Risks and Uncertainties
FINANCIAL RISKS
Foreign currency risk
The Group has significant overseas businesses whose revenues are denominated in the currencies of the countries in which the operations are located. The Group is therefore exposed to foreign exchange risk arising from transactions and funds that are denominated in currencies other than UK sterling. Approximately 50% of the Group’s sales and operating profits generated in the year ended 30 September 2007 were earned in currencies other than UK sterling.
The Group’s treasury function seeks to reduce these risks by operating policies and procedures which are regularly reviewed and approved by the Board. All transactions entered into by the treasury function are required to be in support of, or as a consequence of, underlying commercial transactions.
The Group regularly monitors its currency risk by reviewing the effect on profit before tax of a range of possible changes in exchange rates. It is estimated that a strengthening of the UK sterling by 10% against all the currencies in which the Group does business would reduce operating profit before tax by approximately £1.4m (6.3%) due to currency translation.
The Group does not hedge its exposure to the translation of profits into UK sterling since such hedges provide only a temporary deferral of the effect of exchange rate movements. The Group regularly reviews its foreign exchange exposure in respect of net tangible assets held in currencies other than UK sterling. Following the acquisition of AMT and M Seals in August 2007, the Group’s non-UK sterling capital employed in overseas business at 30 September 2007 had increased to £64.9m (2006: £42.5m), representing 71% of the Group trading capital employed and which is principally held in the United States and Canada. At the present time the Group has decided not to hedge its exposure back into UK sterling.
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 22 to the consolidated financial statements. In comparison to the prior year, the net effect of currency translation was to reduce turnover by £4.7m and to reduce operating profit by £0.9m.
The Group’s UK businesses are also exposed to fluctuations in exchange rates as a significant amount of their stock purchases are denominated in foreign currencies, principally US Dollars, Euros and Japanese Yen. The Canadian businesses are also exposed to fluctuations in the US$ exchange rate as the majority of the purchases are denominated in US$.
Forward foreign exchange contracts are used to hedge against the exposure of individual businesses to variability in cash flows that might arise from the fluctuation of exchange rates in relation to highly probable forecast transactions that are denominated in currencies other than its own functional currencies and which might affect profit or loss. Such forward exchange contracts are accounted for as cash flow hedges in accordance with the accounting policy.
Bad debts and inventory obsolescence
Working capital management is critical to success in specialised distribution businesses as this has a major impact on cash flow. The principal risks lie in uncollectible receivables and in inventory obsolescence and write-off.
Within each business, there are robust processes for the management of receivables and in the last five years, the largest bad debt in the Group has been £65,000.
Inventory write-offs are controlled and minimised by active management of inventory levels based on sales forecasts and regular cycle counts. Where necessary, an impairment charge is made to write-off excess stock and to cover potential obsolescence.
Cash flow and fair value interest rate risk The Group has interest-bearing funds and consequently its income and cash flows are impacted by changes in market interest rates. It is estimated that a reduction of 1% in interest rates would reduce the Group’s profit before tax by a maximum of £0.2m.
The Group’s interest rate risk arises primarily from its cash funds. An analysis of the currency and interest rate profiles of the Group’s funds is shown in note 16 to the consolidated financial statements. The Group continues to manage 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.
Credit and liquidity risk
At the balance sheet date the Group had no significant concentrations of credit risk.
The Group treasury function ensures that there are sufficient levels of facilities, cash and cash equivalents to ensure that the Group and its subsidiaries are at all times able to meet its financial commitments.
Fraud and theft
The Group’s operating businesses are relatively straight-forward businesses where a significant incidence of fraud or theft should become apparent relatively quickly. The risks are also moderated by the fact that the products are relatively specialised industrial products and therefore not particularly valuable or attractive on the open market. Finally, tangible fixed assets are not significant across the Group and generally comprise IT and warehouse equipment, where any loss would be quickly apparent.
As additional security, processes are in place
to further reduce the opportunity for fraud
or theft:
• Specified signature levels and
responsibilities.
• Segregation of responsibilities.
• Controls on shipping addresses.
• Weekly flash reports of cash balances
and regular bank reconciliations.
• Regular review of supplier and creditor
ledgers to identify fictitious suppliers.
• Group wide policy and procedures for “whistle-blowing”.
The Audit Committee carries out an annual
assessment of the fraud risks in the businesses
and discusses these risks with management.