In general, when we're modeling the operations of a business, we don't forecast changes in foreign currency rates.

That's FX rates.

This is because there are too many uncertainties around how currency can impact variable items such as revenues and costs.

However, when a company has foreign currency debt, which is by definition a fixed cash flow, it can be useful to consider the impact of FX rate changes on the forecasts, particularly if the currency of the borrowings is completely different to the currency of the operations, that their financing as this will create a significant FX risk.

Changes in the FX rate will impact balance sheet values and create FX gains and losses.

We can use forward FX rates.

Those are rates which are implied based on forward interest rate curves for borrows in different currencies, and this helps us to predict the effects in our model.

Here we have a US company, which has a bank loan denominated in Euros.

The loan principle is 1000 euros, and the interest rate is 2%.

Over the next four years, the Euro to US dollar forward FX rate is increasing.

This means that one Euro will buy more US dollars each year, so the Euro is strengthening against the US dollar.

This is hugely problematic for a US company which has borrowed in Euros, as it means that the US dollar value of the amount that they owe is increasing each year.

The calculation shown here is effectively a base calculation.

We start off with a loan translated into US dollars at the current rate of 1.1, so the loan value is 1,100 US dollars.

However, for the first forecast year, the forward FX rate is higher at 1.2, so the loan value becomes 1,200 US dollars.

This represents an FX loss of 100 and is added to the base calculation.

This continues each year, and by the end of the fourth forecast year, when the forward rate is 1.5, the loan balance becomes 1,500 US dollars.

It's important to note that the FX gain or loss on retranslate foreign currency loan balances is included as a financing income or expense in the income statement alongside the actual interest on the loan, you can see below the base calculation the calculation of total finance income or expense, which is 123 in the first forecast year.

That includes both the 2% interest on the loan balance in US dollars and the FX loss of 100.

So how does this impact on our model? Well, as We've just seen, the FX gain or loss on the loan balance is included in the income statement alongside the interest on the loan.

Then the ending balance on the loan is also included in the balance sheet translated at the forward rate.

Then we also need to make an adjustment in the cashflow statement.

This is because the FX gain or loss on retranslate, the loan is a non-cash item, yet it is already included in net income.

So an FX loss would need to be added back, and an FX gain would need to be deducted when calculating operating cash flows.

One final item to note when we're modeling with foreign currency debt is that the financing cash flows for debt issuance and repayment should include only debt actually issued or repaid in the year, not changes in the loan balance in the balance sheet.

This is because changes in the balance sheet amounts will include FX gains or losses, which we know are not actual cash flows.

So when we're calculating the financing cash flows, we take the debt issuance or repayment from our debt schedules rather than the balance sheet.