The foreign exchange (forex) market is a volatile trading environment, and understanding the various factors that contribute to exchange rate fluctuations is critical for informed investment decisions. In particular, when two companies have similar gross profit figures yet drastically different net operating income levels, there must be a fundamental difference in the performance of the respective currencies used in their respective transactions. This article will explore how foreign exchange markets and the forces driving them play a role in determining the profitability of international business transactions.
Understanding The Forces Behind Exchange Rate Fluctuations
The behavior of currencies in the global forex market is largely driven by differences in the relative strength of economies. The relative demand for a currency and the supply of the same will determine the exchange rate. Supply and demand are affected by political and economic factors such as interest rates, economic growth, and government actions. Economic indicators such as GDP, Consumer Price Indexes, and the balance of trade—the difference between a country’s imports and exports—have a direct impact on the relative strength of a currency. In times of economic uncertainty, investors often rush to the relative safety of the US Dollar, driving up its value, and sending other currencies into a downward spiral.
FX Forward Prices as an Unbiased Predictor
To the extent that FX forward prices are an unbiased predictor of future spot exchange rates, the market anticipates whether one currency will be able to outpace it’s peers and whether its current level of demand is one that will maintain over a longer horizon. As a result, exchange rate fluctuation can result in drastic differences in performance for businesses dealing in different currencies. By assessing the market forces at play behind any particular currency and comparing it to the relative strengths of its peers, investors can make informed decisions about when to make transactions and to which currency.
The Role of Managing FX Risk
When a company engages in international business and deals in more than one currency, the level of foreign exchange risk faced is greatly increased. Such businesses must manage the risk associated with forex volatility by implementing a strategy designed to minimize losses due to currency fluctuations. As the value of the underlying currency rises or falls, so does the value of the customer’s investment. The value of a currency, or its exchange rate, could fall or rise at any given time for a variety of reasons, and it is up to the business to protect itself from any undue FX risk. This can involve hedging strategies, such as entering into forward contracts to fix exchange rates in advance, or investing in other assets to diversify the company’s exposure.
The markets for foreign currencies are hugely complex and carry various levels of uncertainty. Understanding the various forces driving the fluctuation of exchange rates is key to making well-informed investment decisions in the global markets. With similar gross profit figures, two strongly competitive companies can yield widely different net income results, largely due to the impact of foreign exchange markets. Businesses must take a proactive stance in managing FX risk by implementing strategies such as hedging and diversification.
Comparing Net Operating Income from Two Different Companies
From 2000 to 2018, 35 large pharmaceutical companies reported cumulative revenue of $11.5 trillion, gross profit of $8.6 trillion, and operating expenses of $3.0 trillion respectively. Operating income is measured by taking gross profit and subtracting operating expenses, and is expressed as operating income = gross profit – operating expenses. The goal of many investors is not only to understand the gross profit of a company, but also to evaluate its potential for net operating income. Therefore, it is important to look at corporate performance to understand how two similar companies may have different net operating income outcomes due largely to external economic factors and specific corporate decisions.
Company A is a large pharmaceutical company that posted high gross profits from 2000 to 2018 due to the introduction of several new medications for different illnesses. The company spent heavily on research and development, and occupied one of the top five spots in the global market for the manufacture of generic drugs. Despite the substantial revenue influx, operating expenses rose exponentially as a result of heavy spending in sales and marketing, leading to a decrease in net operating income from 89% of total gross profit in 2000 to a meager 11.7% in 2018.
Company B was a smaller firm in comparison to Company A, but recorded increased profits during the same period of time. This was due to a different strategy consisting mostly of acquisitions of competitors to further expand the company’s business model. Despite the company’s outstanding gross profits overall, relatively low operating expenses kept the net operating income at a steady 73.6% of total gross profit from 2000 to 2018.
Analysis & Conclusion
It is clear that different strategies greatly affected the net operating income of both companies. Company A employed heavy spending in marketing and research, thus decreasing their overall net operating income. Meanwhile, Company B was able to keep operating expenses in check, leading to higher net operating income. This demonstrates the importance of monitoring the budgets of different companies to ensure that profits remain high and costs are kept low. By doing so, investors are able to increase their returns on investment and ensure that their funds are being used in the most efficient and profitable manner.