Currency derivatives that are designated and effective as hedging instruments carried at fair value
| Asset / (liability) | Notional amount
2012
£m | Fair value
2012
£m | Notional amount
2011
£m | Fair value
2011
£m |
|---|
| Current | | | | |
| Forward foreign exchange contracts | 3.6 | (0.1) | 1.3 | (0.1) |
| Non-current | | | | |
| Forward foreign exchange contracts | – | – | 3.2 | (0.2) |
| Total | | | | |
| Forward foreign exchange contracts | 3.6 | (0.1) | 4.5 | (0.3) |
The Group utilises currency derivatives to hedge material future transactions and cash flows. The Group uses foreign currency forward contracts in the management of its exchange rate exposures. The contracts are primarily denominated in the currencies of the Group's principal markets. The unrecognised gains and losses were not significant in either 2012 or 2011.
In accordance with IFRS 7 'Improving Disclosures about Financial Instruments', the Group's financial instruments are considered to be classified as level 2 instruments. Fair value measurements are those derived from inputs other than quoted prices included within level 1 that are observable for the asset or liabilities, either directly (i.e. as prices) or indirectly (i.e. derived from prices).
Fair value is determined using quoted forward exchange rates and yield curves derived from quoted interest rates matching maturities of the contracts.
The Group's interest rate risk is primarily in relation to its fixed rate borrowings (fair value risk) and floating rate borrowings (cash flow risk). From time to time the Group will use interest rate derivative contracts to manage its exposure to interest rate movements within Group policy. However at the balance sheet date the Group had no interest rate derivative contracts.
| Asset / (liability) | Sterling
2012
£m | Euro
2012
£m | US Dollar
2012
£m | Total
fair value
2012
£m |
|---|
| Forward foreign exchange contracts | 0.3 | (3.5) | 3.1 | (0.1) |
| On demand or within one year | 0.3 | (3.5) | 3.1 | (0.1) |
| Asset / (liability) | Sterling
2011
£m | Euro
2011
£m | US Dollar
2011
£m | Total
fair value
2011
£m |
|---|
| Forward foreign exchange contracts | 0.3 | (4.5) | 3.9 | (0.3) |
| On demand or within one year | 0.3 | (1.3) | 0.9 | (0.1) |
| In the second year | – | (3.2) | 3.0 | (0.2) |
| 0.3 | (4.5) | 3.9 | (0.3) |
Financial risk management
The Group's treasury function provides a centralised service to the Group for funding, foreign exchange, interest rate management and counterparty risk. Treasury activities have the objective of minimising risk and treasury operations are conducted within a framework of policies and guidelines reviewed and authorised by the Board.
The Group uses a number of derivative instruments that are transacted, for risk management purposes only, by specialist treasury personnel. The use of financial instruments, including derivatives, is permitted when approved by the Board, where the effect is to minimise risk for the Group. Speculative trading of derivatives or other financial instruments is not permitted. There has been no significant change during the financial year, or since the end of the year, to the types or scope of financial risks faced by the Group.
Liquidity risk
Liquidity risk is defined as the risk that the Group might not be able to settle or meet its obligations on time or at a reasonable price. Liquidity risk arises as a result of mismatches between cash inflows and outflows from the business. This risk is monitored on a centralised basis through regular cash flow forecasting, a three-year rolling strategic plan, an annual budget agreed by the Board each December and a quarterly re-forecast undertaken during the financial year. To mitigate the risk, the resulting forecast net debt/cash is measured against the liquidity headroom policy which, at the current net debt/cash levels, requires committed facilities (plus term loans in excess of one year) to exceed net debt by 50% (minimum facilities of £100m).
As at 31 December 2012, the Group had revolving credit committed borrowing facilities of £226.4m (2011: £229.9m) which exceeded net debt of £34.2m (2011: net cash of £0.1m) by £192.2m (2011: £230.0m). The Group also uses uncommitted short-term bank facilities to manage short-term liquidity but these facilities are excluded from the liquidity headroom policy. The Group manages longer-term liquidity through committed bank facilities and will, if appropriate, raise funds on capital markets. As at 31 December 2012 the Group's principal committed bank facilities have the following maturity dates:
- €125m Revolving Credit Facility 31 July 2013 (0.6 years)
- £125m Revolving Credit Facility 31 August 2016 (3.7 years)
- $10m Letter of Credit Facility 31 August 2016 (3.7 years)
On 18 February 2013, the €125m Revolving Credit Facility maturing on 31 July 2013, was refinanced for the same amount, extending the maturity to 1 March 2018, increasing the weighted average life of the committed facilities at that date to 4.2 years.
In addition, cash management pooling, netting and concentration techniques are used to minimise borrowings. As at 31 December 2012, the Group had gross cash of £10.0m (2011: £18.1m).
Interest rate risk
Interest rate risk arises on borrowings and cash balances (and derivative liabilities and assets) which are at floating interest rates. Changes in interest rates could have the effect of either increasing or decreasing the Group's net profit. Under the Group's interest rate management policy, the interest rates on each of the Group's major currency monetary assets and liabilities are managed to achieve the desired mix of fixed and variable rates for each major net currency exposure. The major interest rate risk is to UK rates but exposures also exist to rates in the USA, Europe and Sweden. Measurement of this interest rate risk and its potential volatility to the Group's reported financial performance is undertaken on a monthly basis and the Board uses this information to determine, from time to time, an appropriate mix of fixed and floating rates.
As at 31 December 2012, 2% of gross debt and 0% of gross cash were at fixed rates (2011: 8% of gross debt, 0% of gross cash). The average tenure of the fixed rate debt was 3.5 years (2011: 3.6 years).
Currency risk
Bodycote has operations in 26 countries and is therefore exposed to foreign exchange translation risk when the profits and net assets of these entities are consolidated into the Group accounts.
Over 89% of the Group's sales are in currencies other than sterling (EUR 36%, USD 33% and SEK 7%). Cumulatively over the year, sterling rates moved such that the sales for the year were £19.6m worse than if sales had been translated at the rates prevailing in 2011.
It is Group policy not to hedge exposure for the translation of reported profits.
The Group's balance sheet translation policy is not to actively hedge currency net assets. However, where appropriate, the Group will still match centrally held currency borrowings to the net assets. The Group principally borrows in sterling but also maintains debt in US Dollar, Euro and Swedish Krona, consistent with the location of the Group's assets. The Group recognises foreign exchange movements in equity for the translation of net investment hedging instruments and balances.
Transaction foreign exchange exposures arise when entities within the Group enter into contracts to pay or receive funds in a currency different from the functional currency of the entity concerned. It is Group policy to hedge exposure to cash transactions in foreign currencies when a commitment arises, usually through the use of foreign exchange forward contracts. Even though approximately 89% of the Group's sales are generated outside the UK, the nature of the business is such that cross border sales and purchases are limited and, other than interest, such exposures are immaterial for the Group.
Market risk sensitivity analysis
The Group has measured the estimated charge to the income statement and equity of either an instantaneous increase or decrease of 1% (100 basis points) in market interest rates or a 10% strengthening or weakening in sterling against all other currencies from the applicable rates as at 31 December 2012, for all financial instruments with all other variables remaining constant. This analysis is for illustrative purposes only. The sensitivity analysis excludes the impact of market risks on net post employment benefit obligations.
Interest rate sensitivity
The interest rate sensitivity analysis is based on the following assumptions:
- changes in market interest rates affect the interest income or expense of variable interest financial instruments;
- changes in market interest rates only affect the income statement in relation to financial instruments with fixed interest if these are recognised at their fair value; and
- changes in market interest rates affect the fair value of derivative financial instruments designated as hedging instruments.
Under these assumptions, a one percentage point fall or rise in market interest rates for all currencies in which the Group has variable net cash or net borrowings at 31 December 2012 would reduce or increase profit before tax by approximately £0.4m (2011: £0.1m). There is no significant impact on equity.
Currency sensitivity
Taking the 2012 sales by currency, a 10% weakening/strengthening in the 2012 cumulative average rates for all currencies versus sterling would have given rise to a +£58.2m/-£47.6m movement in sales respectively. The impact on headline operating profit is affected by the mix of losses and profits in the various currencies. However, taking the 2012 operating profit mix, a 10% weakening/strengthening in 2012 cumulative average rates for all currencies would have given rise to a +£11.1m/-£9.1m movement in headline operating profit.
Counterparty risk
Counterparty risk encompasses settlement risk on derivative financial instruments and money market contracts and credit risk on cash, time deposits and money market funds. The Group monitors its credit exposure to its counterparties via their credit ratings (where applicable) and through its policy, thereby limiting its exposure to any one party to ensure there is no significant concentration of credit risk. Group policy is to enter into such transactions only with counterparties with a long-term credit rating of A-/A3 or better. However, acquired businesses occasionally have dealings with banks with lower credit ratings. Business with such banks is moved as soon as practicable.