As a result of its international operations, Swedish Match is exposed to financial risks.
The term “financial risks” refers to fluctuations in Swedish Match’s cash flow caused by changes in foreign exchange rates and interest rates, and to risks associated with refinancing and credit. To manage its financial risks, Swedish Match has a finance policy in place established by the Board of Directors. The Group’s finance policy comprises a framework of guidelines and rules governing the management of financial risks and finance operations in general.
Currency risks
Exchange rate fluctuations affect Group earnings and shareholders’ equity in various ways:
- Earnings – when sales revenues and production costs are denominated in different currencies (transaction exposure).
- Earnings – when the earnings of foreign subsidiaries are translated to SEK (translation exposure).
- Earnings – if loans and deposits are made in other currencies than the unit’s functional currency (translation exposure).
- Shareholders’ equity – when the net assets of foreign subsidiaries are translated to SEK (translation exposure).
Transaction exposure
For the Group as a whole, there is a balance between inflows and outflows in the major currencies EUR and USD, which effectively limits the Group’s transaction exposure. Limited transaction exposure arises when certain of the Group’s production units in Europe make purchases of raw tobacco in USD, and through the European operations’ exports of lighters and matches in USD.
The anticipated commercial currency flow net of the reverse flows in the same currencies (transaction exposure) amounts to approximately 320 MSEK on an annual basis. Swedish Match policy for managing the Group’s transaction exposure is to hedge within certain limits. The hedging transactions are, if any, based on risk exposures, current market conditions and other strategic considerations. Transactions are mainly initiated via currency forward contracts with durations of up to 12 months, and relate to forecasted currency flows.
At December 31, 2009, the exposure was limited and therefore no transaction exposure for 2010 has been hedged. A general rise of 1 percent in the value of the SEK against all of the Group’s transaction currencies is estimated to reduce consolidated earnings before tax by approximately 4 MSEK (4) for the year ending December 31, 2009.
Translation exposure
The most significant effect of currency movements on consolidated earnings arises from the translation of subsidiaries’ earnings. Earnings in Group companies are translated at average exchange rates. Significant effects mainly pertain to USD, EUR and the Brazilian real (BRL). The single most important currency is the USD.
When the net assets of foreign subsidiaries are translated to SEK, translation differences arise that are recognized directly in equity. The exposures of net investment are 3,936 MSEK in USD (36 percent), 5,934 MSEK in EUR (55 percent) and in other currencies 935 MSEK (9 percent). The Group does not, as a general rule, hedge the net investments in foreign subsidiaries. If the SEK weakened by 1 percent against all the currencies in which Swedish Match has foreign net assets, the effect on shareholders’ equity would be positive in an amount of approximately 110 MSEK, based on the exposure at December 31, 2009.
Interest-rate risk
The Swedish Match Group’s sources of financing mainly comprise shareholders’ equity, cash-flow from current operations, and borrowing.
Interest-bearing loans expose the Group to interest-rate risk. Changes in interest rates have a direct impact on Swedish Match’s net interest expense. Swedish Match’s policy is that the average interest maturity should be less than 5 years. The speed with which a permanent change of interest rate impacts net interest expense depends on the interest maturity periods of the loans. The Group´s objective for interest rate binding is to achieve an even and low cost of interest. Interest rate swaps and currency swaps are used mainly to convert borrowings into SEK and fixed interest rates. At December 31, 2009, the average interest maturity period for Group loans was 2.8 years (2.3 years), taking into account interest rate swaps.
At December 31, 2009, a general rise of 1 percent (100bp) in interest rates was estimated to increase consolidated earnings before tax by approximately 6 MSEK (– 5) on an annual basis. The net interest bearing debt (including net pension obligations) at the same date amounted to 7,188 MSEK (7,640). The assumption is based on the present level of net debt and average interest maturity period.
If interest rates were to rise with 1 percent (100bp), the total effect on equity due to cash flow hedges would increase the amount by 43 MSEK.
Refinancing risk and liquidity
Refinancing risk is defined as the risk of that funds become scarce and thus more expensive than expected, and liquidity risk is defined as not being able to make regular payments as a consequence of inadequate liquidity or difficulty in raising external loans. Swedish Match applies a centralized approach to the Group’s financing, whereby as much external borrowing as possible is conducted centrally. Subsidiary borrowing can take place, however, in countries where regulations and taxes make central financing impossible or uneconomical. Swedish Match tries to limit its refinancing risk by having a good distribution and a certain length on its gross borrowing, and not to be dependent on individual sources of financing.
Liquidity within Swedish Match is handled centrally through local cash pools. Group companies are required to deposit liquid funds in cash pool accounts or, if these are not available, with the Parent Company’s treasury units. Exceptions are only allowed when regulations prohibit cash pools or internal deposits.
Liquidity risks and Credit risks
To limit liquidity and credit risks, investments and transactions in derivative instruments may be made only in instruments with high liquidity and with counterparties having high credit ratings. In addition to bank accounts, Swedish Match invests surplus funds mainly in government bonds, treasury bills and bank and mortgage certificates, as well as in certain approved securities with approved counterparties.
The Group’s finance policy regulates the maximum credit exposure to various counterparties. The aim is that counterparties to Swedish Match in financial transactions should have a credit rating of at least BBB+ from Standard & Poor’s or equivalent from Moody’s. To reduce the credit risk in receivables from banks arising via derivative instruments, Swedish Match has entered into netting agreements, known as ISDA Master Agreements, with all of its counterparties.
Swedish Match reduces the risk of its customers failing to fulfill their undertakings with the result that payment is not received for accounts receivable, by dividing accounts receivable among many different customers. At the reporting date, there was no significant concentration of credit risk in the Group’s accounts receivable.
Source: Swedish Match Annual Report 2009, Note 28 Financial instruments and financial risks.