What is the difference between cash flow and balance sheet risk?

Cash flow risk is generally driven by forecasted revenue and expenses for both the parent and the subsidiary that are external to the organization and occur in currencies other than the parent’s functional currency. Occasionally, this is referred to as margin risk because, unhedged, this risk will manifest itself in the revenue and expense line items for the organization depending on the functional currency strengthening or weakening in comparison to other currencies. The risk though is often “invisible” in the financial statements, because unless the company does additional analysis, any deviations from forecasts will be difficult to attribute to FX versus forecast misses.

Balance sheet risk is driven by non-functional monetary assets and liabilities on any entity’s balance sheet in a currency other than its functional currency. Most often these are line items like A/R, A/P, Cash, and loans. Balance sheet risk often gets more attention because it is specifically called out on the Income Statement and therefore is under additional scrutiny from stakeholders.

Companies can use a variety of strategies to mitigate FX risk across the organization. First, most companies will attempt to create natural hedges by matching currencies for revenues/expenses (or assets/liabilities). At most multi-national companies, it will not be possible to remove all risk purely by matching long and short positions. Another strategy will be to net exposures across different entities to determine the net exposure across the entire organization for that exposure. Finally, once all natural measures have been taken, companies will turn to derivatives to offset risks that cannot be handled any other way. In addition to what strategies to employ for managing FX risk, there are also specific considerations when thinking about addressing cash flow versus balance sheet risk.

There is no clear answer on which risk is more important to hedge. The company’s structure, business model, and strategy will dictate whether they have more risk to cash flow or balance sheet volatility (or an even amount). Companies should perform rigorous analysis to quantify the amount of their exposure in both areas to ensure the hedging strategy will meet their needs. Most companies lack the tools to do this type of analysis in-house. Although banks will often assist in this type of work, in Chatham's experience, their lack of independence often leads them to suggest hedging strategies that are not as cost-efficient as a third-party advisor would recommend.

Chatham Financial corporate treasury advisory

Chatham Financial partners with corporate treasury teams to develop and execute financial risk management strategies that align with organizational objectives. Our full range of services includes risk management strategy development, risk quantification, exposure management (interest rate, currency, and commodity), outsourced execution, technology solutions, and hedge accounting. We work with treasury teams to develop, evaluate, and enhance their risk management programs and to articulate the costs and benefits of strategic decisions.