ENTERPRISES
FACED WITH INFLATION AND DEVALUATION
Economist
Inflation
as well as devaluation bring about a number of implication
to the economic system and consequently to people and
enterprises. Later on, some specific aspects directly
influenced by the mentioned factors will be explained.
It is essential that enterprises be ware of the ways
in which devaluation and inflation affect them in a
positive or negative way.
Effects of inflation
As mentioned before inflation affects economy in different
ways: it reduces the purchasing power of money, it may
favor creditors if debtors have anticipated a lower
inflation, it causes some administrative costs, it distorts
decision making process as well as the role that the
markets plays as a guide for producers, it affects productive
investments as well as the balance of payments. All
this not only influences economy as a whole but also
the enterprise activity. There is an analysis of some
aspects influence by inflation, below.
1. Evaluation of Projects
Inflation influences the capital flows of a project
and also the discount-.rate required by the enterprise,
in this way inflation distorts decisions when developing
the capital budget. The main reason is that depreciation
charges are based on the original cost of the asset
and not in the replacement cost. Due to inflation profits
could increase because some of the costs remain stable
or fixed therefore a greater percentage is subject to
taxation. Thus, the flows in real terms decrease.
Inflation can affect cash flows to moderate or great
extent, depending on the nature of the flows. Thus,
inflation could affect to greater extent the selling
prices or the costs. Businessmen usually fight against
inflation by lowering prices and keep them competitive
but they cannot do anything about generalized inflation
in economy therefore their cash flows could decrease
in real terms due to the reduction of the purchasing
power of money. In this way, inflation encourages investments
that can be recovered quickly and those investments
that require less capital investment.
Therefore, to consider the effect of inflation since
the cash flows are calculated in nominal terms and not
in real terms, it is necessary to take into account
some factor of deflation when calculating the net present
value (NPV) of the project. In this sense Van Horne
(1988) states that the fundamental factor is: if the
criteria for acceptance or in other words, the required
rate of return, includes a premium for the inflation
anticipated then the estimated cash flows have to reflect
the inflation.
It
is necessary hen to adjust revenues as well as costs
and expenses according to an inflation rate for each
of them and their variation estimated. This, the cash
flow Ri will be the result of::
Where:
Ii
Revenues corresponding to the time period i
Ci
Costs and expenses corresponding to the time period
i
By
adjusting the revenues according to a rate of growth
related to inflation f and the costs and expenses according
to a rate of growth which is the result of the inflation
g, then, cash flow will be represented by:
Then
it will be necessary to adjust the discount rate t include
the effect of inflation. Thus, every factor of discount:
Where K is the required rate of return, it will be represented:
Where
pi
Expected Inflation Rate.
Therefore,
the real NPV of the investment could be represented:
The
enterprise also could previously calculate the discount
rate adjusted for inflation, k, as:
As
well as the Internal rate of return (IRR), can be adjusted
to get the real IIR of the project:
Inflation
decreases the real IRR of the project, even when at
the beginning it seems that revenues increase more than
costs, as it was explained before this happens because
some costs are not affected by inflation for example,
depreciation that present a constant fiscal hedge, which
means that even when the volume of pretax profit increases,
the sum of taxes increases as well and even in a greater
way. In other words, taxes increases in a greater proportion
than flows and finally this decreases Real rate of return
of the investment project.
Something similar happens with the work capital, the
greater the inflation the greater the required investment
in work capital, therefore a lower real rate of return
of the investment.
2. Productivity
Inflation not only affects the productive activities
but also the productivity of an enterprise. Thus, inflation
tends to promote short term and speculative less productive
activities and it discourages productive activities.
In addition the enterprise suffers diverse effects according
to the combination of different production factors that
it applies. In this way the relative variations of the
wage costs and the costs of capital goods could bring
about variations in the original resource allocation
because, due to the new conditions, it may not be the
optimal. As the specific prices of the different factors
increase in diverse ways, some of the equipments could
become obsolete. Equipment considered as the ideal one
for certain wage level may not be for a superior wage
level. Demand variations can also bring about obsolescence
of some machinery equipment because a number of machines
could be the best for certain level of production but
they may no longer be the best due to the costs increase
for a different level of production.
When the prices of equipment and machinery increase
it is more difficult to enhance the maximum production
capacity of the enterprise. In addition, planning becomes
more difficult and the depreciation charges required
to be adjusted to the real replacement cost of the asset.
Otherwise the production capacity will decrease due
to the impossibility of replacing the fixed-asset depreciated
at the end of their useful life.
As it is evident, inflation discourages investment because
the real benefits decrease as well as the possibilities
to increase the productivity of the enterprise.
3. The Enterprise's Accounting
Money as a unit of account brings about many advantages,
because it is useful to summarize, control, record and
compare economic transactions. All these benefits are
affected and therefore reduced when the value of money
is not stable in other words when inflation weaken the
purchasing power of money. As a result, thought time
it would not be a homogenous unit of measurement because
in this sense, there is a different unit for each time
period. In addition, this distorts the role of accounting
as a way to obtain enough and opportune information
to appropriate decision making.
In this way it is necessary that financial statements
consider these variations in the purchasing power of
the currency because otherwise they will not reflect
the real condition of the enterprise. It is essential
that accounting data be truthful because if this information
is false then the decision making process will be affected
in a negative way consequently all the goals and objectives
set by the board of directors will be changed.
In this way a lot of situations in which the accounting
data is slanted by inflation can be mentioned. For example,
when setting the selling price of the products depending
on their historical cost, re-stocking is at risk when
facing a rise in their prices. On the other hand, inflation
distorts financial statements thus traditional accounting
is no longer significant when it does not consider the
erosion of both the net worth and the economic results.
The costs of sales recorded are lower than the real
ones when valuing the purchases and the inventories
at their historical cost. The problem is bigger in enterprises
with low inventory turnover. The fact of showing misleading
results in the accounting data can lead to wrong decisions.
On the other hand, traditional accounting does not record
the losses generated by keeping monetary assets, since
they have lost their purchasing power. In addition,
dividend distribution according to conventional accounting,
does not assure that the recourses invested by stockholders
keep their purchasing power up.
For all these reasons, when experiencing inflation it
is essential to adjust conventional accounting, in a
way that it be expressed in homogenous terms and therefore
comparable throughout time. In other words, the effect
of the generalized rise in prices should be eliminated.
In this way some alternative methods have been implemented
to conventional or historical accounting. Adolfo Blanco
(1983) mentioned three criteria to quantify the effects
of inflation:
-
General Price Level Accounting: the quantities that
the financial statements show are converted into a
common monetary unit, the one that corresponds to
the end of the fiscal-year. The accounting adjusted
to the general level of prices tries to keep the purchasing
power of the stockholder’s investment up.
-
Replacement cost accounting: it seeks to maintain
the working capacity of the enterprise for example
in income statement, the cost of sold merchandise
is recorded at the replacement cost of the merchandise
at the time it was sold.
-
Adjusted Replacement cost accounting: It measures
the results of a stable or constant monetary unit,
which allows monitoring the real growth and progress
of the enterprise.
When
facing inflation it is more recommendable to use the Last
in first out (LIFO) inventory pricing method than the
First-in, first-out (FIFO). That is because with LIFO
the income-tax is lower when prices rise. Charles Horngren
(19910) says that FIFO is criticized because when facing
inflation it exaggerates earnings due to the so called
inventory profit.
4. Financial situation and analyses
The financial situation of the enterprise is affected
by the constant rise in prices, thus an enterprise could
be affected to greater or moderate extent according to
its solvency, if it owns few resources its continuity
will be interfered. In other sense, it could maintain
the prices of its products as a decision of the enterprise
or as government control which favours a margin reduction,
decreasing as well the possibilities to grow and even
the enterprise could lack liquidity because of lack of
resources. In addition the methods of the country authorities
to fight against inflation such as price control, credit
restrictions, and increments in the interest rate bring
about greater difficulties in the enterprise management.
When facing inflation the enterprise requires greater
financing due to several reasons. First, when the cost
of raw material increases then the value of inventories
increases as well, this implies that greater financing
is required. On the other hand, in spite of the normal
requirement of financing from the enterprise to grow,
when facing inflation more financial resources are required
to simply maintain the actual dimension because the mere
conservation of capital will require increments in nominal
terms because in real terms it becomes deteriorated.
As a result of the expansion of the circulating medium
and the erosion of capital, more financing is required
in addition to other situations that the enterprise faces
such as liquidity reduction, restrictive credit policies,
increases in interest rates, etc, which complicate the
financial position of producers.
All
this leads enterprises to indebtedness when facing inflation,
especially if the loans extended to the enterprise are
established in monetary terms, because the enterprise
will pay back in the depreciated currency obtaining a
monetary profit due to the indebtedness.
It is also convenient to the enterprise to reduce the
collection periods because the lower the receivables the
lower the monetary loss. It is paradoxically convenient
to extend the collection periods to suppliers because
it could bring about some monetary profit like by the
effect of the financial leverage.
In addition, it is necessary to consider that some assets
bring about more inflation losses because they increase
as monetary assets, inventories and assets whose length
of service is longer increases. In this way, to reduce
the assets to the minimum and to get into debt to the
maximum (of course setting limits) has become an anti
inflationary strategy. In other words, this will favour
a greater real profitability. However, it is essential
to be aware that this greater profitability is reduced
by a greater financial risk because of the reduction of
liquidity and the increasing indebtedness and a greater
flexibility of the e enterprise to face difficult situations.
It is necessary an efficient financial control system
that protects enterprises from high instability of prices
and production costs in a way that the enterprise can
charge these costs to their selling prices or that they
can apply any other strategy against inflation for example
making use of raw-material whose price is less sensitive
to inflation.
The financial ratio analysis is also affected by inflation.
There an explanation about how this analysis based on
historical accounting is affected:
-
Efficiency: efficiency can be measured in several
ways, for example the ratios sales/assets, profits/sales,
that measure the efficiency en the use of assets to
generate sells in the case of the first ratio, and
the other shows the profits which is a measure of
the enterprise’s efficiency . In this way because
of inflation, it seems that enterprise’s efficiency
has increased that is the case of the first ratio
mentioned due to the increase of the selling prices
(which is the historical cost) but not the assets.
It can be perceived that there is a comparison between
quantities expressed in different currencies of different
purchasing power.
-
Profitability: in general the profitability of an
enterprise is measured by two ratios such as profits/assets
and profits/net worth, etc. Inflation brings about
a slant because when facing inflation the value of
sales increases (in nominal terms). Costs also increases
but there are fixed costs (that at least are not affected
in the short term) and in the other hand, sales are
recorded in more recent currency than costs and expenses
therefore the profit-margin increases and revenues
will be overestimated for awhile. In this way the
profitability of the investment calculated based on
the historical data will be greater than the real
one. The magnitude of the slant will depend on how
high inflation rate, the length of service of the
assets and the enterprise’s cost-structure are.
-
Solvency: it refers to the capacity that an enterprise
has to face responsibilities. It is measured as the
number of times that its pretax earnings cover its
liabilities. When facing inflation profits increase
faster and many liabilities remain stable (in nominal
terms) because many of the obligations are not adjusted-according-to-inflation,
so solvency seems to improve. Actually, there is no
improvement, to keep the volume of production in the
long term, the financing must increase.
-
Liquidity: the ratios of liquidity seek to determine
the payment capacity of short term liabilities of
the enterprise. Normally a current ratio is applied
(current asset/current liability) and the acid test
or quick ratio (current asset minus inventories divided
by current liabilities). In this sense both rations
tend to vary inversely to the inflation rate, mainly
the acid test which is affected due to the way inventories
are recorded. If the enterprise applies a Last in
first out (LIFO) inventory pricing method, then the
ending inventory is valued in currency before that
account period thus when the prices rise, the stock
is undervalued and the ratio become more “conservative”.
If the first-in, first-out (FIFO) system is applied
the inventory is valued in more recent terms and then
the compression will be better. It is essential to
mention that when facing inflation try to extend their
accounts payable which results in more bad accounts
and the convertibility of accounts receivable and
consequently there is less liquidity.
5.
Taxes
As mentioned before, when facing inflation profits taxes
increase in a disproportioned way which results in gradual
decapitalisation of the enterprise and a reduction of
its production capacity as well as problems regarding
liquidity. All this happens because the real tax rate
is higher than the nominal tax rate consequently an excessive
pay of taxes in addition to the excessive distribution
of benefits. It could be supposed that the State gets
benefits form inflation, when taxing at real rates greater
than nominal rates.
6. Decision Making
The businessman should have access to enough and valid
data to appropriate decision making, which implies to
be ware of the financial, commercial and industrial condition
of the enterprise in very moment. All this leads to appropriate
planning in order to reach all the goals and objectives
and thus to plan efficient policies in all the areas in
other words, financial, credit, inventory and policies.
But when facing inflation all these steps become more
complex and uncertain. In this sense the must develop
the ability to implement methods to fight against inflation
and its consequences and to make right decisions even
in such unstable and uncertain periods like inflation.
One of the main effects of inflation in the decision making
process is the distortion of accounting data that it brings
about. The general-balance and the profit and loss statement
suffer a huge impact that dramatically affects the strategic
decisions of the enterprise, all decisions concerning
prices, indebtedness, liquidity, dividends and investments
By misapplying the accounting data provided by conventional
accounting leads to uncertainty in the decision making
process especially in the decisions concerning, pricing
policy, resources, dividends, planning etc. the enterprise
must resort to appropriate methods to face inflation and
to get unbiased data. General Price Level Accounting and
replacement cost accounting represent useful tools in
these cases besides, they are complementary to each other
and to conventional accounting.
Effects
of devaluation
Devaluation of domestic currency influences or has an
effect, sometimes positive and sometimes negative, on
the activities of an enterprise as well as inflation does.
To what extend and in what way depreciation affects economic
activities of depend on type of enterprises, their activities
and the sensitivity of enterprises to foreign exchange
risks. Devaluation brings about instability and uncertainty
therefore management becomes difficult and decision making
becomes a process in which a number of variables must
be anticipated, most of them independent from the enterprise’s
control.
1.
Devaluation and interest rates
As mentioned before, when the interest rate parity was
explained, there is a relation between the interest rate
and the current and forward exchange rate. In addition,
as Marin and Ketelhohn (1998) state: the intrinsic risk
of economy is reflected in the interest rates.
In this way, if there is some capital in dollars
Where:
1
+ r ¢ Interest rate in colones
1
+ r US$ Interest
rate in dollars
f(TC ¢/US$ ) Forward
exchange rate ¢/$
S(TC ¢/US$ ) Spot
Exchange rate ¢/$
There
a prize for investing in colones thus the investment in
colones is more profitable since the return in colones
minus the devaluation rate is greater than the dollar
rate.
2.
Foreign exchange risk: devaluation
risk
When
an importer has to wait for awhile until the delivery
and payment of the traded goods, the exchange rate can
fluctuate. Such fluctuations can bring about profit and
loss depending on if they are favourable or not. In some
cases businessmen have to plan their negotiations to carry
out them during certain terms. To them, exchange rate
fluctuations in the exchange rates represent a big problem
that could interfere with their calculations in the future,
which is a situation out of their control.
The
possibility to face losses due to negative fluctuations
in the exchange rate is called foreign exchange risk.
Facing such a risk it is necessary to be protected from
it. In many economies, several methods to eliminate losses
that result from exchange rate fluctuations or at least
to reduce the possibility to face them have been implemented
such as currency futures.
The foreign exchange risk emerged in the 70’s when
the currencies’ gold parity was suspended allowing
currencies to float. In this way the prices of currencies
against other currencies had the possibility to fluctuate
depending on the conditions of the currency market and
the situation of economy.
To Vives (1984) enterprises’ exposure to foreign
exchange risk can be analyzed in three levels:
-
Accounting exposure: It refers to the effects of devaluation
on the financial statements of the enterprise especially
on the balance sheet. It shows the exposure to devaluation
due to the differences between foreign currency denominated
assets and liabilities. The author states that not
only accounting exposure should be taken into consideration
because it would be a completely restrictive and narrow
perspective towards foreign exchange risk exposure.
-
Cash Flow exposure: It considers the future exposure
to foreign exchange risk, this because of the liabilities
acquired or the ones that will be acquired in the
future and that are not included in the balance sheet.
For these purposes, the cash flows of the enterprise
are compared in both ways: taking into consideration
devaluation or ignoring it. All this is carry out
under the supposition that physical quantities remain
constant.
-
Economic exposure: a complete analysis of the exposure
to foreign exchange risk should also consider the
markets in which the enterprise participates, its
characteristics and the possible reactions that can
occur. This leads to anticipate the financial situation
of the enterprise taking into account the factors
already mentioned, which helps to perceive the effect
on the enterprise, the market and on the decisions
of the management.
In
the same way that inflation affects accounting, as explained
before, devaluation can also educe the reliability of
traditional accounting, by making planning more difficult
as well as decision making processes, financial analysis
and project evaluation, by increasing the urgency for
financing, reducing profitability and productivity, etc.
All these factors vary from enterprise to enterprise,
in other words; the effect of devaluation is not uniform.
It will affect those enterprises that have a stronger
relation with the external sector of economy and that
have less capacity to react to these situations.
It
is worth to mention that the analysis of the devaluation
periods usually is more complex because most of the times
an inflation precedes it, therefore; management becomes
more difficult because the number of variables involved
increases as the analysis needs to be more realistic.
3.
–Export and Import- Companies and Enterprises with
Debts in Foreign Currency
Different effects of the exchange rate fluctuations on
enterprises can be expected depending on the type of enterprise,
its operations in foreign currency, and the importance
of such operations. There are three basic situations:
-
An enterprise that exports part or its whole production
-
An enterprise that imports part or all its raw material
or ended product.
-
An enterprise that enjoys or receives financing in
foreign currency.
Thus, there are eight possible situations for example
an enterprise that exports a part of its production does
not import raw material but it does have foreign financing.
Another case would be an enterprise that does not export
its production but imports raw material and it has debts
in foreign currency, etc. Depending on the situation of
the enterprise it can be more or less exposed to foreign
exchange risk. The eight possible situations are described
below as well as the effects of devaluation in each case.
| Situación |
Do
you export some part of your products?
Do you have dollar incomes? |
Do
you import some part of your products?
Do you have dollar expenditures and costs? |
Do
you receive financing in foreign currency? |
Devaluation
Effect: |
| 1 |
No |
No |
No |
It
is not directly affected. It could suffer some
affects due to other enterprises related to it
that are affected (competitors, suppliers, customers,
etc.) |
| 2 |
No |
No |
Si |
It
is dramatically affected because it does not have
incomes in foreign currency and it has liabilities
in foreign currency. |
| 3 |
No |
Si |
No |
It
suffers a negative effect because of the rise
in costs of the more expensive raw material. |
| 4 |
No |
Si |
Si |
It
is facing a critical situation due to the rise
in costs as well as the increasing debt and its
interests. This is the worst case of all the eight
cases. |
| 5 |
Si |
No |
No |
It
is favourable because it reduces the price of
its product abroad which makes the enterprise
more competitive. |
| 6 |
Si |
No |
Si |
It
can be favourable or not depending on if its revenues
generated by exports allow the enterprise to face
its greater financial burden. |
| 7 |
Si |
Si |
No |
It
can be favourable or not depending on if the revenues
generated by exports are greater than the costs
of imports. |
| 8 |
Si |
Si |
Si |
It
depends, if the revenues generated by exports
allow the enterprise to face its greater financial
burden in foreign currency and at the same time
the higher costs. |
The
most complex situation is when the enterprise gets into
debt in foreign currency mainly if it also imports, because
the company is being expose to a greater foreign exchange
risk therefore the financial charge and costs could increase.
Thus, a company with obligations denominated in foreign
currency will have to pay a higher effective rate than
the nominal rate of the loan. This rate would be:
Where:
ie Effective interest rate in other words, real interest
rate with devaluation (taking into account devaluation)
r Nominal interest rate of the loan
d Devaluation rate of the domestic currency against
the foreign currency.
Devaluation
also affects decisions when wondering whether a project
is convenient or not because it influences the profitability
of the project. In this cases, in the same way that with
inflation, the real internal rate of return (IRR) of the
project may be calculated:
Enterprise
could be protected form risk in many ways. First, they
could loan an equivalent amount of money in domestic currency
and give in guarantee a long dated security in foreign
currency. The countries that enjoy of foreign currency
futures markets could resort to them as an efficient method
to be protected from foreign exchange risk.
As explained before, devaluation brings about a variety
of negative consequences to enterprise activities, such
as uncertainty which also have a number of adverse effects,
the rise in imported raw material costs therefore substitute
or alternative inputs may be required (maybe with a better
quality/price relation), more restricted foreign credit,
etc.
As demonstrated before, the impact of devaluation could
be worse in enterprises that have obligations denominated
in foreign currency, companies that require imported raw
material, that produce non commercial goods, or that have
controlled prices, also enterprises that face a very elastic
demand to the price. Among other situations that may difficult
the enterprise practices when the domestic currency is
devaluated.
Some Important Aspects
1. The modern enterprises face an atmosphere that is more
and more changing, unstable, and complex in which survival
depends on their ability to adapt and to take advantage
of benefits and opportunities that will open up.
2. Nowadays, organizations cannot ignore the different
events that take place in the political, legal, economic,
socio cultural and technological environment nationally
and internationally.
3. Even when classical management theories gave little
importance to environment, then with the introduction
of the systemic approach, other theories and methodologies,
the importance of environment to modern management has
been recognized.
4. The external environment is composed of a number of
elements that are out of the control of the enterprise,
the economic environment is one of them. The main aspects
that the economic diagnostic requires can be summarized
in five areas: 1. Level of economic activity and management
of productive resources. 2. The behavior of the foreign
economic relations. 3. Public finance behavior. 4. Monetary
and financial variables behavior. 5. Diverse price levels
behavior.
5. Inflation is basically a phenomenon of economic nature.
The pressure of demand and the rise of costs as well as
structural causes and expectations may bring about a sustained
increase in the general price level only if at the same
time the circulating medium increases as well.
6. Inflation brings about a variety of negative consequences
to economy in general: it reduces the purchasing power
of money, it distorts the financial system, it generates
costs and inefficiency, it discourages productive investment,
it affects the balance of payments and finally it distorts
the role that the market plays as a guide for producers.
Inflation does not affect all of us in the same way, some
are favoured by it and some other are negatively affected
in other words redistribution of wealth takes place.
7. Domestic currency depreciation tends to motivate export
sectors and the opposite happens in the case of importers.
In addition, there is a relation between inflation and
devaluation because when encouraging exports, the aggregate
demand is also encouraged and at the same time costs rise
due to the rise in the price of raw material. Like inflation,
devaluation favours some and negatively affects others.
8. Inflation affects the enterprise capital budget implementation
and interpretation because it affects cash flows, it tends
to artificially increase profits therefore a part of them
is taxed and real flows are reduced. To consider this
effect, the enterprise needs to adjust its revenues, costs
and expenditures to inflation in order to have adjusted
flows for inflation. Then the discount rate, the net present
value and the internal rate of return are adjusted to
consider inflation and therefore to evaluate projects
in a better way.
9. Inflation reduces productivity of enterprises; it varies
the combination of resources applied in the production
process when the relative prices change. In addition,
it interferes with the increases of the maximum production
capacity by hindering assets replacement.
10. Traditional accounting data is distorted due to inflation:
• It affects price setting based on historical
cost since inventory replacement could be not protected
from risk.
• Financial-statements are distorted: economic
results and the net worth become eroded and the composition
of the balance sheet changes.
• Cost of sales are undervalued
• Looses due possession of monetary-assets are
not taken into consideration.
• There is a risk to distribute dividends over
real profits.
• The accounting data is not compatible throughout
time
11. To have appropriate and enough information for the
analysis and decision making process, enterprises need
to apply alternative methods as complements to historical
accounting. For example, the general price level accounting,
the replacement cost accounting and adjusted replacement
cost accounting.
12. During periods of inflation, it is more convenient
to apply the last in first out (LIFO) method for inventory
pricing than the first-in, first-out (FIFO) since the
latter exaggerates profits.
13. When facing inflation, the enterprise needs more financing
due to the rise in costs and to finance its growth, in
other words its production capacity. In addition inflations
tends to favour debtors that is why enterprises get into
debt, extend payment periods to suppliers, reduce collection
periods to customers, and as far as possible to diminish
the possession of assets mainly the monetary ones.
14. The financial ratio analysis is strongly affected,
since a fictitious increase in efficiency rations, in
profitability and finally in solvency takes place, while
the opposite happens with efficiency ratios.
15. During periods of inflation the real tax rate is higher
than the nominal, which may bring about liquidity problems
for the company, decapitalisation and a reduction of production
capacity.
16. The decision making process is affected by the distortion
of the accounting data and the surrounding uncertainty.
Thus, the use of biased data may lead to big mistakes,
which stresses the need to use techniques that allow adjusting
the information to inflation.
17. Due to the possibility that in the future the domestic
currency depreciates, companies could be exposed to exchange
risk, which occurs in three basic levels: the accounting,
the one of flows and the economic one. When considering
the three levels, there is a precise impression of the
enterprise’s vulnerability if it faces devaluation.
18. Devaluation also distorts the accounting data and
affects the financial analysis, planning and the decision
making process basically due to the instability and the
uncertainty that it causes.
19. Companies that have debts in foreign currency or import
raw material or finished products, are the enterprises
most strongly exposed to the exchange risk, mainly if
they do not produce exporting goods. On the contrary the
export companies would be favoured of such situation mostly
if they do not import their raw material and also if they
do not have obligations in foreign currency.
20. Companies can adjust the information to measure the
impact of devaluation and thus, to make more accurate
decisions.
21. The change in price levels and in the exchange rate
of change has a significant and irregular impact on the
financial data of the company. This effect cannot be ignored,
since the management and investors make their decisions
based on this information. Thus the financial statements
must be corrected, in order to eliminate all these biases
and to analyse the situation of the company based on the
new data. In order to do so, the company must implement
adaptation policies and clearly recognize the relevant
variables within the economic system, since these are
phenomena on which the company does not have action capacity,
it can only adapt its policies to decrease negative effects.
Some
Recommendations
After this analysis some recommendations may be suggested.
1.
The modern management must take into consideration the
different events of the environment. It also must learn
to adapt itself to changes and to develop the ability
to turn the unfavourable situations into opportunities
that provide to it advantages to compete. Thus the company
must guide its efforts and resources to study its environment
and the different level of such environment. The enterprise
must analyze all the elements of the setting that affect
it, also their intensity, and how to react to them.
2. The company must recognize the importance of the analysis
of the economic environment and it should be aware that
the variations in the price levels and in the exchange
rate affect it significantly, in the enterprise level
as well as in the general level of economy. This is particularly
important in a country like Costa Rica that during the
last years has experienced sustained inflation and the
devaluation.
3. During periods of inflation, the numbers obtained in
the capital budgets should be adjusted to consider inflation
as well as devaluation, to do so the flows can be deflated,
and then the convenience of the accomplishment of a project
in real terms should be analyzed, using a net present
value (NPV and an internal rate of return (IRR) in a currency
on constant purchasing power.
4. During inflationary periods the organizations need
to adjust their accountancy to inflation, to provide unbiased
data for the decision making process. Suitable techniques,
like the one mentioned in this paper, to achieve such
goal must be applied.
5. The financial analysis also must be developed applying
real terms, since the financial statements become distorted
due to the effects of inflation and devaluation. In this
way the enterprise will fight against the possibility
of drawing false conclusions regarding profitability,
efficiency, solvency and the liquidity of the company.
6. Companies can adopt some strategies to mitigate the
impact of inflation, such as to increase their level of
indebtedness, to extend the periods of payment to suppliers,
to diminish the collection periods, among others. In the
same way enterprises look for some mechanisms to protect
themselves from the exchange risk.
7. The company must carry out a detailed analysis of its
exposure to exchange risk and avoid those situations in
which this one is higher, such as get into debt in foreign
currency or to require importing raw material without
having some income in foreign currency or revaluable assets
denominated in foreign currency.
8. The ones in charge of the management of the enterprise
must be sufficiently skilled or trained to consider the
adverse effects of inflation and devaluation, and even
be able to anticipate them, at the same time to have the
capacity to apply opportune and appropriate mechanisms
to face such situations. This requires to be updated and
to constantly study the environment and its relations
with the company. |
