What are Constant Currencies?
Constant currencies are exchange rates used to eliminate the effect of fluctuations when calculating financial performance numbers for publication in financial statements. Companies with overseas operations often supplement mandatory, reported figures with optional, constant currency numbers. Basically, it enables them to show investors how they performed, independently of foreign currency movements.
How Constant Currencies Work
Companies that sell products overseas will often see their reported revenue and profit become distorted by factors they have little control over. For example, when the greenback strengthens against other currencies it subsequently weighs on international financial figures once they are converted back into U.S. dollars.
Business executives believe these currency fluctuations mask the true financial performance of a company and, as a result, often choose to also disclose figures that assume that exchange rates during the period did not move.
Generally accepted accounting principles (GAAP) require companies to report figures without making any adjustments. However, firms may supplement this information with non-GAAP measures, such as constant currencies, when they feel it is necessary.
Constant currencies can be calculated in numerous ways. One approach is to convert current numbers using the prior period’s average exchange rate. Another is to adjust previous numbers to reflect the current year’s exchange rate.
In both cases, the set of figures that investors look at to see how trading has improved relative to the comparative period will no longer be distorted by foreign currency swings. And a strong U.S. dollar will suddenly not appear so bad for firms whose functional currency is the greenback.
- Companies that sell products overseas will often see their reported financials become distorted by currency fluctuations.
- They regularly respond by disclosing figures that assume that exchange rates during the period did not move.
- Constant currencies can be calculated by converting current numbers using the prior period’s average exchange rate, or by adjusting previous numbers to reflect the current year’s exchange rate.
Example of Constant Currencies
Here is a simple example showing the effects of using constant currencies, versus not using them.
Company X is based in Australia and does business in the United States, earning revenue in U.S. dollars. In year one, the company earns $500,000 and has a net profit of 10%. At the end of year one, the AUD/USD exchange rate is 0.8. In the second year, the company earns $600,000 and has a net profit of 10%. The AUD/USD exchange rate is 1.1 at the end of the second year. Based on this, the financial results, translated to AUD, would be:
|Year One||Year Two|
|USD Net Profit||$50,000||$60,000|
|AUD/USD Exchange Rate||0.8||1.1|
|AUD Net Profit||$62,500||$54,545|
These results do not use constant currency. They show that USD revenue and net profit both increased by 20% year over year and that the exchange rate increased by 37.5%. Due to the exchange rate fluctuation, the AUD revenue and net profit numbers actually decreased by 12.7% each.
Management could argue that this is not a fair number to report because the declines were solely due to currency exchange rates. To eliminate this problem, the company can use constant currency methodology. Here’s how that could look:
|Year One||Year Two|
|USD Net Profit||$50,000||$60,000|
|AUD/USD Exchange Rate||1.1||1.1|
|AUD Net Profit||$45,455||$54,545|
Eliminating the currency fluctuation’s effects, AUD revenue and net profit numbers now show growth of 20%.
Real World Example of Constant Currencies
Let’s now take a look at a real-life example. A strong U.S. dollar weighed on McDonald’s Corp. (MCD) foreign gains once they were converted back into the fast-food giant’s local currency in the first quarter ending March 31, 2019
As you can see in the image above, revenues, operating income and net income (NI) all declined in the first quarter of 2019. However, if exchange rates had not changed, the result looks much more promising, indicating that progress had in fact been made over the past 12 months. McDonald’s translates current year results using the prior year’s average exchange rate.
Disadvantages of Constant Currencies
Like other adjusted figures, constant currency measures can be better or worse than reported GAAP numbers. However, that does not mean that investors should not completely disregard the potential to use these non-compulsory measures to paint the company in a better light.
Management teams, including McDonald’s executives, maintain that constant currencies give a clearer idea of underlying performance. Unfortunately, that is not always the case.
The general consensus is that currency impacts generally even out over time. However, there are some exceptions. For example, in some countries, especially emerging markets, inflation is high and currencies depreciate consistently.
Likewise, if the U.S. dollar continues to appreciate for some time yet, perhaps investors should just accept the reality of lower profits. Chances are that companies will be converting their offshore earnings back into local dollars to fund dividend payments and so forth, and not necessarily at the exchange rates that they choose to report with.
View more information: https://www.investopedia.com/terms/c/constantcurrencies.asp