THE FINANCIAL PARAMETERS THAT GOVERN THE SUCCESS OF SMITHS REMAIN FIRMLY IN PLACE. WHILE ONGOING EPS DECLINED 7% TO 52.3P THE FOCUS ON OVERHEAD REDUCTION AND DISPOSAL OF NON-CORE BUSINESSES MITIGATED THE PROFIT SHORTFALL AND FURTHER STRENGTHENED THE CASH-FLOW. THIS WAS A RESILIENT PERFORMANCE IN DIFFICULT TRADING CONDITIONS. CASH GENERATION WAS £395M, REDUCING NET DEBT FROM £1,120M TO £725M.

Since the merger with TI Group in December 2000, Smiths has disposed of non-core businesses, including automotive, which made up 23% of its 2001 profit.

'Discontinued activities' are shown in a separate column in the profit and loss account in order to illustrate more clearly the ongoing activities. 'Goodwill amortisation' and 'exceptional items' are also shown in separate columns in the profit and loss account – and are discussed below.

Ongoing profit and loss
The ongoing profit and loss account shows the impact of the difficult economic climate.

Activity levels varied sharply across the divisions. The civil part of Aerospace was affected, as were Industrial and Sealing Solutions. Medical and the defence and detection sectors of Aerospace moved ahead.

Operating profit declined 9%. The profit decline was sharper than the sales reduction despite significant overhead reductions as the sales shortfalls were concentrated in higher-margin activities. Operating margins, although slightly lower, remained strong at 15%, with all divisions above 12%.

Interest costs reduced to £46m (2001 £58m). Benefiting from a 1% lower tax rate, earnings per share declined by 7%. The dividend is twice covered by earnings.

Cash-flow
Healthy cash-flow has long been a feature of Smiths' businesses.

In 2002 we achieved a 105% conversion of operating profit to cash, higher than in recent years, and free cash-flow of £315m, 53% higher than last year.

Net borrowings at year-end were £725m, down from £1,120m last year and less than half the level of debt at the time of merger.

Restructuring
The merger-related restructuring programme is nearing completion and the expected savings were achieved.

Following the events of September 11th and the sharp contraction in civil aerospace, the company instigated further restructuring.

The £44m charge relates to significant overhead reduction in Aerospace (£39m) and moving further Medical production to Mexico (£5m).

Together, the merger-related restructuring and the 2002 restructuring programme eliminated £60m of overheads in 2002 and will have a full-year effect of £100m in 2003.

Exceptional charges
The exceptional charges comprise the £44m cost of the restructuring programme and the £24m loss on the book value of the discontinued businesses.

Goodwill
In accordance with UK accounting standards, the goodwill on all acquisitions is capitalised and subsequently amortised over a maximum 20-year period. The carrying value of acquisitions is formally reviewed at the first full year-end following acquisition and is also reviewed when circumstances require it.

Smiths purchased Radio Waves, Inc. in December 2000 for £17m. This business manufactures microwave antennae for the telecoms industry and has not achieved the expected trading performance. An impairment charge of £12m has been made.

Over the last several years the company has invested £120m in telecoms component businesses. With the exception of Radio Waves, each of these businesses performed exceptionally well following acquisition, before falling back to a level of performance that remains encouraging.

Discontinued
The disposals programme continued in 2002 with £247m raised from the sale of non-core businesses.

The 2001 operating profit of the sold businesses was £25m. The sales proceeds represent 14 times after-tax earnings.

Acquisitions
We concentrated on acquiring small, but strategically important bolt-on acquisitions during 2002, principally for our Medical and Aerospace businesses. The acquisition spend was £66m.

A key acquisition was Able Corp., which provided the expertise and technology to enable the flight refuelling systems contract for the Boeing 767 Tanker Programme to be secured.

TI Automotive investment
As part of the demerger of TI Automotive Ltd in July 2001 Smiths received £325m of preference shares in the demerged entity.

The preference shares carry a fixed 15% dividend, of which 5% is payable annually in cash and the balance is deferred. No accrual has been made for this dividend.

TI Automotive Ltd's growth ambitions have been affected by the current slowdown, particularly following September 11th, and TI Automotive is in the process of restructuring its borrowings. The preference dividend will not be paid until this refinancing is completed.

Smiths expects to realise its full investment in the longer term from a flotation of TI Automotive Ltd or on a sale of the investment when the automotive markets regain momentum.

Geographic spread – continuing operations

Taxation
The tax charge for the year represented an effective rate of 28% on profit of ongoing businesses before taxation, goodwill amortisation and exceptional items (2001 29%). This is a reduction of 2.6 percentage points since 2000 and the lowest effective rate for the group for over 10 years, partly assisted by tax efficiencies arising from the merger.

Pensions
The most recent actuarial valuations of the principal schemes were performed as at March 2001 in the UK and July 2001 in the US. In aggregate at these dates, assets exceeded liabilities by 20%.

The company calculates its pension expense under SSAP24 and amortises the surplus over the active members' estimated remaining working lives.

In addition to the full actuarial valuations, all pension plans have been actuarially reviewed at July 2002 under the methodology prescribed by FRS17reflecting the 31 July snapshot. Following the July equity market declines,the funding ratio of the funded pension plans was 97% compared to 114% last year with the UK fund in surplus and a deficit in the US.

The combined pension schemes are approximately 40% invested in equities – a significantly lower exposure than for pension schemes generally.

The pension expense (including post-retirement healthcare) for the year was £15m. The FRS17 basis of calculation would have given a pension expense of £23m.

Treasury
Smiths adopts a centralised treasury approach to manage its financial risks, within a strong control environment. There is no speculation or trading in derivative financial instruments.

Smiths has credit ratings with Standard & Poor's and Moody's of A– and A3 respectively, recognising the strong financial disciplines of the group and high resilience to the current adverse global trading conditions.

The group maintains a broadly even overall mix of fixed rate and floating rate funding. This has served us well in the current period as global interest rates have fallen, so reducing our cost of funding.

Legal issues
No provision has been made in the accounts in respect of litigation involving John Crane, Inc., a subsidiary, which was referred to in an announcement issued in December 2001. An update on this litigation appears in the full Annual Report and Accounts 2002.

Financial controls
While our decentralised organisation delegates day-to-day control to local management, we have comprehensive budgetary control systems in place, with regular reporting to the Board.

The internal audit department reports to the Audit Committee and reviews all key business units over a rolling three-year cycle. Acquisitions are reviewed within 12 months of acquisition, to verify compliance with the company's procedures.

Smiths' traditional financial values have served the company well in the difficult economic conditions of 2002 with profits matched by cash generation.

Cash generation was a priority. Debt at the date of the merger exceeded £1,750m and has now been reduced to £725m.

ALAN THOMSON
FINANCIAL DIRECTOR