An introduction to hedging in HSC Busines Studies

For HSC Business Studies, we don’t need to be hedging experts; we don’t need to solve hedging for big companies. All we have to do is understand the fundamentals and provide an example to demonstrate hedging in action. Try and keep it as simple as possible.

This is an intro to the idea of hedging. It’s not too detailed but aims to get you on the right track in trying to understand this complicated area.

Where does this sit in the syllabus?

Hedging is part of the Finance topic in the HSC Business Studies course. It is a strategy and is part of the set of Global Financial Management strategies. 

What is hedging in HSC Business Studies? 

As a strategy, hedging is a way for a business to minimise risk. 

Let’s think about this from an individual’s perspective. I look out the window and it looks like it might rain. I consult my weather app and there’s a 50% chance it might rain. 

If I’m thinking about my risk of being rained on, I can reduce my risk to zero by staying indoors. But I’ve got things to do. I need to leave the house. So, I can reduce my risk by venturing outside, accepting it might rain, but taking an umbrella. 

The hedge is the umbrella. 

Obviously a business cannot carry an ‘umbrella’ that will protect against all possible outcomes. Instead, businesses use a number of different methods.

The hedge is the umbrella.

Image source: Myer

An example to demonstrate hedging

One risk for international businesses is currency fluctuations.

Let’s think about Qantas. Qantas earns its revenue in Australian dollars. It pays wages in Australian dollars and has many expenses in Australian dollars.

Qantas, however, has expenses in other currencies too.

Australian companies do not manufacture planes. If Qantas needs a new plane, it has to go to the US or Europe to buy this. And these companies DO NOT accept Australian dollars. 

Instead, Qantas has to change some of its Australian dollars into a foreign currency, like US dollars. The amount of US dollars for one Australian dollar depends on movements in exchange rates.

Let’s say that on 1 January 2023, Qantas will buy a plane from Boeing for $US3 million.

We are now in July 2022 and the Australian dollar is at parity with the US dollar. This means that one Australian dollar will buy one US dollar. The Australian dollar is pretty strong!

At this exchange rate, the cost of the plane for Qantas is $A3 million.

Let’s say we get to December 2022. Now, one Australian dollar only buys $US0.50. The Australian dollar is now WEAKER because it takes more Australian dollars to buy the same value of US dollar. (We say that the Australian dollar has depreciated against the US currency).

Now Qantas has a big problem. The plane still costs $US3 million. This has not changed. But what has changed is that $US3 million now equals $A6 million. Qantas’ expenses have now doubled because the value of the currency changed. This could be disastrous for Qantas if it doesn’t have enough money to cover the higher expenses.

But what does this have to do with hedging?

Qantas can prepare for this risk. It can hedge its currency risk.

Go back to July 2022. Qantas can buy some extra US dollars now, when it has parity with the Australian dollar, to have some extra US dollars in reserve in case the value changes.

So in July 2022, Qantas buys $US3 million worth of US dollars and it costs $A3 million.

Then, in December 2022, when the $A depreciates, Qantas doesn’t need to worry. It can pay for the plane using the US dollars it bought earlier. This means that the cost of the plane is $US3 million, which equates to $A3 million BECAUSE Qantas HEDGED and bought currency before it needed it.

What’s the risk of hedging?

Let’s say Qantas buys $US3 million worth of US dollars but then the Australian dollar appreciates. The risk is that the value of the plane will fall in Australian dollars and Qantas is left with a bunch of US dollars it doesn’t need.

So here’s how it could work. Let’s say $A1 now buys $US2. The plane worth $US3 million will now cost $A1.5 million. It is cheaper than Qantas originally thought. The risk is Qantas now has an extra $US1.5 million it doesn’t immediately need.

Hedging is a risk, but it can be a risk worth taking.

Where does the money come from? (Sources of Finance, HSC Business Studies steeze)

In the HSC Business Studies course, an important element is how a business finds the finance for its plans. 

In terms of the syllabus, this relates to the Influences on financial management, and the internal and external sources of finance. 

Look, you need to have a really in-depth understanding of the sources of finance. This is because the HSC Business Studies exam often asks you to compare and contrast different sources of finance.

Let’s take a look at an example form the 2018 NSW Business Studies HSC exam. This is Q24, part c — a five mark question from the short response focusing on finance. You can see the question below.

This is tha question. Click through for the exam and marking guide.

Pay attention to the wording of the question

In HSC exam questions, every word is deliberate. For this question, it can be tempting to just compare leases and mortgages. 

To elevate your response:

• Bring your points back to the business expanding into a larger factory. Connect your response to the stimulus and the language of the question. For example, if you want to expand BUT then business conditions worsen, what then? Are you locked in to the new premises?

• Notice how it says to “discuss” leases and mortgages? The secret code to “discuss” is to include the pros and cons of each.  

Strategies to answer this question

I’d be looking to divide up the question into two: one part to discuss leasing and the other for mortgages. It’s tricky having five marks on offer. But I’d still follow this pattern.  

I’d then suggest providing one pro and one con for each, providing an example to support the discussion.

For leasing 

One pro is that the business has FLEXIBILITY. If trading conditions change, the business can end its lease and go back to a smaller premises. It is much easier and cheaper to break a lease rather than a mortgage. To break a mortgage, you’d likely have to sell the property.

Another pro of leasing is that the property owner is responsible for all maintenance, including organising and paying for repairs. 

A con of leasing? After all these lease payments, the business does not have an asset to show for it. They do not own the factory, or even a piece of it. 

For mortgages

One pro is that, at the end of the mortgage, the business owns the asset outright. This will show up on the balance sheet and could then be sold if needed. 

Lots of cons to mortgages. They’re expensive, as the business needs to find a deposit, repay principal and interest, and cover fees associated with taking out loans. There’s a lack of flexibility, as outlined as a pro for leasing. And, as a property owner, you are responsible for the costs of maintenance. 

You can see more of my process in the video below.

Understanding the limits (of financial reporting)

As of July 2021, this is how the section in the HSC Business Studies Syllabus reads.

(We’re in HSC Topic Three: Finance, in Processes.)

“Limitations of financial reports — normalised earnings, capitalising expenses, valuing assets, timing issues, debt repayments, notes to the financial statements.”

I found this dot point challenging. What is that students really need to grasp here?

I think about it this way. Financial reporting is extremely important. Investors rely on accurate and timely financial reports to gain a complete picture of a business and make an informed decision about whether to invest.

However, there are problems (what the syllabus calls ‘limitations’) with financial reporting. Therefore investors cannot rely on financial reports to automatically be accurate.

(When we talk about ‘financial reporting’ we’re talking about financial statements — balance sheet, income statement, cash flow statement and so on.)

There are a number of ways financial reports can present an inaccurate picture of a business, and these are the limitations of financial reports. Let’s have a quick look at each of these limitations set out in the syllabus.

Normalising earnings

Businesses can avoid normalising earnings, including one-off examples of income in their financial accounts, to boost their revenue levels and overall profit. As an investor, we want a business to normalise earnings — to exclude one-off injections of revenue.

Capitalising expenses

Businesses can also choose to classify spending as an ASSET rather than an EXPENSE. This is not illegal. However, investors should be aware of the consequences of this — namely overstating profit and understating expenses.

Valuing assets

A business can choose how it values its assets. Again, not illegal. But this will affect the valuation of assets on the balance sheet and MAY NOT be accurate in the context of what those assets are worth, right now, on the market (market value).

Timing issues

In addition, a business can bring forward its expenses or delay recording revenue. This will affect the level of expenses and profit for a given financial year. This could artificially inflate or lower profit levels. Investors should be aware this can happen.

Debt repayments

A business may not present all the information that is relevant to its debt repayments in the financial statements. As a result, investors could find it hard to understand the true solvency of the business, the real story when it comes to the business being able to pay off its long-term debts.

Notes to the financial statements

Finally, a business includes many notes to its financial statements. These can be dense and complex and challenging to understand. As a result, investors may not be able to correctly interpret this information and get a true picture of the state of the business, including its health and performance.

The key point: all of these issues are limitations of financial statements. They can stand in the way of investors getting a complete and accurate picture of the business.

I’ve created a summary sheet of these limitations that can also help. Use it to follow along with the video below.

Worked examples to financial ratios questions

I’m more interested in students’ processes than their answers.

To help with this, in my classroom, I try and extensively model how I would answer questions — particularly financial ratio questions — so that students can replicate my thinking, rather than focus on the correct answer.

The benefit here is that it doesn’t really matter what students get asked. If they apply a good quality process, they’ll be in a great position for success.

Here are some past HSC questions on Finance. I’ve sourced them from NESA. I’ve recorded two videos (below) that take students through my precise process for answering each question. You can play this however best you see fit — have the students try and answer them, and then compare their process with the video; have students watch part one and then attempt part two on their own. Whatever works best.

Process is the focus.

But this takes all too long!

One criticism you might get from students is how this all takes too long in the context of an exam.

I don’t disagree. In the HSC exam, I tell students to only spend around 1-2 minutes per multi choice question.

The point is that students will get faster. They'll recognise the patterns of questions and the connections will form more quickly. They'll only need to do an abridged process in the exam setting.

But it takes time to develop great habits and an excellent process. So, I push them to take all the steps even as they protest.

Trust the process.

Sources of finance in Business Studies

You’re in class, talking about sources of finance. The question comes up: “Which is better, debt or equity?” The answer?

“Well, it depends.”

Because, it does. 

Let’s start with some definitions. 

Debt is an external source of finance and involves borrowing money from banks and other lenders. The price of borrowing is the interest rate charged on the loan. A business has to repay the original loan, plus interest, over the life of the loan. The interest payments are an expense.

Equity is a source of finance that involves money that is invested into the business by its owners. In exchange, the owners receive a slice of ownership — a ‘share’ of the business. In return of equity, businesses need to reward their owners/investors, through the distribution of dividends. Equity finance is external to the business.

So, as a business, which should you choose? 

“It depends.”

Each source of finance has a cost. For debt, the loan must be repaid with interest. For equity, existing owners will have to give up some of their ownership shares to give to the new owners, which will also reduce existing owners’ share of business profits. 

With equity, existing owners must give up control. Their ownership of the business is diluted by the new owners. With debt, owners do not need to give up control — they do not have to offer a share of the business to lenders. But, with debt, owners have ongoing expenses in the form of interest repayments (and the principal, the original loan). 

A business needs to consider its circumstances, as well as the economic climate (including the level of interest rates), before deciding which source of finance it should pursue.

For example, if interest rates are relatively high, the size of repayments will also be relatively high. In this case, a business may prefer to seek equity which would be cheaper (in this context). Or maybe a business is focused on pursuing a particular strategy and does not want to lose control of decision making by bringing on new investors (equity finance); in this case, it may choose debt finance.

And think about this. If a business is performing poorly, and holds debt, it will still need to meet its ongoing repayments, even if revenue has decreased. If a business performs poorly, it won’t have the profits to be able to pay dividends, so investors won’t receive a return and the business doesn’t have the ‘cost’ of rewarding investors.

So, it all depends. You have to carefully consider the individual business.

Starting financial ratio analysis (a little less painfully)

Business Studies is a largely accessible subject for students. Except when it comes to the topic of Finance. This looms large as an insurmountable challenge for many students.

I can understand why students don’t love it. Finance has connotations of complex numbers and maths. It also involves higher order thinking — using the results of the financial ratios to analyse businesses and offer strategies to improve.

Given all this, where should teachers even start?

My approach is to try and get to the heart of why we use financial ratios, which is to tell an accurate story about a business.

First, take a selfie.

Success comes easily after that.

Students often evaluate businesses based on a couple of quick observations and snap judgements. It seems ‘good’ or ‘bad’, but they do not paint a comprehensive picture of the business as it stands.

Financial ratios take the guesswork out of things. They give people the numbers and the evidence to make informed decisions about the true state of a business, encompassing elements such as:

• how good it is at earning profit

• the sustainability of its debt levels

• how well it uses its expenses to drive sales.

So. This is my message to students at the start of the finance topic: we use ratios to tell an accurate story about a business. Moreover, we use a range of ratios to compare businesses on a range of measures and figure out where best to invest our money, or the best strategies to implement to improve operations.

I’ve also created a video, primarily targeted for students, to introduce financial ratios. This could also help in giving students a little more confidence.

Start HERE with financial ratios.

Revenue does not = profit

Let’s clear up a bit of confusion around revenue and profit. Basically, they’re not the same thing. I’ve been reading a bunch of student responses that talk about a company earning profit when they really mean revenue…

I want to clarify this misconception. And I’m trying to clarify it by using apples.

Quick facts: revenue is income received by a business (in our example). Profit is the difference between revenue earned AND the cost of selling the products. 

Try this example (given to me by a Year 6 student). 

You sell apples. You buy them from the wholesaler for $1 each. You then turn around and sell these apples to consumers for $10 each.

Your revenue is $10 (received from the consumer).

Your costs are $1 (the purchase price of the apple for you).

Thus, your profit is a tidy $9 per apple.

Can I also mention that governments don’t generally earn profit? Governments earn taxation revenue. They don’t earn profits from taxation. So, don’t write this. Please.