NOTES TO THE FINANCIAL STATEMENTS
3. Financial risk management
(a) Financial risk factors
The Group's activities expose it to a variety of financial risks: market risk (interest rate risk), liquidity risk and credit risk. The Group's treasury function seeks to ensure that sufficient funding is available to meet foreseeable needs, maintains reasonable headroom for contingencies and manages inflation and interest rate risk.
The principal financial risks faced by the Group relate to interest rate and counterparty credit risk.
These risks and treasury operations are managed by the Group Director of Finance in accordance with policies established by the Board. Major transactions are individually approved by the Board. Treasury activities are reported to the Board and are subject to review by internal audit.
Financial instruments are used to raise finance, manage risk and optimise the use of surplus funds. The Group does not engage in speculative activity.
i) Market risk
The Group has a policy of maintaining at least 50% of interest bearing liabilities at fixed rates. The Group uses a combination of fixed rate and index-linked borrowings and fixed rate interest swaps as cash flow hedges of future variable interest payments to achieve this policy. At the year end 65% of net borrowings were at fixed rates (including 50% of South West Water's borrowings fixed for the period to March 2015) and 23% index-linked after the impact of financial derivatives. The notional principal amounts of the interest rate swaps are used to determine settlement under those swaps and are not therefore an exposure for the Group. These instruments are analysed in note 27.
The interest rate for index-linked debt is based upon an RPI measure which is also used in determining the amount of income from customers in South West Water.
The Group has no significant interest-bearing assets upon which the net return fluctuates from market risk. Deposit interest receivable is expected to fluctuate in line with interest payable on floating rate borrowings. Consequently the Group's income and operating cash flows are substantially independent of changes in market interest rates.
For 2010 if interest rates on net borrowings had been on average 0.5% higher/lower with all other variables held constant, post-tax profit for the year would have decreased/increased by £2.3m (2009 £2.0m).
ii) Liquidity risk
The Group actively maintains a mixture of long-term and short-term committed facilities which are designed to ensure the Group has significant available funds for operations and planned expansions equivalent to at least one year's forecast requirements at all times. Details of undrawn committed facilities and short-term uncommitted facilities are provided in note 27.
Refinancing risk is managed under a Group policy that permits no more than 20% of Group net borrowings to mature in any financial year.
The Group and South West Water have entered into covenants with lenders. Whilst terms vary, these typically provide for limits on gearing (primarily based on South West Water Limited's Regulatory Capital Value and Viridor Limited's EBITDA) and interest cover. More details are provided in the Directors' Report; Principal risks and uncertainties.
Contractual undiscounted cash flows were:
Due within 1 year |
Due between 1 and 2 years |
Due between 2 and 5 years |
Over 5 years |
Total |
|
Group |
|||||
31 March 2010 |
|||||
Non-derivative financial liabilities |
|||||
Borrowings excluding finance lease liabilities |
197.3 |
31.7 |
425.2 |
949.6 |
1,603.8 |
Interest payments on borrowings |
27.1 |
22.9 |
43.0 |
348.2 |
441.2 |
Finance lease liabilities |
46.9 |
47.0 |
193.7 |
2,322.9 |
2,610.5 |
Derivative financial liabilities |
|||||
Derivative contracts - net payments |
14.3 |
8.3 |
12.9 |
- |
35.5 |
31 March 2009 |
|||||
Non-derivative financial liabilities |
|||||
Borrowings excluding finance lease liabilities |
232.8 |
194.1 |
73.3 |
997.4 |
1,497.6 |
Interest payments on borrowings |
24.0 |
17.8 |
32.5 |
367.4 |
441.7 |
Finance lease liabilities |
62.3 |
62.2 |
264.6 |
1,951.1 |
2,340.2 |
Derivative financial liabilities |
|||||
Derivative contracts - net payments |
17.9 |
4.4 |
3.2 |
0.3 |
25.8 |
Company |
|||||
31 March 2010 |
|||||
Non-derivative financial liabilities |
|||||
Borrowings excluding finance lease liabilities |
70.6 |
10.6 |
351.9 |
99.8 |
532.9 |
Interest payments on borrowings |
19.3 |
14.5 |
13.9 |
- |
47.7 |
31 March 2009 |
|||||
Non-derivative financial liabilities |
|||||
Borrowings excluding finance lease liabilities |
205.8 |
80.0 |
10.0 |
100.0 |
395.8 |
Interest payments on borrowings |
11.3 |
7.2 |
0.1 |
- |
18.6 |
Derivative financial liabilities |
|||||
Derivative contracts - net payments |
1.5 |
- |
- |
- |
1.5 |
iii) Credit risk
Credit and counterparty risk arises from cash and cash deposits, derivative financial instruments and deposits with bank and financial institutions, as well as exposure to customers, including outstanding receivables. Further information on the credit risk relating to trade receivables is given in note 22.
Counterparty risk arises from the investment of surplus funds and from the use of derivative financial instruments. The Board has agreed a policy for managing such risk which is controlled through credit limits, counterparty approvals, and rigorous monitoring procedures. The Group has no other significant concentration of credit risk. The Group's surplus funds are usually placed in short-term fixed interest deposits or the overnight money markets. Deposit counterparties must meet a credit rating threshold set by the Board of Aa2 (Moody's) or AA (Standard and Poor's).
iv) Foreign currency risk
Foreign currency risk occurs at transactional and translation level from borrowings in foreign currencies. These risks are managed through cross-currency interest rate swaps which provide certainty over all interest and principal repayments.
(b) 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 to minimise the cost of capital.
In order to maintain or adjust the capital structure the Group seeks to maintain a balance of returns to shareholders through dividends and an appropriate capital structure of debt and equity for each business segment and the Group.
The Group monitors capital on the basis of the gearing ratio. This ratio is calculated as net borrowings divided by total capital. Net borrowings are analysed in note 37 and calculated as total borrowings less cash and cash deposits. Total capital is calculated as total shareholders' equity plus net borrowings.
The gearing ratios at the balance sheet date were:
2010 |
2009 |
|
Net borrowings (note 37) |
1,895.3 |
1,892.0 |
Total shareholders' equity |
660.9 |
600.6 |
Total capital |
2,556.2 |
2,492.6 |
Gearing ratio |
74.1% |
75.9% |
South West Water Limited is also monitored on the basis of the ratio of its net borrowings to Regulatory Capital Value. Ofwat's optimum range for gearing is 55% - 65%.
The Group has entered into covenants with lenders, whilst terms vary, these typically provide for limits on gearing and interest cover. The Group has been in compliance with its covenants during the year.
2010 |
2009 |
|
Regulatory Capital Value |
2,555.0 |
2,461.0 |
Net borrowings |
1,547.2 |
1,571.1 |
Net borrowings/Regulatory Capital Value |
60.6% |
63.8% |
(c) Determination of fair values
Effective 1 April 2009. The Group adopted the amendment to IFRS 7 for financial instruments which are measured in the balance sheet at fair value. This requires disclosure of fair value measurements by level of the following fair value measurement hierarchy:
- Quoted prices (unadjusted) in active markets for identical assets or liabilities (level 1).
- Inputs other than quoted prices included within level 1 that are observable for the asset or liability, either directly (that is, as prices) or indirectly (that is, derived from prices) (level 2).
- Inputs for the asset or liability that are not based on observable market data (that is, unobservable inputs) (level 3).
The disclosures are set out in note 23.
The fair value of financial instruments traded in active markets (such as trading and available-for-sale securities) is based on quoted market prices at the balance sheet date. The quoted market price used for financial assets held by the Group is the current bid price.
The fair value of financial instruments not traded in an active market (for example over-the-counter derivatives) is determined by using valuation techniques. A variety of methods and assumptions are used based on market conditions existing at each balance sheet date. Quoted market prices or dealer quotes for similar instruments are used for long-term debt. Other techniques, such as estimated discounted cash flows, are used to determine fair value for the remaining financial instruments. The fair value of interest rate swaps is calculated as the present value of the estimated future cash flows.
The carrying values less impairment provision of trade receivables and payables are assumed to approximate to their fair values. The fair value of financial liabilities is estimated by discounting the future contractual cash flows at the current market interest rate available to the Group for similar financial instruments.