Financial review
Accounting policies
The accounts in this report are prepared under International Financial Reporting Standards (IFRS), as adopted by the European Union (EU). The accounting policies used in preparing these accounts are set out elsewhere in this report.
The 2007 financial year ended on 31 July. The 2006 financial year ended on 5 August 2006.
Significant judgements, key assumptions and estimates
Applying accounting policies requires the use of certain judgements, assumptions and estimates. The most important of these are set out elsewhere in this report.
The uncertainty affecting the estimation of provisions has increased following the commutation of certain insurance policies in respect of product liability. See legal issues section for details.
Taxation
The tax charge for the year represented an effective rate for continuing operations of 25.1% on the headline profit before taxation, compared to 25.6% in 2006. The rate reduced due to taking advantage of global tax incentives, the tax-efficient use of capital and active tax compliance management. On a statutory basis, the tax charge on continuing activities was £53m.
The fundamental tenets of the Smiths approach to taxation are to enhance the Company’s competitive position on a global basis, while engaging with tax authorities around the world on a basis of full disclosure, full co-operation and full legal compliance. The Board considers and approves the management of the Company’s tax affairs in the context of the Company’s commercial objectives.
Accordingly, Smiths seeks to build open relationships with tax authorities to bring about timely agreement of tax affairs and to remove uncertainty on business transactions.
In summary, the Company’s taxation strategy is to mitigate the burden of taxation in a responsible manner for competitive advantage, and, in this way, to enhance long-term shareholder value.
Cost of capital and return on shareholders’ funds
Smiths uses its weighted average cost of capital as one measure to appraise both internally-generated investment opportunities and acquisitions. During 2007, the Company’s weighted average cost of capital (WACC) increased from 8% to 9%.
The after-tax headline return on shareholders’ funds for continuing operations, including goodwill set-off against reserves, was 14.9%. In order to adjust for the Aerospace disposal, this ratio has been calculated using the closing net assets adjusted for movements in goodwill set-off against reserves relating to the continuing operations. The 2006 Group return on shareholders’ funds was 13.6%.
Retirement benefits
As required by IFRS the balance sheet reflects the net surplus or deficit in retirement benefit plans, taking assets at their market values at 31 July 2007 and evaluating liabilities at year-end AA corporate bond interest rates.
The year-end retirement benefit position was:
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|
2007 |
2006 |
|
Funded plans: |
|
|
|
UK plans – funding status |
113% |
105% |
|
US plans – funding status |
92% |
84% |
|
Other plans – funding status |
83% |
68% |
|
|
||
|
|
£m |
£m |
|
Surplus/(deficit): |
|
|
|
Funded plans |
297 |
75 |
|
Unfunded plans |
(114) |
(127) |
|
Total surplus/(liability) |
183 |
(52) |
Company contributions to the funded pension plans were £103m (2006: £110m). In 2007 special contributions were made totalling £56m, including £21m in respect of the aerospace disposal. In 2006 a £61m special payment was made to facilitate UK scheme mergers.
Full details of the retirement benefits are shown in note 10.
Exchange rates
The results of overseas operations are translated into sterling at average exchange rates. The net assets are translated at year-end rates. The principal exchange rates, expressed in terms of the value of sterling, are shown in the following table.
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|
2007 |
2006 |
|
|
Average rates: |
|
|
|
|
US Dollar |
1.95 |
1.79 |
Dollar weakened 9.0% |
|
Euro |
1.48 |
1.46 |
Euro weakened 1.5% |
|
Year-end rates: |
|
|
|
|
US Dollar |
2.04 |
1.91 |
Dollar weakened 6.7% |
|
Euro |
1.49 |
1.48 |
Euro weakened 0.4% |
Dividend policy
An interim dividend of 10.5p per share was paid on 27 April 2007. A final dividend of 23.5p per share is proposed.
Information on the return of cash to shareholders is set out in the aerospace disposal section.
The 31 July 2007 balance sheet includes a £18m liability, and a matching cash balance, in respect of the B Shares whose redemption has been deferred.
Smiths objective is to increase dividends annually when trading results and prospects justify it, and, in the long term, for dividend cover relative to headline earnings of 1.8.
Goodwill and intangibles
Goodwill on acquisitions has been capitalised since 1998. Until 1 August 2004 it was amortised over a maximum 20-year period. Under IFRS goodwill is no longer amortised but instead is subject to annual reviews to test for impairment.
The goodwill balance was tested for impairment in 2007 and 2006.
Treasury
The aim of Treasury management in Smiths is to ensure a robust and prudent financial profile while driving value throughout the Company to attain the business’s full potential. With this goal in mind, Treasury aims to reduce the cost of capital by optimising financial liabilities with the support of world-class banks.
Smiths continues to apply centralised treasury management over its financial risks, operating within a strong control environment. The Company uses financial instruments to raise money for its operations and to manage the related financial risks. Smiths neither speculates nor trades in derivative financial instruments and all financial instruments are properly recognised on the balance sheet. The Board has approved a Treasury Policy, which governs the financial risk profile, and a treasury compliance report is presented annually to the Audit Committee.
The objectives of the treasury function remain the same as in previous years and are explained in further detail below.
1. To deliver the liquidity requirements of the businesses cost-effectively.
The Group aims to minimise the level of surplus cash but, where surpluses arise, tight controls apply to ensure that they are securely placed with highly-rated counterparties and are available for redeployment at short notice. The Company is required under IFRS to show gross borrowings and cash under its cash pooling arrangements, despite these balances being netted for interest purposes, which exaggerates the Company’s surplus cash balance. Local working capital needs and capital expenditure requirements are typically funded by local bank facilities.
2. To manage the central funding demands and provide a low cost of debt.
The Company’s funding requirements are largely driven by acquisition activity and met by centrally arranged debt finance. Smiths has net debt as at 31 July 2007 of £588m (2006: £923m) with average maturity of 4.5 years (2006: 5 years) and at an average effective interest rate after interest and currency swaps of 5.8% (2006: 5.6%). Through the use of interest rate swaps, Smiths maintains a broadly even mix of fixed and floating rate debt.
Credit ratings are BBB+/Baa2 with Standard & Poor’s and Moody’s respectively. The ratings fell after the aerospace disposal and consequential return of cash to shareholders, reflecting Smiths increased exposure to industrial products with short sales order cycles and higher relative anticipated gearing. The ratings are stable.
3. To develop and maintain strong and stable banking relationships and services.
Smiths has a core group of eleven leading global banks and financial institutions that competitively tender for treasury business. Credit exposures to any one bank are carefully controlled. All business transacted with the banks is on consistent terms and is fairly allocated.
4. To provide reasonable protection from the effect of foreign currency volatility.
Material cross-border sales or purchase contracts in foreign currencies are hedged at their inception by appropriate derivative financial instruments, principally forward foreign exchange contracts and swaps, with the Group’s core banks as counterparties. Whilst the trends of foreign currency movements cannot be eliminated, this hedging programme reduces volatility, protecting cash-flow and margins.
Smiths has adopted hedge accounting for the majority of the Group’s business at its larger sites, thereby mitigating the impact of transactional exposures in the income statement.
Smiths protects its reserves from foreign currency fluctuations by ensuring that at least 75% of the total net overseas operational assets are offset either by borrowings in the respective currency or by currency swaps. This excludes goodwill which is only partly hedged.
Overseas earnings are translated at average currency rates for the year, which smoothes the effect of currency volatility.
The Group’s strategy is to continue to take a risk-averse approach to managing and controlling financial risks, be it hedging currency and interest rate risk, liquidity or management of refinancing risk.
Financial controls
While the Group’s decentralised organisation delegates day-to-day control to local management, Smiths has comprehensive control systems in place with regular reporting to the Board. The Group has continuous formalised business risk management processes operating at each business unit.
The internal audit department reviews all units over a rolling three-year cycle, and its findings are reported to the Audit Committee. All acquisitions are reviewed within 12 months of acquisition, to verify compliance with Group procedures.
Further information regarding the Group’s procedures to maintain strict controls over all aspects of risk, including financial risk, are set out in the Corporate governance report elsewhere in this report.