Note 19
19. Derivative Financial Instruments
An explanation of the Group's treasury policy and controls is included in the Financial Review on page 13.
Exposure to credit, interest rate and currency risks arises in the normal course of the Group's business. Derivative financial instruments are used to hedge exposure to fluctuations in foreign exchange rates only.
Credit Risk
The Group has a credit policy in place and the exposure to credit risk is monitored on an ongoing basis. Credit evaluations are performed on all customers requiring credit over a certain amount. The Group does not require collateral in respect of financial assets.
Investments are allowed only in liquid securities and only with counterparties that have a credit rating equal to or better than the Group. Transactions involving derivative financial instruments are with counterparties with whom the Group has a signed netting agreement as well as sound credit ratings. Given their high credit ratings management does not expect any counterparty to fail to meet its obligations.
At the balance sheet there were no significant concentrations of credit risk. The maximum exposure to credit risk is represented by the carrying amount of each financial asset, including derivative financial instruments, in the balance sheet.
Interest Rate Risk
All the Group's borrowings and investments are at floating rates. Given the Group's low net debt, management believes that the benefits of fixing a proportion of its interest costs are outweighed by the costs.
Foreign Currency Risk
The Group is exposed to foreign currency risk on sales, purchases and borrowings that are denominated in a currency other than the functional currency of the business unit. The currencies giving rise to this risk are primarily US$, Euros and Japanese Yen.
The Group aims to hedge 75 per cent of its forecasted foreign currency exposure in respect of forecasted sales and purchases for the following 12 months and up to 50 per cent of the exposure for between 12 months and 18 months. The Group uses forward exchange contracts ("forwards"), simple options and "cylinders" (a combination of two offsetting simple options at different rates) to hedge its foreign currency risk. The majority of these contracts have maturities of less than one year at the balance sheet date.
In respect of other monetary assets and liabilities held in currencies other than Sterling, the Group ensures that the net exposure is kept to an acceptable level, by buying or selling foreign currencies at spot rates where necessary to address short term imbalances.
Forecasted Transactions
The Group classifies its derivatives hedging forecasted transactions as cash flow hedges and states them at fair value. The fair value of these derivatives as 1 January 2006 was adjusted against the opening balance of the hedging reserve at that date.
Recognised Assets and Liabilities
Changes in the fair value of derivatives that economically hedge monetary assets and liabilities in foreign currencies and for which no hedge accounting is applied are recognised in the income statement. Both the changes in fair value of the derivatives and the foreign exchange gains and losses relating to the monetary items are recognised as part of "Cost of Sales" .
Hedge of net investment in foreign subsidiary
The Group's US$, Euro and Yen loans and certain forward contracts are designated as a hedge of the Group's investment in subsidiaries overseas. Inter-company loans for which payment is not planned in the foreseeable future are classified as net investments and so are taken to reserves.
Sensitivity Analysis
In managing interest rate and currency risks the Group aims to reduce the impact of short term fluctuations on the Group's earnings. Over the longer term, however, permanent changes in foreign exchange and interest rates would have an impact on consolidated earnings.
At 31 December 2006, it is estimated that a general increase of one percentage point in interest rates would decrease the Group's profit before tax by approximately £0.2 million. This reflects increased interest costs on the Group's borrowings and increased interest income on the Group's investments.
Fair Value
The fair values together with the carrying amounts shown in the balance sheet are as follows:
a) Fair value of financial assets and liabilities
| |
2006
Fair value
and book value
£m |
2005
Fair value
and book value
£m |
| Forward exchange contracts - Assets |
1.6 |
0.1 |
| Forward exchange contracts - Liabilities |
- |
(0.9) |
| Option exchange contracts - Assets |
0.7 |
0.1 |
| Cash at bank and in hand |
9.4 |
12.7 |
| Trade receivables |
31.2 |
30.5 |
| Trade payablesh |
(20.3) |
(16.6) |
| Bank overdraft |
(1.9) |
0.9 |
| Other borrowings |
(0.1) |
- |
| Floating rate borrowings (1) |
(26.3) |
(17.2) |
| |
(5.7) |
7.8 |
Market rates have been used to determine fair values.
(1) Floating rate borrowings are used for the purpose of net investment hedging.
Estimation of Fair Values
The following summarises the major methods and assumptions used in estimating the fair values of financial instruments reflected in the table:
Derivatives
Forwards are marked-to-market by calculating the contractual forward price and deducting the current spot rate. Options and cylinders are marked-to-market by obtaining quotes from banks of their market value as at the 31 December.
(i) Maturity profile of Derivatives
| |
Total
2006
£m |
Within
one year
or less
£m |
More than
one year
but not more
than two
years
£m |
| Forward exchange contracts - Assets |
1.6 |
1.6 |
- |
| Option exchange contracts - Assets |
0.7 |
0.7 |
- |
| |
2.3 |
2.3 |
- |
| |
2005
£m |
£m |
£m |
| Forward exchange contracts - Assets |
0.1 |
0.1 |
- |
| Forward exchange contracts - Liabilities |
(1.1) |
(1.0) |
(0.1) |
| Option exchange contracts - Assets |
0.1 |
0.1 |
- |
| |
(0.9) |
(0.8) |
(0.1) |
All the options are to sell US Dollars for Euro and have an exercise price between US$1.15 = €1 and US$1.31 = €1.
Interest bearing loans and borrowings All interest bearing loans and borrowings are at floating rates. Therefore, the fair value of these loans and borrowings is their carrying value.
Trade and other receivables/payables For trade receivables and payables with a remaining life of less than one year, the notional amount is deemed to reflect the fair value. All other trade receivables and payables are discounted to determine the fair value
b) Financial liabilities
i) Analysis of borrowings
| |
2006
£m |
Group
2005
£m |
| Other borrowings |
0.1 |
- |
| Overdrafts |
1.9 |
0.9 |
| Bank loans |
26.3 |
17.2 |
| Total borrowings |
28.3 |
18.1 |
| Forward exchange contracts |
- |
0.9 |
| Gross financial liabilities |
28.3 |
19.0 |
ii) Maturity profile
| |
2006
£m |
Group
2005
£m |
| Within one year or less |
2.0 |
1.7 |
| More than one year but not more than two years |
- |
0.1 |
| More than two years but not more than five years |
26.3 |
17.2 |
| |
28.3 |
19.0 |
On 25 January 2005 the Group signed a five year £100 million Multicurrency Revolving Credit Facility Agreement with a syndicate of UK banks.
The total amount of bank loans and overdrafts any part of which falls due after five years is £nil (2005: £nil).
The Group had the following undrawn borrowing facilities at the end of the period.
| |
2006
£m |
2005
£m |
| Expiring in one year or less |
|
|
| - uncommitted facilities |
13.1 |
8.6 |
| More than two years but not more than three years |
|
|
| - committed facilities |
73.7 |
82.8 |
| Total |
86.8 |
91.4 |
iii) Interest rate profile
Currency
| |
Total
£m |
Floating rate
borrowings
£m |
| Yen |
1.0 |
1.0 |
| Sterling |
2.0 |
2.0 |
| US$ |
5.1 |
5.1 |
| Euro |
20.2 |
20.2 |
| At 31 December 2006 |
28.3 |
28.3 |
| Sterling |
0.9 |
0.9 |
| US$ |
3.5 |
3.5 |
| Euro |
13.7 |
13.7 |
| At 31 December 2005 |
18.1 |
18.1 |
The floating rate borrowings comprise bank loans and overdrafts bearing interest at rates based on LIBOR.
c) Financial assets
| |
Floating rate
2006
£m |
Floating rate
2005
£m |
| Currency |
|
|
| Sterling |
- |
0.2 |
| US$ |
4.8 |
6.3 |
| Euro |
3.8 |
5.4 |
| Other |
0.8 |
0.8 |
| Total cash balances |
9.4 |
12.7 |
| Forward exchange contracts |
1.6 |
0.1 |
| Option contracts |
0.7 |
0.1 |
| Gross financial assets |
11.7 |
12.9 |
The floating rate financial assets comprise bank deposits bearing interest at rates based on local money market rates.
Sterling, US$, Euro and Yen balances within the UK can be offset.
The forward exchange and option contracts all mature within 18 months.
Information correct at 23/04/2007