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19. Financial risk management

The Group’s activities give rise to a number of financial risks: market risk, credit risk and liquidity risk. Market risk includes foreign exchange risk, cash flow and fair value interest rate risk and commodity price risk. The Group has in place risk management policies that seek to limit the adverse effects on the financial performance. Derivative financial instruments, mainly forward foreign exchange contracts, are used to hedge risk exposures that arise in the ordinary course of business.

Risk management policies have been set by the Board and are implemented by the central Treasury Department that receives regular reports from all the operating companies to enable prompt identification of financial risks so that appropriate actions may be taken. The Treasury Department has a policy and procedures manual that sets out specific guidelines to manage foreign exchange risks, interest rate risk, financial credit risk and liquidity risk and the use of financial instruments to manage these. These disclosures should be read in conjunction with the financing and risk commentary in the business review.

(a) Foreign exchange risk

The Group has transactional currency exposures arising from sales or purchases by operating subsidiaries in currencies other than the subsidiaries’ functional currency. These exposures are forecast on a monthly basis by operating companies and are reported to the central Treasury Department. Under the Group’s foreign exchange policy, such exposures are hedged on a reducing percentage basis over a number of forecast time horizons.

The Group has a significant investment in overseas operations. As a result, the sterling value of the Group’s balance sheet can be affected by movements in exchange rates. Until December 2008, the Group’s policy was to mitigate the effect of these translational currency exposures for major currencies (US dollar, euro and yen) by hedging 70% to 90% of the net investment in overseas operations using forward foreign currency contracts or foreign currency borrowings. Such hedging instruments were in place until maturity in December 2008. The net investment hedging policy was suspended in December 2008 due to concerns about settlement values at a time of exchange rate volatility.

The main impact of foreign exchange risk on the Group’s results arises from the translation into sterling of the results of operations outside of the UK. The Group’s largest exposures are the euro and the US dollar where a 1% movement in the average rate impacts trading profit of subsidiaries and joint ventures by £1.2 million and £0.8 million respectively.

Regarding financial instruments, a 1% strengthening of sterling against the currency rates indicated below would have the following impact on operating profit:

  Trading Profit    
  Payables and
receivables
£m
Derivative
financial
instruments
£m
Intra-group
funding
£m
Euro 0.2 (0.4) (1.3)
US dollar (0.3) 8.3 (1)

The derivative sensitivity analysis has been prepared by reperforming the calculations used to determine the balance sheet values adjusted for the changes in the individual currency rates indicated with all other cross currency rates remaining constant. The sensitivity is a fair value change relating to derivatives for which the underlying transaction has not occured at 31 December. The Group intends to hold all such derivatives to maturity. The analysis of other items has been prepared based on an analysis of a currency balance sheet.

Analysis of net borrowings by currency

  2008 2007
  Borrowings
£m
Cash and
cash
equivalents
£m
Total
£m
Borrowings
£m
Cash and
cash
equivalents
£m


Total
£m
Sterling (726) 24 (702) (702) 152 (550)
US dollar (27) 15 (12) (36) 10 (26)
Euro (10) 35 25 (12) 41 29
Others (59) 40 (19) (38) 79 41
  (822) 114 (708) (788) 282 (506)

(b) Interest rate risk

The Group is exposed to fair value interest rate risk on fixed rate borrowings and cash flow interest rate risk on variable rate net borrowings/ funds. The Group’s policy is to optimise interest cost in reported earnings and reduce volatility in the debt related element of the Group’s cost of capital. This policy is achieved by maintaining a target range of fixed and floating rate debt for discrete annual periods, over a defined time horizon. 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 12 month horizon. This policy remains suspended following a Board decision in December 2004 after receipt of the original sale proceeds on the sale of the GKN share in AgustaWestland given the absence of floating rate bank debt. Following repayment of the fixed interest Westland Group plc debenture in September 2008 the Group has operated close to the policy parameters. At 31 December 2008 83% (2007 – 89%) of the Group’s gross borrowings were subject to fixed interest rates.

As at 31 December 2008 £12 million (2007 – £147 million) was in bank deposits of which £12 million (2007 – £145 million) was on deposit with UK banks.

A 1% change in interest rates would have a £0.4 million impact on net interest. This sensitivity flexes the interest rate of variable rate borrowings, assuming the level and currency mix at 31 December 2008 remains in place for 12 months.

(c) Credit risk

The Group is exposed to credit-related losses in the event of non-performance by counterparties to financial instruments. In terms of substance, and consistent with the related balance sheet presentation, the Group considers it has two types of credit risk; operational and financial. Operational credit risk relates to non-performance by customers in respect of trade receivables and by suppliers in respect of other receivables. Financial credit risk relates to non-performance by banks and similar institutions in respect of cash and deposits, facilities and financial contracts, including forward foreign currency contracts.

Operational

As tier-one suppliers to automotive, off-highway and aerospace original equipment manufacturers, the Group may have substantial amounts outstanding with a single customer at any one time. The credit profiles of such original equipment manufacturers are available from credit rating agencies. The failure of any such customer to honour its debts could materially impact the Group’s results. However, there are many advantages in these relationships. In certain parts of the Group, mainly Industrial Distribution Services within Driveline and OffHighway there are a greater proportion of amounts receivable from small and medium sized customers.

Credit risk and customer relationships are managed at a number of levels within the Group. At a subsidiary level documented credit control reviews are required to be held at least every month. The scope of these reviews includes amounts overdue and credit limits. At a divisional level debtor ratios, overdue accounts and overall performance are reviewed regularly. Provisions for doubtful debts are determined at these levels based upon the customer’s ability to pay and other factors in the Group’s relationship with the customer.

At 31 December the amount of trade receivables analysed by major segment due from the largest 5 customers as a proportion of total trade receivables is as follows:

  2008
%
2007
%
Driveline 48 46
Powder Metallurgy 20 21
OffHighway 32 32
Aerospace 54 45

The amount of trade receivables outstanding at the year end does not represent the maximum exposure to operational credit risk due to the normal patterns of supply and payment over the course of a year. Based on management information collected as at month ends the maximum level of trade receivables at any one point during the year was £714 million (2007 – £650 million).

Financial

Credit risk is mitigated by the Group’s policy of only selecting counterparties with a strong investment graded long term credit rating, normally at least AA- or equivalent, and assigning financial limits to individual counterparties.

The maximum exposure with a single bank for deposits is £12 million (2007 – £25 million), whilst the maximum mark to market exposure for forward foreign currency contracts at 31 December 2008 to a single bank was nil (2007 – £3 million). The amounts on deposit at year end represent the Group’s maximum exposure to financial credit risk with Group indebtedness varying over the course of a year in line with normal financing and trading patterns.

(d) Capital risk management

The Group’s objectives when managing capital are to safeguard the ability to continue as a going concern in order to provide returns for shareholders and benefits for other stakeholders and to maintain a capital structure which optimises the cost of capital.

In order to maintain or adjust the capital structure, the Group may adjust the amount of dividends paid to shareholders, return capital to shareholders, issue new shares or sell assets to reduce borrowings.

The Group monitors capital on the basis of the ratio of Gross borrowings to EBITDA.

The Group seeks to operate at an EBITDA of subsidiaries to Gross debt ratio of 2.5 times or less and the ratios at 31 December 2008 and 2007 were as follows:

  2008
£m
2007
£m
Gross borrowings 822 788
EBITDA 377 428
Gross borrowings to EBITDA ratio 2.2 times 1.8 times

The Group’s only external banking covenant requires an EBITDA of subsidiaries to net interest payable and receivable ratio of 3.5 times or more. The ratios at 31 December 2008 were as follows:

  2008
£m
2007
£m
EBITDA 377 428
Net interest payable and receivable (47) (43)
EBITDA to net interest payable and receivable ratio 8.0 times 10.0 times

(e) Liquidity risk

The Group is exposed to liquidity risk as part of its normal financing and trading cycle at times when peak borrowings are required. Borrowings normally peak in May and September following dividend and bond coupon payments. The Group’s policies are to ensure that sufficient liquidity is available to meet obligations when they fall due and to maintain sufficient flexibility in order to fund investment and acquisition objectives. Liquidity needs are assessed through short and long term forecasts. Committed bank facilities of £350 million expire in July 2010 and on which there were drawings at the year end of £34 million (2007 – £350 million expiring in July 2010 and undrawn at the year end). A further £9 million of the facility had been utilised for Letters of Credit on Group borrowings in China. Additional committed facilities were agreed in the year amounting to £55 million, maturing in 2013 and €50 million maturing in 2013. Committed facilities are provided through 12 banks.

Maturity analysis of borrowings and derivative financial instrument liabilities

  Within
one year £m
One to
two years £m
Two to
five years £m
More than
five years £m
Total £m
2008          
Borrowings (note 18 ) (97) (39) (334) (352) (822)
Contractual interest payments and finance lease charges (50) (49) (107) (144) (350)
Derivative financial instruments liabilities — receipts 319 111 220 211 861
Derivative financial instruments liabilities — payments (373) (133) (269) (260) (1,035)
  (201) (110) (490) (545) (1,346)
2007          
Borrowings (note 18 ) (92) (6) (335) (355) (788)
Contractual interest payments and finance lease charges (50) (47) (128) (169) (394)
Derivative financial instruments liabilities — receipts 883 16 23 18 940
Derivative financial instruments liabilities — payments (894) (17) (23) (18) (952)
  (153) (54) (463) (524) (1,194)

There is no significant difference in the contractual undiscounted value of other financial liabilities from the amounts stated in the balance sheet and balance sheet notes.

(f) Commodity price risk

The Group is exposed to changes in commodity prices, particularly of metals, which has a significant impact on input costs and the overall financial results. The Group seeks to mitigate this exposure in a variety of ways including medium term price agreements, surcharges and advance purchasing. In rare circumstances and only in respect of certain specified risks, the Group uses derivative commodity hedging instruments. The impact of such financial instruments in respect of the overall commodity price risk is not material.

(g) Categories of financial assets and financial liabilities

      Held for trading    
  Loans and receivables
£m
Amortised cost
£m
Financial assets
£m
Financial liabilities
£m
Derivatives
used for
hedging
£m
Total £m
2008            
Other receivables and investments 4 4
Trade and other receivables 600 600
Derivative financial instruments 62 (184) (8) (130)
Cash and cash equivalents 114 114
Borrowings (822) (822)
Trade and other payables (717) (717)
Provisions (5) (5)
  718 (1,544) 62 (184) (8) (956)
2007            
Other receivables and investments 9 9
Trade and other receivables 538 538
Derivative financial instruments 24 (13) (16) (5)
Cash and cash equivalents 282 282
Borrowings (788) (788)
Trade and other payables (631) (631)
Provisions (1) (1)
  829 (1,420) 24 (13) (16) (596)

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