The Operations and Spread of Markets of Howden Joinery Group - Term Paper Example

? Question Answer Table of Contents 3 Executive Summary 4 Annual report for three years from 2009 to 5 Different sources of risk and nature of those risks 20 Interest rate risk 20 Counterparty risk 21 Foreign currency risk 21 Plausible strategies to hedge risks 22 Proposal of a Risk Management structure for the company 24 Conclusion 26 References 27 Abstract Running a business requires analysing the nature of business that a company undertakes, understanding the geographical spread of its markets and activities included in its value chain, identifying the plausible risks associated with the business, adopting suitable strategies to hedge the risk and at the same time prepare a contingency plan and an effective risk management structure to deal with hazards in future. Inability to prepare and implement timely risk management could incur severe damages from the risk associated with the business. With wide spread markets a company should identify several risks such as Interest rate risk, counterparty risk, foreign currency risk and other market risks to mitigate the damage of business. Appropriate strategies to deal with the volatility of the risks could help the business survive and sustain in the long run. The effective risk management structure of the company focussing on restructuring of its operations, implementing risk mitigating procedures would help the company to deal with hazards. Executive Summary In our discussion, we have considered the operations and spread of markets of Howden Joinery Group. Howden Joinery Group. is a leading supplier of kitchens and joineries. Annual reports and financial statements have been analysed. The major risks identified for the company are the interest rate risk, counterparty risk and foreign currency risk. The company can hedge the interest rate risk by investing in hedging securities which would offset the devaluation of some securities due to change in interest rates. Counterparty risk which the company may incur due to default of payment obligations of the counterparties may be hedged by selecting counterparties above a certain credit rating. Foreign currency risk may be hedged by entering transactions at spot rate. Based on past experience, annual reports, Howden Joinery Group Plc must prepare appropriate strategies for risk management in order to align the business with market conditions and to maintain adequate cash flows and liquidity. Annual report for three years from 2009 to 2011 The Annual Reports are given below for the company under consideration, i.e. Howden Joinery Gr. Plc. The data given below represents the consolidated Income Statement, Cash Flow Statement and Balance sheet for the above-mentioned years followed by a comparative study of the performance of the company from 2009 to 2011. For the year 2009, the consolidated cash flow statement of the company is given. For the year 2009, the consolidated Income statement of Howden Joinery Group Plc. is given (Howden Joinery Group Plc, 2013, p.1). For the year 2009, the consolidated Balance sheet of Howden Joinery Gr. Plc. is given. For the year 2010, the consolidated Income statement of Howden Joinery Gr. Plc. is given. For the year 2010, the consolidated Cash Flow statement of Howden Joinery Gr. Plc. is given below. For the year 2010, the consolidated Balance sheet of Howden Joinery Gr. Plc. is given below. For the year 2011, the consolidated Income statement of Howden Joinery Gr. Plc. is given. For the year 2011, the consolidated Cash Flow statement of Howden Joinery Gr. Plc. is given. For the year 2011, the consolidated Balance sheet of Howden Joinery Gr. Plc. is given. A comparative study of the performance of the company from 2009 – 2011 is given below. Based on the financial statements of the Annual Reports of Howden Joinery Gr. Plc. the following aspects have been described. Different sources of risk and nature of those risks Some of the different sources of risk for Howden Joinery Gr. Plc. are - a) Interest rate risk b) Counterparty risk, and c) Foreign currency risk. Interest rate risk Interest rate risk can be described as follows. Interest rate risk is the risk of change in the value of market securities when there is a fluctuation in market interest rates. Due to rise in interest rates, the marketable value of fixed income securities would lower down and due to fall of interest rates, the marketable value of those securities would go up. This variation in interest rate affects the welfare of the market investors due to variation of values of securities in which they have invested their funds. For example a bond with face value of $1000 with a coupon rate of 8% would face a sharp decline in price if the market interest rates rise to from 8% to 10%. This can be explained from the fact that the opportunity cost of the investor for holding on to that bond would be much less as compared to the interest rates on a similar security. Thus the bond would sell at a discount in order to match the market yield curve. Similarly, the bond with coupon rate more than the prevailing market interest rates would sell at a premium, i.e. more than the par value. Thus the nature of Interest rate risk is such that the market interest rates vary inversely with the value of the securities. The market interest rates directly affect the value of the securities and also have an indirect effect of the value of the stocks. The Howden Joinery Group’s strategy has been to borrow on a fixed rate basis and enter into fixed rate swaps, fixed rate caps and forward rate agreements in order to minimize their exposure to interest rate risk. The Howden Joinery’s policy objective has been to undertake transactions of this nature only when net debt exceeds ?150m. Net debt has not exceeded ?150m during the years 2009 to 2011. Counterparty risk Counterparty risk can be describe as the risk that is faced by a company due to default by the counterparties on payment obligations especially in a bond, credit derivative, trade credit insurance and payment protection insurance. Large insurers play the role of counterparties in financial industry. Counterparty risk arises mainly due to liquidity problems and also problems in lieu of long systematic errors. The Howden Joinery’s policy restricts the company to invest with counterparties who have a minimum Standard and Poor’s long term credit rating of AA- and a short term credit rating of A-1/P-1. From the Annual Report, it can be observed that The Howden Joinery Gr. Plc. mainly invests in Bank deposits and Certificates of Deposit. The Group also periodically reviews the quality of counterparties, individual credit exposure with the counterparties and the category of investment. Foreign currency risk Foreign currency risk is the risk that an investor or a company faces on its investment due to unanticipated changes in foreign currency exchange rates (Mayo, 2010, p.132). The risk should be managed by companies in a timely manner in order to mitigate the effect of such risks. Foreign currency may be of the following nature – Transaction, Economic, Translation and Contingent. Transaction exposure relates to the uncertainty in contractual cash-flows in terms of receivable and payments of the company when the contract is denominated in a foreign currency and the probability of unanticipated fluctuation in the foreign exchange rates arise. Economic exposure of a company is the effect on its operation and market value due to foreign currency rate fluctuation. The foreign currency risk is likely to affect the firm’s future cash flows, present value of future cash flows and its liquidity. The most significant currencies of The Howden Joinery Gr. Plc. are the US dollar and the Euro. The Group is a supplier of kitchens and joineries and target a large customer base across UK. As the effect of volatility on the Profit and Loss account cannot be avoided, the governing body of The Howden Joinery Gr. Plc. decided to review the transactional conversions and ensure that the currency conversion is done at spot exchange rate. Plausible strategies to hedge risks The plausible strategies that the company can adopt to hedge Interest Rate risk is given below. Hedging interest rate risk is like buying an insurance cover to protect the net worth in many ways. Fluctuation of interest rate is going to affect the valuation of securities of the company and also the net worth of the company. It up to the decision of the management to choose hedging strategy in an optimal way such that while fluctuation of the market interest rate the value of the securities would be compensated by the hedging assets (Jolly, 2003, p.32). Let us explain the term hedging asset. Hedging assets are assets which the firm will judiciously choose such that any fluctuation in interest rates would have an equal and opposite effect on the change in value of the hedging asset such that it can compensate the change in value of the securities that get affected due to change in interest rates. The Howden Joinery Gr. Plc. classifies and holds non-current assets for sale whose carrying value on sale would compensate the difference in valuation due to fluctuation of interest rates. No depreciation is charged by the Group for the non-classified and held for sale. For the company under consideration, any changes in value of the hedging instrument are recognized directly in equity and not in the income statement. When hedged item is shown in the financial statements, the accumulated gains / losses are recognized in equity and is either recycled to the Income Statement. If the hedged item results into a non-financial asset, it is recognized as an adjustment to the initial carrying amount. The plausible strategies that the company can adapt to hedge Counterparty risk are given below. A company’s decision on investment strategies help in hedging Counterparty risk. Companies should choose counterparties by looking at the aspects of liquidity, financial loss, potential regulatory claims or operational failures. Companies should also look at the prospects of solvency before investing with counterparty. In the financial market, there is a series of interconnected relations of institutions and agents starting from investment and commercial banks, financial institutions, agents, broker and sub-brokers (Madhumathi, 2012, p.13). Hence, the counterparty risk can be hedged by ensuring smooth functioning of the involved parties. The Howden Joinery Gr. Plc. reviews the solvency of the counterparties involved in their investments and also the extent of exposure to the individual counterparties. The Howden Joinery Gr. Plc. shows discontinued operations and cash flows from a specific geographical region or counterparties that have been kept on hold for sale separately from the areas of continuing operations. The plausible strategies that the company can adapt to hedge foreign currency risk are given below. Foreign currency risk is posed to a firm on account of exchange rate fluctuations when an investment is dominated by foreign currency. Foreign currency risk can be hedged with the help of forwards, options, currency futures but their complicacies have created obstruction in widespread prevalence among the investors. Exchange Traded Funds are a commonly used instrument for hedging Foreign Currency Risk. The Howden Joinery Gr. Plc. does not use derivative instruments to hedge its position over foreign currency risk (Chance and Brooks, 2009, p.355). Proposal of a Risk Management structure for the company The management of risk for a company is an important section that is contained in its Annual Reports. The Howden Joinery Gr. Plc. undertakes assumption based on the prediction of future uncertainties and discussion in held among all stakeholders in the Board Meeting. Based on the projected figures, budgeted financial statements are prepared (Handlechner, 2008, p.3). When the assumptions vary with respect to the actual conditions, the difference amounts either results in the deficits or surplus which are recorded in the financial statements of the Annual Report of The Howden Joinery Gr. Plc. In order to manage Interest rate risk, counterparty risk, foreign currency risk, Business risk and overall market risk, The Howden Joinery Gr. Plc. closely monitors the market and takes swift management action to cope up with such adverse changes. The companies should take necessary action to ensure that the business align to the market conditions in order to effectively manage risks (Conrow, 2003, p.40). For example, in 2008-09, The Howden Joinery Gr. Plc. suspended opening of depots for supply and reduced their staff members in order to align themselves with the required cash flow and liquidity. The business involves high transaction volumes and logistics. The Howden Joinery Gr. Plc. is dependent on its application software and its data-processing network for effective logistics in their depots. In order to manage the interest rate risk, The Howden Joinery Gr. Plc. adopts a policy on absolute no to speculative use of derivative, financial instruments and currencies. The treasury of the company is not operated as a profit centre but only supports the underlying operations of the company to meet business funding and liquidity. The group reviews the amount of exposure of each associate and also the quality of the associates to manage the risk structure. The group enforces spot currency conversion rates to manage foreign currency risk in a timely manner to reduce the proportional exposure to it. The most favourable impact of currency transactions in the year 2011 was that it reduced the cost of sales to 2.4m Pound sterling as compared to previous year. During 2009, the company had an asset backed facility of 175m Pound Sterling which was due to mature in 2011 and the maturity was extended to 2014 by the company. As a part of the extension the facility has been reduced to 160m Pound Sterling along with a revised interest rate and fixed charge covenant. The Group’s committed borrowing facility contains certain financial covenants which have been met throughout the year 2011. The covenants are tested every four weeks and are based on fixed charges, tax, tangible net worth, earnings before interest and depreciation. A company can use internal tactics like leading and lagging to minimize the exposure of foreign currency risk. This means at a probable time of foreign currency fluctuation, the firm can lead payment that is pay in advance to minimize the exposure and similarly lag receipts that is accept payments or receipts later. These are the various ways in which risk management can be adopted by The Howden Joinery Gr. Plc. for efficient operation and sustenance of their business (Khatta, 2008, p.49). Conclusion As explained from the annual reports, Howden Joinery Group has been able to adopt appropriate strategies to hedge the several risks associated in their business of supplying kitchens and joineries. By putting proper risk management in place, Howden Joinery Group Plc. has been able to run its business successfully by the dealing with the risks in an effective manner. References Chance, D. M. and Brooks, R. E. 2009. Introduction to Derivatives and Risk Management. Cengage Learning; USA. Conrow, E. H. 2003. Effective Risk Management: Some Keys to Success. AIAA; America. Handlechner, M. 2008. Risk Management. GRIN Verlag; Germany. HowdenJoineryGroupPlc. 2013. Annual and Half-yearly reports. [Online]. Available at: http://www.howdenjoinerygroupplc.com/investors/financial-reporting/reports. [Accessed on 21 February 2013]. Jolly, A. 2003. Managing Business Risk. Kogan Page Publishers; USA. Khatta, R. S. 2008. Risk Management. Global India Publications; New Delhi. Madhumathi, R. 2012. Derivatives and Risk Management. Pearson Education India; India. Mayo, H. B. 2010. Investments: An Introduction. Cengage Learning; USA. Read More