british american tobacco p.l.c. annual report 2008 - Financial review (3 of 5)

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Cash flow

The IFRS cash flow includes all transactions affecting cash and cash equivalents, including financing. The alternative cash flow above is presented to illustrate the cash flows before transactions relating to borrowings.

The growth in underlying operating performance, as well as the timing of working capital movements and higher dividends from associates, partially offset by the adverse impact of the £102 million cash outflow arising from the Canadian settlement, explained above, resulted in a £1,036 million increase in cash flow before restructuring costs and taxation, to £4,692 million. Although there was a £77 million increase in tax outflows reflecting higher profits and the timing of payments, with the above operating cash flows and higher restructuring costs, the Group's net cash flow from operating activities was £939 million higher at £3,539 million.

Free cash flow is the Group’s cash flow before dividends, share buy-back and investing activities.

With higher capital expenditure, the free cash flow was £893 million higher than 2007 at £2,604 million. The free cash flow exceeded the total cash outlay on dividends to shareholders and share buy-back by £811 million.

The ratio of free cash flow per share to adjusted diluted earnings per share was 101 per cent (2007: 77 per cent), with free cash flow per share increasing by 55 per cent.

During 2008, the cash outflows of £873 million and £1,243 million on the purchase of Tekel assets and ST businesses respectively, comprise the purchase price, part of the acquisition costs less acquired net cash and cash equivalents and overdrafts.

The other net flows in 2008 principally reflect the impact of the level of shares purchased by the employee share ownership trusts, together with the impact of flows in respect of certain derivative financial instruments. The comparative figure for 2007 largely relates to the sale of the Belgian cigar factory and associated brands, as well as the disposal of the pipe tobacco business.

The above flows resulted in a net cash outflow of £1,532 million compared to an outflow of £85 million in 2007. After taking account of transactions related to borrowings, the above flows resulted in a net increase of cash and cash equivalents of £779 million compared to a net decrease of £143 million in 2007, as shown in the IFRS cash flow.

Cash flow

Treasury operations

Treasury is responsible for raising finance for the Group, managing the Group's cash resources and managing the financial risks arising from underlying operations. All these activities are carried out under defined policies, procedures and limits.

The Board reviews and agrees the overall treasury policies and procedures, delegating appropriate authority to the Finance Director, the Treasury function and the boards of the central finance companies. The policies include a set of financing principles, including the monitoring of credit ratings, interest cover and liquidity. These provide a framework within which the Group’s capital, including debt, is managed. The Finance Director chairs the boards of the major central finance companies. Any departure from agreed policies is subject to the prior approval of the Board.

Clear parameters have been established, including levels of authority, on the type and use of financial instruments to manage the financial risks facing the Group. Such instruments are only used if they relate to an underlying exposure; speculative transactions are expressly forbidden under the Group’s treasury policy. The Group’s treasury position is monitored by the Group Corporate Finance Committee, which meets regularly throughout the year and is chaired by the Finance Director. Regular reports are provided to senior management and treasury operations are subject to periodic independent reviews and audits, both internal and external.

One of the principal responsibilities of Treasury is to manage the financial risk arising from the Group’s underlying operations. Specifically, Treasury manages, within an overall policy framework, the Group's exposure to funding and liquidity, interest rate, foreign exchange and counterparty risks. Derivative contracts are only entered into to facilitate the management of these risks.

It is the policy of the Group to maximise financial flexibility and minimise refinancing risk by issuing debt with a range of maturities, generally matching the projected cash flows of the Group and obtaining this financing from a wide range of providers. The Group has a target average centrally managed debt maturity of 5 years with no more than 20 per cent of centrally managed debt maturing in a single year. As at 31 December 2008, the average centrally managed debt maturity was 5.1 years (2007: 5.4 years) and the highest proportion of centrally managed debt maturing in a single year was under 18 per cent (2007: 17 per cent).

The Group utilises cash pooling and zero balancing bank account structures in addition to inter company loans and borrowings to ensure that there is the maximum mobilisation of cash within the Group. The amount of debt issued by the Group is determined by forecasting the net debt requirement after the mobilisation of cash.

The Group continues to maintain investment-grade credit ratings; as at 31 December 2008 the ratings from Moody’s and S&P were Baa1/BBB+ with a stable outlook (end 2007: Baa1/BBB+). The strength of the ratings has underpinned the debt issuances during 2007 and 2008 and, despite the impact of the turbulence in financial markets, the Group is confident of its ability to successfully access the debt capital markets, as demonstrated with the issue of US$1 billion bonds in the US bond market in November 2008.

Subsidiary companies are funded by share capital and retained earnings, loans from the central finance companies on commercial terms, or through local borrowings by the subsidiaries in appropriate currencies. All contractual borrowing covenants have been met and none of them is expected to inhibit the Group’s operations or funding plans.