Notes to the consolidated accounts
17 Financial instruments and treasury risk management
Treasury Risk Management
Unilever manages a variety of market risks, including the effects of changes in foreign exchange rates, interest rates, liquidity and counterparty risks.
Currency risks
Because of Unilever's broad operational reach, it is subject to risks from changes in foreign currency values that could affect earnings. As a practical matter, it is not feasible to fully hedge these fluctuations. Additionally, Unilever believes that most currencies of major countries in which it operates will equalise against the euro over time. Unilever does have a foreign exchange policy that requires operating companies to manage trading and financial foreign exchange exposures within prescribed limits. This is achieved primarily through the use of forward foreign exchange contracts. On a case by case basis, depending on potential income statement volatility that can be caused by the fair value movement of the derivative, companies decide whether or not to apply cash flow hedge accounting. Regional groups monitor compliance with this foreign exchange policy. At the end of 2007, there was no material exposure from companies holding assets and liabilities other than in their functional currency.
In addition, as Unilever conducts business in many foreign currencies but publishes its financial statements and measures its performance in euros, it is subject to exchange risk due to the effects that exchange rate movements have on the translation of the underlying net assets of its foreign subsidiaries. Unilever aims to minimise its foreign exchange exposure in operating companies by borrowing in the local currency, except where inhibited by local regulations, lack of local liquidity or local market conditions. For those countries that in the view of management have a substantial retranslation risk, Unilever may decide on a case by case basis, taking into account amongst others the impact on the income statement, to hedge such net investment. This is achieved through the use of forward foreign exchange contracts on which hedge accounting is applied. Nevertheless, from time to time, currency revaluations on unhedged investments will trigger exchange translation movements in the balance sheet.
Interest rate risks
Unilever has an interest rate management policy aimed at achieving an optimal balance between fixed and floating rate interest rate exposures on expected net debt (gross borrowings minus cash and cash equivalents) levels for the next five calendar years. The objective of the policy is to minimise annual interest costs and to reduce volatility. This is achieved by issuing fixed rate long-term debt and by modifying the interest rate exposure of debt and cash positions through the use of interest rate swaps. The fixing levels per calendar year are determined by fixing bands, with minimum and maximum fixing level percentages, decreasing by 10 percentage points per calendar year. The minimum level in the first year amounts to 50% and the maximum level amounts to 90%. The minimum level is set to avoid unacceptable interest cost volatility and the maximum level is set to prevent over-fixing, recognising that future debt levels can be volatile.
At the end of 2007, interest rates were fixed on approximately 68% of the projected net of cash and financial liability positions for 2008 and 53% for 2009 (compared with 48% for 2007 and 52% for 2008 at the end of 2006).
Liquidity risk
A material and sustained shortfall in our cash flow could undermine our credit rating and overall investor confidence and could restrict the Group's ability to raise funds.
Operational cash flow provides the funds to service the financing of financial liabilities and enhance shareholder return. Unilever manages the liquidity requirements by the use of short-term and long-term cash flow forecasts. Unilever maintains access to global debt markets through an infrastructure of short-term and long-term debt programmes. In addition to this, Unilever has committed credit facilities in place to support its commercial paper programmes and for general corporate purposes.
Unilever had the following undrawn committed facilities at 31 December 2007:
- revolving 364-day bilateral credit facilities of in aggregate US $3 630 million (2006: US $3 930 million) with a 364-day term out;
- revolving 364-day notes commitments of US $200 million (2006: US $200 million) with the ability to issue notes with a maturity up to 364 days; and
- 364-day bilateral money market commitments of in aggregate US $1 720 million (2006: US $1 420 million), under which the underwriting banks agree, subject to certain conditions, to subscribe for notes with maturities of up to three years.
These facilities have been renewed until November 2008.
The revolving five-year bilateral credit facilities of in aggregate US $334 million and a revolving 364-day bilateral credit facility of in aggregate US $333 million matured in November 2007 and were not renewed.
The financial market turbulence and associated illiquidity in credit markets during the second half of 2007 did not impact Unilever's ability to meet its financing requirements.
The following table shows Unilever's contractually agreed (undiscounted) cash flows payable under financial liabilities and derivative assets and liabilities as at the balance sheet date:
| € million | € million | € million | € million | € million | € million | |
|---|---|---|---|---|---|---|
| Undiscounted cash flows | Due within 1 year |
Due between 1 and 2 years |
Due between 2 and 3 years |
Due 3 years and beyond |
Total | Net carrying amount as shown in balance sheet |
| 2007 | ||||||
| Non derivative financial liabilities: | ||||||
| Financial liabilities excluding related derivatives | ||||||
| and finance lease creditors | (4 101) | (1 060) | (1 314) | (2 877) | (9 352) | (9 243) |
| Interest on financial liabilities | (304) | (270) | (236) | (1 916) | (2 726) | |
| Finance lease creditors including related finance cost | (81) | (41) | (36) | (362) | (520) | (311) |
| Trade payables and other liabilities | ||||||
| excluding social security and sundry taxes(a) | (7 643) | (204) | – | – | (7 847) | (7 847) |
| (12 129) | (1 575) | (1 586) | (5 155) | (20 445) | ||
| Derivative financial liabilities: | ||||||
| Interest rate derivatives: | ||||||
| Derivative contracts - receipts | 6 | 4 | 3 | 2 | 15 | |
| Derivative contracts - payments | (9) | (4) | (3) | (2) | (18) | |
| Foreign exchange derivatives: | ||||||
| Derivative contracts - receipts | 5 315 | 22 | 22 | 45 | 5 404 | |
| Derivative contracts - payments | (5 411) | (26) | (26) | (52) | (5 515) | |
| (99) | (4) | (4) | (7) | (114) | (116)(b) | |
| 31 December | (12 228) | (1 579) | (1 590) | (5 162) | (20 559) | |
| 2006 | ||||||
| Non derivative financial liabilities: | ||||||
| Financial liabilities excluding related derivatives | ||||||
| and finance lease creditors | (4 338) | (405) | (280) | (3 601) | (8 624) | (8 601) |
| Interest on financial liabilities | (328) | (234) | (219) | (2 251) | (3 032) | |
| Finance lease creditors including related finance cost | (71) | (68) | (22) | (135) | (296) | (187) |
| Trade payables and other liabilities | ||||||
| excluding social security and sundry taxes(a) | (7 452) | (261) | – | – | (7 713) | (7 713) |
| (12 189) | (968) | (521) | (5 987) | (19 665) | ||
| Derivative financial liabilities: | ||||||
| Interest rate derivatives: | ||||||
| Derivative contracts - receipts | 2 | – | – | – | 2 | |
| Derivative contracts - payments | (3) | (3) | (2) | (1) | (9) | |
| Foreign exchange derivatives: | ||||||
| Derivative contracts - receipts | 5 272 | 100 | – | – | 5 372 | |
| Derivative contracts - payments | (5 302) | (121) | – | – | (5 423) | |
| (31) | (24) | (2) | (1) | (58) | (60)(b) | |
| 31 December | (12 220) | (992) | (523) | (5 988) | (19 723) | |
(a) See note 18.
(b) Includes financial liability-related derivatives amounting to €(95) million (2006: €(47) million).
Credit risk on banks and received collateral
Credit risk related to the use of treasury instruments is managed on a group basis. This risk arises from transactions with banks like cash and cash equivalents, deposits and derivative financial instruments. To reduce the credit risk, Unilever has concentrated its main activities with a limited group of banks that have secure credit ratings. Per bank, individual risk limits are set based on its financial position, credit ratings, past experience and other factors. The utilisation of credit limits is regularly monitored. To reduce the credit exposures, netting agreements are in place with Unilever's principal banks that allow Unilever, in case of a default, to net assets and liabilities across transactions. To further reduce Unilever's credit exposures, Unilever has collateral agreements with Unilever's principal banks based on which they need to deposit securities and/or cash as a collateral for their obligations in respect of derivative financial instruments. At 31 December 2007 the collateral received by Unilever amounts to €nil (2006: €2 million). At 31 December 2007 there was no significant concentration of credit risk with any single counterparty. default, to net assets and liabilities across transactions. To further reduce Unilever's credit exposures, Unilever has collateral agreements with Unilever's principal banks based on which they need to deposit securities and/or cash as a collateral for their obligations in respect of derivative financial instruments. At 31 December 2007 the collateral received by Unilever amounts to €nil (2006: €2 million). At 31 December 2007 there was no significant concentration of credit risk with any single counterparty.
Derivative financial instruments
The Group has comprehensive policies in place, approved by the Boards, covering the use of derivative financial instruments. These instruments are used for hedging purposes. The Group has an established system of control in place covering all financial instruments; including policies, guidelines, exposure limits, a system of authorities and independent reporting, that is subject to periodic review by internal audit. Hedge accounting principles are described in note 1. The use of leveraged instruments is not permitted. In the assessment of hedge effectiveness the credit risk element on the underlying hedged item has been excluded. Hedge ineffectiveness is immaterial.
The Group uses the following types of hedges:
- cash flow hedges used to hedge the risk on future foreign currency cash flows, floating interest rate cash flows, and the price risk on future purchases of raw materials;
- fair value hedges used to convert the fixed interest rate on financial liabilities into a floating interest rate;
- net investment hedges used to hedge the investment value of our foreign subsidiaries; and
- natural hedges used to hedge the risk on exposures that are on the balance sheet. No hedge accounting is applied.
Details of the various types of hedges are given below.
The fair values of forward foreign exchange contracts represent the unrealised gain or loss on revaluation of the contracts at the year-end forward exchange rates. The fair values of interest rate derivatives are based on the net present value of the anticipated future cash flows.
Cash flow hedges
The fair values of derivatives hedging the risk on future foreign currency cash flows, floating interest rate cash flows and the price risk on future purchases of raw materials amount to €85 million (2006: €9 million) of which €88 million relates to commodity contracts (2006: €5 million), €(10) million to foreign exchange contracts (2006: €2 million) and €7million to interest rate derivatives (2006: €2 million). Of the total fair value of €85 million, €82 million is due within one year (2006: €7 million).
The following table shows the amounts of cash outflows that are designated as hedged item in the cash flow hedge relations (no cash inflows are designated as hedged item):
| € million | € million | € million | € million | € million | |
|---|---|---|---|---|---|
| Due within 1 year | Due between 1-2 years | Due between 2-3 years | Due between 3-4 years | Total | |
| 2007 | |||||
| Foreign exchange cash flows | (235) | – | – | – | (235) |
| Interest rate cash flows | (18) | (19) | (21) | – | (58) |
| Commodity contracts cash flows | (310) | (1) | – | – | (311) |
| 2006 | |||||
| Foreign exchange cash flows | (298) | – | – | – | (298) |
| Interest rate cash flows | (31) | (43) | (19) | (20) | (113) |
| Commodity contracts cash flows | (107) | – | – | – | (107) |
Fair Value hedges
The fair values of derivatives hedging the fair value interest rate risk on fixed rate debt at 31 December 2007 amounted to €nil million (2006: €5 million) of which €nil million (2006 €5 million) is included under other financial assets.
Net investment hedges
The following table shows the fair values of derivatives outstanding at year end designated as hedging instruments in hedges of net investments in foreign operations:
| € million | € million | € million | € million | |
|---|---|---|---|---|
| Assets | Assets | Liabilities | Liabilities | |
| Fair values of derivatives used as hedge of net investments in foreign entities | 2007 | 2006 | 2007 | 2006 |
| Current | ||||
| Foreign exchange derivatives | – | 11 | 337 | 350 |
Of the above mentioned fair values, an amount of €nil million (2006: €11 million) is included under other financial assets and €(337) million (2006: €(350) million) is included under financial liabilities.
The impact of exchange rate movements on the fair value of forward exchange contracts used to hedge net investments is recognised in reserves.
Natural hedges
A natural hedge – sometimes known as an economic hedge – is where exposure to a risk is offset, or partly offset, by an opposite exposure to that same risk. Hedge accounting is not applied to these relationships.
The following table shows the fair value of derivatives outstanding at year end that are natural hedges.
| € million | € million | € million | € million | |
|---|---|---|---|---|
| Assets | Assets | Liabilities | Liabilities | |
| Fair values of natural hedges | 2007 | 2006 | 2007 | 2006 |
| Current | ||||
| Interest rate derivatives | 1 | 2 | 3 | 1 |
| Cross currency swaps | – | – | – | 6 |
| Foreign exchange derivatives | 377 | 371 | 41 | 31 |
| 378 | 373 | 44 | 38 | |
| Non-current | ||||
| Interest rate derivatives | – | – | – | 1 |
| Cross currency swaps | – | – | 18 | 12 |
| – | – | 18 | 13 | |
| 378 | 373 | 62 | 51 | |
Of the fair values disclosed above, the fair value of financial liability-related derivatives at 31 December 2007 amounted to €320 million (2006: €323 million) of which €78 million (2006: €20 million) is included under other financial assets and €242 million (2006: €301 million) is included under financial liabilities as a positive amount partly offsetting the €(337) million (2006: €(350) million) included under financial liabilities relating to the fair values of derivatives used as net investment hedges. The remaining balances are shown under trade and other receivables and other liabilities.
Sensitivity to not applying hedge accounting
Derivatives have to be reported at fair value. Those derivatives used for cash flow hedging and net investment hedging for which we do not apply hedge accounting will cause volatility in the income statement. Such derivatives did not have a material impact on the 2007 income statement.
Embedded derivatives
In accordance with IAS 39, 'Financial instruments: Recognition and Measurement', Unilever has reviewed all contracts for embedded derivatives that are required to be separately accounted for if they do not meet specific requirements set out in the standard; no material embedded derivatives have been identified.
Fair values of financial assets and financial liabilities
The following table summarises the fair values and carrying amounts of the various classes of financial assets and financial liabilities. All trade and other receivables and trade payables and other liabilities have been excluded from the analysis below and from the interest rate and currency profiles in note 15 and note 16, as their carrying amounts are a reasonable approximation of their fair value, because of their short-term nature.
| € million | € million | € million | € million | |
|---|---|---|---|---|
| Fair | Fair | Carrying | Carrying | |
| value | value | amount | amount | |
| 2007 | 2006 | 2007 | 2006 | |
| Financial assets | ||||
| Other non-current assets | 733 | 748 | 738 | 735 |
| Cash and cash equivalents | 1 098 | 1 039 | 1 098 | 1 039 |
| Other financial assets | 138 | 237 | 138 | 237 |
| Derivatives related to financial liabilities | 78 | 36 | 78 | 36 |
| 2 047 | 2 060 | 2 052 | 2 047 | |
| Financial liabilities | ||||
| Bank loans and overdrafts | (1 212) | (1 307) | (1 212) | (1 307) |
| Bonds and other loans | (8 073) | (7 402) | (7 907) | (7 170) |
| Finance lease creditors | (313) | (192) | (311) | (187) |
| Preference shares | (114) | (122) | (124) | (124) |
| Derivatives related to financial liabilities | (95) | (47) | (95) | (47) |
| (9 807) | (9 070) | (9 649) | (8 835) | |
The fair values and the carrying amount of listed investments included in financial assets and preference shares included in financial liabilities are based on their market values. Cash and cash equivalents, other financial assets, bank loans and overdrafts have fair values that approximate to their carrying amounts because of their short-term nature. The fair values of listed bonds are based on their market value; non-listed bonds and other loans are based on the net present value of the anticipated future cash flows associated with these instruments. Fair values for finance lease creditors have been assessed by reference to current market rates for comparable leasing arrangements.
Commodity contracts
The Group uses commodity forward contracts and futures to hedge against price risk in certain commodities. All commodity forward contracts and futures hedge future purchases of raw material. Settlement of these contracts will be in cash or by physical delivery. Those contracts that will be settled in cash are reported in the balance sheet at fair value and, to the extent that they are considered as an effective hedge under IAS 39, fair value movements are recognised in the cash flow reserve.
Capital management
The Group's financial strategy supports Unilever's aim to be in the top third of a reference group including 20 other international consumer goods companies for Total Shareholder Return. The key elements of the financial strategy are:
- • appropriate access to equity and debt markets;
- • sufficient flexibility for acquisitions that we fund out of current cash flows;
- • A1/P1 short-term credit rating;
- • sufficient resilience against economic turmoil; and
- • optimal weighted average cost of capital, given the constraints above.
For the A1/P1 sort-term credit rating the company monitors the qualitative and quantitative factors utilised by the rating agencies. This information is publicly available and is updated by the credit rating agencies on a regular basis.
The capital structure of the company is based on management's judgement of the appropriate balancing of all key elements of its financial strategy in order to meet the company's strategic and day-to-day needs. Annually the overall funding plan is presented to the Board for approval.
Return on Invested Capital is one of Unilever's key performance measures. Within this definition we defined the components of our Invested Capital. See Financial review for the details of this definition and the calculation of Unilever's Return on Invested Capital.
Income statement sensitivity to changes in foreign exchange rates
The values of debt, investments and related hedging instruments, denominated in currencies other than the functional currency of the entities holding them, are subject to exchange rate movements. The translation risk on the foreign exchange debtors and creditors is excluded from this sensitivity analysis as the risk is considered to be immaterial because positions will remain within prescribed limits (see currency risks set out within this note).
The remaining foreign exchange positions at 31 December 2007 mainly relate to unhedged US $ loans (total amount at 31 December 2007 US $37 million). A reasonably possible 10% change in rates would lead to a €7 million movement in the income statement (2006: €16 million).
Income statement sensitivity to changes in interest rate
Interest rate risks are presented by way of sensitivity analysis. As described in interest rate risk within this note, Unilever has an interest rate management policy aimed at optimising net interest cost and reducing volatility in the income statement. As part of this policy, part of the funds/debt have fixed interest rates and are no longer exposed to changes in the floating rates. The remaining floating part of our funds/debt (see interest rate profile tables in note 15 for the assets and note 16 for the liabilities) is exposed to changes in the floating interest rates.
The analysis below shows the sensitivity of the income statement to a reasonably possible one percentage point change in floating interest rates on a full-year basis.
| Sensitivity to a reasonably possible one percentage point change in floating rates as at 31 December | |||
|---|---|---|---|
| € million | € million | ||
| 2007 | 2006 | ||
| Funds | 25 | 24 | |
| Debt | (55) | (59) | |
Net investment hedges: sensitivity relating to changes in foreign exchange rates
To reduce the retranslation risk of Unilever's investments in foreign subsidiaries, Unilever uses net investment hedges. The fair values of these net investment hedges are subject to exchange rate movements and changes in these fair values are recognised directly in equity and will offset the retranslation impact of the related subsidiary.
At 31 December 2007 the nominal value of these net investment hedges amounts to €7.5 billion (2006: €7.6 billion) mainly consisting of US$/€ contracts. A reasonably possible 10% change in rates would lead to a fair value movement of €750 million (2006: €760 million). This movement would be fully offset by an opposite movement on the retranslation of the book equity of the foreign subsidiary.
Cash flow hedges: sensitivity relating to changes in interest rates and foreign exchange rates
Unilever uses on a limited scale both interest rate and forex cash flow hedges. The fair values of these instruments are subject to changes in interest rates and exchange rates. Because of the limited use of these instruments and the amount of Unilever's equity, possible changes in interest rates and exchange rates will not lead to fair value movements that will have a material impact on Unilever's equity.
