Write a paper to train your staff on international financial management (IFM)

Outline

Definition (IFM) Motives for internationalization The need for international financial management Components of International financial management Challenges/risks of international management Managing international financial risks Conclusion

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Definition

Definition of IBM and its link to IFM

International financial management refers to the process of applying the principles of financial

management across borders or in an international arena/environment. It deals with how an

organization goes about making financial decisions in an international setting. While financial

management is concerned with the acquisition, financing and management of assets with overall

goal in mind. In other words, it involves the application of the general management principles of

planning, organizing, directing and controlling to the financial resources of an international

organization. It is concerned with three major decisions: investment, financing and asset

management.

Motives for investing capital abroad

In financial management, the most commonly accepted goal for the organization is the

maximization of shareholder wealth. In line with this, several reasons accounts for a firm’s

decisions to invest abroad. Motivation to invest capital in foreign markets is to provide a return

in excess of what is required.

The motives for a business going international may be categorized broadly into the pull and push

factors. The pull factors can be described as those that attract a firm to internationalize due to

profitability and growth prospects. These may also be looked at as proactive reasons for

internationalize.

The push motives on the other hand are those that compel businesses to operate outside their

domestic markets. These are the factors that lead to a saturation of the domestic market.

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Important push or reactive factors include increased competition in domestic markets, surplus

production in home market, decreased home demand for domestic product as well as limited

home markets.

The need for international financial management

International finance plays a significant role in modern economics due to the globalization of

business transactions. Globalization has led to an explosion in international investments; capital

is now increasingly being raised across borders while financial deregulation has promoted

increased integration of capital markets. International financial management is the bedrock that

allows organizations to engage in cross-border transactions with foreign business partners, such

as customers, suppliers and lenders. Also, Government agencies and non-profit institutions use

international finance tools to meet their operating needs. Thus it is now of utmost importance

that the financial manager has a global perspective. Understanding of international financial

management principles is thus crucial to both large multinational companies and small firms

conducting international business.

International financial management is equally important to companies with no international

business because these companies must recognize how their foreign competitors are affected by

factors such as movement in exchange rates, foreign interest rates, labor costs, inflation etc. as

these economic characteristics can greatly affect the foreign competitors’ costs of production and

pricing policies. Other domestic competitors that obtain foreign supplies or foreign financing

will also be affected by economic conditions in foreign countries. It is possible for these

competitors to reduce their cost by capitalizing on opportunities in international markets.

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What is International financial management all about (components/elements)

Financial management of a company is a complex process, involving its own methods and

procedures. It is made even more complex because of the globalization taking place, which is

making the world’s financial and commodity markets more and more integrated. The integration

is both across countries as well as markets. Not only the markets, but even the companies are

becoming international in their operations and approach.

Consequently, managers of international firms have to understand the environment in which they

function if they are to achieve their objective in maximizing the value of their firms, or the rate

of return from foreign operations. The environment consists of:

1. The international financial system, which consists of two segments: the official part

represented by the accepted code of behavior by governments comprising the international

monetary system, and the private part, which consists of international banks and other

multinational financial institutions that participate in the international money and capital

markets.

2. The foreign exchange market, which consists of multinational banks, foreign exchange

dealers, and organized exchanges where currency futures are regularly traded.

3. The foreign country’s environment, consisting of such aspects as the political and

socioeconomic systems, and people’s cultural values and aspirations. Understanding of the host

country’s environment is crucial for successful operation and essential for the assessment of the

political risk.

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The multinational financial manager has to realize that the presence of his firm in a number of

countries and the diversity of its operations present challenges as well as opportunities. The

challenges are the unique risks and variables the manager has to contend with which his or her

domestic counterpart does not have to worry about. One of these challenges, for example, is the

multiplicity and complexity of the taxation systems, which impact the MNC’s operations and

profitability. But this same challenge presents the manager with opportunities to reduce the

firm’s overall tax burden, through transfer of funds from high- to low-tax affiliates and by using

tax havens.

The financing function is another such challenge, due to the multiplicity of sources of funds or

avenues of investment available to the financial manager. The manager has to worry about the

foreign exchange and political risks in positioning funds and in mobilizing cash resources. This

diversity of financial sources enables the MNC at the same time to reduce its cost of capital and

maximize the return on its excess cash resources, compared to firms that raise and invest funds in

one capital market.

A multinational company (MNC)’s financial decisions include how much business to conduct in

each country and how much financing to obtain in each currency. These decisions determine its

exposure to the international environment.

The main components of international financial management are:

International investing (international capital budgeting and working capital management)

International financing (determining sources of funding available on the international

market)

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In a real sense MNCs are particularly situated to make the geographic, currency, and institutional

diversity work for them. This diversity, if properly managed, helps to reduce fluctuations in their

earnings and cash flows, which would translate into higher stock market values for their shares.

This observation is especially valid for the well-diversified MNCs.

This is not to suggest that the job of the manager of an MNC is easier or less demanding, than if

he or she were to operate within the confines of one country. The challenges and the risks are

greater, but so are the rewards accruing to intelligent, flexible, and forward-looking management.

The key to such a management is to make the diversity and complexity of the environment work

for the benefit of the firm and to lessen the adverse impact of conflicts on its progress.

International financial management risks

International financial management is all about managing risks at the international level.

When an organization decides to engage in international financing activities, they also take on

additional risk as well as opportunities. The main risks that are associated with businesses

engaging in international finance include foreign exchange (currency) risk and country risk.

These risks may sometimes make it difficult to maintain constant and reliable revenue.

Foreign exchange risk or currency risk refers to the volatility of the exchange rate of one

currency for another, for instance the Ghana cedi per US dollar. This volatility can greatly affect

the operations/performance of a multinational company (a company with foreign operations).

A company’s exposure to currency risk can be manifested in three forms:

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Translation exposure: This relates to changes in accounting income and balance

sheet statements caused by changes in exchanges rates. For example, when

a domestic currency appreciates against a foreign currency, profit or

returns earned in the foreign country will decrease when translated to the

domestic currency.

Transaction exposure: Refers to the settling of a particular transaction at one

exchange rate when the obligation was originally recorded at another. For

instance, if a Ghanaian company exporting goods to Nigeria makes a credit sale in

Naira and subsequent to the sale, the Naira depreciates against the cedi; the

Ghanaian company will suffer an exchange loss in Cedi when the Nigeria

customer settles the debt at the time of the lower Cedi to Naira exchange rate.

Economic exposure: Involves changes in expected future cash flows, and hence

economic value, caused by a change in exchange rates. In this instance, a United

States company that decides to build a factory in Ghana at an estimated cost US$2

million at the time when the dollar to cedi exchange rate was $ 1: GHC 1.2,

(estimated cost of GHC 2.4 million) will suffer an economic loss of (GHC

600,000), if the cedi depreciates to $ 1: GHC 1.5 (actual cost of GHC 3 million) at

the time the actual building takes place.

Country risk represents the potentially adverse impact of a country’s environment on the

operations and performance of a business. This risk can be sub-divided into economic and

political risks.

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Economic risk: A country’s economic growth is dependent on several factors such as interest

rates, inflation, exchange rates etc. Adverse movements in these factors can impact negatively on

the performance of an MNC. For instance, a recession in a country can severely reduce demand

for the company’s goods while a financial distress can cause the government to restrict the

MNC’s operations

Political risk refers to vulnerability of returns from a project due to the political acts of a host

government. It transpires when a country’s government unexpectedly changes its policies, which

now negatively affect the foreign company. These policy changes can include such things as

trade barriers in the form of tariffs and quotas, which serve to limit or prevent international trade;

restriction on the transfer of funds from the host country; subsidies to protect domestic producers

from foreign competition and even failure to enforce copyright laws .These practices can have a

huge adverse impact on the profits of an organization .Although the amount of trade barriers

have diminished over the years due to free-trade agreements and other similar measures, the

everyday differences in the laws of foreign countries can influence the profits and overall success

of a company doing business transactions abroad. An extreme form of political risk may involve

the expropriation of the MNC’s assets or even the taking over of a subsidiary by the host

country’s government, eg. the case of the white farmers in Zimbabwe.

Managing international financial risks

In general, organizations engaging in international finance activities can experience much greater

uncertainty in their revenues. An unsteady and unpredictable stream of revenue can make it hard

to operate a business effectively. Despite these negative exposures, international business can

open up opportunities for reduced resource costs and larger lucrative markets.

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In addition, there are several ways of mitigating the risks discussed above. For instance, the

international firm can manage its exchange rates exposure risk by the use of :

Natural hedges (the firm reduces its currency exposure by restructuring its operations to

balance its exchange rate sensitive cash flows eg. using revenue received in a foreign

currency to pay commitments in the same foreign currency);

Cash management (this includes techniques to reduce it cash holdings in a foreign

currency, that it predicts will depreciate against its home currency, to a minimum by

purchasing inventory or other real assets whose values are in their use rather than tied to

a currency as well as reducing or avoiding extended trade credit in that currency);

International financing (in order to cover an exposure in an investment in a foreign

currency that may weaken in value, an international firm can borrow in that foreign

currency to finance the investment so as to offset that exposure) and

Currency hedges such as forward & future contracts, currency options and swaps- these

spectrum of financial instruments assist the company to gain greater control over the

exchange rates at which it can acquire or dispose-off foreign currencies. The contracts

allow the firm to obtain a fixed rate of exchange rates for future foreign currency

transactions so as to avoid volatility in exchange rate movements.

Similarly the economic risks can be reduced by diversifying the firm’s portfolio of businesses

across different countries so that economic downturns in one country can be compensated by an

economic boom in another. This is based on the principle that the economies of different

countries are not perfectly positively correlated.

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In the case of exposures from political risks, a company can acquire political insurance against

specific government actions; it can also engage practices such as using a short-term planning

horizon that concentrates on recovering cash flows quickly, relying on unique sources of supplies

and proprietary technology that will make it difficult for a host government to take over and

operate a subsidiary successfully, hiring local labour and borrowing from local banks(both the

local employees and banks can apply pressure on government in the case of adverse policies).

Conclusion

What a company must decide is whether the pros outweigh the cons when deciding to venture

into the international market.

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References:

1. International Business Management Lecture Manual – Dr. Adelaide Katsner

2. http://www.investopedia.

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