RMA-SOCL: Industry & Management Evaluation (Dev Strischek)

May 2013 Florida RMA Lending School 1

INDUSTRY AND MANAGEMENT EVALUATION

Dev StrischekSVP & senior credit policy officer

[email protected]

SunTrust Bank, Atlanta


Introduction to Industry and Management Evaluation

Purpose • Show you how its industry impacts your

borrower’s ability to repay

• Show you how its management impacts your borrower’s ability to repay

• Show you how to evaluate management’s ability to operate successfully within its industry


Content of Session

Industry evaluation• I-Industry structure

• II-Competitive position

• III-Company’s resources and capabilities

Management evaluation• I-Managerial strengths and weaknesses

• II-Key factors in management evaluation

• III-Management red flags


Content of Session

Industry Evaluation• I. Industry structure

• II. Competitive position

• III. Company’s resources and capabilities

Management Evaluation• I. Managerial strengths and weaknesses

• II. Key factors in management evaluation

• III. Management red flags


Industry Evaluation

Borrower’s objective—increase its value Bank’s goal—prudent profitability Industry analysis

• Is there room for your borrower?

• Does your borrower have what it takes to compete successfully?

• Can your borrower repay your loan?


ROE (PAT/NW) vs.. ROA? Points to ponder

• Borrowers want high ROE to maximize shareholder value, but replacing equity with cheaper debt generates bigger return and more risk for creditors

• Growing the firm is usually the road to success, but how easy is it to grow in the borrower’s industry?

• Growth requires funding from lenders and/or investors, but is the borrower’s industry attractive to funds providers?

• Borrow cheaply or attract more investors

• Covenants and conditions vs. dilution and less control

• Pay interest or pay dividends

• “Manage income” or reduce taxes

• Will management be able to achieve desired ROE within its industry and repay your loan?


ROE > ROA (EBIT/TA)? EBIT/TA

• Good measure of how profitably a company has managed its resources:• Earnings before interest and taxes/total assets=EBIT/TA

• Sometimes referred to as return on assets (ROA)

• EBIT is the pre-tax pool of funds available to pay both interest to debt holders and dividends to stock holders

• Comparing companies’ EBIT/TA eliminates potential distortions among firms caused by differences in financing sources and by differences in sales size:

• Debt/equity mix

• Revenue size


ROE > ROA?

So how do we reconcile these two points of view?• PAT/NW (ROE)= EBIT/TA (ROA)?

• Borrower’s goal vs.. funds provider’s goals?

What factors connect these two measures? Answer:

• PAT/NW = (TA/NW)(PBT/EBIT)(PAT/PBT) EBIT/TA


ROE > ROA?

PAT/NW = (LF)(IF)(TF) EBIT/TA Definitions:

• LF = leverage factor = TA/NW = 1 + (TL/NW)

• IF = interest factor = PBT/EBIT = 1 – [1/(EBIT)/I)]

• TF = tax factor = PAT/PBT = 1- (T/PBT)

Let’s see how the math works . . .


ROE-ROA Dilemma How to bridge the gap between ROE and ROA?

• LFdebt/equity balance• How easy is it to borrow or raise equity for this management in this

industry?

• IFinterest/dividend balance• Which is more advantageous for this management in this industry, to

pay interest or pay dividends?

• TFtax-deductible/non tax-deductible balance• What are the tax laws applicable to this company in this industry?

See Appendix A for more details on the math . . . You haven’t seen the last of these factors because they help

shape both the industry environment and the industry members . . .

So how does management satisfy both lenders and investors in repaying debt and paying dividends?


Repayment Ability

Good credit decision is based on• Prudent profitability—balance of reward & risk

• Logical conclusion—sound decision

Systematic decision-making• Purpose

• Repayment ability

• structure


Triple Trinities Purpose

• Logical• Ethical• Policy-compliant

Repayment Ability• Cash flow• Collateral• Guarantees

Structure• Repay in full• Repay on time• Repay as agreed


Impact of Industry and Management on Repayment Sources

Management’s job is to figure out how to be successful—repay creditors and satisfy shareholders--within the industry it operates

Lenders want their borrowers to be successful enough to repay their loans, and so they look to the traditional sources of repayment:

Repayment Sources: Industry Management

Cash flow

Collateral

Guarantees


Industry and management do impact repayment sources

Repayment Sources

Industry Management

Cash Flow Demand potentialSales growthProfit margins

Marketing strategyCredit strategyOperating strategy

Collateral Goods or servicesTrade credit termsValue stability

Inventory a/o ReceivablesPurchasingWarehousing

Guarantees Access to capitalScaleLeverage

Public vs.. privateCompetitive strategyRisk appetite


Credit Decision—Inside or Outside the Box?

Lenders expect borrowers to be positively “inside the box” . . .

Repayment Source Positive Negative

Cash flow Sufficient Insufficient

Collateral Secured Unsecured

Guarantees Full Non-recourse


What it takes for all 3 sources to be positively “inside the box”

Repayment Sources

Inside the box Outside the box

Cash Flow SufficientCF > (P+i)

Insufficient

Collateral SecuredColl > (P+i)

Unsecured

Guarantees GuaranteedGuar > (P+i)

Unguaranteed

(non-recourse)


So let’s build the box--cash Flow Positive Cash

Flow (+)

Negative CashFlow (-)


Building the box--cash flow and collateral

Positive Cash

Flow (+)


Unsecured (-) Secured (+)


Building the box--cash flow, collateral, and guarantees

Positive Cash

Flow (+)


Unsecured (-) Secured (+)

Guaranteed (+)

Non-recourse (-)


An axis to grind . . .Which box is better?

CashFlow(+)

CashFlow(-)

Secured(+)

Unsecured (-)

Guaranteed(+)

Unguaranteed (-)


An axis to grind . . .Other options?

CashFlow(+)

CashFlow(-)

Secured(+)

Unsecured (-)

Guaranteed(+)

Unguaranteed (-)


Possible Options1 cube = 8 little boxes Options CF Sec Guar

1 (right box) + + +

2 + + -

3 + - -

4 (wrong box) - - -

5 - + -

6 - + +

7 - - +

8 + - +

1

4


Possible Options—Typical Borrowers

1 cube = 8 little boxesOptions CF Sec Guar Borrower

1 (right box) + + + Ideal borrower

2 + + - CRE project

3 + - - Fortune 500

4 (wrong box) - - - Special assets

5 - + - Large ABL

6 - + + Small ABL

7 - - + Rich relative

8 + - + Services firm

1

4


Borrowers do move from box to box . . .

The single biggest reason? Cash flow . . .

• Over the life of the firm, cash flow changes . . .

• As the firm grows up and matures, its cash flow changes, too . . .


Cash flows vary over a firm’s life cycle . . .


So does the firm’s financial condition and performance . . .


Fast growth—negative cash flows and stressed financial ratios . . .

A B

C D

E F

G H


Stability comes at a price

When a firm’s actual growth rates syncs with its sustainable growth rate, the firm is able to cover all its needs internally:• Interest

• Principal

• Rents and leases

• Working capital investment

• Maintenance CAPEX

• Dividends or draws


Quick Summary of Differences between Fast Growth and Mature Firms

Fast growth

• Very negative CFO

• Very negative investing CF

• Very positive financing CF

• High profitability goal

• Low liquidity

• High leverage

• Low solvency

Mature firm

• Positive CFO

• Min neg investing CF

• Negative financing CF

• Stable profitability

• Liquid

• Capitalized

• Solvent


Maturity comes at a price

But its ROE tends to fall and so the firm is less attractive to investors until it starts to grow again . . .

By definition, a mature firm doesn’t need to borrow, so the firm is less attractive to lenders

So what’s a lender to do?


Good News--Firms and Industries Go through Cycles

Your borrower does not exist in a vacuum

Your borrower’s industry is an economic environment in which the firm must learn to survive, grow, and prosper over many business cycles . . .

Hawaii’s whaling industry cycle

Started 1820, ended 1880

• Near extinction of right whales forces American whalers to shift from Atlantic to Pacific Ocean’s larger whales—slow grays, huge blues, baleen humpbacks, valuable sperms

• 1820--Whalers arrive in Hawaii—R&R, labor supply, fresh water and food Expansion

• 1830’s—Hawaii evolves into transshipment center, whalers offload oil, resupply, fewer long trips back to New England improves economic life of ships

• 1840’s—industry peaks Decline and End

• 1849—Gold Rush

• 1850—oil discovered in Pennsylvania

• 1861-5—Civil War

• Whaling ships sunk to blockade Savannah & Charleston harbors

• Confederate navy targets, captures, and sinks Yankee whaling ships

• Island economy shifts to sugar to take advantage of war shortages of sugar on West Coast

• 1875—Arctic freeze

• 1880—second Arctic freeze



Content of Session




Management evaluation• Managerial strengths and weaknesses

• Key factors in management evaluation

• Management red flags


I. Industry Analysis

Purpose• Show how the industry shapes its member

firms and influences their relative success

• Identify the industry factors that drive your borrower’s ability to compete successfully


Key Factors in Industry Analysis

1. Industry structure• Where can firm be successful?

2. Competitive position• How can firm be successful?

3. Company resources and capabilities• What does firm have & need to be successful?


Industry structural analysis

Where can firm be successful?• Which markets?

• Which segments?

• Which business? Analytical steps

• Industry strengths and weaknesses

• Industry life cycle

• Value chain

• Industry trends and future outlook

• Industry’s overall attractiveness

Some Measures of Industry Financial Structure

Industry Sector Manufacturer Wholesaler Retailer Service Remarks

NFA/TA (%) High Low Scale economies

Labor/Rev (%) Low High High Capital/labor mix

GP Margin (%) Low High Demand elasticity

Inventory TO (x) Fast Slow Fast Carrying costs capacity

Receivables TO (x) Slow Fast Nil nil Channel control

AP TO (x) Slow Fast Channel control

Debt/Worth (x) Low High high Credit risk volatility

Legend:NFA = Net Fixed AssetsTA = Total AssetsRev = RevenueGP = Gross ProfitAP = Accounts PayableTO = Turnover


Structural Differences among 4 FirmsFinancial Ratios RMA Industry Averages Notes

A B C D

Operating Performance

Revenue/Total Assets (%) 1.4 3.9 4.1 3.2

Revenue/Net Fixed Assets (%) 3.0 21.7 31.7 8.3

Gross Profit/Revenues (%) 36.7 25.1 23.3 58.2

Profit before taxes/Revenues (%) 2.6 2.6 2.0 3.1

Profit before taxes/Net Worth (%) 18.1 29.8 19.5 40.1

Profit before taxes/Total Assets (%) 4.8 7.4 5.2 6.6

Liquidity

Net Working Capital/Revenue (x) 46.2 32.3 18.5 (93.3)

Days Receivables 17 5 0 0

Days Inventory 41 22 54 16

Days Payables 29 12 22 14

Current Assets/Current Liabilities (x) 1.2 1.4 1.7 .8

Net Fixed Assets/Total Assets (x) 52.8 23.3 18.2 48.5

Leverage

Debt/Worth (x) 2.3 2.1 2.9 3.5

Long-Term Debt/Total Assets 37.8 26.4 28.6 52.3

Net Worth/Total Assets 37.0 41.4 30.6 6.7

Solvency

Earnings before interest and taxes/interest (x) 1.9 3.5 3.0 2.0


Structural Differences among 4 Firms-Which is a manufacturer, wholesaler, retailer, service provider?

Financial Ratios RMA Industry Averages Notes

A B C D








Liquidity







Leverage

Debt/Worth (x) 2.3 2.1 2.9 3.5



Solvency



Structural Differences among 4 firms-- Where is the most opportunity to build shareholder value—as a manufacturer, wholesaler, retailer, or service

provider?

Financial Ratios RMA Industry Averages Notes

A B C D








Liquidity







Leverage

Debt/Worth (x) 2.3 2.1 2.9 3.5



Solvency




6 Shareholder Value Drivers

Sales growth rate actual vs.. sustainable

Operating profit margincost leadership vs.. differentiation

Tax Rate deferral vs.. expensing

Working capital investment goods vs.. service

Fixed asset investment capital intensity vs.. labor intensity

Weighted cost of capital risk vs..reward


Content of Session








II. Firm’s Competitive Position

Firm’s success depends on its strategy to compete with other firms within the industry structure

One way to assess competitive position is Porter’s Five Forces• Threat of new entrants

• Threat of substitutes

• Bargaining power of suppliers

• Bargaining power of buyers

• Competitive rivalry


Porter’s Five ForcesHow the forces drive competition

Competitiverivalry buyers

substitutes

ease of entry

suppliers


Details of Porter’s 5 Forces Threat of Entry

• economies of scale• product differentiation• capital requirements• switching costs to buyers• access to distribution channels• other cost advantages• governmental policies• incumbent defense of market share• industry growth rate

Supplier Power• supplier concentration• availability of substitute inputs• importance of supplier’s input to buyers• suppliers’ product differentiation• importance of industry to suppliers• buyer’s switching costs to other input• suppliers’ threat of forward integration• buyers’ threat of backward integration

Substitutes• relative price of substitute• relative quality of substitute• switching costs to buyers

Buyer Power• number of buyers relative to sellers• product differentiation• switching costs of use other product• buyers’ profit margins• buyers’ use of multiple sources• buyers’ threat of backward integration• sellers’ threat of forward integration• importance of product to buyer• buyers’ volume

Competitive Rivalry• number of competitors (concentration)• relative size of competitors (balance)• industry growth rate• fixed costs vs.. variable costs• product differentiation• capacity augmented in large increments• buyers’ switching costs• diversity of competitors• exit barriers• strategic stakes


Porter’s Five Forces: Example Beer producer (brewery)

Competitiverivalry buyers

substitutes

ease of entry

suppliers

RMA Industry Resources



Competitive position Value decision—low cost provider or

quality leader?• Good value vs. high quality?

• Mass market vs. upscale market?

• Local market vs. national market?

Demand and supply• Elasticity

• Price

• Revenue and profits


Competitive position—product value

Cost and Quality Options

high cost

low quality

high cost

high quality

low cost

low quality

low cost

high quality

COST

QUALITY


Competitive position—product diversity

Product and market options

Broad product line

Local market

Broad product line

National market

Narrow product line

Local market

Narrow product line

National market

PRODUCT

LINE

MARKET BREADTH


Maintain Competitive Positionby Competitive Advantage

Through product differentiation• Higher prices

• Unique

• dependable

• Higher value• quality

• scarcity

• Higher profits• Limited market

• National market


Competitive position & competitive advantage

Product Market and Value Options

Broad scope

Low cost

Broad scope

Higher value

Narrow scope

Low cost

Narrow scope

Higher value

PRDCT

MK T

SCOPE

PRDCT VALUE DIFFFERENTIATION


Competitive position & competitive advantage

Beer producer?

Broad scope

Low cost

Broad scope

Higher value

Narrow scope

Low cost

Narrow scope

Higher value

PRDCT

MK T

SCOPE

PRDCT VALUE DIFFFERENTIATION


Value Propositions

High Quality (+)

Good Value (-)

Mass Market (-) Upscale Market (+)

Local Market (+)

National Market (-)


Value Proposition Options

1 cube = 8 options Options High Quality-Good Value

National-Local Mkt

Mass Mkt-Upscale

1 (Palm Beach Apparel Shoppe)

HQ (+) Local (+) Upscale (+)

2 + + -

3 + - -

4 (WalMart) Good Value (-) National (-) Mass Mkt (-)

5 - + -

6 - + +

7 - - +

8 + - +

1

4


Content of Session








III. Resources and capabilities Value chain analysis

• Value created by interplay of• Support activities

• Firm infrastructure• Human resources• technology• Input management (procurement)

• Primary activities• Inbound logistics• Operations• Outbound logistics• Marketing and sales• service


Value Chain Analysis

Interplay of Support and Primary Activities

SUPPORT

ACTIVITIES

PRIMARY ACTIVITIES

INBOUND

LOGISTICS

OPERATIONS OUTBOUND

LOGISTICS

MARKETING

& SALES

SERVICE

Firm

Infrastructure

Human

Resources

Technology

procurement



Support activities

SUPPORT

ACTIVITIES

PRIMARY ACTIVITIES

INBOUND

LOGISTICS

OPERATIONS OUTBOUND

LOGISTICS

MARKETING

& SALES

SERVICE

Firm

Infrastructure

Human

Resources

Technology

procurement


Support: Firm Infrastructure

Depth and experience of management• Does management have background to direct

successful purchasing, finance, manufacturing, sales, and distribution functions?

Systems • Are systems sufficient and adequate to

provide timely information and responsive decisions?


Support: Human Resources Labor intensity

• Capital/Labor ratio Unionization

• Industry’s degree of unionization• Union shop or closed shop?• Susceptibility to strikes, shutdowns, other actions?

Skill levels• How reliant is industry on employees with specialized knowledge,

training or skills?• How difficult is it to hire and retain these individuals?

Environment• How attractive are facilities to employees?• How attractive is location-geography to employees?


Support: Technology Plant and equipment

• Current capacity

• Current production and productivity rates

• Production—16 tons of coal a day

• Productivity—16 tons per miner each day Technological Change

• Industry’s innovation rate—agriculture vs. coal mining

• Likelihood of new products or processes

• Cell phone’s impact on CB radios & land line phones

• Iphone’s impact on cell phone industry

• Ipod’s impact on music industry

• Ipad’s impact on computer industry


Support: Procurement

Materials and other inputs• Commodity or scarcity?

• Stability of value—perishable, storable?

Logistics• Impact of time and distance on quality of inputs

• Transportation alternatives

• Geographic constraints

• Storage capacity



Primary Activities

SUPPORT

ACTIVITIES

PRIMARY ACTIVITIES

INBOUND

LOGISTICS

OPERATIONS OUTBOUND

LOGISTICS

MARKETING

& SALES

SERVICE

Firm

Infrastructure

Human

Resources

Technology

procurement


Primary Activities Inbound logistics

• Getting it here Operations

• Getting it made Outbound logistics

• Getting it to the client Marketing & sales

• Getting the most sold at the best price Service

• Getting the client to come back for more


Primary activities’ impact on value driversValue Drivers Linkage to Primary Activities

1. Sales Growth Rate (G)

Inbound logistics

operations Outbound logistics

Marketing & sales

service

2. Operating Profit Margin (P)

Materials, warehousing, freight-in admn

Processing, assembly, testing, packaging

Materials, warehousing, freight-out admn

Sales force, advertising, promotion, admn

Installation, training, maintenance, returns

3. Wkg Cptl Investment (W)

Raw materials W-I-P inventory, accts payable

Finished goods, accts payable

Accounts receivable

Parts inventory, service fees

4. Fxd Asst Investment (F)

Warehouses, transportation fleet, equipment

Production facilities

Warehouses, transportation fleet, equipment

Distribution facilities, sales force offices

Service facilities, transportation fleet, service equipment




What combination of sales growth rate, operating profit margin, working capital investment, fixed asset investment, a/o cost of capital will increase cash flow and shareholder value?

SUPPORT

ACTIVITIES

PRIMARY ACTIVITIES

INBOUND

LOGISTICS

OPERATIONS OUTBOUND

LOGISTICS

MARKETING

& SALES

SERVICE

Firm

Infrastructure

Human

Resources

Technology

procurement


Value Chain Analysis: Example

Beer Producer

SUPPORT

ACTIVITIES

PRIMARY ACTIVITIES

INBOUND

LOGISTICS

OPERATIONS OUTBOUND

LOGISTICS

MARKETING

& SALES

SERVICE

Firm

Infrastructure

Human

Resources

Technology

procurement


Sales growth strategy options for management

Sales growth rate • Existing capacity vs. future requirements

• Warehouse, storage, processing facilities

• Transportation and distribution

• Capital assets• Technologically up to date to support sales?

• Obsolescence rate impact on liquidation value?

• What’s needed to give products and services their marketing edge?



Expansion consequences for Beer Producer?

SUPPORT

ACTIVITIES

PRIMARY ACTIVITIES

INBOUND

LOGISTICS

OPERATIONS OUTBOUND

LOGISTICS

MARKETING

& SALES

SERVICE

Firm

Infrastructure

Human

Resources

Technology

procurement

Likely Cash flow impact of regional vs. national distribution strategies

Cash Flow Impact Analysis

Strategy Value Driver Assumptions

Value Created ($MM)

Probability of Success

Regional •Concentrate on existing western US markets•Maintain quality on existing products•Stop new product development

•Maintain 7% sales growth•Maintain 9% operating margin•Maintain $60MM CAPEX•Maintain 15% WC investment

•Base: $273•Best: $436•Worst: $218

?

National •Expand sales & distribution nationwide•Increase ad & promo expense•Expand brewing capacity•Loosen credit for new distributors

•12-14% sales growth•8% operating margin initially, but 10-11% later•$90MM CAPEX•20-25% WC investment

•Base: $336•Best: $516•Worst: $118

?

“If at first you don’t succeed, try, try again. Then quit. No use being a damn fool about it.” W. C. Fields



The rest of the story . . . .

Geographic expansion east of the Mississippi Elitist cache diminishes as product tries to

broaden appeal to mass market Initial market share gain shrinks No significant increase in shareholder value So what can a firm do to increase shareholder

value in highly competitive industry?


Shareholder Value= Company Value =??

A company’s value =Present value (PV) of operating cash flow

+ PV of residual value

+ Non operating assets

= Corporate value

-Market value of debt & other obligations

= Shareholder value


Discounted Cash Flow (DCF)

DCF Framework

in action

PV of Operating Cash flow

Forecast Period2003 2004 2005 2005 2007

Residual Period2008 . . . . . . . . . . . . . . .

PV of Residual

Value

Non-operating

assets

+

+

=Corporate

Value -Mkt Value ofDebt & other

obligations= Shareholder

Value


DCF’s shareholder value drivers

Value Drivers Description Formula

Sales growth rate (G) Sales growth rate for forecast period [future sales/last historical sales] - 1

Operating profit margin (P)

Pre-tax operating profit as % of sales P = (sales – operating expenses)/sales

Cash tax rate (T) Cash taxes that would have been paid if the firm had no debt as % of operating profits

T = cash taxes/operating profit where cash taxes = book taxes –non-oper taxes + interest tax shield – increase in deferred tax liability

Incremental Fixed Capital Investment (F)

Addition to fixed assets over & above maintenance CAPEX, as % of change in sales

F = [total CAPEX – maintenance CAPEX]/change in sales

Incremental Working Capital

Investment (W)

Addition to WC as % of change in sales

W = change in working capital/change in sales

Cost of capital (K) Weighted average return that a company’s debt and equity holders require given the levels of risk in their respective investments

K = [cost of equity X (equity/(equity+debt))] + [cost of debt X (1 – T) (debt/(equity/equity+debt))]

Where T = cash tax rate


Impact of Industry on Value Drivers

Averages and norms tend to define ranges of acceptable performance and operating limits

So look at Industry norms for • Sales growth rate

• Capital expenditures

• Profit margins

• Working capital . . .


10% WC/Sales=>$35.66Year 2007 2008 2009 2010 2011 2012

Sales 1648.0 1895.2 2179.5 2506.4 2882.4 3314.7

Operating Costs 1635.6 1880,9 2163.0 2487.5 2860.6

Operating Profit 259.6 298.6 343.4 394.9 454.1

Taxes 106.5 122.4 140.8 161.9 186.2

NOPAT 153.2 176.2 202.6 233.0 267.9

F 61.8 71.1 81.7 94.0 108.1

W 24.7 28.4 32.7 37.6 43.2

Cash Flow (CF) 66.7 76.7 88.2 101.4 116.6

Discount Factor for K @ 10% 0.9091 0.8264 0.7513 0.6830 0.6209

PV of CF 60.6 63.4 66.2 69.3 72.4

Cum PV of CR 60.6 124.0 190.2 259.5 331.9

Residual Value 1531.9 1761.7 2025.9 2329.8 2679.3

PV of perpetuity 1392.6 1455.9 1522.1 1591.3 1663.6

Mkt Securities 10.0 10.0 10.0 10.0 10.0

Corp Value 1463.2 1589.9 1722.3 1860.8 2005.5 2156.8

Mkt Vale of Debt 1007.0 1007.0 1007.0 1007.0 1007.0

Shhldr Value 456.2 582.9 715.3 853.8 998.5

Share Price 16.29 20.82 25.55 30.49 35.66

13.8% WC/Sales=>$33.99


Year 2007 2008 2009 2010 2011 2012

Sales 1648.0 1895.2 2179.5 2506.4 2882.4 3314.7

Operating Costs 1635.6 1880,9 2163.0 2487.5 2860.6

Operating Profit 259.6 298.6 343.4 394.9 454.1

Taxes 106.5 122.4 140.8 161.9 186.2

NOPAT 153.2 176.2 202.6 233.0 267.9

F 61.8 71.1 81.7 94.0 108.1

W 34.1 39.2 45.1 51.9 59.7

Cash Flow (CF) 57.3 65.9 75.7 87.1 100.2

Discount Factor for K at 10% 0.9091 0.8264 0.7513 0.6830 0.6209

PV of CF 52.1 54.4 56.9 59.5 62.2

Cum PV of CR 52.1 106.5 163.4 222.9 285.1

Residual Value 1531.9 1761.7 2025.9 2329.8 2679.3

PV of perpetuity 1392.6 1455.9 1522.1 1591.3 1663.6

Mkt Securities 10.0 10.0 10.0 10.0 10.0

Corp Value 1463.2 1454.7 1572.4 1695.5 1824.2 1958.7

Mkt Vale of Debt 1007.0 1007.0 1007.0 1007.0 1007.0

Shhldr Value 447.7 565.4 688.5 817.2 951.7

Share Price 15.99 20.19 24.59 29.19 33.99


Consequences of overinvestment in WC investment

Too much working capital investment can reduce shareholder value . . .

Shareholder

Comparison

Cum NW Investment

Cum Value PV of Cash Flow

Shareholder Value

Share Price

10% NWC $1,666 $331.9 $998.5 $35.66

13.8% NWC $2,300 $285.1 $951.7 $33.99

Consequences of 38% more NWC

$634 or 38% more spent on WC

$46.8 or 14.1% less cash flow

$46.8 or 4.7% less SV

$1.67 or 4.7% less share price


Changes in working capital assets and liabilities cause changes in cash flow. . .

Working capital needs also vary over a borrower’s life cycle

• Cash absorbing to support growth

• Cash neutral at sustainable growth

• Cash generating in declining sales periods Cash not consumed in working capital can be used for other

purposes

• Pay creditors

• Reward owners

• Pay dividends

• Build shareholder value


Some internal WC measures

some other WC measures of growth: • Actual sales growth rate (AGR)

• FY’06/FY’07=> $1,113 to $1,648=>up $535 & 48%

• Sustainable growth rate (SGR)• Ideally, AGR < SGR• SGR= (P/S)[(1-(D/P)][1+(L/E)] (A/S) - (P/S)[(1-(D/P)][1+(L/E)]

• P/S = PAT/ Sales = 3.23% and 3.82% for FY’00 and FY’01, respectively• D/P = dividends/PAT = 27.8% and 15.9%• L/E = debt/worth = 1.58 and 3.00• A/S = total assets/sales = .93 and 1.08

• Green’s SGR was -33.3% for FY’06 and -7.7% for FY’07• Green’s growth outstripping its ability to grow itself• Strategy options?

• NWC growth rate• FY’06/FY’07=>$103 to $177=>up $74 & 72%

• changes in NWC/changes in sales• $74/$535 = 13.8%


Industry Measures of Working Capital Appropriateness

Some industry measures of working capital (WC) appropriateness Green Financial Data RMA Industry**

WC item Measure FY”06 FY’07 2006 2007cash csh/total assets % 6.1 6.5 7.7 5.8Accts receivable AR/TA % 18.5 15.4 14.7 15.0Inventory Inv/TA % 24.0 27.6 28.6 28.1Current assets Tot CA/TA % 50.6 50.8 54.8 52.4Accts payable AP/TA % 9.0 9.5 11.0 10.3Notes payable NP/TA % 14.4 13.3 11.4 11.3AR turnover days receivable 37 29 26 25Inventory turnover days inventory 68 76 90 92Payables turnover days payable 23 25 26 23WC sales efficiency sales/NWC 15.1 14.3 11.7 9.7

_____________ *“The Impact of Working Capital Investment on the Value of a Company,” The RMA Journal, April 2003, pp.48-55**Risk Management Association, Annual Statement Studies, One Liberty Place, Suite 2300, Philadelphia PA 19103-7398, 800-

677-7621


Industry influences on WC ratios Common working capital ratios

• Cash• Cash turnover = sales/cash• Days cash = 365/(sales/cash)

• Receivables• Receivables turnover = sales/receivables• Days receivable = 365/(sales/receivables)

• Inventory• Inventory turnover = Cost of Goods Sold (COGS)/inventory• Days inventory = 365/(COGS/inventory)

• Payables• Payables turnover = COGS/accounts payable• Days payable = 365/(COGS/accounts payable)

• Working capital• Sales/net working capital• Net working capital/sales


Working capital asset conversion cycle

How long does it take for cash to cycle through a business? Example SLOGO FUEGO

Days cash 10 15

Days receivable 60 30

Days inventory 90 60

Sub-total 160 105

Days payable -40 -30

Asset Conversion cycle 120 75 Faster cycling allows lower level of WC to support sales


Working capital asset conversion cycle

If faster cycling allows lower level of WC to support sales, what strategies would accelerate cycling for• Cash

• Zero-balance account• Overdraft financing• Other?

• Receivables• Cash only• Accept credit cards• Raise cash discounts for early payment and/or increase time period for early payment• Other?

• Inventory• Reduce breadth and/or depth of inventory• Consignment inventory• Floor samples/catalog sales• Other?

• Payables• Lean on trade• Other?

Are strategy options viable for industry?


Industry influences on WC Cash

• Cash-and-carry sales• COD trade terms or limited credit terms• Labor/capital assets ratio and payroll frequency

Receivables• Cash or credit card sales—restaurants, stores• credit terms as competitive tool—no payments for 6 months

Inventory• Volatility of values—commodities• Perishability—fresh food vs.. canned goods

Payables• Demand for creditor-seller’s goods and services• Industry trade terms


A note on sales terms

Terms do vary from industry to industry• 1.5%/10, net 60 canned goods

• 2/10, net 60 stationery

• 5/10, net 4 months jewelry

Why?


Working capital differences among different lines of business

Working capital component

Beer brewery Beer wholesaler Package Store Tavern

Cash

Receivables

Inventory

Payables


Working capital strategy options for management

Working capital options• Match competitors in inventory breadth and

depth—impact on inventory turnover?

• Match competitors in customer-friendly credit terms—impact on receivables turnover?

• Match competitors in favorable terms from suppliers—bulk purchases, consignment inventory?


Industry consequences and management decisions . . .

A firm’s ability to survive, grow, and prosper depends on its management’s ability to make the right decisions at the right time

Now we should learn how to assess management’s ability to do the right thing . . .


Content of Session

Industry Evaluation• I. Industry structure

• II. Competitive position

• III. Company’s resources and capabilities

Management Evaluation• I. Managerial strengths and weaknesses

• II. Key factors in management evaluation

• III. Management red flags


I. Management Evaluation Can management make the firm successful—repay the

creditors and reward the owners? Generally, success is enhanced by a combination of factors:

1. Performance2. Experience3. Education & training4. Skills5. Organization6. Compensation7. Board of directors8. Management depth and succession


1. Performance

Successes• Revenues or profits?

Failures• What was learned?

• Were mistakes repeated?

Competence• Ability to repay

Character• Willingness to repay


2. Experience

Relevance• Industry

• Job

Currency• Recent?

• Skills up to date?


3. Education & Training

Relevance• Formal

• Informal

Currency• Recent?

• Knowledge up to date?


4. Skills

Technical Interpersonal Managerial

• Planning

• Organizing

• Staffing

• Directing

• controlling


5. Organization Functional

• Production• Marketing• Financial

Geographic• Local• Regional• national

Line of business• Product• service


6. compensation

Tied to performance?• Of sales

• Of profits

• Other?

Form of compensation• In-kind

• Stock

• Cash

• other


7. Board of directors

Knowledge Skills Experience Control

• Internal

• external


8. Management Depth & Succession

Depth• Cross-training• Rotation• Assistant managers?

Succession• Formal plan?

• Buy-out plan• Will• Trust

• Key person insurance?• Disability• life


Content of Session








II. Management evaluation

Analyzing key managers:KEY FACTORS

(FUNCTIONAL MGR’S NAME)

TECHNICAL

( )

PRODUCTION

( )

MARKETING

( )

FINANCIAL

( )

EXECUTIVE

( )

PERFORMANCE

EXPERIENCE

EDUCATION

SKILLS

COMPENSATION


Management Analytical Summary

Typical Management Summary Position Title/

Responsibilities

Name Age Education and Experience

Ownership

#shares/%

Compensation Outside Affiliation, Remarks

Pres

VP-production

VP-marketing

VP-finance

Treas

Sec’y

Director

Director

Totals # /100% $


Management Overview

Summary: Rocking Chair Rollers, Inc.Position Title/

Responsibilities

Name Age Education and Experience

Ownership

#shares/%

Compensation

($MM)

Outside Affiliation, Remarks

Pres Mick Jagger 68 London School/

50 yrs rock band

250/25% 1,000 Knight of England

VP-production Keith Richards 68 School of Hard Knocks/50 yrs

250/25% 1,000 AA

VP-marketing Charlie Watts 75 Drum School/50 yrs rock band

100/10% 500 AARP

VP-finance Jack Wyman 77 Art School/50 yrs

Rock band

100/10% 500 Stage Design Ltd

Treas-Secy Ron Wood 66 Oxford/40 yrs rock band

100/10% 500 Maggie May School for Retired Rockers

Director Jack Nietsche 70 London School/ 50 yrs producer

100/10% 400 BMI Productions

Director Mick Taylor 60 UCLA/40 yrs rock bands

100/10% 200 Surfing Safaris

Totals 1000 /100% $4,100


Content of Session








III. What raises management red flags--7 D’s of Desperation?

1. Disability

2. Disease

3. Death

4. Divorce

5. Debts

6. Drugs

7. Denial

III. Typical Management Red Flags


Flag Able to do right? Willing to do right?

1. Highly domineering senior management

2. Highly pressured business conditions

3. High turnover in financial positions

4. Premature announcements/retractions of profits

5. Deterioration in quality of earnings

6. Slowdown in delivery of interim financial statements

7. Unusual fluctuations in financial statement components

8. Unexpected year-end transactions

9. Frequent changes in auditors & lawyers

10. Uncorrected internal control weaknesses

11. Related party transactions

12. Compensation out of line with performance

13. Widely dispersed business locations

14. Complex corporate structure

15. Diminishing communication—unreturned phone calls, unanswered e-mails, returned mail

16. Declining civility—uncooperative, rude, argumentative, impolite

Character Red Flag—willing to repay?

An affirmative answer to one or more of these questions raises a red flag warning of questionable character:

1. Has any of the principals ever walked away from a loan or refused to pay a creditor?

2. Is the firm or its principals delinquent in payment of its taxes, fees, licenses, etc?

3. Have any of the principals or the firm ever been involved in deceptive, misleading, or fraudulent practices?

4. Do the firm and its principals fail to pay their creditors according to terms?

5. Do any of the firm’s principals lack the skills, training, and experience necessary to perform their functional

responsibilities?

6. Have any of the firm’s principals misrepresented their background, experience, skills, training, or education?

7. Are the principals or the firm unwilling or unable to provide financial information?

8. Are the principals unwilling to offer personal guarantees, provide collateral, or accept any conditions or

covenants?

9. Does the firm fail to meet its projections and/or meet its budget?

10. Do the firm’s facilities appear poorly maintained, look unsafe, or feel uncomfortable?

11. Does the firm’s management and major stockholders or its partners disagree about the firm’s goals and

objectives?

12. Are the principals unwilling or unable to provide references from colleagues, competitors, suppliers, lenders,

customers, lawyers, accountants, etc.?



Management Assessment—Desirable and Undesirable Attributes

Evaluation Point Desirable Attributes/Strengths (+) Undesirable Attributes/Weaknesses (-)

1. Organization Organization is grouped around some basic factor—geography, product, process; sense of integration, teamwork

Organization lacks coherence; sense of disorder, chaos, anarchy

2. Board of directors Independent outside directors w/professional expertise not in firm Internal board dependent on principals, no impartial, objective advisors

3. Principals broad ownership base with written plan for transfer of ownership and management succession

Control vested in one individual; no succession plan or transfer of ownership in place

4. Managers All positions are filled; no one person wears more than one hat Numerous vacancies; multiple responsibilities concentrated in one or two people

5. Education & training

Education & training relevant to responsibilities and tasks; management keeps up with industry innovations

Little or no formal education or training; frequent references to “street smarts” and “school of hard knocks;” no indication of attention to industry changes

6. Experience Experience relevant to company; steady progression up the organizational ladder; years at firm and in industry indicating commitment to both firm and its line of business

Job hopping; extremely rapid advancement with little depth of experience; previous jobs have little relevance to current position

7. Management planning

Written annual plan & budget; 5-year strategic plan; regular management team meetings

No written plan, conflicting “hidden agendas,” inability to forecast or adjust plans for changes in marketplace

8. Management organizing

Organization chart, divisions, departments, units; job descriptions, job content

Informal organizations, job assignments change frequently; no chain of command

9. Management staffing

Low turnover, much cross-training; educational reimbursement programs, human resources function, promotion from within

High turnover and absenteeism; no training “troops hired to hit the beaches running;” relies on outside to management positions

10. Management directing

Regular, frequent communication between management and workforce; declines met, promises kept, “get-it-done” attitude

Deadlines missed, promises forgotten, messages unanswered; crisis atmosphere, “putting out fires”

11. Management controlling

Routine actual-budget comparisons; actions taken with deadlines for completion; financials provided to bank promptly along with explanations

Always behind target with no explanation; budget disregarded; cost overruns and unexpected expenses common


Fraud? As we compete harder for customers, we are being asked to respond

faster As we look for more customers, we have to look for more new clients Quick turnarounds on new clients takes longer When we aim to please, we tend to miss the fine points

• Background checks, verifications, etc. By the time you detect a fraud, it’s usually too late Are fraudulent borrowers likely to give you correct information? Best defense against fraud is

• Getting to know your customer• References from customers, suppliers, creditors• Payment history in credit agency reports• Financials, including tax returns

• Staying in touch with your customer• Visiting premises• Face-to-face encounters


Fraud—unwilling to pay? Basic fallacy in information data bases

• Civil stuff available—liens, judgments, etc

• Criminal records less accessible and reliable• Access to public criminal records varies from state

to state

• Non-public criminal records are available only to approved law enforcement agencies

• Besides, what crook is going to use the name under which he was convicted again?

So how do we look for crooks?

Fraud Prevention and Character Protection

Fraud Control CIP ($M) CNIP ($M) % reduced

1. Hotline 100 245 59%

2. Employee support program 100 244 59

3. Surprise audit 97 200 52

4. Fraud training for employees 100 200 50

5. Fraud training for management 100 200 50

6. Job rotation/mandatory vacation 100 188 47

7. Code of conduct 140 262 47

8. Anti-fraud policy 120 200 40

9. Management review 120 200 40

10. External audit 140 215 35

11. Internal audit 145 209 31

12. Independent audit committee 140 200 30

13. Management certification of financial statements 150 200 25

14. External audit of financial statements 150 200 25

15. Rewards for whistle blowers 119 156 23

Source: Association of Certified Fraud Examiners Legend: CIP=control in place; CNIP=control not in place


Example of Borrower Action Plan for Fraud Prevention

Borrower Action Plan*1. start at the top with executive management

2. Educate employees

3. Change corporate culture fast

4. Conduct surprise audits

5. Check employee backgrounds

6. Prepare data breach plan

7. Ensure board of directors is involved in risk management and results reviews

*Remember--Audits don’t work by themselves—you need management review, job rotation, hotlines, surprise audits, etc.



Summary The industry does shape the firm In order to increase its value, a firm must evaluate the

industry structure, its own competitive position, and its resources and capabilities

Basic drivers of shareholder value• Sales growth

• Profit margins

• Working capital investment

• Fixed asset investment

• Tax rate

• Cost of capital


Summary (continued)

Purpose of industry evaluation is to determine the firm’s potential for value creation within its industry

Purpose of management evaluation is to assess the ability of the firm’s management to increase shareholder value within its industry

Key factors:• 1. Performance 5. Organization

• 2. Experience 6. Compensation

• 3. Education 7. Board of Directors

• 4. Skills 8. Management Depth & Succession


Summary (continued)

Ultimately, management’s job is to figure out how to maximize its value drivers within the constraints of its industry in order to increase shareholder value

Your job is to figure out if management has the ability and the willingness to be successful within its industry and repay you for your financial support!


Related publications by Dev Strischek

“Airing out Revenue Projections: Letting the Wind Out of Sales Projections,” RMA Journal, Nov 2010, pp. 40-5.

.“Assessing Creditworthiness: Importance of Evaluating Company Management,” Journal of Commercial Bank Lending, March 1990, pp. 4-17.

Coming to Terms with Financial Covenants,” The RMA Journal, June 2007, pp. 69-73. “EBITDA: It Doesn’t Spell Cash Flow,” RMA Journal, November 2001, pp. 30-40. “Five C’s of Credit, RMA Journal, May 2009, pp. 34-37. “Character and Fraud: Prevention and Protection, RMA Journal, Nov 2011,pp. 32-5. “The Impact of Working Capital Investment on the Value of a Company,” The RMA Journal, April

2003, pp.48-55 “Industry Analysis: Keys to Similarities of Different Lines of Business,” Journal of Credit Risk

Management, June 1997 “Ins and Outs of Lending inside the Box, The RMA Journal, Feb 2010, pp. 38-46. “Numb and Number: Bankers and Accountants, The RMA Journal, Sep 2002, pp.72-75. “Return of the Leveraged Debtor: ROE vs.. ROA,” Journal of Commercial Bank Lending, May 1987 “Set Your Sights on Your Next Site Visit,” The RMA Journal, April 2011, pp. 20-23. “Underwriting Loans: Do Basic Considerations Change for Specialized Industries?” Journal of

Commercial Bank Lending, March 1989, p. 4-14.

APPENDICES

App A: ROE –ROA App B: Glossary



App A-1: Borrower’s Goal

Maximize return on equity (ROE=profit after taxes/net worth= PAT/NW) to increase shareholder value (NW/#shares)

Shareholder value drivers• Sales growth rate

• Profit margin

• Tax rate

• NWC (net working capital) needed to support sales

• CAPEX (capital expenditures) needed to support sales

• COC (Cost of Capital)—borrowed and invested $$


App A-2: ROE > Cost of Capital? Points to ponder

• Borrowers want high ROE

• Growing the firm is usually the road to success, but how easy is it to grow in the borrower’s industry?

• Growth requires funding from lenders and/or investors, but is the borrower’s industry attractive to funds providers?• Borrow cheaply or attract more investors

• Covenants and conditions vs. dilution and less control

• Pay interest or pay dividends

• “Manage income” or reduce taxes

• Will management be able to achieve desired ROE within its industry and repay your loan?


App A-3: ROE > Cost of Capital? EBIT/TA

• Good measure of how profitably a company has managed its resources:• Earnings before interest and taxes/total assets=EBIT/TA

• Sometimes referred to as return on assets (ROA)

• EBIT is the pre-tax pool of funds available to pay both interest to debt holders and dividends to stock holders

• Comparing companies’ EBIT/TA eliminates potential distortions among firms caused by differences in financing sources and by differences in sales size:

• Debt/equity mix

• Revenue size


App A-4: ROE > Cost of Capital?

So how do we reconcile these two points of view?• PAT/NW = EBIT/TA?

• Borrower’s goal vs.. funds provider’s goals?

What factors connect these two measures? Answer:

• PAT/NW = (TA/NW)(PBT/EBIT)(PAT/PBT) EBIT/TA



PAT/NW = (LF)(IF)(TF) EBIT/TA Definitions:

• LF = leverage factor = TA/NW = 1 + (TL/NW)

• IF = interest factor = PBT/EBIT = 1 – [1/(EBIT)/I)]

• TF = tax factor = PAT/PBT = 1- (T/PBT)

Let’s see how the math works . . .



PAT/NW = EBIT/TA(LF)(IF)(TF) PAT/NW = (EBIT/TA)(TA/NW)(PBT/EBIT)(PAT/PBT) PAT/NW = (EBIT/TA)(1+TL/NW)(1-[1/(EBIT/I)])(1-[T/PBT])

TL NW TA EBIT I PBT T PAT ROA LF IF TF ROE

200 800 1,000 100 10 90 36 54 10.0% 1.25 0.90 0.60 6.75%

500 500 1,000 100 30 70 21 49 10.0% 2.00 0.70 0.70 9.80%

800 200 1,000 100 64 36 9 27 10.0% 5.00 0.36 0.75 13.50%

I rate = 5%, 6%, 8% for 200, 500, 800 in TL, respectively

T rate = 40%, 30%, 25% for 90, 70, 36 in PBT, respectively


App A-7: ROE > Cost of Capital? ROE = PAT/NW COC (Cost of Capital) = Dividends/NW + I/TL

• Tax adjustments to put dividends and interest on same basis

• Weighted by % of funds provided from debt and equity

ROE > WACC (Weighted Average Cost of Capital)?

TL NW TA EBIT I PBT T PAT ROE Div TAD* I/TL TAD/NW WACC**

200 800 1,000 100 10 90 36 54 6.75% 25 41.7 5% 5.21% 5.17%

500 500 1,000 100 30 70 21 49 9.80% 20 28.6 6% 5.72% 5.86%

800 200 1,000 100 64 36 9 25 13.50% 10 13.3 8% 6.65% 7.73%

*TAD = tax adjusted Dividends; 25/TF= 25/.60 = 41.7; 20/TF = 20/.70 = 28.6; 10/TF = 10/.75 = 13.3

**WACC = weighted average cost of capital = 20% x 5% + 80% x 5.21% = 5.17%

= 50% x 6% + 50% x 5.72% = 5.86%

= 80% x 8% + 20% x 6.65% = 7.73%


App A-8: ROE-ROA Dilemma How to bridge the gap between ROE and ROA?

• LFdebt/equity balance• How easy is it to borrow or raise equity for this management in this

industry?

• IFinterest/dividend balance• Which is more advantageous for this management in this industry, to

pay interest or pay dividends?

• TFtax-deductible/non tax-deductible balance• What are the tax laws applicable to this company in this industry?

You haven’t seen the last of these factors because they help shape both the industry environment and the industry members . . .

So how does management satisfy both lenders and investors in repaying debt and paying dividends?

App B: Glossary AGR=actual growth rate AR=accounts receivable CAPEX=capital expenditures Coll=collateral D/W =debt/worth=total liabilities/net worth EBIT=earnings before interest and taxes EBITDA-earnings before interest, taxes, depreciation and amortization GUAR=Guarantor, guarantee INV=inventory P+i=principal and interest PAT = profit after taxes PBT= profit before taxes Neg=negative Nt=net NW= net worth NWC=net working capital ROA= return on assets ROE j= return on equity SGR=sustainable growth rate TA=total assets TL=total liabilities TNW=tangible net worth WC=working capital
