What are constant currencies?
The constant currencies are exchange rate used to eliminate the effect of fluctuations when calculating financial performance publication numbers in financial state. Companies with overseas operations often supplement the mandatory and declared figures with optional and constant figures in currency. Basically, this allows them to show investors their performance, independent of foreign currency movements.
How constant currencies work
Companies that sell products overseas will often see their report revenue and profit are distorted by factors over which they have little control. For example, when the dollar strengthens against other currencies, it then weighs on international financial figures once they are converted back into US dollars.
Company executives believe that these currency fluctuations mask a company’s true financial performance and therefore often choose to also disclose figures that assume that exchange rates during the period have not moved.
Important
Generally Accepted Accounting Principles (GAAP) require companies to publish numbers without making any adjustments. However, companies may supplement this information with non-GAAP measures, such as constant currencies, when deemed necessary.
Constant currencies can be calculated in many ways. One approach is to convert the current figures using the average exchange rate from the previous period. Another is to adjust previous figures to reflect the current year’s exchange rate.
In either case, the set of numbers that investors look at to see how trading has improved compared to the comparative period will no longer be distorted by exchange rate fluctuations. And a strong US dollar suddenly won’t look so bad for companies whose functional currency is the greenback.
Key points to remember
- Companies that sell products overseas will often find their reported financial statements distorted by currency fluctuations.
- They regularly respond by disclosing figures that assume that exchange rates over the period have not budged.
- Constant currencies can be calculated by converting the current figures using the average exchange rate for the previous period or by adjusting the previous figures 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 income in US dollars. In the first year, the company earns $500,000 and makes a net profit of 10%. At the end of the first year, the AUD/USD exchange rate is 0.8. In the second year, the company earns $600,000 and makes a net profit of 10%. The AUD/USD exchange rate is 1.1 at the end of the second year. On this basis, the financial results, translated into AUD, would be:
| First year | Second year | |
|---|---|---|
| Turnover in USD | $500,000 | $600,000 |
| Net profit in USD | $50,000 | $60,000 |
| AUD/USD exchange rate | 0.8 | 1.1 |
| Earnings in Australian dollars | $625,000 | $545,455 |
| Net profit in Australian dollars | $62,500 | $54,545 |
These results do not use constant currency. They show that revenue and net profit in USD both increased by 20% year over year and the exchange rate increased by 37.5%. Due to fluctuating exchange rates, the revenue and net profit figures in AUD actually decreased by 12.7% each.
Management could argue that this is not a fair number to report, as the declines were solely due to exchange rates. To eliminate this problem, the company can use the constant currency methodology. Here’s what it might look like:
| First year | Second year | |
|---|---|---|
| Turnover in USD | $500,000 | $600,000 |
| Net profit in USD | $50,000 | $60,000 |
| AUD/USD exchange rate | 1.1 | 1.1 |
| Earnings in Australian dollars | $454,545 | $545,455 |
| Net profit in Australian dollars | $45,455 | $54,545 |
Eliminating the effects of currency fluctuation, revenue and net profit in AUD now show 20% growth.
Real example of constant currencies
Now let’s take a concrete example. A strong US dollar weighed on McDonald’s Corp. (MCD) foreign earnings once converted back into the fast food giant’s local currency in the first quarter ending March 31, 2019
Image by Sabrina Jiang © Investopedia 2021
As you can see from the image above, revenue, operating result and net revenue (NI) all fell 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 converts the current year’s results using the average exchange rate for the previous year.
Disadvantages of constant currencies
Like other adjusted numbers, constant currency measures may be better or worse than the reported GAAP numbers. However, this does not mean that investors should not completely ignore the possibility of using these non-mandatory measures to present the company in a better light.
Management teams, including McDonald’s leaders, maintain that constant exchange rates provide a more accurate picture of underlying performance. Unfortunately, this is not always the case.
The general consensus is that currency impacts generally balance out over time. However, there are some exceptions. For example, in some countries, including Emerging Markets, inflation is high and currencies are constantly depreciating.
Likewise, if the US dollar continues to appreciate for some time to come, perhaps investors should just accept the reality of declining earnings. Businesses are likely to convert their off the coast income in local dollars to finance dividend payments and so on, and not necessarily at the exchange rates with which they choose to report.