If a company sells in a foreign currency that means that underlying trends in its sales and profits can be obscured by foreign currency movements. The result is that growth in turnover or profits in the company's reporting currency (the currency its accounts are in) will not give investors a full view of how the business performed.
Consider a very common situation: a British company sells largely abroad and sets its prices (and is paid) in dollars. Suppose sales increased in dollar terms by 10%, but that the dollar fell against the pound and was on average 4% lower during the year than it was the previous year. The result is that the sales growth shown in the accounts will only be about 6%.
Most companies that are significantly affected by exchange rate fluctuations disclose sales, and sometimes profits, in a way that strips out the effects of exchange rate changes.
This can be done in a number of ways including:
- Translating the current year's turnover and operating profit using the previous year's exchange rate. This is what we mean by constant exchange rates.
- Stating the sales and profits in the appropriate foreign currencies.
- Stating how much sales or profits were reduced or increased as a result of exchange rate changes.
Constant exchange rates are not always better indicators of performance. Some countries have high inflation and currencies that depreciate persistently (the two are linked, see interest rate parity). This means that adjusting for the fall in such a currency gives an overoptimistic view of growth. This most often happens when looking at companies with significant emerging markets operations.
The ideal solution would be to look at inflation adjusted growth numbers but this requires a considerable amount of analysis.