Notes to the accounts

22 Financial instruments

Financial risk management

The Group’s international operations and debt financing expose it to a range of financial risks that include the effects of changes in debt market prices, foreign exchange rates, credit risks, liquidity and interest rates. The Group has in place risk management policies that seek to limit the adverse effects on the financial performance of the Group by using various instruments and techniques, including foreign currency derivatives, debt and other interest rate derivatives.

Risk management policies are set by the Board. The Central Treasury function receives regular reports from all the businesses to enable prompt identification of financial risks so that appropriate actions may be taken. The treasury policy sets out specific guidelines to manage foreign exchange risks, interest rate risk, credit risk and the use of financial instruments to manage these.

(a) Foreign exchange risk

Transactional currency exposure

The Group has transactional currency exposure arising from sales or purchases by businesses in currencies other than their functional currency. It is Group policy that, when a sale or purchase in a currency which is not the functional currency of that operation has been agreed or is highly probable, the net foreign exchange exposure is hedged. The net exposure is calculated by adjusting the expected cash-flow for payments or receipts in the same currency linked to the sale or purchase. This policy minimises the risk that the profits generated from the transaction will be affected by foreign exchange movements which occur after the price has been determined. Hedging is undertaken using forward foreign exchange contracts.

Hedge accounting documentation and effectiveness testing are only undertaken if it is cost effective. At 31 July 2007 the Group had outstanding foreign currency contracts with a nominal amount of £131m (2006: £97m) which were being used to manage transactional foreign exchange exposures, but not accounted for as cash flow hedges.

The following table shows the financial instruments arising from trading activities, principally trade receivables and payables, analysed by currency. The comparatives presented do not include balances relating to operations which were discontinued in 2007:

	At 31 July 2007
	Sterling £m	US$ £m	Euro £m	Other £m	Total £m
Financial assets and liabilities of continuing operations
Financial instruments included in trade and other receivables	43.6	198.0	122.5	86.0	450.1
Financial instruments included in trade and other payables	(21.9)	(94.3)	(59.7)	(21.0)	(196.9)
	21.7	103.7	62.8	65.0	253.2

	At 5 August 2006
	Sterling £m	US$ £m	Euro £m	Other £m	Total £m
Financial assets and liabilities of continuing operations
Financial instruments included in trade and other receivables	55.7	173.2	127.8	59.9	416.6
Financial instruments included in trade and other payables	(34.9)	(103.9)	(52.5)	(28.5)	(219.8)
	20.8	69.3	75.3	31.4	196.8

Financial instruments included in trade and other receivables comprise trade receivables, accrued income and other debtors which qualify as financial instruments. Similarly, financial instruments included in trade and other payables comprise trade payables, accrued expenses and other creditors which qualify as financial instruments. This balance includes £4.6m (2006: £10.5m) which is due after more than one year.

The table below shows the future cash flows translated at forward rate which will arise in respect of both the purchase and (sale) obligations of all open forward foreign exchange contracts.

	31 July 2007 £m	5 August 2006 £m
Sterling	(2.4)	237.5
US dollar	(39.6)	(227.7)
Euro	14.6	(6.0)
Other	27.4	(3.8)

During the course of the year Smiths entered into a one-off hedge contract to fix the sterling equivalent of the projected net proceeds arising from the Aerospace disposal (note 7). This hedge contract had a nominal value of US$4.2 billion; a maturity date of 8 May 2007; and an effective exchange rate of 1.9791. A gain of £18.5m was realised on this contract, which has been recognised in calculating the fair value of the consideration.

Cash-flow hedging

At 31 July 2007, the Group had outstanding foreign currency contracts designated as hedging instruments in cash-flow hedges of future foreign currency sales and purchases with a nominal amount of £211m (2006: £354m). The fair value of the hedging instruments is disclosed in the derivative table below.

The majority of hedged transactions will be recognised in the income statement in the same period as the cash-flows are expected to occur, with the only differences arising as a result of normal commercial credit terms on sales and purchases. Of the foreign exchange contracts designated as hedging instruments 93% are for periods of 12 months or less (2006: approximately 75%). The proportion of current contracts has increased as a result of the aerospace disposal.

The movements in the cash-flow hedge reserve during the period are summarised in the table below:

	Period ended 31 July 2007 £m	Period ended 5 August 2006 £m
Brought forward cash-flow hedge reserve at start of period	13.3	0.6
Gains and losses on effective cash-flow hedges recognised in equity	4.8	18.4
Amounts removed from the hedge reserve and recognised in the income statement	(16.7)	(5.7)
Carried forward cash-flow hedge reserve at end of period	1.4	13.3

Translational currency exposure

The Group has a significant investment in overseas operations, particularly in the Americas and Europe, but to a lesser extent the rest of the world. As a result, the sterling value of the Group’s balance sheet can be affected by movements in exchange rates. The Group therefore seeks to mitigate the effect of these translational currency exposures by matching the net investment in overseas operations with borrowings denominated in their functional currencies, except where significant adverse interest differentials or other factors would render the cost of such hedging activity uneconomic. This is achieved by borrowing either directly in the local domestic markets or indirectly through the use of rolling annual forward foreign exchange contracts.

The table below sets out the currency of:

cash, cash equivalents and borrowings; and
the impact of the cross-currency swap contracts used for net investment hedging.

	At 31 July 2007
	Sterling £m	US$ £m	Euro £m	Other £m	Total £m
Cash and cash equivalents	68.3	11.6	62.5	46.9	189.3
Borrowings	(439.2)	(140.2)	(168.9)	(30.9)	(779.2)
	(370.9)	(128.6)	(106.4)	16.0	(589.9)
Effect of currency swaps	255.9	(89.5)	(125.0)	(41.4)
	(115.0)	(218.1)	(231.4)	(25.4)	(589.9)

	At 5 August 2006
	Sterling £m	US$ £m	Euro £m	Other £m	Total £m
Cash and cash equivalents	54.2	1.3	30.1	35.0	120.6
Borrowings	(464.9)	(307.4)	(246.8)	(28.2)	(1,047.3)
	(410.7)	(306.1)	(216.7)	6.8	(926.7)
Effect of currency swaps	241.2	(89.5)	(100.0)	(51.7)
	(169.5)	(395.6)	(316.7)	(44.9)	(926.7)

Net investment hedges

Cross-currency swap contracts for US dollars, euros, yen and Canadian dollars with a nominal value of £238m (2006: £232m) and foreign currency borrowings of €100m (2006: €275m) have been designated as net investment hedges in respect of the currency translation risk arising on foreign operations. The contracts mature between August 2007 and September 2008. The fair value of the hedging instruments is disclosed in the derivative table below.

Gains and losses on net investment hedges that have been deferred in the net investment hedge reserve are shown in the table below:

	Period ended 31 July 2007 £m	Period ended 5 August 2006 £m
Brought forward net investment hedge reserve at start of period	13.2	(3.9)
Amounts deferred in the period on effective net investment hedges	8.2	17.1
Amounts removed from the hedge reserve and recognised in the income statement	(4.2)
Carried forward net investment hedge reserve at end of period	17.2	13.2

(b) Interest rate risk

The Group operates an interest rate policy designed to optimise interest cost and reduce volatility in reported earnings. The Group’s normal policy is to require interest rates to be fixed for 30% to 70% of the level of underlying borrowings forecast to arise over a three-year horizon. This is achieved partly through fixed rate borrowings, and partly through the use of interest rate swaps. At 31 July 2007, 55% (2006: 38%) of the Group’s gross borrowings excluding the cash pool gross up were at fixed interest rates after adjusting for interest rate swaps.

Interest rate profiles of financial assets and liabilities

The following table indicates the exposure of cash and borrowings to interest rate risk. The other financial assets and liabilities do not earn or bear interest.

	Cash and cash equivalents 31 July 2007 £m	Borrowings 31 July 2007 £m	Cash and cash equivalents 5 August 2006 £m	Borrowings 5 August 2006 £m
Fixed interest financial assets/(liabilities) (adjusted for interest rate hedging):
Less than one year	14.1	(3.0)		(3.1)
Between one and two years		(0.5)		(0.5)
Between two and three years		(149.9)		(0.6)
Between three and four years		(0.3)		(149.9)
Between four and five years		(0.4)		(0.6)
Greater than five years		(207.9)		(211.4)
Total fixed interest financial assets/(liabilities) (adjusted for interest rate hedging)	14.1	(362.0)		(366.1)
Floating rate interest financial assets/(liabilities)	165.6	(417.2)	112.5	(681.2)
Total interest bearing financial assets/(liabilities)	179.7	(779.2)	112.5	(1,047.3)
Non-interest bearing assets/(liabilities) in the same category	9.6		8.1
Total	189.3	(779.2)	120.6	(1,047.3)

Interest rate hedging

The Group has designated US$150m interest rate swaps which mature on 28 January 2013 as fair value hedges on the US private placement which matures on the same date. This hedges the risk of variability in the fair value of borrowings arising from interest rate fluctuations. The fair value of the hedging instrument is disclosed in the derivative table below.

The effect of the interest rate swap is to convert £73.7m (2006: £78.6m) debt from fixed rate to floating rate.

Sensitivity of interest charges to interest rate movements

Based on the composition of net debt and financing arrangements at 31 July 2007, and taking into consideration all fixed rate borrowings in place and interest rate swaps, a one percentage point (100 basis points) change in average floating interest rates would have a £3m (2006: £6m) impact on the Group’s profit before tax.

(c) Credit risk

Financial

The Group is exposed to credit-related losses in the event of non-performance by counterparties to financial instruments, but does not expect any counterparties to fail to meet their obligations. Credit risk is mitigated by the Group’s Board-approved policy of only selecting counterparties with a strong investment graded long-term credit rating, normally at least AA- or equivalent, and assigning financial limits to individual counterparties. In the normal course of business, the Group operates notional cash pooling systems, where a legal right of set-off applies. The maximum exposure with a single bank for deposits is £27m (2006: £11m), whilst the maximum mark to market exposure for forward foreign exchange contracts at 31 July 2007 to a single bank is £4.6m (2006: £12m).

Operational

Concentrations of credit risk with respect to trade receivables are limited due to the wide spread of business activities. The largest single customer is the US Federal Government representing less than 4% of group turnover. Owing to these factors management believe that impairment provisions for trade receivables (note 17) fully address the operational credit risks.

The maximum credit risk exposure in the event of other parties failing to perform their obligations under financial assets totals £639.4m at 31 July 2007 (2006: £772m).

(d) Liquidity risk

The Group actively maintains committed facilities that are designed to ensure the Group has sufficient available funds for operations and planned expansions. During the period, the Group extended its principal credit facility (£660m revolving credit facility) to 2012.

Borrowing facilities

To provide adequate liquidity committed unused credit facilities of at least £100m (or equivalent free cash) are maintained at all times. Liquidity in 2007 was provided by undrawn revolving credit facilities.

	2007 £m	2006 £m
Expiring within one year	50.0	90.0
Expiring between one and two years
Expiring after two years	593.0	305.0
	643.0	395.0

As at 31 July 2007, £40.8m (2006: £18.3m) of cash and cash equivalents was on deposit with various banks and in money market funds of which £32.2m (2006: £16.4m) was on deposit in the UK.

Fair value of financial assets and liabilities

The fair values of financial assets and financial liabilities are the amounts at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale. The following methods have been used to estimate the fair values of the financial instruments:

cash, trade receivables and payables and floating rate borrowings – the carrying value is a good approximation of the fair value;
fixed rate borrowings – quoted market prices of equivalent instruments;
forward exchange contracts and currency swaps – market valuations at the balance sheet date; and
interest rate instruments and embedded derivatives – based on the net present value of discounted cash-flows.

All financial instruments except for borrowings are carried at a value which is not materially different from their fair value. Borrowings are recorded initially at the fair value of the consideration received and subsequently recorded at amortised cost. The following table summarises the carrying value under IFRS and the fair value for borrowings after interest rate swaps.

	Carrying amount 31 July 2007 £m	Estimated fair value 31 July 2007 £m	Carrying amount 5 August 2006 £m	Estimated fair value 5 August 2006 £m
Borrowings
Non-current
Fixed rate	(359.0)	(374.1)	(363.0)	(386.2)
Floating rate	(208.1)	(208.1)	(499.3)	(499.3)
Total non-current	(567.1)	(582.2)	(862.3)	(885.5)
Current
Fixed rate	(3.0)	(3.0)	(3.1)	(3.1)
Floating rate	(209.1)	(209.1)	(181.9)	(181.9)
Total current	(212.1)	(212.1)	(185.0)	(185.0)
Total borrowings	(779.2)	(794.3)	(1,047.3)	(1,070.5)

Financial derivatives

The tables below set out the nominal amount and fair value of derivative contracts held by the Group, identifying the derivative contracts which qualify for hedge accounting treatment:

	Contract or underlying nominal amount		Fair value
At 31 July 2007	Assets £m	Liabilities £m	Assets £m	Liabilities £m	Net £m
Currency and interest-related instruments:
Foreign exchange contracts (cash-flow hedges)	147.6	(63.4)	2.6	(0.8)	1.8
Foreign exchange contracts (not hedge accounted)	64.3	(67.1)	0.9	(1.7)	(0.8)
Total foreign exchange contracts	211.9	(130.5)	3.5	(2.5)	1.0
Cross-currency swaps (net investment hedges)		(238.2)	9.0		9.0
Cross-currency swaps (not hedge accounted)		(17.7)	1.4		1.4
Total cross-currency swaps		(255.9)	10.4		10.4
Interest rate swaps (fair value hedges)		(73.7)		(2.8)	(2.8)
Embedded derivatives	15.8		0.2	(1.3)	(1.1)
Total financial derivatives	227.7	(460.1)	14.1	(6.6)	7.5
Balance sheet entries:
Non-current			0.4	(2.5)	(2.1)
Included in assets/(liabilities) of disposal group (note 19)			0.2	(1.3)	(1.1)
Current			13.5	(2.8)	10.7
Total financial derivatives			14.1	(6.6)	7.5

	Contract or underlying nominal amount		Fair value
At 5 August 2006	Assets £m	Liabilities £m	Assets £m	Liabilities £m	Net £m
Currency and interest-related instruments:
Foreign exchange contracts (cash-flow hedges)	300.7	(53.3)	18.1	(1.1)	17.0
Foreign exchange contracts (not hedge accounted)	65.3	(31.7)	0.9	(1.0)	(0.1)
Total foreign exchange contracts	366.0	(85.0)	19.0	(2.1)	16.9
Cross-currency swaps (net investment hedges)		(231.8)	13.1	(0.1)	13.0
Cross-currency swaps (not hedge accounted)		(9.4)
Total cross-currency swaps		(241.2)	13.1	(0.1)	13.0
Interest rate swaps (fair value hedges)		(78.6)		(3.7)	(3.7)
Embedded derivatives	57.9		0.2	(3.4)	(3.2)
Total financial derivatives	423.9	(404.8)	32.3	(9.3)	23.0
Balance sheet entries:
Non-current			6.2	(4.4)	1.8
Current			26.1	(4.9)	21.2
Total financial derivatives			32.3	(9.3)	23.0

Hedge accounting

The hedge reserve on the balance sheet comprises:

	31 July 2007 £m	5 August 2006 £m
Cash-flow hedge reserve	1.4	13.3
Net investment hedge reserve	17.2	13.2
	18.6	26.5

See foreign exchange risk management disclosures above for additional details of cash flow and net investment hedges and interest rate risk management disclosure above for additional details of fair value hedges.

Accounting for other derivative contracts

Any foreign exchange contracts which are not formally designated as hedges and tested are classified as ‘held for trading’ and not hedge accounted.

Amounts recognised in respect of embedded derivatives primarily represent the value of currency terms in commercial contracts between Smiths European subsidiaries and customers and suppliers outside the USA which are denominated in US dollars.

Smiths Group divisions:
Smiths Detection, Smiths Medical, Smiths Specialty Engineering