Jamal Mecklai: 'Additional other income'

MARKET MANIAC

To be able to make better forecasts of business performance, companies need to more accurately assess how much of their operating margin is genuinely attributable to business operations and how much is the result of forces outside management's control "" for instance, market fluctuations, which could always move adversely. In other words, how much of business income is really "additional other income"?

Examples abound. The steel industry, over the past few years, has seen its profits "" and share prices "" soar, in large measure because of the sharp rise in steel prices. The IT industry historically enjoyed super-premium margins, again, to some degree at least, because of the continuous weakening of the rupee (till 2002).

While thoughtful analysts would, of course, be cognisant of these broad sweep impacts, it is critical for company managements to have in place processes to quantify these impacts, since without this understanding business planning "" a wobbly process at best "" would be that much wobblier.

In trying to assess the impact of, say, copper prices or the volatility of the euro against the dollar, on your operating margin, the first step is to create an objective benchmark. Many companies use the current market price or some estimated (or expected) price of the variable in their business plan and then measure the impact of market movements by the difference between the actual cost and the budgeted cost of, say, copper purchases.

While this does give a first-pass estimate of the impact of, say, copper fluctuation on the company's bottom line, it does not strip out the savings (or loss) associated with any smart (or poor) buying decisions that the company's purchase department may have made.

Thus, in creating the objective benchmark, it is necessary to have not only a market-determined (objective) value of the variable (say, copper or euro or whatever) at the start of the financial year, but also a benchmark buying or hedging process, which is also objective "" that is, which does not use any market view to take buying (or hedging) decisions.

Consider a manufacturing company with significant dollar exports and imports in a range of different currencies, including the euro, pound and yen. At the start of the financial year, the company sets the "target value" of its net foreign exchange flows using an objective process like, say, option pricing.

Let us assume this "target value" is Rs 250 crore. Through the financial year, the treasury attempts to maximise the value of the portfolio, while ensuring that it never falls below the target value. Let us say the treasury has been successful, and, at the end of the financial year, the value delivered is Rs 255 crore.

While this is an excellent performance "" the difference of Rs 5 crore is about 2 per cent of the top line "" management needs to know what part of this gain, if any, accrued because the market moved favourably and how much was a direct result of treasury action.

To be able to assess this, the company needs to run an objective benchmark hedging process "" that is, one that could have been implemented without the skills of the treasury. One such is to use an analytic tool, like value at risk (VaR), to hedge whenever the target value is threatened; this process simply ensures that the target value is never breached, and that's it.

There are no decisions taken based on any market view, on what the treasury (or anyone else) thinks. This is obviously a theoretical simulation and the company should run it in parallel with actual treasury activity to come with the benchmark portfolio value at the end of the financial year. In the example, say, this value turned out to be Rs 254 crore.

The learning from this, then, is that the treasury actually "earned" Rs 1 crore (the difference between the actual performance and the benchmark) during the year rather than Rs 5 crore. And the difference of Rs 4 crore (between the gain compared to the target value and the treasury earnings) actually accrued to the company's top line as the result of favourable market movements.

To my mind, this is hugely significant information. If more than 1.5 per cent of the company's top line was a result of favourable market movements, this amount should correctly be treated "" at least in internal management accounting "" as "additional other income", since it was not the result of business operations and, importantly, the market could just as easily move in the opposite direction. Thus, this amount needs to be deducted from the top line to assess the company's true operating margin.

These numbers would be even more significant for companies who have commodity inputs (or outputs), since commodity prices are typically even more volatile.

Of course, most companies do have processes to measure how much they have gained (or lost) as a result of market movements. The trick is to make these processes more reflective of business (and market) realities.