What is a Cash Flow Hedge?
A cash flow hedge is a method of investment method which is used to control and mitigate the sudden changes that can occur in cash inflow or outflow with respect to the asset, liability, or forecasted transactions and such sudden changes can arise due to many factors like interest rate change, asset price changes, or foreign exchange rates fluctuations.
The forecasted transaction is the transaction with another party, which is expected to happen on some future date. It is also possible to hedge risks associated with only the portion of the effectiveness can be measured of the related hedge that can be measured. The cash flow hedge reserve helps companies to latch onto investment opportunities that boost their growth as well.
- Cash flow hedge is a risk management strategy companies use to mitigate the potential impact of future cash flow fluctuations due to changes in certain variables such as interest rates, foreign currency exchange rates, or commodity prices.
- The purpose of a cash flow hedge is to offset the potential adverse effects of these variables on future cash flows by using derivative instruments, such as forward contracts or options.
- Cash flow hedges are accounted for under the guidance of accounting standards like International Financial Reporting Standards (IFRS) and Generally Accepted Accounting Principles (GAAP).
- Cash flow hedges can help companies reduce uncertainty, improve budgeting and forecasting accuracy, and protect against adverse movements in cash flows.
Cash Flow Hedge Explained
Cash flow hedge is a hedge of the exposure to the variability in cash flow of specific liability or asset or fore-casted transaction which is attributable to a particular risk; in simple words, it is a method of investment method which is used to deflect the sudden changes that can occur in cash inflow or outflow.
All the manufacturing companies or some of the service firms as well buy commodities like sugar, cotton, meat, oil, wheat, etc. on a regular basis for their work, so, in that case, a cash flow hedge is important in order to deflect the sudden changes that can occur in cash inflow or outflow of these commodities.
Cash flow hedge accounting gives the management acushion to plan their production and sales as the daily activities within the organization remain unaffected to the buffer cash that can be used to keep the show running despite changes in factors that are beyond the control of the management.
It is often believed that companies use the reserve cash to buy raw materials when the prices are high and they run out of cash from their regular inflows and outflows. However, most successful businesses purchase larger quantities using the cash in their reserves when the prices are lower so that they can benefit from acquiring a larger quantity at lower prices. These purchases also increase the profitability of the business.
However, accounting of the Cash flow hedge should be terminated in case any of the following situations arises:
- The hedging arrangement is not effective anymore.
- The hedging instrument is expired or terminated.
- Hedging designation being revoked by the organization.
The hedging is effective only if changes in the cash flow of the hedged instrument and hedging offset each other. On the other hand, if changes in the cash flow of hedged instruments and hedging do not offset each, then hedging will be considered ineffective.
Let us understand the concept of cash flow hedge accounting with the help of a couple of examples. These examples will help us understand the intricate details of the concept.
X Ltd has a textile business and requires tons of cotton as its raw material every quarter for the production of its textile finished products and sale in the market. It purchases the raw material from the US market and pays the dollar in exchange for the product purchased.
The prices in the market of the US depend on various factors like environmental factors, demand, and supply of the product, exchange rate variations, etc. Due to these factors, the prices of the different commoditiesCommoditiesA commodity refers to a good convertible into another product or service of more value through trade and commerce activities. It serves as an input or raw material for the manufacturing and production units., including cotton, increase or decrease, and sometimes this increase or decrease is very sharp.
Now, as cotton is required by the company every quarter, the management of the company wants to minimize the risk of fluctuation of the prices of raw material, so wants to know how they can do the same?
In the present case, company X Ltd. requires tons of cotton as its raw material every quarter for the production of its finished textile products, but the prices of cotton in the US market depend on various factors like environmental factors, demand, and supply of the product, exchange rates variations, etc. due to which it increases and decreases frequently.
So the company doesn’t know that after several months what will happen to the cotton prices and the payment would depend on the cotton market price in the US on the date of the purchase of cotton. Any Fluctuation in the prices of cotton could have a major impact on the company’s total production costs, and finally, on the bottom lineBottom LineThe bottom line refers to the net earnings or profit a company generates from its business operations in a particular accounting period that appears at the end of the income statement. A company adopts strategies to reduce costs or raise income to improve its bottom line. .
For the purpose of minimizing this risk, the company can create a cash flow hedge and convert its future payment, which is variable into the fixed future payment. As the company planned to purchase the cotton after several months, this exposes to the cash flowsCash FlowsCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. variability and is thus the hedged item.
In order to create a hedge, the company can go for a forward contract with some other party. Suppose it is decided that the company will purchase 100,000 pounds of the cotton after three months period when the price of cotton is $ 0.85 on the present date, so the $ 0.85 becomes the agreed price or the contract price, and the company has locked the total price as $ 85,000 regardless of the cotton market price on the purchase date.
Now after three months, one out of the three situations could arise, i.e., the price will increase, the price will decrease, or the price will remain neutral, which are analyzed below:
- Price increases: The prices after three months increase to $ 1.2 per pound, but the net cash payment of the company will still be $ 85,000 as the company has to pay $ 120,000 to the Supplier, but it will receive $ 35,000 ($ 120,000 – $85,000) out of the forwarding contract.
- Price decreases: The prices after three months decreased to $ 0.60 per pound, but the net cash payment of the company will still be $ 85,000 as the company has to pay $ 60,000 to the Supplier, but along with this, it will have to pay $ 25,000 ($ 85,000 – $60,000) to the party with whom the forward contract is made
- Price remains: The prices after three months remain $ 8.5 per pound, so the net cashNet CashNet Cash represent the company's liquidity position and is calculated by deducting the current liabilities from the cash balance reported on the company’s financial statements at the end of a particular period. Analysts and investors examine it to have a better understanding of the company's financial and liquidity position. payment of the company, in that case, will be $ 85,000, which is to be paid to the Supplier, and there will be no loss or gain from forwarding contract.
Here, a forward contract is a hedging instrument, and the hedging is effective only if changes in the cash flow of hedged instruments and hedging offset each other. On the other hand, if changes in the cash flow of hedged instruments and hedging do not offset each, then hedging will be considered ineffective.
In the present case, a change in the cash flow of cotton purchase (hedged item) is offset totally by forwarding contract cash flow (hedging instrument), making hedging 100% effective.
In January 2023, Alkimiya, a decentralized market protocol from the world of cryptocurrency raise $7.2 million in funding to attract and incentivize miners and stakers looking to hedge the risks of their cash flows in the bear-ish market at the time.
True to its nature, the cryptocurrency market had been extremely volatile. The only difference was that it showed downward trend, indicating a bear market. To ensure the gap between uncertain miners and finding funds could be bridged, Alkimiya curated a protocol.
The protocol stated that the miners could submit a projection of their transactions for a certain period so that they can arrange the cash for them. In return, they would earn a part of the rewards earned by the miners as their fees.
Let us understand the advantages of cash flow hedge accounting through the discussion below.
- It helps the company in minimizing the risk associated with the hedged item
- The hedge accountingHedge AccountingHedge accounting is a way to mitigate or eliminate the risks involved in stock or money market. It refers to the the additional investment done by applying the opposite strategy as to the main investment. aligns the accounting treatment of a hedged item,s i.e., cash flow and hedging instrument.
Despite the advantages mentioned above, there are a few factors that prove to be cons. Let us understand the disadvantages of a cash flow hedge reserve through the points below.
- A main issue with the cash flow hedge is the time when the gains or losses are to be recognized in earnings in case the hedging transaction is related to the forecasted transaction.
- If changes in the cash flow of hedged instruments and hedging do not offset each, then hedging will be considered ineffective, and the purpose of hedging becomes un-useful.
Frequently Asked Questions (FAQs)
In a cash flow hedge, a company enters into a derivative contract to offset the risk of a specific future cash flow. For example, suppose a company has a foreign currency-denominated receivable due in the future. In that case, it can enter into a currency forward contract to lock in the exchange rate, thereby hedging against potential currency fluctuations.
The effectiveness of a cash flow hedge is evaluated by comparing changes in the fair value of the hedged item with changes in the fair value of the hedging instrument. If the wall is deemed highly effective, the gains or losses on the hedging device are recorded in other comprehensive income (OCI) and reclassified to the income statement when the hedged item affects earnings.
Yes, a cash flow hedge can result in a profit or loss. The gains or losses on the hedging instrument are recorded in OCI. If the wall is effective, the accumulated gains or losses in OCI are released to the income statement. Depending on the movement of the variables being hedged, the company may realize a profit or loss on the hedging instrument.
This has been a guide to what is a Cash Flow Hedge. Here we explain examples of Cash Flow Hedge with analysis and also its advantages, and disadvantages. You can learn more about financing from the following articles –