Long Term Purchase Contracts

I attended an interesting seminar the other day where a corporate finance expert was explaining the different ways to raise finance. He also explained how business can sometimes misunderstand the relationship between cash flow and profitability. The example he gave was one where a company had agreed to reduce the time it paid one of its main suppliers for a discount in the cost of goods. However, the net affect was that they needed to find additional cash to fund the increased working capital of just under £1m. This wasn’t easy and the business very nearly went bust even though they were profitable and early payment discount increased profitability.

That is why we find that a lot of our clients in the railway industry tend to maximise the length of time they have to pay their suppliers so that don’t unbalance their working capital.

But that can lead to other problems especially if they are buying from overseas as the company then becomes exposed to a currency risk. As many importers have found the cost of goods have gone up by over 25% in the last two years and this can quickly change a profitable contract into a loss making contract. And none of us like working hard when we don’t make any money.

So how do you handle marry the two; working capital vs. profitability.

Lets work with a recent situation we helped resolve. A client had entered into a supply contract where he needed to pay just under €1m in nine months time. He had budgeted for an exchange rate of €1.10/£1 for these goods. However they also knew that the nine months could change depending on how quickly the job progressed and therefore they needed flexibility in any commitment they entered into to.

The main risk was that sterling weakened. Nine months is a long time. Not that long ago sterling nearly hit parity against the euro. That would represent an increased cost of nearly £100,000 and make the contract marginal if not loss making for their business.

In the end we entered into a forward contract for the purchase of just under €1m at a rate of €1.147 at any time up to the 31st December 2010. The client paid us a deposit of €40,000 to secure this contract. Against budget he had made a saving of nearly €50,000. An added flexibility was he could very easily extend the period of the contract if he needed and any cost would be minimal. He could also buy his euros early as he had entered into what is known as an “open forward contract” which again means that there was no penalty for paying early.

We did discuss the possibility of only securing the rate for part of the purchase cost because there has been talk of the euro weakening because of Greek debt problems. But the conclusion reached was who really knows what could happen over a nine month period given the extreme volatility of the last two years. So best to secure the reduced cost and focus on what they were good at.

If your business is in a similar position please give us a ring because we know how important it is to get these things right and always easier to do it with an expert who understands all the different alternatives that exist.

For more information on Smart Currency Business call: 0845 638 0571 (or +44 (0)207 898 0541 from outside the UK) or visit our website at: SmartCurrencyBusiness.com