Risk analysis

Companies have to inform in the financial statements about how can certain risks influence their business and how these risks are managed.

Philip Morris ČR is exposed to a variety of financial risks, namely market, credit and liquidity risk. Market and liquidity risks are managed centrally by Treasury group in Lausanne, while credit risk is managed primarily by the Company. In this subchapter I will evaluate the risk.

4.3.1.1 Market risk

Due to the doing business abroad Company is exposed to the foreign currency risk arising from transactions performed mainly with companies in the European Union, including its Slovak subsidiary, and Swiss subsidiaries. Company uses EUR, USD and used SKK in the past. The foreign currency risk is measured against the functional currency CZK by applying the Czech National Bank exchange rate.

The Company applies sensitivity analysis in order to asses how the potential depreciation or appreciation will affect profit and loss before taxes. The sensitivity analysis takes into account

40 Palepu et. al., p.3-3 41 PM Annual Report, p. 55

only unpaid financial assets or liabilities denominated in foreign currencies. The Group consider the exchange rate movements against CZK of +(-)20% as possible, as shown in the next illustration:

Source: PM Annual Report 2009, p. 43

Yet, the Group does not consider currency risk that serious since they do not currently use any hedging tools for managing the risk.

Another part of market risk are interest rates. The Company is exposed to interest rates mainly because of short-term loans and on-demand deposits with PMI companies. The interest rate is set as overnight PRIMEAN less 0.25%.⁴² The Company applies sensitivity analysis, similarly to the exchange rates. The Group assumes the possible movements in the range of +100/-50 basis points, as shown in the following illustration.

Source: PM Annual Report 2009, p. 43

42 PM Annual Report 2009 p. 71

Illustration 13: Sensitivity Analysis for Interest rates

4.3.1.2 Credit risk

The Company sticks to strict policies concerning on sales on credit. Philip Morris ČR closely cooperates with PMI central Treasury and uses the services of external rating agencies.

Therefore, acceptance of new credit counterparty has to go through standard approval controls and procedures through the relevant department. The Company's involvement with counterparties is monitored and re-evaluated on regular basis. PM uses some financial market instruments like bank guarantees or advance payments to reduce the underlying risk.

Philip Morris ČR classifies receivables and on-demand deposits according to few criteria, especially closely monitors those that are past due. In the year 2008, they counted for around 3,5% of the net profit, while in 2009 they count for mere 0.4% of the net profit. And majority of these is past due not more than 3 months.

From these information I conclude that credit risk is carefully managed and should not post any serious problem for the Company.

4.3.1.3 Short-term liquidity risk

It is almost impossible to time cash inflows with cash outflows. Some cash outflows, like employees salaries, have to be paid on a regular basis and cannot be postponed. However, e.g.

customers can delay their payments.

The Company maintain sufficient cash funds. Liquidity is managed and controlled by the central PMI treasury via domestic and international Cash pool arrangements.

Liquidity analysis evaluates company's ability to meet its short-term obligations. Short-term liquidity can be analysed by using few financial ratios.

The most common liquidity ratios are current ratio (current assets/current liabilities) and the quick ratio (current assets excluding inventories/current liabilities). They measure the firm's ability to pay bills coming due with cash currently being collected. The ratios are considered as good if above 1.0.⁴³ The main problem with these kind of ratios is the requestion of how liquid are the current assets in real.

Better ratio which measures company's ability to generate cash is revenues to cash ratio

43 Stickney et al., p. 290

(revenues/average cash balance). Because company collects revenues in cash and pay operating costs and current liabilities with cash. And the amount of cash on the balance sheet reflects the net effect of operating, investing, and financing activities in cash, as well as management's judgements about the desired level of cash.⁴⁴

Source: own computations

In the previous table we can see computations of the liquidity ratios. Current ratio is always, except the year 2007, above 2, which is good result.

When I move on to the quick ratio, where the inventories are excluded, there is a declining trend and the results are not so good, especially for the years 2007 and 2008. However, in the last year the trend reversed and the result is the best so far. This is mainly due to the huge decline in inventories, when inventories decreased by more than 50%. But we have to consider that the inventories include excise tax. Excise tax counts for most of the value of inventories. In the years 2008 and 2007, excise tax was around 75% of value of the inventories and in the year 2009, the excise tax creates more than 63% of the value of inventories. And we cannot forget that excise tax is rising year by year, which can be solid explanation of the downtrend between years 2005 and 2008.

I also computed adjusted quick ratio, where I exclude the excise tax of inventories.

Unfortunately, I could find this information only for last three years. But anyway, we can see that this adjusted quick ratio has a rising trend and the results are fine. In 2009 it even goes over 2, which is really good result.

The revenues to cash ratio is in fact cash turnover. For easier interpretations we can express the ratio in number of days of revenue hold in cash. Interpreting of this ratio is very dependant from which side of view we want to interpret. Lenders will prefer smaller ratios, but management will prefer bigger ratio, meaning that the cash is not tied up too much in idle

44 Stickney et al., p. 295

Liqudity ratios 2009 2008 2007 2006 2005

Current ratio 2.36 2.13 1.51 2.16 2.08

Quick ratio 1.62 0.64 0.68 1.06 1.21

Quick ratio (adjusted) 2.08 1.75 1.31 n/a n/a

Revenues to cash 3.16 5.43 3.37 1.87 2.65

Days revenues held in cash 115.64 67.23 108.28 195.2 137.94

cash.

During the years 2004 and 2005 we can see uptrend peaking in 2006, followed by downtrend until 2008. But in 2009 the downtrend reversed and the figure reached higher level than in 2007.

From the liquidity perspective, Company has sufficient funds of cash ready to pay for the expenses. On the other hand, it seems like that idle cash is held for too long, especially in the year 2006.

4.3.1.4 Long-term solvency risk

Long-term solvency risk is measured in order to examine a firm's ability to to make interest and principal payments on long-term debt and similar obligations as they come due.

Perhaps the best indicator for assessing long-term solvency risk is to generate earnings over a period of years. Moreover, if a company wants to survive in a long run, they have to be able to survive in short-term. Short-term liquidity was analysed in the preceding subchapter.

I decided not to go deeply in analysing of long-term solvency risk, as the company in fact does not have any long-term liabilities on its balance sheet.

4.3.1.5 Conclusion

After analysing various risks that the Company is facing, we can conclude that they are managed carefully and they do not present any potential threat for the Company due to their small relative size as compared to net profits etc.

The Company is stable over the long-term and is expected not to have problems post by various kinds of risk in the future.