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What is constant currency and why is it important this earnings season?

Constant currency refers to a fixed exchange rate that eliminates fluctuations when calculating financial performance figures

July 13, 2018 / 07:37 AM IST

When the world moved away from constant currency rates pegged to gold and silver, it was meant to be a temporary measure. The global floating currency system was adopted on August 15, 1971, whereby currencies were allowed to fluctuate on the basis of foreign exchange market mechanisms.

Constancy, though, has its benefits. Globalization spurred free trade. Trade spawned businesses with footprints extending beyond international borders. With globalization adding another dimension to modern capitalism, floating currency rates acquire greater importance to the fortunes of multinational corporations.

Companies with overseas operations have taken to declaring earnings in both constant currency terms and also on actual realized currency rates. Here’s a look at what this implies.

What is ‘constant currency’?

Constant currency refers to a fixed exchange rate that eliminates fluctuations when calculating financial performance figures. Companies with significant operations in other countries often represent their earnings in constant currency terms since floating exchange rates can often mask true performance. In the Indian context, export-oriented companies, especially those in the service sector, can see their performance distorted by a swing in the rupee’s valuation.

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Since the performance of a company is accurately depicted by its revenue and profit metrics, accounting for the same by fixing the exchange rate at the prevailing value or that of the previous year, is often done to give a clearer picture to investors.

For example, if a Japanese company that sells automobiles in India recorded a 10 percent increase in sales in rupee terms, but the value of the rupee fell five percent in the intervening year, then only a five percent increase in sales will be reported back to the company’s investors back in Japan. In accounting terms, this represents a travesty since sales in India actually grew by 10 percent. By representing their numbers in constant currency terms, companies can depict performance unaffected by currency fluctuations.

How does it work?

Consider the case of an Indian oil exploration company that has a refinery in Russia. Since the company is based in India, it reports its results in rupees, despite earning revenue and profit in roubles.

 
20162017
Revenue in roubles5,00,0006,00,000
Profit in roubles50,00060,000
Rupee/Rouble exchange rate0.91.2
Revenue in rupees5,55,5555,00,000
Profit in rupees55,55550,000

 

If the company’s revenue for 2016 amounted to 5,00,000 roubles, and its profit was 50,000 roubles, it implies that the company made a profit of 10 percent. Assume that the rupee/rouble exchange rate was 0.9 for the year ended 2016. Therefore, revenue and profit, as reported to Indian investors was Rs 5,55,555 and Rs 55,555 respectively.

In 2017, the company’s revenue was 6,00,000 roubles, and its profit, 60,000 roubles. In rouble terms, revenue and profit grew by 20 percent. However, with the exchange rate going up to 1.2, revenue and profit amounted to Rs 5,00,000 and Rs 50,000 respectively.

For Indian investors, a strengthening of the rupee has caused an erosion in their profits, even though the company recorded robust in 2017. Revenue and profit fell by 10 percent each in Indian rupees.

To eliminate such discrepancies, companies also record their earnings in constant currency terms. This can be done either by fixing the exchange rate at either that witnessed in 2016 or 2017.

 
20162017
Revenue in roubles5,00,0006,00,000
Profit in roubles50,00060,000
Rupee/Rouble exchange rate0.90.9
Revenue in rupees5,55,5556,66,666
Profit in rupees55,55566,666

 

For the sake of comparison, if the rupee-rouble exchange rate is fixed at the 2016 level of 0.9, the revenue and profits for 2017 will be Rs 6,66,666 and Rs 66,666 respectively. This implies that revenue and profits grew at 20 percent, thereby eliminating the adverse effect of currency fluctuation on the company’s performance.

Why is it important?

Constant currency can help shed light on the actual performance of a company, devoid of the unpredictability of foreign exchange mechanisms.

Many Indian service sector companies such as Tata Consultancy Services, Infosys, HCL, and Wipro have clients who are predominantly based in foreign countries. With services rendered overseas, their clients will be billed in the local currency, and the weakening of the rupee vis-à-vis the dollar, pound, or the euro will help these companies pull up their growth numbers. Examining their account books in constant currency terms will give a more realistic picture of how the company fared.

Often companies that have recorded healthy numbers can see their gains slashed by unfavourable exchange rates. On the other hand, weakening of the domestic currency can help exporters record inflated numbers. This is where constant currency comes in handy when evaluating the performance of companies.
Rohan Abraham

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