• DEUTSCH

Financial Risks

Credit risks

A credit risk arises if a customer or other counterparty to a financial instrument fails to meet its contractual obligations. The adidas Group is exposed to credit risks from its operating activities and from certain financing activities. Credit risks arise principally from accounts receivable and to a lesser extent from other third-party contractual financial obligations such as other financial assets, short-term bank deposits and derivative financial instruments see Note 28. Without taking into account any collateral, the carrying amount of financial assets and accounts receivable represents the maximum exposure to credit risk.

At the end of 2010, there was no relevant concentration of credit risk by type of customer or geography. Instead, our credit risk exposure is mainly influenced by individual customer characteristics. Under the Group’s credit policy, new customers are analysed for creditworthiness before standard payment and delivery terms and conditions are offered. Tolerance limits for accounts receivable are also established for each customer. Both creditworthiness and accounts receivable limits are monitored on an ongoing basis. Customers that fail to meet the Group’s minimum creditworthiness are in general allowed to purchase products only on a prepayment basis.

Other activities to mitigate credit risks include retention of title clauses as well as, on a selective basis, credit insurances, accounts receivable sales without recourse and bank guarantees.

Objective evidence that financial assets are impaired includes, for instance, significant difficulty of the issuer or debtor, indications of the potential bankruptcy of the borrower and the disappearance of an active market for a financial asset because of financial difficulties. The Group utilises allowance accounts for impairments that represent our estimate of incurred credit losses with respect to accounts receivable.

Allowance accounts are used as long as the Group is satisfied that recovery of the amount due is possible. Once this is no longer the case, the amounts are considered irrecoverable and are directly written off against the financial asset.

The allowance consists of two components:

(1) an allowance established for all receivables dependent on the ageing structure of receivables past due date and

(2) a specific allowance that relates to individually assessed risk for each specific customer – irrespective of ageing.

At the end of 2010, no Group customer accounted for more than 10% of accounts receivable. We therefore believe that the potential financial impact of our credit risks from customers, particularly smaller retailers, is moderate and we rate the likelihood of occurrence as possible see Economic and Sector Development.

The adidas Group Treasury department arranges currency and interest rate hedges, and invests cash, with major banks of a high credit standing throughout the world. adidas Group companies are authorised to work with banks rated BBB+ or higher.

Only in exceptional cases are subsidiaries authorised to work with banks rated lower than BBB+. To limit risk in these cases, restrictions are clearly stipulated, such as maximum cash deposit levels. In addition, the credit default swap premiums of our partner banks are monitored on a weekly basis. In the event that the defined threshold is exceeded, credit balances are shifted to banks compliant with the limit. During 2010, the credit default swap premiums for many banks further declined from their highs in the aftermath of the financial turmoil in 2008. This development indicates a slight decrease of the associated risks.

Although financial market conditions improved in 2010, we continue to believe that the potential financial impact of credit risks from these assets is moderate and the likelihood of occurrence is possible. Nevertheless, we believe our risk concentration is limited due to the broad distribution of our investment business with more than 24 banks. At December 31, 2010, no bank accounted for more than 8% of our investment business and the average concentration, including subsidiaries’ short-term deposits in local banks, was 1%. This leads to a maximum exposure of € 105 million in the event of default of any single bank.

Furthermore, we held derivatives with a positive fair market value in the amount of € 86 million. The maximum exposure to any single bank resulting from these assets amounted to € 8 million and the average concentration was 1%.

Financing and liquidity risks

Liquidity risks arise from not having the necessary resources available to meet maturing liabilities with regard to timing, volume and currency structure. In addition, the adidas Group faces the risk of having to accept unfavourable financing terms due to liquidity restraints. Our Group’s Treasury department uses an efficient cash management system to manage liquidity risk. At December 31, 2010, Group cash and cash equivalents amounted to € 1.16 billion (2009: € 775 million). Moreover, our Group maintains € 2.17 billion bilateral short-term credit lines and a € 1.86 billion committed medium-term syndicated loan facility with international banks, which does not include a market disruption clause. The € 4.03 billion in credit lines are designed to ensure sufficient liquidity at all times see Treasury.

Future cash outflows arising from financial liabilities that are recognised in the Consolidated Statement of Financial Position are presented in the adjacent table:

This includes payments to settle obligations from borrowings as well as cash outflows from cash-settled derivatives with negative market values. Financial liabilities that may be settled in advance without penalty are included on the basis of the earliest date of potential repayment. Cash flows for variable-interest liabilities are determined with reference to the conditions at the balance sheet date.

In 2010, we reduced net debt to € 221 million (2009: € 917 million). With a ratio of net borrowings over 12-month rolling EBITDA of 0.2 times at year-end, we are within the Group’s medium-term guideline of a ratio below two times. In the light of our available credit lines, financing structure and business model, we assess the likelihood of occurrence of financing and liquidity risks as unlikely, and therefore expect only a minor potential financial impact on the Group.

Currency risks

Currency risks for the adidas Group are a direct result of multi-currency cash flows within the Group. The biggest single driver behind this risk results from the mismatch of the currencies required for sourcing our products versus the denominations of our sales. The vast majority of our sourcing expenses are in US dollars while sales are denominated in other currencies to a large extent – most notably the euro. Our main exposures are presented in the adjacent table see  05. The exposure from firm commitments and forecasted transactions was calculated on a one-year basis.

In line with IFRS 7 requirements, we have estimated the impact on net income and shareholders’ equity based on changes in our most important currency exchange rates. The calculated impacts mainly result from fair value changes of our hedging instruments. The analysis does not include effects that arise from the translation of our foreign entities’ financial statements into the Group’s reporting currency. The sensitivity analysis is based on the net balance sheet exposure, including intercompany balances from monetary assets and liabilities denominated in foreign currencies. Moreover, all outstanding currency derivatives were re-evaluated using hypothetical foreign exchange rates to determine the effects on net income and equity. The analysis was performed on the same basis for both 2009 and 2010.

Based on this analysis, a 10% increase in the euro versus the US dollar at December 31, 2010 would have led to a € 3 million increase in net income. The more negative market values of the US dollar hedges would have decreased shareholders’ equity by € 157 million. A 10% weaker euro at December 31, 2010 would have led to a € 4 million decrease in net income. Shareholders’ equity would have increased by € 193 million see  06. To better reflect the current foreign exposure structure, we have included EUR/JPY sensitivity analysis. Following the change in the business model in 2010, the exposure of the currency pair USD/JPY was bifurcated into EUR/JPY and EUR/USD. The impacts of fluctuations of the US dollar against the Russian rouble and of the euro against the British pound and the Japanese yen on net income and shareholders’ equity are also included in accordance with IFRS requirements.

However, many other financial and operational variables that could potentially reduce the effect of currency fluctuations are excluded from the analysis. For instance:

• Interest rates, commodity prices and all other exchange rates are assumed constant.
• Exchange rates are assumed at a year-end value instead of the more relevant sales-weighted average figure, which we utilise internally to better reflect both the seasonality of our business and intra-year currency fluctuations.
• The underlying forecasted cash flow exposure (which the hedge instrument mainly relates to) is not required to be revalued in this analysis.
• Operational issues, such as potential discounts to key accounts, which have high transparency regarding the impacts of currency on our sourcing activities (due to their own private label sourcing efforts), are also excluded from this presentation.

Utilising a centralised currency risk management system, our Group hedges currency needs for projected sourcing requirements on a rolling 12- to 24-month basis see Treasury. Our goal is to have the vast majority of our hedging volume secured six months prior to the start of a given season. In rare instances, hedges are contracted beyond the 24-month horizon. The Group also largely hedges balance sheet risks. Due to our strong global position, we are able to minimise currency risk to a large extent by utilising natural hedges.

Nevertheless, our net US dollar cash flow exposure after natural hedges calculated for 2011 was roughly € 3.3 billion at year-end 2010, which we hedged using forward contracts, currency options and currency swaps see  05. Our Group’s Treasury Policy allows us to utilise hedging instruments, such as currency options or option combinations, which provide protection while – at the same time – retaining the potential to benefit from future favourable exchange rate developments in the financial markets.

As 2011 hedging has almost been completed, it is clear that conversion rates on major currencies will be slightly less favourable compared to those of 2010. Volume forecast variances, greater currency volatility and an increasing portion of our business in emerging markets will expose the adidas Group to additional currency risks in 2011. Furthermore, translation impacts from the conversion of non-euro-denominated results into our Group’s functional currency, the euro, might lead to a material negative impact on our Group’s financial performance. As a consequence, the assessment of currency risks has increased. We now believe the likelihood of currency risks is highly probable and we regard the possible financial impact of currency risks as major.

Interest rate risks

Changes in global market interest rates affect future interest payments for variable-interest liabilities. As a result, significant interest rate increases can have an adverse effect on the Group’s profitability, liquidity and financial position.

In line with IFRS 7 requirements, we have analysed the impact of changes in the Group’s most important interest rates on net income and shareholders’ equity. The effect of interest rate changes on future cash flows is excluded from this analysis. Nevertheless, accrued interest, which is recognised as a liability, has been re-calculated based on the hypothetical market interest rates as at December 31, 2010. Fair values for derivative interest rate instruments accounted for as cash flow hedges were then re-evaluated based on the hypothetical market interest rates with the resulting effects on net income and equity included in the sensitivity analysis. The fair value interest rate risk from private placements that are hedged with fair value hedges was also taken into consideration.

However, the effect on the income statement from changes in the fair values of hedged items and hedging instruments attributable to interest rate changes was not material. Exclusions from this analysis are as follows:

• Some fixed-rate financial instruments, such as certificates of deposit, which our Group values at “fair value through profit or loss” due to the short-term maturity of these instruments. Potential effects due to changes in interest rates are considered immaterial and are not recognised in the sensitivity analysis.
• Other fixed-rate financial instruments are measured at amortised cost. Since a change in interest rates would not change the carrying amount of this category of instruments, there is no net income impact and they are excluded from this analysis.

The interest rate sensitivity analysis assumes a parallel shift of the interest yield curve for all currencies and was performed on the same basis for both 2009 and 2010. A 100 basis point increase in interest rates at December 31, 2010 would have increased shareholders’ equity by € 0.04 million (2009: € 0.50 million) and decreased net income by € 0.22 million (2009: € 0.65 million). A 100 basis point decrease of the interest rates at December 31, 2010 would have resulted in a € 0.04 million decrease in shareholders’ equity (2009: € 0.05 million) and a € 0.22 million increase in net income (2009: € 0.63 million).

We believe the IFRS 7 interest rate analysis represents a realistic if rough estimate of our current interest rate risk.

To moderate interest rate risks and maintain financial flexibility, a core tenet of our Group’s financial strategy is to continue to use surplus cash flow from operations to reduce net borrowings see Treasury. Beyond that, the adidas Group is constantly looking for adequate hedging strategies through interest rate derivatives in order to mitigate interest rate risks.

In 2010, interest rate levels in North America and Europe reached new all-time lows. In the light of the low interest rate levels, the easing of government fiscal action to stimulate economic growth and rising inflation, the risk of upward interest rate adjustments compared to the prior year has increased. Therefore, we now believe that the likelihood of a Group-wide interest rate increase is highly probable. Nevertheless, given the increase in our Group’s portion of longer-term fixed rate financing in 2010, we project any potential interest rate increases as having a moderate financial effect.