Many businesses buy and sell products from foreign countries. They may buy from one country and for example export to the United States. What happened if the old owner of the business purchased foreign exchange contracts to cover his/her exposure to fluctuations in the exchange rate. If he bet properly, he/she saved a lot of money. If he/she made a wrong guess and it cost the company money, is the error part of normalized earnings?
When buying a business, the most important information is the normalized earnings of the business. If the owner of the company made a wrong decision, is this overlooked when buying the business. For example, if the owner never speculated on currency, purchased everything in say Canadian dollars and sold all their goods to the United States. In the past, he has always taken the risk and whatever the exchange rate was, he pocketed since he really was selling the same goods to Canadian customers, for say $1, now he was selling to the US for 4$1 US. Any additional exchange received was a bonus. Many companies did that in Canada.
What happens if he has a large transaction, say $1 million order and he wants to protect his profits so he locks in his profits by locking in the sale of US dollars for Canadian dollar at a preset exchange rate. What happens if he bets wrong and the exchange rate improves? His profits are understated. What happens if he makes the same mistake all year long. Let’s say that the total wrong bets cost the company $50,000 for the year. When you buy the business, how do you treat the foreign currency losses. On the other hand, if the owner of the business did not hedge his US dollar purchases, and profits were $50,000 lower because he did not watch his foreign currency transactions, is the $50,000 part of normalized earnings or do you just treat it as a normal business loss?
As the world is getting smaller and smaller and transactions are becoming more global, goods may be sold to anywhere in the world, the monitoring of foreign currency transactions are very important. The Canadian dollar dropped $.07 to the US dollar in 7 weeks, the euro dropped significantly to the US and Canadian dollar. When doing your due diligence, do you need to start looking more closely at how the business is making money. Is the business losing money but making money on the foreign exchange speculation? Did you realize this before you bought the business? The business may be more or less profitable than you thought unless you look closely at what makes up profit.
Are the items making up profits temporary, are they because of financial speculation (currency hedges) or are they truly business profits. How should you determine the price that the business is worth, do you look at these factors in determining a price to offer to buy the business?