Notes to the accounts
20. Financial risk management
The Group's international operations and debt financing expose it to financial risks which include the effects of changes in foreign exchange rates, changes in debt market prices, interest rates, credit risks and liquidity risks.
Treasury and risk management policies are set by the Board. The 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 exposures include foreign currency derivatives, debt and other interest rate derivatives. The central treasury function monitors financial risks and compliance with risk management policies. 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.
The following table shows the currency of financial instruments. It excludes loans and derivatives designated as net investment hedges.
|
At 31 July 2009 |
||||
|---|---|---|---|---|---|
|
Sterling |
US$ |
Euro |
Other |
Total |
Financial assets and liabilities |
|
|
|
|
|
Financial instruments included in trade and other receivables |
36.0 |
256.6 |
142.2 |
98.5 |
533.3 |
Financial instruments included in trade and other payables |
(34.0) |
(126.1) |
(75.9) |
(37.5) |
(273.5) |
Cash and cash equivalents |
13.3 |
16.0 |
25.3 |
37.1 |
91.7 |
Borrowings not designated as net investment hedges |
(306.5) |
(22.7) |
(33.4) |
(19.1) |
(381.7) |
|
(291.2) |
123.8 |
58.2 |
79.0 |
(30.2) |
Exclude balances held in operations with the same functional currency |
294.0 |
(84.9) |
(52.4) |
(77.5) |
79.2 |
Exposure arising from intra-group loans |
|
|
(12.0) |
23.2 |
11.2 |
Forward foreign exchange contracts |
70.7 |
(82.3) |
(2.4) |
14.0 |
|
|
73.5 |
(43.4) |
(8.6) |
38.7 |
60.2 |
|
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) |
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.
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 |
4.9 |
5.0 |
(0.1) |
(3.3) |
Euro |
0.2 |
(1.2) |
4.8 |
(1.0) |
Sterling |
1.8 |
5.1 |
2.1 |
2.8 |
These sensitivities were calculated before adjusting for tax and exclude the effect of quasi-equity intra-group loans.
Cash-flow hedging
The Group uses foreign currency contracts to hedge future foreign currency sales and purchases. At 31 July 2009 contracts with a nominal value of £310.7m (2008: £222.2m) were designated as hedging instruments. In addition, the Group had outstanding foreign currency contracts with a nominal value of £121.7m (2008: £130.1m) which were being used to manage transactional foreign exchange exposures, but were not accounted for as cash-flow hedges. The fair value of the contracts is disclosed in note 21.
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 (2008: 99%).
The movements in the cash-flow hedge reserve during the period are summarised in the table below:
|
Year ended |
Year ended |
|---|---|---|
Brought forward cash-flow hedge reserve at start of period |
1.1 |
1.4 |
Exchange adjustments |
0.3 |
0.2 |
Gains and losses on effective cash-flow hedges recognised in equity |
(8.0) |
(1.0) |
Amounts removed from the hedge reserve and recognised in the following lines on the income statement: |
|
|
– revenue |
9.6 |
0.2 |
– cost of sales |
(2.8) |
0.3 |
– administrative expenses |
1.6 |
|
Carried forward cash-flow hedge reserve at end of period |
1.8 |
1.1 |
Translational currency exposure
The Group has significant investments in overseas operations, particularly in the United States and Europe. As a result, the sterling value of the Group's balance sheet can be significantly 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 primarily in the local currency or in some cases indirectly through the use of forward foreign exchange contracts and cross currency swaps.
Net investment hedges
The table below sets out the currency of loans and swap contracts designated as net investment hedges:
|
At 31 July 2009 |
||||
|---|---|---|---|---|---|
|
Sterling |
US$ |
Euro |
Other |
Total |
Loans designated as net investment hedges |
|
(551.3) |
|
(36.9) |
(588.2) |
Cross-currency swap contracts |
|
59.9 |
(59.9) |
|
|
Currency swap contracts |
380.8 |
(92.6) |
(207.4) |
(80.8) |
|
|
380.8 |
(584.0) |
(267.3) |
(117.7) |
(588.2) |
|
At 31 July 2008 |
||||
|---|---|---|---|---|---|
|
Sterling |
US$ |
Euro |
Other |
Total |
Loans designated as net investment hedges |
|
(139.6) |
(70.6) |
|
(210.2) |
Currency swap contracts |
371.4 |
(150.6) |
(163.0) |
(57.8) |
|
|
371.4 |
(290.2) |
(233.6) |
(57.8) |
(210.2) |
Currency loans in other currencies hedge the Group's exposure to Canadian dollars and Australian dollars and the swap contracts hedge the Group's exposure to Japanese yen and Chinese renminbi.
Of the contracts designated as net investment hedges, 53% are current and the balance matures over the next four years. The contracts maturing within one year include £150m of contracts maturing on the same day as the 2010 Sterling Eurobond.
The gains and losses that have been deferred in the net investment hedge reserve are shown in the table below:
|
Year ended |
Year ended |
|---|---|---|
Brought forward net investment hedge reserve at start of period |
(30.3) |
17.2 |
Amounts deferred in the period on effective net investment hedges |
(58.6) |
(47.5) |
Carried forward net investment hedge reserve at end of period |
(88.9) |
(30.3) |
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 £70.8m (2008: £14.9m) 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 £10.7m (2008: £17.4m). 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.
During the year the Group de-designated currency swaps which had previously been used to hedge translational currency exposures, and entered into offsetting currency swaps to eliminate any future exchange exposure arising from these contracts. At the balance sheet date, contracts with a nominal value of £436.7m were outstanding. However the net currency profile of these contracts, translating both legs of the contract at the balance sheet rates, is:
|
At 31 July 2009 |
||||
|---|---|---|---|---|---|
|
Sterling |
US$ |
Euro |
Other |
Total |
Currency swap contracts |
(28.6) |
|
|
|
(28.6) |
(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 current policy is to require interest rates to be fixed for 50% to 80% of the level of net debt. This is achieved primarily through fixed rate borrowings, and also through the use of interest rate swaps. At 31 July 2009 79% (2008: 46%) of the Group's net 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 2009, after interest rate swaps, is 5.8% (2008: 4.6%).
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 |
|
(141.4) |
(146.8) |
|
(3.8) |
(4.0) |
Between one and five years |
|
(152.5) |
(156.4) |
|
(203.5) |
(207.1) |
Greater than five years |
|
(406.4) |
(430.6) |
|
(160.1) |
(166.2) |
Total fixed interest financial assets/(liabilities)(adjusted for interest rate hedging) |
|
(700.3) |
(733.8) |
|
(367.4) |
(377.3) |
Floating rate interest financial assets/(liabilities) |
77.1 |
(276.3) |
(268.9) |
122.1 |
(535.7) |
(535.7) |
Total interest bearing financial assets/(liabilities) |
77.1 |
(976.6) |
(1,002.7) |
122.1 |
(903.1) |
(913.0) |
Non-interest bearing assets/(liabilities) in the same category |
14.6 |
|
|
10.4 |
|
|
Total |
91.7 |
(976.6) |
(1,002.7) |
132.5 |
(903.1) |
(913.0) |
Interest rate hedging
The Group has designated US$150m interest rate swaps and US$100m cross-currency 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 fluctuations in base rates. The fair values of the hedging instruments are disclosed in note 21. The effect of the swaps is to convert £149.7m (2008: £75.7m) 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 2009, 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 £2.2m (2008: £4.3m) 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 currently expect any counterparties to fail to meet their obligations. Credit risk is mitigated by the Board approved policy of only selecting counterparties with a strong investment grade 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 £99.5m at 31 July 2009 (2008: £132.5m). This includes cash of £44.0m (2008: £100.6m) held in interest compensation pools where Smiths has a legal right of set-off. Of the £99.5m, 84% is with banks with at least a AA- credit rating.
At 31 July 2009 the maximum exposure with a single bank for deposits and cash is £24.1m (2008: £12.4m), whilst the maximum mark to market exposure for derivatives is £6.4m (2008: £1.5m). These exposures were with the same bank, which has a AA credit rating.
(d) Liquidity risk
Borrowing facilities
The Board policy specifies the maintenance of unused committed credit facilities of at least £200m at all times to ensure it has sufficient available funds for operations and planned development. The principal £660m revolving credit facility matures in 2012. At the balance sheet date the Group had the following undrawn credit facilities:
|
2009 |
2008 |
|---|---|---|
Expiring within one year |
|
|
Expiring between one and two years |
|
|
Expiring after two years |
622.8 |
449.8 |
|
622.8 |
449.8 |
Cash deposits
As at 31 July 2009, £7.7m (2008: £10.0m) of cash and cash equivalents was on deposit with various banks and in money market funds of which £5.9m (2008: £7.2m) 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 |
(224.4) |
(0.2) |
(58.4) |
(283.0) |
(182.4) |
|
(42.3) |
(224.7) |
Between one and two years |
(1.6) |
|
(47.9) |
(49.5) |
(150.9) |
(0.4) |
(41.5) |
(192.8) |
Between two and three years |
(38.2) |
|
(47.7) |
(85.9) |
(71.3) |
|
(26.4) |
(97.7) |
Between three and four years |
(157.0) |
6.8 |
(42.8) |
(193.0) |
(210.7) |
(0.5) |
(25.0) |
(236.2) |
Between four and five years |
(149.0) |
(1.2) |
(36.7) |
(186.9) |
(127.7) |
1.2 |
(14.6) |
(141.1) |
Greater than five years |
(406.4) |
(2.5) |
(101.1) |
(510.0) |
(160.1) |
(1.2) |
(34.4) |
(195.7) |
Total |
(976.6) |
2.9 |
(334.6) |
(1,308.3) |
(903.1) |
(0.9) |
(184.2) |
(1,088.2) |
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 |
592.2 |
(545.3) |
46.9 |
256.4 |
(247.7) |
8.7 |
Greater than one year |
182.7 |
(217.7) |
(35.0) |
63.9 |
(60.1) |
3.8 |
Liabilities |
|
|
|
|
|
|
Less than one year |
460.2 |
(513.7) |
(53.5) |
379.8 |
(400.6) |
(20.8) |
Greater than one year |
256.0 |
(232.7) |
23.3 |
28.1 |
(28.4) |
(0.3) |
Total |
1,491.1 |
(1,509.4) |
(18.3) |
728.2 |
(736.8) |
(8.6) |
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 21.
Gross contractual cash-flows for other financial liabilities
The contractual cash-flows for financial liabilities included in trade and other payables are: £261.9m (2008: £285.8m) due in less than one year, £7.3m (2008: £10.9m) due between one and five years and £4.3m (2008: £1.6m) due after more than five years.