Principal Risks and Uncertainties
FINANCIAL AND ACCOUNTING RISKS
The Group's activities expose it to a variety of financial and accounting risks, including foreign currency, liquidity, interest rate and credit. The policies for managing these financial risks, as well as the management of capital risks, are set out in note 18 to the consolidated financial statements in the 2011 Annual Report. The principal financial and accounting risks are summarised below. The Group's overall management of these risks is carried out by a central treasury team (Group treasury) under policies and procedures which are reviewed and approved by the Board. Group treasury identifies, evaluates and where appropriate, hedges financial risks in close co-operation with the Group's operating businesses. The Group treasury team does not undertake speculative foreign exchange dealings for which there is no underlying exposure.
Foreign currency risk - Translational exposure
Foreign currency risk is the risk that changes in currency rates will affect the Group's results. The Group operates internationally and is exposed to foreign exchange risk arising from various currency exposures, primarily with respect to the US dollar, the Euro and the Canadian dollar. The Group also has operations outside the UK whose net assets are also exposed to foreign currency translation risk.
During the year ended 30 September 2011, ca. 75% of the Group's revenue and operating profits were earned in currencies other than UK sterling. In comparison to the prior year, the net effect of currency translation was to increase revenue by £0.5m and to increase operating profit by £Nil. It is estimated that a strengthening of UK sterling by 10% against all the currencies in which the Group does business, would reduce operating profit, before acquisition related charges and tax, by approximately £3.4m (7.5%) due to currency translation.
Currency exposures also arise from the net assets of the Group's foreign operations. At 30 September 2011, the Group's non-UK sterling trading capital employed in overseas businesses was £130.9m (2010: £103.1m), which represented 86% of the Group's trading capital employed. It is estimated that a strengthening of UK sterling of 10% against all the non-UK sterling capital employed would reduce shareholders' funds by £12.6m.
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 28 to the consolidated financial statements in the 2011 Annual Report.
Mitigation
The Group does not hedge translational exposure.
Foreign currency - Transactional exposure
The Group's UK businesses are also exposed to foreign currency risk on purchases that are denominated in a currency other than their local currency, principally US dollars, Euro and Japanese yen. The Group's Canadian and Australian businesses are also exposed to a similar risk as the majority of their purchases are denominated in US dollars.
Mitigation
The Group's businesses may hedge up to 80% of forecast (being a maximum of eighteen months) foreign currency exposures using forward foreign exchange contracts. The Group classifies its forward foreign exchange contracts, hedging forecasted transactions, as cash flow hedges and states them at fair value.
Inventory obsolescence
Working capital management is critical to success in specialised distribution businesses as this has a major impact on cash flow. The principal risk to working capital, is in inventory obsolescence and write-off.
The charge against operating profit in respect of old or surplus inventory is generally ca. £0.7m per year, but inventories are generally not subject to technological obsolescence.
Mitigation
Inventory write-offs are controlled and minimised by active management of inventory levels based on sales forecasts and regular cycle counts. Where necessary, a provision is made to cover excess inventory and potential obsolescence.