Risks and Uncertainties
FINANCIAL RISKS
The Group’s activities expose it to a variety of financial risks; foreign currency, liquidity, interest rate and credit. The Group’s overall management of these risks is carried out by a central treasury team (Group treasury) under policies and procedures which are reviewed and approved by the Board. Group treasury identifies, evaluates and where appropriate, hedges financial risks in close co-operation with the Group’s operating businesses. The Group treasury team does not undertake speculative foreign exchange dealings for which there is no underlying exposure. The policies for managing these financial risks are set out below and further analyses of these risks are set out in note 18 to the consolidated financial statements.
Foreign currency risk
Foreign currency risk is the risk that changes in currency rates will affect the Group’s results. The Group operates internationally and is exposed to foreign exchange risk arising from various currency exposures, primarily with respect to the US dollar, the euro and the Canadian dollar (translational exposure). During the year ended 30 September 2009, ca. 70% of the Group’s revenue and operating profits from continuing businesses were earned in currencies other than UK sterling. In comparison to the prior year, the net effect of currency translation was to increase revenue by £14.8m and to increase operating profit by £2.4m. It is estimated that a strengthening of UK sterling by 10% against all the currencies in which the Group does business, would reduce operating profit, before amortisation of acquisition intangible assets and tax, by approximately £1.8m (7.0%) (2008: £2.0m (7.5%)) due to currency translation.
The Group has certain investments in foreign operations whose net assets are also exposed to foreign currency translation risk. Currency exposure arising from the net assets of the Group’s foreign operations are not hedged. At 30 September 2009, the Group’s non-UK sterling trading capital employed in overseas businesses was £87.7m (2008: £75.0m), which represented 76% of the Group’s trading capital employed. It is estimated that a strengthening of UK sterling of 10% against all the non-sterling capital employed would reduce shareholders’ funds by £7.8m (2008: £6.9m).
The Group’s UK businesses are also exposed to foreign currency risk on purchases that are denominated in a currency other than their local currency, principally US dollars, euro and Japanese yen (transactional exposure). The Group’s Canadian businesses are also exposed to a similar risk as the majority of their purchases are denominated in US dollars.
The UK and Canadian businesses hedge up to 80% of forecast US dollar and euro foreign currency exposures using forward foreign exchange contracts. The Group classifies its forward foreign exchange contracts, hedging forecasted transactions, as cash flow hedges and states them at fair value.
Details of average exchange rates, used in the translation of overseas earnings, and of year end exchange rates, used in the translation of overseas balance sheets, for the principal currencies used by the Group, are shown in note 27 to the consolidated financial statements.
Liquidity risk
Liquidity risk is the risk that the Group will not be able to meet its financial obligations as they fall due. The Group’s approach to managing liquidity is to ensure, as far as possible, that it will always have sufficient liquidity to meet its liabilities when due, under both normal and stressed conditions, without incurring unacceptable losses or risking damage to the Group’s reputation.
The Group is highly cash generative and uses monthly cash flow forecasts to monitor cash requirements and to optimise its return on investments. Typically the Group ensures that it has sufficient cash on hand to meet foreseeable operational expenses, but it maintains a £5m overdraft facility on which interest is payable at UK Base Rate plus 100 bps. The Group also has an undrawn committed £20m revolving bank facility which expires on 23 November 2010. Interest on this facility is payable at 80 bps over LIBOR.
Interest rate risk
Interest rate risk is the risk that changes in interest rates will affect the Group’s results. The Group’s interest rate risk arises primarily from its cash funds. An analysis of the currency and interest rate profile of the Group’s funds is shown in note 18 to the consolidated financial statements. The Group manages its interest-bearing funds in a manner designed to maximise interest income, while at the same time minimising any risk to these funds. Surplus funds are deposited with commercial banks that meet the credit criteria approved by the Board, for periods of between one to six months at rates that are generally fixed by reference to the relevant UK Base Rate, or equivalent rates. The Group does not undertake any hedging activity of interest rates.
It is estimated that an increase of 1% in interest rates would increase the Group’s profit before tax by a maximum of £0.2m (2008: £0.1m)
Credit risk
Credit risk is the risk of financial loss to the Group if a customer or counterparty to a financial instrument fails to meet its contractual obligations; this arises principally from the Group’s trade and other receivables from customers and from cash balances (including deposits) held with financial institutions.
Trade receivable exposures are managed locally in the operating units where they arise and credit limits are set as deemed appropriate for the customer. The Group is exposed to customers ranging from government backed agencies and large public and private wholesalers, to small privately owned businesses and the underlying local economic risks vary throughout the world. An analysis of the Group’s credit risk to trade receivables is set out in note 15 to the consolidated financial statements.
The Group establishes an allowance for impairment that represents its estimate of incurred losses in respect of specific trade and other receivables where it is deemed that a receivable may not be recoverable. When the receivable is deemed irrecoverable, the allowance account is written off against the underlying receivable.
Exposure to financial counterparty credit risk is controlled by the Group treasury team in establishing and monitoring counterparty limits. Centrally managed funds are invested entirely with counterparties whose credit rating is ‘A’ or better.
Capital risk management
The Group’s objectives when managing capital are to safeguard the Group’s ability to continue as a going concern in order to provide returns for shareholders and benefits for other stakeholders and to maintain an optimal capital structure.
In order to maintain or adjust the capital structure the Group may adjust the amount of dividends paid to shareholders, return capital to shareholders or issue new shares.