Notes to the accounts
21 Financial risk management
The Group’s international operations and debt financing expose it to financial risks including the effects of changes in foreign exchange rates, changes in debt market prices, interest rates, credit risks and liquidity risks.
Risk management policies are set by the Board. The treasury policy sets out specific guidelines to manage foreign exchange risk, interest rate risk, credit risk and the use of financial instruments to manage risk. The instruments and techniques used to manage risk exposures include foreign currency derivatives, debt and other interest rate derivatives. The central treasury function monitors financial risks and compliance with risk management policies using regular reports from all the businesses.
The management of operational credit risk is discussed in note 16.
(a) Foreign exchange risk
Transactional currency exposure
The Group is exposed to foreign currency risks arising from sales or purchases by businesses in currencies other than their functional currency. It is Group policy that, when such a sale or purchase is certain or highly probable, the net foreign exchange exposure is hedged using forward foreign exchange contracts. 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.
Hedge accounting documentation and effectiveness testing are only undertaken if it is cost effective. At 31 July 2008 the Group had outstanding foreign currency contracts with a nominal value of £130m (2007: £131m) which were being used to manage transactional foreign exchange exposures, but were not accounted for as cash-flow hedges.
The following table shows the currency of financial instruments. It excludes loans and derivatives designated as net investment hedges.
At 31 July 2008 |
|||||
Sterling |
US$ |
Euro |
Other |
Total |
|
Financial assets and liabilities |
|||||
Financial instruments included in trade and other receivables |
40.6 |
237.4 |
162.2 |
96.5 |
536.7 |
Financial instruments included in trade and other payables |
(49.9) |
(121.4) |
(86.9) |
(40.1) |
(298.3) |
Cash and cash equivalents |
32.7 |
16.5 |
48.0 |
35.3 |
132.5 |
Borrowings not designated as net investment hedges |
(412.1) |
(163.2) |
(13.8) |
(103.8) |
(692.9) |
(388.7) |
(30.7) |
109.5 |
(12.1) |
(322.0) |
|
Exclude balances held in operations with the same functional currency |
389.3 |
56.4 |
(35.6) |
(62.0) |
348.1 |
Exposure arising from intra-group loans |
(15.5) |
(11.2) |
(26.7) |
||
Forward foreign exchange contracts |
48.9 |
(50.0) |
(1.9) |
3.0 |
|
49.5 |
(39.8) |
72.0 |
(82.3) |
(0.6) |
|
At 31 July 2007 |
|||||
Sterling |
US$ |
Euro |
Other |
Total |
|
Financial assets and liabilities |
|||||
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) |
Cash and cash equivalents |
68.3 |
11.6 |
62.5 |
46.9 |
189.3 |
Borrowings not designated as net investment hedges |
(439.2) |
(140.2) |
(101.6) |
(30.9) |
(711.9) |
(349.2) |
(24.9) |
23.7 |
81.0 |
(269.4) |
|
Exclude balances held in operations with the same functional currency |
350.8 |
54.8 |
(22.1) |
(73.9) |
309.6 |
Exposure arising from intra-group loans |
(5.5) |
(18.4) |
(23.9) |
||
Forward foreign exchange contracts |
(2.4) |
(39.6) |
14.6 |
27.4 |
|
(0.8) |
(15.2) |
16.2 |
16.1 |
16.3 |
|
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.
In the period ended 31 July 2007 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. The gain of £18.5m realised on this contract was recognised in calculating the fair value of the consideration.
Based on the assets and liabilities held at the year end, if the specified currencies were to strengthen 10% while all other market rates remained constant, the change in the fair value of financial instruments not designated as net investment hedges would have the following effect:
Impact on profit |
Gain/(loss) |
Impact on profit |
Gain/(loss) |
|
US dollar |
(0.1) |
(3.3) |
1.5 |
(1.7) |
Euro |
4.8 |
(1.0) |
(0.7) |
2.6 |
Sterling |
2.1 |
2.8 |
1.1 |
2.3 |
These sensitivities were calculated before adjusting for tax and do not include the effect of intra-group loans which have been designated as quasi-equity.
Cash-flow hedging
The Group uses foreign currency contracts to hedge future foreign currency sales and purchases. At 31 July 2008 contracts with a nominal value of £222.2m (2007: £211.0m) were designated as hedging instruments. The fair value of the hedging instruments is disclosed in note 22.
The majority of hedged transactions will be recognised in the income statement in the same period that 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 99% are for periods of 12 months or less (2007: 93%).
The movements in the cash-flow hedge reserve during the period are summarised in the table below:
Year ended |
Period ended |
|
Brought forward cash-flow hedge reserve at start of period |
1.4 |
13.3 |
Exchange adjustments |
0.2 |
|
Gains and losses on effective cash-flow hedges recognised in equity |
(1.0) |
4.8 |
Amounts removed from the hedge reserve and recognised in the following lines on the income statement: |
||
– Revenue |
0.2 |
(2.7) |
– Cost of sales |
0.3 |
1.1 |
– Profit after taxation – discontinued operations |
(15.1) |
|
Carried forward cash-flow hedge reserve at end of period |
1.1 |
1.4 |
Translational currency exposure
The Group has a significant investment in overseas operations, particularly in America and Europe. As a result, the sterling value of the Group’s balance sheet can be affected by movements in exchange rates. The Group 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 currency or indirectly through the use of rolling annual forward foreign exchange contracts.
The table below sets out the currency of loans designated as net investment hedges and cross-currency swap contracts:
At 31 July 2008 |
|||||
Sterling |
US$ |
Euro |
Other |
Total |
|
Loans designated as net investment hedges |
(139.6) |
(70.6) |
(210.2) |
||
Cross currency swap contracts |
371.4 |
(150.6) |
(163.0) |
(57.8) |
|
371.4 |
(290.2) |
(233.6) |
(57.8) |
(210.2) |
|
|
At 31 July 2007 |
|||||
Sterling |
US$ |
Euro |
Other |
Total |
|
Loans designated as net investment hedges |
(67.3) |
(67.3) |
|||
Cross currency swap contracts |
255.9 |
(89.5) |
(125.0) |
(41.4) |
|
255.9 |
(89.5) |
(192.3) |
(41.4) |
(67.3) |
|
The fair values of these net investment hedges are subject to exchange rate movements. Based on the hedging instruments in place at the year end a 10% increase in the value of the US dollar while all other market rates remained constant would lead to a fair value loss of £14.9m (2007: £8.2m) and a 10% increase in the value of the euro while all other market rates remained constant would lead to a fair value loss of £17.4m (2007: £19.0m). These movements would be recognised in equity and fully offset by an opposite movement on the retranslation of the net assets of the overseas subsidiaries. These sensitivities were calculated before adjusting for tax.
Net investment hedges
Cross-currency swap contracts for US dollars, Euros, Yen, Renminbi and Canadian dollars with a nominal value of £371m (2007: £238m) and foreign currency borrowings of US $277m (2007: $nil) and €90m (2007: €100m) have been designated as net investment hedges in respect of the currency translation risk arising on foreign operations. The contracts mature within twelve months. See note 22 for the fair value of the contracts.
The gains and losses that have been deferred in the net investment hedge reserve are shown in the table below:
Year ended |
Period ended |
|
|
Brought forward net investment hedge reserve at start of period |
17.2 |
13.2 |
Amounts deferred in the period on effective net investment hedges |
(47.5) |
8.2 |
Amounts removed from the hedge reserve and recognised in the income statement |
(4.2) |
|
Carried forward net investment hedge reserve at end of period |
(30.3) |
17.2 |
(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. Excluding the cash pool gross up, at 31 July 2008 46% (2007: 55%) of the Group’s borrowings were at fixed interest rates, after adjusting for interest rate swaps.
The weighted average interest rate on borrowings and cross currency swaps at 31 July 2008, after interest rate swaps, is 4.6% (2007: 5.3%).
Interest rate profile of financial assets and liabilities and the fair value of borrowings
The following table shows the interest rate risk exposure of cash and borrowings. The other financial assets and liabilities do not earn or bear interest and for all financial instruments except for borrowings the carrying value is not materially different from their fair value.
Cash and |
Borrowings |
Fair value of |
Cash and |
Borrowings |
Fair value of |
|
Fixed interest (adjusted for interest rate hedging): |
||||||
Less than one year |
(3.8) |
(4.0) |
14.1 |
(3.0) |
(3.0) |
|
Between one and five years |
(203.5) |
(207.1) |
(151.1) |
(157.3) |
||
Greater than five years |
(160.1) |
(166.2) |
(207.9) |
(216.8) |
||
Total fixed interest financial assets/(liabilities) (adjusted for interest rate hedging) |
(367.4) |
(377.3) |
14.1 |
(362.0) |
(377.1) |
|
Floating rate interest financial assets/(liabilities) |
122.1 |
(535.7) |
(535.7) |
165.6 |
(417.2) |
(417.2) |
Total interest bearing financial assets/(liabilities) |
122.1 |
(903.1) |
(913.0) |
179.7 |
(779.2) |
(794.3) |
Non-interest bearing assets/(liabilities) in the same category |
10.4 |
9.6 |
||||
Total |
132.5 |
(903.1) |
(913.0) |
189.3 |
(779.2) |
(794.3) |
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 note 22. The effect of the interest rate swap is to convert £75.7m (2007: £73.7m) debt from fixed rate to floating rate.
Sensitivity of interest charges to interest rate movements
The Group has exposure to sterling, US dollar and Euro interest rates. However the Group does not have a significant exposure to interest rate movements for any individual currency. Based on the composition of net debt and foreign exchange rates at 31 July 2008, and taking into consideration all fixed rate borrowings and interest rate swaps in place, a one percentage point (100 basis points) change in average floating interest rates for all three currencies would have a £4.3m (2007: 3.9m) impact on the Group’s profit before tax.
(c) Financial credit risk
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 for cash deposits, 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 credit risk exposure in the event of other parties failing to perform their obligations under financial assets, excluding trade and other receivables, totals £132.5m at 31 July 2008 (2007: £189.3m). This includes cash of £100.6m (2007: £123.2m) held in interest compensation pools where Smiths has a legal right of set-off and the net pool balance at the year end was a creditor.
The maximum exposure with a single bank for deposits and cash is £12.4m (2007: £27.8m), whilst the maximum mark to market exposure for foreign exchange contracts at 31 July 2008 to a single bank is £1.5m (2007: £4.6m). These banks had credit ratings of AA and AA+ respectively.
(d) Liquidity risk
Borrowing facilities
The Group actively maintains committed unused credit facilities of at least £200m (or equivalent free cash) at all times to ensure it has sufficient available funds for operations and planned expansions. In 2007 the principal £660m revolving credit facility was extended to 2012. At the balance sheet date the Group had the following undrawn credit facilities:
2008 |
2007 |
|
Expiring within one year |
50.0 |
|
Expiring between one and two years |
||
Expiring after two years |
449.8 |
593.0 |
449.8 |
643.0 |
Cash deposits
As at 31 July 2008, £10.0m (2007: £40.8m) of cash and cash equivalents was on deposit with various banks and in money market funds of which £7.2m (2007: £32.2m) was on deposit in the UK.
Gross contractual cash-flows for borrowings
Borrowings |
Fair value |
Contractual |
Total |
Borrowings |
Fair value |
Contractual |
Total |
|
Less than one year |
(182.4) |
(42.3) |
(224.7) |
(212.1) |
(37.7) |
(249.8) |
||
Between one and two years |
(150.9) |
(0.4) |
(41.5) |
(192.8) |
(0.5) |
(37.0) |
(37.5) |
|
Between two and three years |
(71.3) |
(26.4) |
(97.7) |
(149.9) |
(0.5) |
(36.3) |
(186.7) |
|
Between three and four years |
(210.7) |
(0.5) |
(25.0) |
(236.2) |
(70.3) |
(21.2) |
(91.5) |
|
Between four and five years |
(127.7) |
1.2 |
(14.6) |
(141.1) |
(67.6) |
(0.6) |
(20.4) |
(88.6) |
Greater than five years |
(160.1) |
(1.2) |
(34.4) |
(195.7) |
(278.8) |
(4.1) |
(48.6) |
(331.5) |
Total |
(903.1) |
(0.9) |
(184.2) |
(1,088.2) |
(779.2) |
(5.2) |
(201.2) |
(985.6) |
The figures presented in the borrowings column include the non-cash adjustments which are highlighted in the adjacent column. The contractual interest reported for borrowings is before the effect of interest rate swaps.
Gross contractual cash-flows for derivative financial instruments
Receipts |
Payments |
Net cash-flow |
Receipts |
Payments |
Net cash-flow |
|
Assets |
||||||
Less than one year |
256.4 |
(247.7) |
8.7 |
398.1 |
(382.8) |
15.3 |
Greater than one year |
63.9 |
(60.1) |
3.8 |
44.4 |
(43.6) |
0.8 |
Liabilities |
||||||
Less than one year |
379.8 |
(400.6) |
(20.8) |
109.3 |
(112.5) |
(3.2) |
Greater than one year |
28.1 |
(28.4) |
(0.3) |
42.4 |
(45.6) |
(3.2) |
Total |
728.2 |
(736.8) |
(8.6) |
594.2 |
(584.5) |
9.7 |
This table presents the undiscounted future contractual cash-flows for all derivative financial instruments. For this disclosure, cash-flows in foreign currencies are translated using the spot rates at the balance sheet date. The fair values of these financial instruments are presented in note 22.
Gross contractual cash-flows for other financial liabilities
The contractual cash-flows for financial liabilities included in trade and other payables are: £285.8m (2007: £192.3m) due in less than one year, £10.9m (2007: £4.6m) due between one and five years and £1.6m (2007: £nil) due after more than five years.