final payment. By using a forward contract, the business can lock in the current exchange rate for the 70% payment due in three months, thereby avoiding the risk of unfavorable rate changes.

Benefits of Using Forward Contracts1. Predictable Cash Flow

Forward contracts provide businesses with the ability to predict their cash flow more accurately. By locking in exchange rates, small businesses can avoid unexpected costs and ensure that their budgets remain intact.

2. Protection Against Exchange Rate Volatility

Exchange rates can be highly volatile, influenced by various economic and political factors. A forward contract shields businesses from adverse movements in currency values, providing stability in financial planning.

3. Improved Supplier Relationships

When suppliers are paid promptly and predictably, it strengthens the business relationship. Using forward contracts ensures that payments are made on time without being affected by unfavorable exchange rate shifts.

4. Better Financial Planning

With known costs, small businesses can plan their financial strategies more effectively. This helps in setting prices, forecasting profits, and managing expenses without the added uncertainty of currency fluctuations.

How to Implement Forward Contracts

To use forward contracts, a small business needs to work with a financial institution that offers FX services. The process typically involves:

1. Determining the Amount and Date: Identifying the exact amount of currency needed and the future date of the transaction.
2. Agreeing on the Rate: Locking in the current exchange rate for the future transaction.
3. Making a Deposit: Paying a small deposit to secure the contract.
4. Finalizing the Transaction: Completing the currency exchange on the agreed date at the predetermined rate.

Reconciling Forward Contracts in Accounting Software

When it comes to accounting for forward contracts, platforms like Xero make the process straightforward. The accounting treatment for forward contracts is typically handled at the point of settlement, which is when the actual currency exchange takes place.

Steps to Reconcile Forward Contracts in Xero:

1. Record the Forward Contract: Initially, the forward contract can be noted in your records, but no actual accounting entry is made until the settlement date.
2. Monitor Exchange Rates: Keep track of the agreed-upon exchange rate and the settlement date.
3. Settle the Contract: On the maturity date, perform the currency exchange as per the forward contract.
4. Record the Transaction: In Xero, enter the actual transaction amount. There will be a debit entry for the expense or asset acquired and a credit entry for the cash or bank account used for the payment. Ensure that the transaction reflects the agreed-upon rate from the forward contract.

By following these steps, businesses can ensure that their forward contracts are accurately represented in their financial records, reflecting the true cost and eliminating the uncertainty of fluctuating exchange rates.

Conclusion

Small businesses that deal with international suppliers or customers should consider utilizing forward contracts to stabilize their financial operations. By locking in exchange rates, they can protect themselves against market volatility, ensure predictable cash flow, and maintain strong relationships with their suppliers. Forward contracts are not just for the mega-corporations; they are accessible and beneficial for businesses of all sizes, providing a valuable tool for managing currency risk in an unpredictable global market.