2.2 Focusing on clear financial KPIs

Operating margins

Aim: to maintain and strengthen margins.

We constantly monitor operating margins and manage operating costs to keep the business efficient and cost effective.

In 2008, we continued our long term trend of improving operating margins (before amortisation) with an annual increase of 6 basis points (bpts) to 13.15% (2007: 13.09%). We achieved this progression even though we invested heavily in our Life & Pensions business and implemented a record number of major new contracts.

Cash flow

Aim: to maintain strong operating and free cash flow. Capita generates a predictable and consistent cash flow.

In 2008, we generated operating cash flow of £392m, representing an operating profit to cash conversion rate of 122%. Our underlying free cash flow, defined as operating cash flow less capital expenditure, interest and taxation, increased by 19% to £219m.

Our success reflects the strength of our business model and management approach, in particular:

Economic profit

Aim: achieve steadily increasing Group economic profit. We are focused on delivering value for our shareholders.

An effective way of measuring this is to assess whether our after tax returns are sufficient to cover the returns required from all our capital providers. Group economic profit allows us to assess whether the return generated on the average capital base is sufficient to meet the return requirements of our investors (debt and equity). Positive economic profit therefore means that we have created value.

* excluding exceptional items

Return on capital employed (ROCE)

Aim: steadily increasing ROCE which exceeds our cost of capital.

This ensures that we add shareholder value over the long term. In recent years we have successfully widened the margin between the cost of our capital and the returns we generate by investing it.

In the chart below the weighted average cost of capital (WACC) indicates the return that could be expected from the capital invested in the business. It is calculated by weighting the cost of our debt and equity financing in line with the amounts of debt and equity that we use to finance our activities. We have calculated our WACC assuming a risk free rate of 4.47%, an equity risk premium of 5.93% and a Beta of 0.749.

During 2008, our post tax return on average capital employed improved to 20.4% (2007: 19.6%).This compares to our estimated WACC which is 8.2%.

Gearing

Aim: maintain a conservative and efficient capital structure, with a relatively low level of gearing.

It is important for our clients that we are a low risk, stable partner, particularly where we are delivering large scale operations on their behalf and even more so during the current volatile economic conditions. The Group has considerable headroom to take on further debt if necessary, as indicated by the interest cover ratio and net debt to earnings before interest, tax, depreciation and amortisation (EBITDA). However, we would be unlikely to incur borrowings which would reduce interest cover below 7 times. Group interest cover for the year ended 31 December 2008 was 7.4 times.

^† Underlying net debt after impact of currency and interest swaps

Interest rate profile
We aim to maintain a balanced interest rate risk profile. We have £679m of private placement debt (£100m matures later this year and £579m matures between 2012 and 2018). In February 2008, Capita executed a series of callable swaps to convert from a variable rate based upon paying 6 month LIBOR to a fixed rate of interest of 5.25% on £479m of placement debt. Following the dramatic fall in interest rates at the end of 2008 and an increase in the implied volatilities, these swaps show a negative mark to market value of £32m at 31 December 2008. This represents a non-cash accounting loss in the year that will reverse as the mark to market valuation will tend towards zero as the swaps approach maturity or cancellation. The Group maintains a balanced interest rate risk profile by way of the remaining private placement debt of £200m and a revolving credit facility of £245m that both pay floating rate interest. As at 31 December 2008, all of this credit facility was unutilised. See note 24.

Capital expenditure

Aim: keep capital expenditure (capex) at or below 4% of revenue.

This helps us to focus investment on the opportunities that generate greatest shareholder value and avoid tying up too much capital in long term projects.

In 2008 we met this objective, with net capex at 3.5% of annual revenue. We believe capex at or below 4% is sustainable for the foreseeable future. There are currently no indications of significant capex requirements in our business forecasts or bid pipeline. But we would not rule out the possibility of exceeding 4% if we saw an exceptional opportunity to use our financial strength as a competitive advantage.