Our financial performance improved again in 2005. Rising volumes and good management of costs resulted in higher profits and lower levels of average borrowing.

Results for the year

Underlying profit before tax, on a 'like-for-like' basis (see table) increased by 49 per cent to £584 million (2004 £392 million), and underlying earnings per share were 24.14p (2004 15.56p). Basic earnings per share were 20.11p (2004 15.56p).

The Group implemented International Financial Reporting Standards (IFRS) during the year. Comparative figures for 2004 are restated accordingly. A full analysis of the impact is provided in note 33 to the financial statements.

Sales growth in all market segments

Sales increased by 11 per cent.

• Civil aerospace engine deliveries increased by seven per cent to 881 engines. Civil aftermarket sales grew by 14 per cent.
• Defence aerospace sales increased slightly, with small increases in both original equipment sales and services revenues.
• Marine sales increased by 14 per cent, with strong growth in the offshore oil & gas support market sector.
• Energy sales increased by three per cent, with sales in the oil & gas sector offsetting the effects of the depressed power generation market.

Group aftermarket-services revenues including 100 per cent of repair and overhaul joint ventures grew by 12 per cent to £3.9 billion and have grown by 11 per cent per annum compound over the past ten years. Service revenues accounted for 54 per cent of total revenues.

87 per cent of sales were to customers outside the UK.

Margins benefited from some improvement in demand, continuing growth in services sales and our focus on cost reduction, which mitigated headwinds caused by commodity price inflation and an adverse trend in our achieved US dollar exchange rate.

Underlying financing costs amounted to £95 million, comprising principally net interest (£39 million), risk and revenue sharing partners' finance cost (£43 million) and net pension scheme finance cost (£9 million).

Group interest was covered 16.2 times (2004 7.6 times), based upon underlying profit before interest, excluding joint ventures. Restructuring charges of £48 million (2004 £37 million), which were incurred for ongoing operational improvements, were included within operating costs.

The Group made an underlying profit before tax of £584 million (2004 £364 million). The Group defines an underlying measure of profit to avoid the distortions caused primarily by the treatment of derivative foreign exchange and commodity contracts under IAS 39 (see note 28). The adjustments to reported profit are: a) reverse the impact of releasing the transition hedging reserve arising on the valuation of derivatives on January 1, 2005; b) eliminate the impact of unrealised gains and losses on derivatives and other financial assets and liabilities recognised during the year; and c) include the realised gains and losses of derivative contracts settled in the year. An adjustment is also made to eliminate the restructuring, re-measurement and foreign exchange gains and losses of financial RRSPs. Profit before tax was £477 million (2004 £364 million).

A final payment to ordinary shareholders of 5.38p is proposed making a total of 8.72p per ordinary share (2004 8.18p). The Company will continue to issue B Shares in place of dividends in order to accelerate the recovery of its advance corporation tax.

Order book

The order book, at constant exchange rates, was £22.9 billion (2004 £18.9 billion). Items are included in the order book when a firm, signed contract exists.

In civil aerospace it is common for a customer to take options for future orders in addition to firm orders placed. Such options are excluded from the order book until they become firm, signed orders.

In defence aerospace, long-term programmes are often ordered for only one year at a time. In such circumstances, even though there may be no alternative engine choice available to the customer, only the contracted business is included in the order book.

Aftermarket-services agreements, including TotalCare packages, represented 38 per cent of the order book. These are long-term contracts where only the first seven years' revenue is included in the order book.

Business which has been announced but for which contracts have not yet been signed is excluded from the order book. This amounted to a further £1.5 billion at the year end (2004 £2.4 billion).

Aftermarket services

The Group continues to be successful in developing its aftermarket-services activities. These accounted for 54 per cent of revenue in 2005.

In particular, TotalCare packages in the civil aerospace sector now cover 45 per cent, by value, of the installed fleet. TotalCare packages cover long-term management of the maintenance and associated logistics for our engines and systems, monitoring the equipment in service to deliver the system availability our customers require with predictable costs. The pricing of such contracts reflects their long-term nature. Revenues and costs are recognised based on the stage of completion of the contract, generally measured by reference to flying hours. The overall net position of assets and liabilities on the balance sheet for TotalCare packages was an asset of £367 million (2004 £389 million).

Cash

The Group cash flow statement is shown in the financial statements.

The Group generated a positive cash flow of £552 million during 2005 (2004 £251 million). The net cash balance at the year-end was £335 million (2004 net debt £217 million, after adjustment for the implementation of IFRS). Net working capital reduced year-on-year with the main items being increased inventories of £219 million, offset by an increase in customer advances of £181 million and an increase in payables of £294 million. The average net debt level reduced from £632 million to £260 million.

With positive cash flow expected again in 2006, there should be little if any average net debt and the balance sheet will strengthen further.

Net cash flow from operating activities was £1,060 million (2004 £610 million).

Taxation

The overall tax charge on the profit before tax was £130 million (2004 £100 million), a rate of 27.3 per cent (2004 27.5 per cent).

The tax charge was reduced by £18 million (2004 £13 million) in respect of the expected benefit of the UK research and development tax credit.

The tax charge on underlying profit was £167 million (2004 £100 million), a rate of 28.6 per cent (2004 27.5 per cent).

Pensions

As a result of the transition to IFRS, the charges for pensions are now calculated in accordance with the requirements of IAS 19 Employee Benefits; the amounts for 2004 have been restated accordingly. IAS 19 is broadly similar to FRS 17, the effects of which were disclosed in previous years. Its principal impact is to include the entire surplus or deficit of any defined benefit scheme on the balance sheet, based on defined valuation requirements.

Details of the pensions charge and the defined benefit schemes' assets and liabilities are shown in note 23 to the financial statements. This shows a net deficit, after taking account of deferred tax, of £1,154 million (2004 £984 million). Changes in this deficit are affected by the assumptions made in valuing the liabilities and the market performance of the assets. Most importantly, the discount rate used for measuring the UK defined benefit liabilities has fallen from 5.3 per cent in 2004 to 4.7 per cent in 2005. In addition, the mortality assumptions have been updated for the Rolls-Royce Pension Fund (the largest Scheme in the Group) based on the actual mortality experience within the scheme and also to allow for future mortality improvements. These factors more than offset the better than expected returns on the scheme assets.

During 2005, a revised benefit structure was agreed with the members of the Rolls-Royce Group Pension Scheme, similar to that implemented in the Rolls-Royce Pension Fund in 2003.

The next actuarial review is due in 2006 in respect of the Rolls-Royce Pension Fund.

Investments

The Group continues to subject all investments to rigorous examination of risks and future cash flows to ensure that they create shareholder value. All major investments require Board approval.

The Group has a portfolio of projects at different stages of their life cycles. Discounted cash flow analysis of the remaining life of projects is performed on a regular basis. Sales of engines in production are assessed against criteria in the original development programme to ensure that overall value is enhanced.

Gross research and development investment amounted to £663 million (2004 £601 million). Net research and development was £282 million (2004 £288 million). The level of self-funded investment in research and development is expected to remain at approximately five per cent of sales in the future. The impact of this investment on the income statement will reflect the mix and maturity of individual development programmes and will result in a significantly lower level of capitalisation of costs in 2006. Investment in training was £30 million (2004 £30 million).

Capital expenditure on property, plant and equipment was £248 million (2004 £191 million) and is expected to increase over the next year.

Partnerships

The development of effective partnerships continues to be a key feature of the Group's long-term strategy. Major partnerships are of two types: joint ventures and Risk and Revenue Sharing Partners.

Joint ventures

Joint ventures are an integral part of our business. They are involved in engineering and manufacturing, repair and overhaul, and financial services. They are also normal business structures for companies participating in international, collaborative defence projects.

They share risk and investment, bring expertise and access to markets, and provide external objectivity. Some of our joint ventures have become substantial businesses. A major proportion of the debt of the joint ventures is secured on the assets of the respective companies and is non-recourse to the Group.

The Group's share of joint venture assets and liabilities is shown in the chart below:

Joint ventures: Rolls-Royce share £m
	Repair and overhaul	Financial services	Other	Total
Gross assets	131	499	604	1,234
Debt	(13)	(392)	(75)	(480)
Other liabilities	(50)	(66)	(391)	(507)
Gross liabilities	(63)	(458)	(466)	(987)
Net assets	68	41	138	247

Risk and revenue sharing partners (RRSPs)

RRSPs have enabled the Group to build a broad portfolio of engines, thereby reducing the exposure of the business to individual product risk. The primary financial benefit is a reduction of the burden of research and development (R&D) expenditure on new programmes. The related R&D expenditure is expensed through the income statement and the initial programme receipts from partners, which re-imburse the Group for past R&D expenditure, are also recorded in the income statement, as other operating income.

RRSP agreements are a standard form of co-operation in the civil aero-engine industry. They bring benefits to the engine manufacturer and the partner. Specifically, for the manufacturer they bring some or all of the following benefits: additional financial and engineering resource; sharing of risk; and initial programme contribution. As appropriate, the partner also supplies components and as consideration for these components, receives a share of the long-term revenues generated by the engine programme in proportion to its purchased programme share.

The sharing of risk is fundamental to RRSP agreements. In general, partners share financial investment in the programme; they share market risk as they receive their return from future sales; they share currency risk as their returns are denominated in US dollars; they share sales financing obligations; they share warranty costs; and, where they are manufacturing or development partners, they share technical and cost risk. Partners that do not undertake development work or supply components are referred to as financial RRSPs and, under IFRS from 2005, are accounted for as financial instruments as described below.

In 2005, the Group secured new partners for the Trent 1000 engine programme. However, as the number of new programmes has reduced and in particular as government launch investment was not sought for the Trent 1000 programme, receipts from partners have declined. In 2005, other operating income amounted to £60 million (2004 £73 million) and is expected to be at a similar level in 2006.

Payments to RRSPs are recorded within cost of sales and increase as the related programme sales increase. These payments amounted to £146 million (2004 £240 million, including £98 million in respect of financial RRSPs).

The classification of financial RRSPs as financial instrument has resulted in a liability of £423 million being incorporated in the balance sheet and an associated underlying financing cost of £43 million recorded in the income statement. In 2005 the restructuring of arrangements with a financial partner resulted in a reduction of the liability, of £86 million, with an associated gain within financing costs in the income statement. This gain has been excluded from the underlying profit calculation.

In the past, the Group has also received government launch investment in respect of certain programmes. The treatment of this investment is similar to non-financial RRSPs.

Financial services

The financial services businesses comprise: engine leasing (Rolls-Royce & Partners Finance), aircraft leasing (Pembroke), and electrical power project development (Rolls-Royce Power Ventures).

Rolls-Royce & Partners Finance, the Group's joint venture engine-leasing business, owns a portfolio of 281 engines with 35 customers. The proportion of engines on lease remains high, at 98 per cent, by value.

Pembroke, the Group's joint venture aircraft-leasing business, owns 19 aircraft all of which are on lease to 12 customers. A charge of £13 million was incorporated in the 2005 results to reflect the current market valuation of Pembroke's aircraft assets.

Rolls-Royce Power Ventures, the Group's power-project developer, has 11 power-generation projects under way. The business is being restructured and proceeds of £49 million were raised from asset sales.

Intangible assets

The Group carried forward £1,281 million (2004 £1,227 million) of intangible assets. This comprised purchased goodwill of £751 million, engine certification costs and participation fees of £146 million, development costs of £265 million and recoverable engine costs of £119 million. The recognition of development costs and recoverable engine costs has resulted from the transition to IFRS (see note 33).

Risk management

The Board has an established, structured approach to risk management. The risk committee (see report of the directors) has accountability for the system of risk management and reporting the key risks and associated mitigating actions. The Director of Risk reports to the Finance Director. The Group's policy is to preserve the resources upon which its continuing reputation, viability and profitability are built, in order to enable the corporate objectives to be achieved through the operation of the Rolls-Royce business processes. Risks are formally identified and recorded in a corporate risk register and its subsidiary registers within the business, which are reviewed and updated on a regular basis, with risk mitigation plans identified for all significant risks.

Financial risk

The Group uses various financial instruments in order to manage the exposures that arise from its business operations as a result of movements in financial markets. All treasury activities are focused on the management and hedging of risk. It is the Group's policy not to trade financial instruments or to engage in speculative financial transactions. There have been no significant changes in the Group's policies in the last year.

The principal economic and market risks continue to be movements in foreign currency exchange rates, interest rates and commodity prices. The Board regularly reviews the Group's exposures and financial risk management and a specialist committee also considers these in detail. All such exposures are managed by the Group Treasury function, which reports to the Finance Director and which operates within written policies approved by the Board and within the internal control framework described in the report of the directors.

Counterparty credit risk

The Group has an established policy towards managing counterparty credit risk. A common framework exists to measure, report and control exposures to counterparties across the Group using Value at Risk and fair value techniques. Counterparties are assigned a credit limit that reflects their credit standing. The Group assigns an internal credit rating to each counterparty, which is assessed with reference to publicly available credit information such as that provided by Moody's, Standard & Poor's and other recognised market sources and is reviewed regularly.

Financial instruments are only transacted with counterparties that have a publicly assigned long-term credit rating from Standard & Poor's of 'A-' or better and from Moody's of 'A3' or better.

Funding and liquidity

The Group finances its operations through a mixture of shareholders' funds, bank borrowings, bonds, notes and finance leases. The Group borrows in the major global markets in a range of currencies.

It employs derivatives where appropriate to generate the desired currency and interest rate profile.

The Group took advantage of favourable market conditions during 2005 to extend the maturity profile of its main £250 million revolving credit facility from 2009 to 2012 on improved pricing and terms. As at December 31, 2005 the Group had total committed borrowing facilities of £1.7 billion on an IFRS basis (2004 £1.8 billion).

There are no rating triggers contained in any of the Group's facilities that could require the Group to accelerate or repay any facility for a given movement in the Group's credit rating and no material impact on the Group's interest charge is expected to arise from a movement in the Group's credit rating.

The Group holds financial investments and maintains undrawn committed facilities at a level sufficient to ensure the Group has available funds to meet its medium-term capital and funding obligations and to meet any unforeseen obligations and opportunities. The Group from time to time holds cash and short-term investments which, together with the undrawn committed facilities, enable the Group to manage its liquidity risk.

The Group continues to have access to all the major global debt markets.

Credit rating

The Group subscribes to both Moody's Investors Service and Standard & Poor's for its official publicised credit ratings. As at December 31, 2005 the Group's assigned long-term credit ratings were:

Rating Agency	Rating	Outlook	Category
Moody's	Baa1	Stable	Investment grade
Standard & Poor's	BBB+	Stable	Investment grade

During the year the Group saw positive actions by Moody's and Standard & Poor's such that the ratings and outlook from both agencies are now equivalent.

The Group attaches significant importance to maintaining an investment grade credit rating, which it views as necessary for the business to operate effectively.

The Group's medium-term objective is to achieve, through the normal course of business, an 'A' category investment grade credit rating from both agencies.

Currency risk

The Group is exposed to movements in exchange rates for both foreign currency transactions and the translation of net assets and profit and loss accounts of foreign subsidiaries.

The Group regards its interests in overseas subsidiary companies as long-term investments. The Group has tended to manage its translational exposures through the currency matching of assets and liabilities where applicable. The matching is reviewed regularly. Appropriate risk mitigation is undertaken where material mismatches arise.

The Group is exposed to a number of foreign currencies. The most significant transactional currency exposure is the US dollar followed by the Euro. US dollar income, net of expenditure represented 27 per cent of Group turnover in 2005 (2004 26 per cent).

The Group operates a hedging policy using a variety of financial instruments with the objective of minimising the impact of fluctuations in exchange rates on future transactions and cash flows.

The permitted range of the amount of cover taken is determined by the written policies set by the Board, based on known and forecast income levels.

The forward cover is managed within the parameters of these policies in order to achieve the Group's objectives, having regard to the Group's view of long-term exchange rates. Forward cover is in the form of standard foreign exchange contracts and instruments on which the exchange rates achieved are dependent on future interest rates. The Group may also write currency options against a portion of the unhedged dollar income at a rate which is consistent with the Group's long-term target rate. At the end of 2005 the Group had approximately US$10.5 billion of forward cover (2004 US$9.0 billion).

The consequence of this policy has been to maintain relatively stable long-term foreign exchange rates. Note 20 includes the impact of revaluing forward currency contracts at market values on December 31, 2005, showing a value of £228 million (2004 £986 million) which will fluctuate with exchange rates over time. The Group has entered into these forward contracts as part of the hedging policy, described above, in order to mitigate the impact of volatile exchange rates.

Interest rate risk

The Group uses fixed rate bonds and floating rate debt as funding sources. The Group's policy is to maintain a higher proportion of net debt at fixed rates of interest having regard to the prevailing interest-rate outlook. To implement this policy the Group may utilise a combination of interest-rate swaps, forward-rate agreements and interest-rate caps to manage the exposure.

Commodity risk

The Group has an ongoing exposure to the price of jet fuel and base metals arising from business operations. The Group's objective is to minimise the impact of price fluctuations. The exposure is hedged in accordance with parameters contained in a written policy set by the Board.

Sales financing

In connection with the sale of its products, the Group will, on some occasions, provide financing support for its customers. This may involve the Group guaranteeing financing for customers, providing asset-value guarantees (AVGs) on aircraft for a proportion of their expected future value, or entering into leasing transactions.

The Group manages and monitors its sales finance related exposures to customers and products within written policies approved by the Board and within the internal framework described in the report of the directors. The contingent liabilities represent the maximum discounted aggregate gross and net exposure that the Group has in respect of delivered aircraft, regardless of the point in time at which such exposures may arise.

The Group uses Airclaims Limited as an independent appraiser to value its security portfolio at both the half-year and year-end. Airclaims provides specific values (both current and forecast future values) for each asset in the security portfolio. These values are then used to assess the Group's net exposure.

The permitted levels of gross and net exposure are limited in aggregate, by counterparty, by product type and by calendar year. The Group's gross exposures are divided approximately 60:40 between AVGs and credit guarantees. They are spread over many years and relate to a number of customers and a broad product portfolio.

The Board regularly reviews the Group's sales finance related exposures and risk management activities. Each financing commitment is subject to a credit and asset review process and prior approval by the Chief Executive and the Finance Director.

The Group operates a sophisticated risk-pricing model to assess risk and exposure. Costs and exposures associated with providing financing support are incorporated in any decision to secure new business.

The Group seeks to minimise the level of exposure from sales finance commitments by:

• the use of third party non-recourse debt where appropriate;
• the transfer, sale, or re-insurance of risks; and
• ensuring the proportionate flow down of risk and exposure to relevant RRSPs.

Each of the above forms an active part of the Group's exposure management process.

Where exposures arise, the strategy has been, and continues to be, to assume where possible liquid forms of financing commitment that may be sold or transferred to third parties when the opportunity arises.

Note 30 to the accounts describes the Group's contingent liabilities as revised following the adoption of IFRS.

There were no material changes to the Group's gross and net contingent liabilities in this respect in 2005.

International Financial Reporting Standards

As we described last year, from 2005 all European Union listed companies are required to adopt International Financial Reporting Standards (IFRS) for their financial statements. Accordingly these are the first financial statements prepared on this basis. On April 14, 2005, we announced the impact on Rolls-Royce of the transition to IFRS. This is set out in note 33 to the financial statements and further details are available in the Investors section on the Group's website at www.rolls-royce.com

In summary, the key areas of impact for Rolls-Royce relate to:

• financial instruments accounting under IAS 32 and IAS 39;
• capitalisation of development expenditure under IAS 38;
• the impact of IAS 32 and IAS 39 on accounting for financial RRSP receipts and payments;
• pension-scheme accounting under IAS 19;
• fair valuing share-option schemes in accordance with IFRS 2; and
• the cessation of goodwill amortisation in accordance with IFRS 3.

During 2005, the International Accounting Standards Board has published further new standards and amendments to existing standards. Of these, the Group has chosen to adopt early the amendment to IAS 19 Employee Benefits allowing the recognition, in full, of actuarial gains and losses on post-retirement benefit schemes in the statement of recognised income and expense in 2005.

A summary of other changes, which have not been adopted in 2005, is included within the accounting policies in note 1 to the financial statements.

Share price

During the year the Rolls-Royce share price increased by 73 per cent from 247p to 427.5p per share, compared to a 55 per cent increase for the aerospace and defence sector and a 17 per cent increase for the FTSE 100. The Company's shares ranged in price from 236p in April to 430.5p in December.

The number of shares in issue at the end of the year was 1,759 million, an increase of 54 million of which 19 million related to share options and 35 million related to conversion of B Shares into ordinary shares.

The average number of shares in issue was 1,740 million (2004 1,690 million). Underlying earnings per share were 24.14p an increase of 55 per cent over 2004.

Andrew Shilston

Finance Director