2007 Financial statements
Note 33 - Financial risk management
The Group's policies with regard to financial risk management are clearly defined and consistently applied. They are a fundamental part of the Group's long term strategy covering areas such as foreign exchange risk, interest rate risk, commodity price risk, credit risk and liquidity risk and capital management.
Generally, the Group only sells commodities it has produced but may purchase commodities to satisfy customer contracts from time to time and to balance the loading on production facilities. In the long term, natural hedges operate in a number of ways to help protect and stabilise earnings and cash flow. From 1 January 2008, Rio Tinto Alcan has adopted the Rio Tinto Group policy on trading and hedging.
The Group has a diverse portfolio of commodities and markets, which have varying responses to the economic cycle. The relationship between commodity prices and the currencies of most of the countries in which the Group operates provides further natural protection in the long term. These natural hedges significantly reduce the necessity for using derivatives or other forms of synthetic hedging. Such hedging is therefore undertaken to a strictly limited degree, as described below. In addition, the Group's policy of borrowing at floating US dollar interest rates helps to counteract the effect of economic and commodity price cycles.
Treasury operates as a service to the business of the Rio Tinto Group and not as a profit centre. Strict limits on the size and type of transaction permitted are laid down by the Rio Tinto board and are subject to rigorous internal controls. Senior management is advised of corporate debt and currency, commodity and interest rate derivatives through a monthly reporting framework.
Rio Tinto does not acquire or issue derivative financial instruments for trading or speculative purposes; nor does it believe that it has exposure to such trading or speculative holdings through its investments in joint ventures and associates. Derivatives are used to separate funding and cash management decisions from currency exposure and interest rate management. The Group uses interest rate and cross currency interest rate swaps in conjunction with longer term funds raised in the capital markets to achieve a predominantly floating rate obligation which is consistent with the Group's interest rate policy, primarily US dollar LIBOR.
(i) Foreign exchange risk
Rio Tinto's shareholders' equity, earnings and cash flows are influenced by a wide variety of currencies due to the geographic diversity of the Group's sales and the countries in which it operates. The US dollar, however, is the currency in which the great majority of the Group's sales are denominated. Operating costs are influenced by the currencies of those countries where the Group's mines and processing plants are located and also by those currencies in which the costs of imported equipment and services are determined. The Australian and Canadian dollars and the Euro are the most important currencies (apart from the US dollar) influencing costs.
Given the dominant role of the US currency in the Group's affairs, the US dollar is the currency in which financial results are presented both internally and externally. It is also the most appropriate currency for borrowing and holding surplus cash, although a portion of surplus cash may also be held in other currencies, most notably Australian dollars, Canadian dollars and the Euro, in order to meet short term operational and capital commitments and, for the Australian dollar, dividend payments. The Group finances its operations primarily in US dollars, either directly or using cross currency interest rate swaps. A substantial part of the Group's US dollar debt is located in subsidiaries having a US dollar functional currency.
Certain US dollar debt and other financial assets and liabilities including intragroup balances are not held in the functional currency of the relevant subsidiary. This results in an accounting exposure to exchange gains and losses as the financial assets and liabilities are translated into the functional currency of the subsidiary that accounts for those assets and liabilities. These exchange gains and losses are recorded in the Group's income statement except to the extent that they can be taken to equity under the Group's accounting policy which is explained in note 1(d). Gains and losses on US dollar net debt and intragroup balances are excluded from Underlying earnings. Other exchange gains and losses are included in Underlying earnings.
As noted above, Rio Tinto hedges interest rate and currency risk on most of its foreign currency borrowings by entering into cross currency interest rate swaps and/or interest rate swaps when required. These have the economic effect of converting fixed rate foreign currency borrowings to floating rate US dollar borrowings. See section B (d) of note 34 - Financial Instruments for the details of currency and interest rate contracts relating to borrowings.
After taking into account relevant swap instruments, almost all of the Group's net debt is either denominated in US dollars or in the functional currency of the entity holding the debt. The table below summarises the net debt by currency.
(Net debt)/net funds by currency |
2007 US$m |
2006 US$m |
|---|---|---|
| United States dollar | (44,737) | (2,213) |
| Australian dollar | (256) | (291) |
| South African rand | 103 | 2 |
| UK sterling | (112) | (30) |
| Euro | (150) | 67 |
| Canadian dollar | (62) | (14) |
| Other | 62 | 42 |
| Total | (45,152) | (2,437) |
Currency hedging
The Group does not generally believe that active currency hedging of transactions would provide long term benefits to shareholders. Currency protection measures may be deemed appropriate in specific commercial circumstances and are subject to strict limits laid down by the Rio Tinto board, typically hedging of capital expenditures and other significant financial items such as tax and dividends. There is a legacy of currency forward contracts used to hedge operating cash flow exposures which was acquired with Alcan and the North companies. Refer to section B ((a) to (d)) of note 34 - Financial Instruments for the currency forward and option contracts used to manage the currency risk exposures of the Group at 31 December 2007.
Foreign exchange sensitivity: Risks associated with exposure to financial instruments
The sensitivities below derive from the estimated impact of a ten per cent change in the full year closing US dollar exchange rate on the value of financial instruments. The impact is expressed in terms of the effect on net earnings, underlying earnings and equity, assuming that each exchange rate moves in isolation.
The sensitivities are based on financial assets and liabilities held at 31 December 2007, where balances are not denominated in the functional currency of the subsidiary. A strengthening of the US dollar would result in exchange gains based on financial assets and financial liabilities held at 31 December 2007. These balances will not remain constant throughout 2008, however, and therefore these numbers should be used with care.
Functional currency |
Closing exchange rate US cents |
Effect on net earnings of 10% change US$m |
Of which amount impacting underlying earnings US$m |
Impact directly on equity of 10% change in full year closing
rate US$m |
|---|---|---|---|---|
| Australian dollar (a) | 88 | 204 | 99 | (20) |
| Canadian dollar | 101 | (3) | 53 | - |
| South African rand | 15 | 14 | 12 | (4) |
| Euro | 147 | 33 | 14 | 149 |
| New Zealand dollar | 78 | (9) | 3 | - |
Functional currency |
Closing exchange rate US cents |
Effect on net earnings of 10% change US$m |
Of which amount impacting underlying earnings US$m |
Impact directly on equity of 10% change in full year closing
rate US$m |
|---|---|---|---|---|
| Australian dollar (a) | 79 | 37 | 56 | (30) |
| Canadian dollar | 86 | (29) | 12 | - |
| South African rand | 14 | (6) | 5 | - |
| New Zealand dollar | 71 | (15) | 3 | - |
| Notes | Expand |
|
|
(ii) Interest rate risk
Interest rate risk refers to the risk that the value of a financial instrument or cash flows associated with the instruments will fluctuate due to changes in market interest rates. Rio Tinto's interest rate management policy is generally to borrow and invest at floating interest rates. This approach is influenced by the historical correlation between interest rates and commodity prices. In some circumstances, an element of fixed rate funding may be considered appropriate. As noted above, Rio Tinto hedges interest rate and currency risk on most of its foreign currency borrowings by entering into cross currency interest rate swaps and interest rate swaps in order to convert fixed rate foreign currency borrowings to floating rate US dollar borrowings. See section B (d) of note 34 - Financial Instruments for the details of currency and interest rate contracts relating to borrowings. At 31 December 2007, US$4.9 billion (2006: US$1.2 billion) of the Group's debt was at fixed rates after taking into account interest rate swaps and finance leases.
A monthly Treasury report is provided to senior management which summarises corporate debt exposed to currency and interest rate risks and, where applicable, the offsetting derivatives. See section B (d) of note 34 - Financial Instruments for the details of currency and interest rate contracts relating to borrowings. See note 22 - Borrowings for the details of debt outstanding at 31 December 2007.
Based on net debt and other floating rate financial instruments outstanding as at 31 December 2007, the effect on net earnings of a half percent movement in US dollar LIBOR interest rates, with all other variables held constant, is estimated to be US$158 million (2006: US$3 million). These balances will not remain constant throughout 2008, however, and therefore these numbers should be used with care.
(iii) Commodity price risk
The Group's normal policy is to sell its products at prevailing market prices. Exceptions to this rule are subject to strict limits laid down by the Rio Tinto board and to rigid internal controls. Rio Tinto's exposure to commodity prices is diversified by virtue of its broad commodity base and the Group does not generally believe commodity price hedging would provide long term benefit to shareholders. The Group may hedge certain commitments with some of its customers or suppliers.
Metals such as copper and aluminium are generally sold under contract, often long term, at prices determined by reference to prevailing market prices on terminal markets, such as the London Metal Exchange (LME) and COMEX in New York, usually at the time of delivery. Prices fluctuate widely in response to changing levels of supply and demand but, in the long run, prices are related to the marginal cost of supply. Gold is also priced in an active market in which prices respond to daily changes in quantities offered and sought. Newly mined gold is only one source of supply; investment and disinvestment can be important elements of supply and demand. Contract prices for many other natural resource products including iron ore and coal are generally agreed annually or for longer periods with customers, although volume commitments vary by product.
Certain products, predominantly copper concentrate, are 'provisionally priced', ie the selling price is subject to final adjustment at the end of a period normally ranging from 30 to 180 days after delivery to the customer, based on the market price at the relevant quotation point stipulated in the contract. Revenue on provisionally priced sales is recognised based on estimates of fair value of the consideration receivable based on forward market prices. At each reporting date provisionally priced metal is marked to market based on the forward selling price for the period stipulated in the contract. For this purpose, the selling price can be measured reliably for those products, such as copper for which there exists an active and freely traded commodity market such as the London Metal Exchange and the value of product sold by the Group is directly linked to the form in which it is traded on that market.
The marking to market of provisionally priced sales contracts is recorded as an adjustment to sales revenue.
At the end of 2007, the Group had 270 million pounds of copper sales (2006: 324 million pounds) that were provisionally priced at US$ 304 cents per pound (2006: US$287 cents per pound). The final price of these sales will be determined in 2008. A ten per cent change in the price of copper realised on the provisionally priced sales would increase or reduce net earnings by US$58 million (2006: US$66 million).
Alcan is the counterparty to certain forward metal sales contracts with Novelis, a company which was spun-off from Alcan in early 2005. Alcan has in substance fixed the LME price for a portion of its future aluminium sales. At 31 December 2007, these contracts had a positive fair value of US$45 million.
Commodity price sensitivity: Risks associated with derivatives
The table below summarises the impact of changes in the market price on the following commodity derivatives including those aluminium and option contracts embedded in electricity purchase contracts outstanding at 31 December 2007. The impact is expressed in terms of the resulting change in the Group's net earnings for the year or, where applicable, the change in equity. The sensitivities are based on the assumption that the market price increases by ten per cent with all other variables held constant. The Group's 'own use contracts' are excluded from the sensitivity analysis below as they are outside the scope of IAS 39. Such contracts are to buy or sell non financial items that can be net settled but were entered into and continue to be held for the purpose of the receipt or delivery of the non financial item in accordance with the business unit's expected purchase, sale or usage requirements.
These sensitivities should be used with care. The relationship between currencies and commodity prices is a complex one and changes in exchange rates can influence commodity prices and vice versa.
Products |
Effect on underlying and net earnings of 10% increase from
year end price US$m |
Effect directly on equity attributable to Rio Tinto of
10% increase from year end price US$m |
|---|---|---|
| Copper | - | 40 |
| Coal | - | 25 |
| Aluminium | 41 | 50 |
| Total | 41 | 115 |
Products |
Effect on underlying and net earnings of 10% increase from
year end price US$m |
Effect directly on equity attributable to Rio Tinto of
10% increase from year end price US$m |
|---|---|---|
| Copper | - | 49 |
| Coal | - | 20 |
| Total | - | 69 |
(iv) Credit risk
Credit risk is the risk that a counterparty will not meet its obligations under a financial instrument or customer contract, leading to a financial loss. The Group is exposed to credit risk from its operating activities (primarily from customer receivables) and from its financing activities, including deposits with banks and financial institutions, foreign exchange transactions and other financial instruments.
Credit risks related to receivables
Customer credit risk is managed by each business unit subject to Rio Tinto's established policy, procedure and control relating to customer credit risk management. Credit limits are established for all customers based on internal or external rating criteria.
Where customers are rated by an independent credit rating agency, these ratings are used to set credit limits. In circumstances where no independent credit rating exists, the credit quality of the customer is assessed based on an extensive credit rating scorecard. Outstanding customer receivables are regularly monitored and any credit concerns highlighted to senior management. High risk shipments to major customers are generally covered by letters of credit or other forms of credit insurance.
At 31 December 2007, the Group had approximately 140 customers (2006: 75 customers) that owed the Group more than US$5 million each and accounted for approximately 81 per cent (2006: 70 per cent) of all receivables owing. There were 33 customers (2006: 20 customers) with balances greater than US$20 million accounting for just over 48 per cent (2006: 34 per cent) of total amounts receivable. A balance of approximately US$254 million relates to one customer group.
The maximum exposure to credit risk at the reporting date is the carrying value of each class of financial assets mentioned in note 34. The Group does not hold collateral as security.
Credit risk related to financial instruments and cash deposits
Credit risk from balances with banks and financial institutions is managed by Group Treasury in accordance with a Board approved policy. Investments of surplus funds are made only with approved counterparties and within credit limits assigned to each counterparty.
Counterparty credit limits are reviewed by the Rio Tinto Board on an annual basis, and may be updated throughout the year subject to approval of the Rio Tinto Finance Committee. The limits are set to minimise the concentration of risks and therefore mitigate financial loss through potential counterparty failure.
No material exposure is considered to exist by virtue of the possible non performance of the counterparties to financial instruments.
(v) Liquidity and Capital risk management
The Group's total capital is defined as Rio Tinto's shareholders' funds plus amounts attributable to outside equity shareholders plus net debt, and amounted to US$71 billion at 31 December 2007 (31 December 2006: US$22 billion).
The Group's over-riding objectives when managing capital are to safeguard the business as a going concern; to maximise returns for shareholders and benefits for other stakeholders and to maintain an optimal capital structure in order to reduce the cost of capital.
The unified credit status of the Group is maintained through cross guarantees whereby contractual obligations of Rio Tinto plc and Rio Tinto Limited are automatically guaranteed by the other. Rio Tinto plc and Rio Tinto Limited continue to maintain solid investment grade credit ratings from Moody's and Standard and Poor's, despite the credit rating downgrade announced on completion of the Alcan acquisition. These ratings continue to provide access to global debt capital markets in significant depth.
Rio Tinto does not have a target debt/equity ratio, but has a policy of maintaining a flexible financing structure so as to be able to take advantage of new investment opportunities that may arise. Following the acquisition of Alcan, the Group has publicly stated an objective to reduce its debt from current levels through a targeted asset divestment programme to a level consistent with a 'single-A' credit rating. This policy is balanced against the desire to ensure efficiency in the debt/equity structure of the Rio Tinto balance sheet in the longer term through pro active capital management programmes.
On 2 February 2006 the Group announced a US$4 billion capital management programme which was subsequently increased to US$7 billion in October 2006. The capital return was comprised of a US$1.5 billion special dividend (US$1.10 per share) paid in April 2006 and an initial US$2.5 billion share buyback programme (increased to US$5.5 billion) to be completed over the remaining period to the end of 2007. The programme was suspended on 12 July 2007 at the time the Alcan offer was announced, by which time US$3.9 billion had been returned under the US$7 billion capital management programme, bringing the total cash returned to shareholders under announced capital management programmes since 2005 to US$6.4 billion.
The Group maintains backup liquidity for its commercial paper programmes and other debt maturing within 12 months by way of bank standby credit facilities, of which US$3.7 billion was undrawn as at 31 December 2007. The Group's committed bank standby credit facilities contain no financial undertakings relating to interest cover and are not affected to any material extent (other than an increase in interest margin) by a reduction in the Group's credit rating.
The main covenant in the Rio Tinto Group relates to a financial covenant over corporate debt drawn under the Syndicated Acquisition Facility, for which a compliance certificate must be produced attesting a certain ratio of Net Borrowings to EBITDA. There are no covenants relating to corporate debt which are under negotiation at present.
The Group's policy is to centralise debt and surplus cash balances whenever possible.
The table below analyses the Group's financial liabilities into relevant maturity groupings based on the remaining period from the balance sheet date to the contractual maturity date. As the amounts disclosed in the table are the contractual undiscounted cash flows, these balances will not necessarily agree with the amounts disclosed in the balance sheet.
| Trade and other payables US$m |
Borrowings before swaps US$m |
Expected future interest payments US$m |
Derivatives related to net debt US$m |
Other financial liabilities US$m |
Total financial liabilities US$m |
|
|---|---|---|---|---|---|---|
| Financial liabilities | ||||||
| Within 1 year, or on demand | (5,303) | (8,263) | (2,310) | (5) | (810) | (16,691) |
| Between 1 and 2 years | - | (10,628) | (1,862) | (4) | (309) | (12,803) |
| Between 2 and 3 years | - | (10,441) | (1,322) | (6) | (222) | (11,991) |
| Between 3 and 4 years | - | (37) | (892) | - | (190) | (1,119) |
| Between 4 and 5 years | - | (13,298) | (768) | - | (187) | (14,253) |
| After 5 years | - | (4,352) | (2,084) | - | (174) | (6,610) |
| Total | (5,303) | (47,019) | (9,238) | (15) | (1,892) | (63,467) |
| Trade and other payables US$m |
Borrowings before swaps US$m |
Expected future interest payments US$m |
Derivatives related to net debt US$m |
Other financial liabilities US$m |
Total financial liabilities US$m |
|
|---|---|---|---|---|---|---|
| Financial liabilities | ||||||
| Within 1 year, or on demand | (2,233) | (1,504) | (148) | (3) | (320) | (4,208) |
| Between 1 and 2 years | - | (723) | (96) | (15) | (288) | (1,122) |
| Between 2 and 3 years | - | (107) | (71) | (2) | (148) | (328) |
| Between 3 and 4 years | - | (478) | (44) | (3) | (43) | (568) |
| Between 4 and 5 years | - | (68) | (39) | - | (31) | (138) |
| After 5 years | - | (631) | (42) | - | (68) | (741) |
| Total | (2,233) | (3,511) | (440) | (23) | (898) | (7,105) |
| Notes | Expand |
|
|
As at 31 December 2007, the Group had unutilised standby credit facilities totalling US$3.7 billion (2006: US$2.3 billion). These facilities which have terms of between 4 and 5 years, are for backup support for the Group's commercial paper programmes and for general corporate purposes. US$1.6 billion is available to be drawn under the US$2.3 billion provided under Bilateral facility agreements, while the balance of US$2.1 billion is available under the US$40 billion syndicated facility agreement.