Last editedOct 20223 min read
All business activities come with some element of risk attached. A hedge is a type of financial instrument that helps reduce this risk, and in the case of cash flow hedging, this means any risk pertaining to sudden changes in your cash inflows and outflows. This is particularly important for small businesses that may not have a wide margin of error when it comes to cash flow. Could a cash flow hedge help you better manage your finances? Here’s what you need to know.
What is a cash flow hedge?
There are numerous factors that can impact the cash flow associated with your assets and liabilities. A few examples include changes in foreign exchange rates, changes in raw material prices, and fluctuations in interest rates. A cash flow hedge is any financial instrument used to mitigate the risks associated with these sudden changes in cash inflow and outflow.
For example, imagine that you design a sustainable clothing line that uses pure organic cotton as a material. The price of cotton is subject to many variables, ranging from exchange rates to supply and demand as well as climate change. These sudden changes to the price of cotton will directly impact your cash flow, as you’ll need to pay more when the price of cotton increases. A cash flow hedge for this situation would be to enter into a forward contract to purchase cotton at a fixed price at a fixed point in the future. The price of cotton is the hedged item in this case.
How does a cash flow hedge work?
What would this look like? With the case of the clothing company, imagine that you’ve agreed to purchase 1,000 pounds of cotton in six months, locking in today’s price of $0.60 per pound. No matter what the cotton market is doing in six months’ time, you will still pay the agreed-upon $0.60 per pound to fulfil the forward contract. This is the hedging instrument that protects against changes in cash flow.
For a cash flow hedge to be considered effective, the cash flow changes of the hedging instrument (forward contract) and hedged item (cotton price) need to balance each other out.
Ineffective cash flow hedge example
Not all cash flow hedging will be effective, unfortunately. If the hedging instrument and hedged item don’t balance one another out, this would be an ineffective cash flow hedge example. Imagine that the forward contract expires but the price of cotton has fallen below the $0.60 so you end up paying more in the long run. This would be an ineffective hedge because it didn’t protect your cash flow. You should stop accounting for your cash flow hedge if the instrument expires or the arrangement is ineffective.
Cash flow hedge accounting example
Whether it’s through forward contracts or foreign exchange trades, there are many different types of cash flow hedges. No matter which one you choose, you’ll need to recognize the gain or loss in income in your financial statements. This is the case for both effective and ineffective cash flow hedging.
To get started with hedge accounting, record any effective gains or losses under comprehensive income. These can then be reclassified and reported as earned income when the forecasted transaction is complete.
Is cash flow hedging right for your small business?
Cash flow hedging can be beneficial to your small business if you need to mitigate the risk of volatile markets. For example, businesses operating at an international level might choose foreign exchange hedging to prevent any sudden swings in earnings due to currency fluctuations. Those purchasing raw materials subject to price fluctuations might opt for forward contracts. However, if your business works with a small number of clients and is service based, you might not have any need for this type of hedging. Be sure to weigh all your options carefully to determine whether a cash flow hedge could work for you.
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