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

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  • 1. May 2013 Florida RMA Lending School 1INDUSTRY ANDMANAGEMENTEVALUATIONDev StrischekSVP & senior credit policy officer404-230-5242Dev.strischek@suntrust.comSunTrust Bank, Atlanta
  • 2. May 2013 Florida RMA Lending School 2Introduction to Industry andManagement Evaluation Purpose• Show you how its industry impacts yourborrower’s ability to repay• Show you how its management impacts yourborrower’s ability to repay• Show you how to evaluate management’sability to operate successfully within itsindustry
  • 3. May 2013 Florida RMA Lending School 3Content 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
  • 4. May 2013 Florida RMA Lending School 4Content 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
  • 5. May 2013 Florida RMA Lending School 5Industry 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 tocompete successfully?• Can your borrower repay your loan?
  • 6. May 2013 Florida RMA Lending School 6ROE (PAT/NW) vs.. ROA? Points to ponder• Borrowers want high ROE to maximize shareholder value, but replacingequity with cheaper debt generates bigger return and more risk forcreditors• Growing the firm is usually the road to success, but how easy is it to growin the borrower’s industry?• Growth requires funding from lenders and/or investors, but is theborrower’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 andrepay your loan?
  • 7. May 2013 Florida RMA Lending School 7ROE > ROA (EBIT/TA)? EBIT/TA• Good measure of how profitably a company hasmanaged 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 bothinterest to debt holders and dividends to stock holders• Comparing companies’ EBIT/TA eliminates potentialdistortions among firms caused by differences infinancing sources and by differences in sales size:• Debt/equity mix• Revenue size
  • 8. May 2013 Florida RMA Lending School 8ROE > ROA? So how do we reconcile these two points ofview?• 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
  • 9. May 2013 Florida RMA Lending School 9ROE > 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 . . .
  • 10. May 2013 Florida RMA Lending School 10ROE-ROA Dilemma How to bridge the gap between ROE and ROA?• LFdebt/equity balance• How easy is it to borrow or raise equity for this management in thisindustry?• IFinterest/dividend balance• Which is more advantageous for this management in this industry, topay interest or pay dividends?• TFtax-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 helpshape both the industry environment and the industrymembers . . . So how does management satisfy both lenders and investorsin repaying debt and paying dividends?
  • 11. May 2013 Florida RMA Lending School 11Repayment Ability Good credit decision is based on• Prudent profitability—balance of reward & risk• Logical conclusion—sound decision Systematic decision-making• Purpose• Repayment ability• structure
  • 12. May 2013 Florida RMA Lending School 12Triple Trinities Purpose• Logical• Ethical• Policy-compliant Repayment Ability• Cash flow• Collateral• Guarantees Structure• Repay in full• Repay on time• Repay as agreed
  • 13. May 2013 Florida RMA Lending School 13Impact of Industry and Managementon Repayment Sources Management’s job is to figure out how to be successful—repaycreditors and satisfy shareholders--within the industry it operates Lenders want their borrowers to be successful enough to repay theirloans, and so they look to the traditional sources of repayment:Repayment Sources: Industry ManagementCash flowCollateralGuarantees
  • 14. May 2013 Florida RMA Lending School 14Industry and management do impactrepayment sourcesRepaymentSourcesIndustry ManagementCash Flow Demand potentialSales growthProfit marginsMarketing strategyCredit strategyOperating strategyCollateral Goods or servicesTrade credit termsValue stabilityInventory a/oReceivablesPurchasingWarehousingGuarantees Access to capitalScaleLeveragePublic vs.. privateCompetitive strategyRisk appetite
  • 15. May 2013 Florida RMA Lending School 15Credit Decision—Inside orOutside the Box?Lenders expect borrowers to be positively“inside the box” . . .Repayment Source Positive NegativeCash flow Sufficient InsufficientCollateral Secured UnsecuredGuarantees Full Non-recourse
  • 16. May 2013 Florida RMA Lending School 16What it takes for all 3 sources to bepositively “inside the box”RepaymentSourcesInside the box Outside the boxCash Flow SufficientCF > (P+i)InsufficientCollateral SecuredColl > (P+i)UnsecuredGuarantees GuaranteedGuar > (P+i)Unguaranteed(non-recourse)
  • 17. May 2013 Florida RMA Lending School 17So let’s build the box--cash FlowPositive CashFlow (+)Negative CashFlow (-)
  • 18. May 2013 Florida RMA Lending School 18Building the box--cash flow andcollateralPositive CashFlow (+)Negative CashFlow (-)Unsecured (-) Secured (+)
  • 19. May 2013 Florida RMA Lending School 19Building the box--cash flow, collateral,and guaranteesPositive CashFlow (+)Negative CashFlow (-)Unsecured (-) Secured (+)Guaranteed (+)Non-recourse (-)
  • 20. May 2013 Florida RMA Lending School 20An axis to grind . . .Which box is better?CashFlow(+)CashFlow(-)Secured(+)Unsecured (-)Guaranteed(+)Unguaranteed(-)
  • 21. May 2013 Florida RMA Lending School 21An axis to grind . . .Other options?CashFlow(+)CashFlow(-)Secured(+)Unsecured (-)Guaranteed(+)Unguaranteed(-)
  • 22. May 2013 Florida RMA Lending School 22Possible Options1 cube = 8 little boxes Options CF Sec Guar1 (right box) + + +2 + + -3 + - -4 (wrong box) - - -5 - + -6 - + +7 - - +8 + - +14
  • 23. May 2013 Florida RMA Lending School 23Possible Options—Typical Borrowers1 cube = 8 little boxes Options CF Sec Guar Borrower1 (right box) + + + Idealborrower2 + + - CRE project3 + - - Fortune 5004 (wrong box) - - - Specialassets5 - + - Large ABL6 - + + Small ABL7 - - + Richrelative8 + - + Servicesfirm14
  • 24. May 2013 Florida RMA Lending School 24Borrowers do move from box tobox . . . The single biggest reason? Cash flow . . .• Over the life of the firm, cash flow changes . . .• As the firm grows up and matures, its cashflow changes, too . . .
  • 25. May 2013 Florida RMA Lending School 25Cash flows vary over a firm’s lifecycle . . .
  • 26. May 2013 Florida RMA Lending School 26So does the firm’s financialcondition and performance . . .
  • 27. May 2013 Florida RMA Lending School 27Fast growth—negative cash flowsand stressed financial ratios . . .A BC DE FG H
  • 28. May 2013 Florida RMA Lending School 28Stability comes at a price When a firm’s actual growth rates syncswith its sustainable growth rate, the firmis able to cover all its needs internally:• Interest• Principal• Rents and leases• Working capital investment• Maintenance CAPEX• Dividends or draws
  • 29. May 2013 Florida RMA Lending School 29Quick Summary of Differences between FastGrowth 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
  • 30. May 2013 Florida RMA Lending School 30Maturity comes at a price But its ROE tends to fall and so the firmis less attractive to investors until it startsto grow again . . . By definition, a mature firm doesn’t needto borrow, so the firm is less attractive tolenders So what’s a lender to do?
  • 31. May 2013 Florida RMA Lending School 31Good News--Firms andIndustries Go through Cycles Your borrower does not exist in avacuum Your borrower’s industry is an economicenvironment in which the firm must learnto survive, grow, and prosper over manybusiness cycles . . .
  • 32. Hawaii’s whaling industry cycle Started 1820, ended 1880• Near extinction of right whales forces American whalers to shift from Atlantic to PacificOcean’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, fewerlong 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 sugaron West Coast• 1875—Arctic freeze• 1880—second Arctic freezeMay 2013 Florida RMA Lending School 32
  • 33. May 2013 Florida RMA Lending School 33Content of Session Industry evaluation• I-Industry structure• II-Competitive position• III-Company’s resources and capabilities Management evaluation• Managerial strengths and weaknesses• Key factors in management evaluation• Management red flags
  • 34. May 2013 Florida RMA Lending School 34I. Industry Analysis Purpose• Show how the industry shapes its memberfirms and influences their relative success• Identify the industry factors that drive yourborrower’s ability to compete successfully
  • 35. May 2013 Florida RMA Lending School 35Key Factors in Industry Analysis1. Industry structure• Where can firm be successful?1. Competitive position• How can firm be successful?1. Company resources and capabilities• What does firm have & need to be successful?
  • 36. May 2013 Florida RMA Lending School 36Industry 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
  • 37. Some Measures of IndustryFinancial StructureIndustry Sector Manufacturer Wholesaler Retailer Service RemarksNFA/TA (%) High Low Scale economiesLabor/Rev (%) Low High High Capital/labor mixGP Margin (%) Low High Demand elasticityInventory TO (x) Fast Slow Fast Carrying costs capacityReceivables TO (x) Slow Fast Nil nil Channel controlAP TO (x) Slow Fast Channel controlDebt/Worth (x) Low High high Credit risk volatilityLegend:NFA = Net Fixed AssetsTA = Total AssetsRev = RevenueGP = Gross ProfitAP = Accounts PayableTO = TurnoverMay 2013 Florida RMA Lending School 37
  • 38. Structural Differences among 4 FirmsFinancial Ratios RMA Industry Averages NotesA B C DOperating PerformanceRevenue/Total Assets (%) 1.4 3.9 4.1 3.2Revenue/Net Fixed Assets (%) 3.0 21.7 31.7 8.3Gross Profit/Revenues (%) 36.7 25.1 23.3 58.2Profit before taxes/Revenues (%) 2.6 2.6 2.0 3.1Profit before taxes/Net Worth (%) 18.1 29.8 19.5 40.1Profit before taxes/Total Assets (%) 4.8 7.4 5.2 6.6LiquidityNet Working Capital/Revenue (x) 46.2 32.3 18.5 (93.3)Days Receivables 17 5 0 0Days Inventory 41 22 54 16Days Payables 29 12 22 14Current Assets/Current Liabilities (x) 1.2 1.4 1.7 .8Net Fixed Assets/Total Assets (x) 52.8 23.3 18.2 48.5LeverageDebt/Worth (x) 2.3 2.1 2.9 3.5Long-Term Debt/Total Assets 37.8 26.4 28.6 52.3Net Worth/Total Assets 37.0 41.4 30.6 6.7SolvencyEarnings before interest and taxes/interest (x) 1.9 3.5 3.0 2.0May 2013 Florida RMA Lending School 38
  • 39. Structural Differences among 4 Firms-Which is a manufacturer,wholesaler, retailer, service provider?Financial Ratios RMA Industry Averages NotesA B C DOperating PerformanceRevenue/Total Assets (%) 1.4 3.9 4.1 3.2Revenue/Net Fixed Assets (%) 3.0 21.7 31.7 8.3Gross Profit/Revenues (%) 36.7 25.1 23.3 58.2Profit before taxes/Revenues (%) 2.6 2.6 2.0 3.1Profit before taxes/Net Worth (%) 18.1 29.8 19.5 40.1Profit before taxes/Total Assets (%) 4.8 7.4 5.2 6.6LiquidityNet Working Capital/Revenue (x) 46.2 32.3 18.5 (93.3)Days Receivables 17 5 0 0Days Inventory 41 22 54 16Days Payables 29 12 22 14Current Assets/Current Liabilities (x) 1.2 1.4 1.7 .8Net Fixed Assets/Total Assets (x) 52.8 23.3 18.2 48.5LeverageDebt/Worth (x) 2.3 2.1 2.9 3.5Long-Term Debt/Total Assets 37.8 26.4 28.6 52.3Net Worth/Total Assets 37.0 41.4 30.6 6.7SolvencyEarnings before interest and taxes/interest (x) 1.9 3.5 3.0 2.0May 2013 Florida RMA Lending School 39
  • 40. Structural Differences among 4 firms-- Where is the most opportunityto build shareholder value—as a manufacturer, wholesaler, retailer,or service provider?Financial Ratios RMA Industry Averages NotesA B C DOperating PerformanceRevenue/Total Assets (%) 1.4 3.9 4.1 3.2Revenue/Net Fixed Assets (%) 3.0 21.7 31.7 8.3Gross Profit/Revenues (%) 36.7 25.1 23.3 58.2Profit before taxes/Revenues (%) 2.6 2.6 2.0 3.1Profit before taxes/Net Worth (%) 18.1 29.8 19.5 40.1Profit before taxes/Total Assets (%) 4.8 7.4 5.2 6.6LiquidityNet Working Capital/Revenue (x) 46.2 32.3 18.5 (93.3)Days Receivables 17 5 0 0Days Inventory 41 22 54 16Days Payables 29 12 22 14Current Assets/Current Liabilities (x) 1.2 1.4 1.7 .8Net Fixed Assets/Total Assets (x) 52.8 23.3 18.2 48.5LeverageDebt/Worth (x) 2.3 2.1 2.9 3.5Long-Term Debt/Total Assets 37.8 26.4 28.6 52.3Net Worth/Total Assets 37.0 41.4 30.6 6.7SolvencyEarnings before interest and taxes/interest (x) 1.9 3.5 3.0 2.0May 2013 Florida RMA Lending School 40
  • 41. May 2013 Florida RMA Lending School 416 Shareholder Value Drivers Sales growth rate actual vs.. sustainable Operating profit margin cost 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
  • 42. May 2013 Florida RMA Lending School 42Content of Session Industry evaluation• I-Industry structure• II-Competitive position• III-Company’s resources and capabilities Management evaluation• Managerial strengths and weaknesses• Key factors in management evaluation• Management red flags
  • 43. May 2013 Florida RMA Lending School 43II. Firm’s Competitive Position Firm’s success depends on its strategy tocompete with other firms within the industrystructure One way to assess competitive position isPorter’s Five Forces• Threat of new entrants• Threat of substitutes• Bargaining power of suppliers• Bargaining power of buyers• Competitive rivalry
  • 44. May 2013 Florida RMA Lending School 44Porter’s Five ForcesHow the forces drive competitionCompetitiverivalry buyerssubstitutesease of entrysuppliers
  • 45. May 2013 Florida RMA Lending School 45Details 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
  • 46. May 2013 Florida RMA Lending School 46Porter’s Five Forces: ExampleBeer producer (brewery)Competitiverivalry buyerssubstitutesease of entrysuppliers
  • 47. RMA Industry ResourcesMay 2013 Florida RMA Lending School 47
  • 48. May 2013 Florida RMA Lending School 48Competitive position Value decision—low cost provider orquality leader?• Good value vs. high quality?• Mass market vs. upscale market?• Local market vs. national market? Demand and supply• Elasticity• Price• Revenue and profits
  • 49. May 2013 Florida RMA Lending School 49Competitive position—productvalueCost and Quality Optionshigh costlow qualityhigh costhigh qualitylow costlow qualitylow costhigh qualityCOSTQUALITY
  • 50. May 2013 Florida RMA Lending School 50Competitive position—productdiversityProduct and market optionsBroad product lineLocal marketBroad product lineNational marketNarrow product lineLocal marketNarrow product lineNational marketPRODUCTLINEMARKET BREADTH
  • 51. May 2013 Florida RMA Lending School 51Maintain Competitive Positionby Competitive Advantage Through product differentiation• Higher prices• Unique• dependable• Higher value• quality• scarcity• Higher profits• Limited market• National market
  • 52. May 2013 Florida RMA Lending School 52Competitive position &competitive advantageProduct Market and Value OptionsBroad scopeLow costBroad scopeHigher valueNarrow scopeLow costNarrow scopeHigher valuePRDCTMKTSCOPEPRDCT VALUE DIFFFERENTIATION
  • 53. May 2013 Florida RMA Lending School 53Competitive position &competitive advantageBeer producer?Broad scopeLow costBroad scopeHigher valueNarrow scopeLow costNarrow scopeHigher valuePRDCTMKTSCOPEPRDCT VALUE DIFFFERENTIATION
  • 54. May 2013 Florida RMA Lending School 54Value PropositionsHigh Quality (+)Good Value (-)Mass Market (-) Upscale Market (+)Local Market (+)National Market (-)
  • 55. May 2013 Florida RMA Lending School 55Value Proposition Options1 cube = 8 options Options High Quality-Good ValueNational-Local MktMass Mkt-Upscale1 (Palm BeachApparel Shoppe)HQ (+) Local (+) Upscale (+)2 + + -3 + - -4 (WalMart) Good Value (-) National (-) Mass Mkt (-)5 - + -6 - + +7 - - +8 + - +14
  • 56. May 2013 Florida RMA Lending School 56Content of Session Industry evaluation• I-Industry structure• II-Competitive position• III-Company’s resources and capabilities Management evaluation• Managerial strengths and weaknesses• Key factors in management evaluation• Management red flags
  • 57. May 2013 Florida RMA Lending School 57III. 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
  • 58. May 2013 Florida RMA Lending School 58Value Chain AnalysisInterplay of Support and Primary ActivitiesSUPPORTACTIVITIESPRIMARY ACTIVITIESINBOUNDLOGISTICSOPERATIONS OUTBOUNDLOGISTICSMARKETING& SALESSERVICEFirmInfrastructureHumanResourcesTechnologyprocurement
  • 59. May 2013 Florida RMA Lending School 59Value Chain AnalysisSupport activitiesSUPPORTACTIVITIESPRIMARY ACTIVITIESINBOUNDLOGISTICSOPERATIONS OUTBOUNDLOGISTICSMARKETING& SALESSERVICEFirmInfrastructureHumanResourcesTechnologyprocurement
  • 60. May 2013 Florida RMA Lending School 60Support: Firm Infrastructure Depth and experience of management• Does management have background to directsuccessful purchasing, finance,manufacturing, sales, and distributionfunctions? Systems• Are systems sufficient and adequate toprovide timely information and responsivedecisions?
  • 61. May 2013 Florida RMA Lending School 61Support: 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?
  • 62. May 2013 Florida RMA Lending School 62Support: 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
  • 63. May 2013 Florida RMA Lending School 63Support: 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
  • 64. May 2013 Florida RMA Lending School 64Value Chain AnalysisPrimary ActivitiesSUPPORTACTIVITIESPRIMARY ACTIVITIESINBOUNDLOGISTICSOPERATIONS OUTBOUNDLOGISTICSMARKETING& SALESSERVICEFirmInfrastructureHumanResourcesTechnologyprocurement
  • 65. May 2013 Florida RMA Lending School 65Primary 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
  • 66. Value Chain AnalysisPrimary activities’ impact on value driversValue Drivers Linkage to Primary Activities1. Sales GrowthRate (G)Inboundlogisticsoperations OutboundlogisticsMarketing &salesservice2. OperatingProfit Margin (P)Materials,warehousing,freight-inadmnProcessing,assembly,testing,packagingMaterials,warehousing,freight-outadmnSales force,advertising,promotion,admnInstallation,training,maintenance,returns3. Wkg CptlInvestment (W)Raw materials W-I-P inventory,accts payableFinished goods,accts payableAccountsreceivableParts inventory,service fees4. Fxd AsstInvestment (F)Warehouses,transportationfleet, equipmentProductionfacilitiesWarehouses,transportationfleet, equipmentDistributionfacilities, salesforce officesServicefacilities,transportationfleet, serviceequipmentMay 2013 Florida RMA Lending School 66
  • 67. May 2013 Florida RMA Lending School 67Value Chain AnalysisWhat combination of sales growth rate, operating profit margin, workingcapital investment, fixed asset investment, a/o cost of capital willincrease cash flow and shareholder value?SUPPORTACTIVITIESPRIMARY ACTIVITIESINBOUNDLOGISTICSOPERATIONS OUTBOUNDLOGISTICSMARKETING& SALESSERVICEFirmInfrastructureHumanResourcesTechnologyprocurement
  • 68. May 2013 Florida RMA Lending School 68Value Chain Analysis: ExampleBeer ProducerSUPPORTACTIVITIESPRIMARY ACTIVITIESINBOUNDLOGISTICSOPERATIONS OUTBOUNDLOGISTICSMARKETING& SALESSERVICEFirmInfrastructureHumanResourcesTechnologyprocurement
  • 69. May 2013 Florida RMA Lending School 69Sales growth strategy optionsfor 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 theirmarketing edge?
  • 70. May 2013 Florida RMA Lending School 70Value Chain AnalysisExpansion consequences for Beer Producer?SUPPORTACTIVITIESPRIMARY ACTIVITIESINBOUNDLOGISTICSOPERATIONS OUTBOUNDLOGISTICSMARKETING& SALESSERVICEFirmInfrastructureHumanResourcesTechnologyprocurement
  • 71. Likely Cash flow impact of regional vs.national distribution strategiesCash Flow ImpactAnalysisStrategy Value DriverAssumptionsValue Created($MM)Probabilityof SuccessRegional •Concentrate on existingwestern US markets•Maintain quality on existingproducts•Stop new productdevelopment•Maintain 7% sales growth•Maintain 9% operatingmargin•Maintain $60MM CAPEX•Maintain 15% WCinvestment•Base: $273•Best: $436•Worst: $218?National •Expand sales & distributionnationwide•Increase ad & promo expense•Expand brewing capacity•Loosen credit for newdistributors•12-14% sales growth•8% operating margininitially, 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. FieldsMay 2013 Florida RMA Lending School 71
  • 72. May 2013 Florida RMA Lending School 72The rest of the story . . . . Geographic expansion east of the Mississippi Elitist cache diminishes as product tries tobroaden appeal to mass market Initial market share gain shrinks No significant increase in shareholder value So what can a firm do to increase shareholdervalue in highly competitive industry?
  • 73. May 2013 Florida RMA Lending School 73Shareholder 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
  • 74. May 2013 Florida RMA Lending School 74Discounted Cash Flow (DCF)DCF Frameworkin actionPV ofOperatingCash flowForecast Period2003 2004 2005 2005 2007Residual Period2008 . . . . . . . . . . . . . . .PV ofResidualValueNon-operatingassets++=CorporateValue -Mkt Value ofDebt & otherobligations= ShareholderValue
  • 75. May 2013 Florida RMA Lending School 75DCF’s shareholder value driversValue Drivers Description FormulaSales growth rate (G) Sales growth rate for forecast period [future sales/last historical sales] - 1Operating profit margin(P)Pre-tax operating profit as % of sales P = (sales – operating expenses)/salesCash tax rate (T) Cash taxes that would have beenpaid if the firm had no debt as % ofoperating profitsT = cash taxes/operating profit where cash taxes =book taxes –non-oper taxes + interest tax shield –increase in deferred tax liabilityIncremental FixedCapital Investment (F)Addition to fixed assets over & abovemaintenance CAPEX, as % ofchange in salesF = [total CAPEX – maintenance CAPEX]/changein salesIncremental WorkingCapitalInvestment (W)Addition to WC as % of change insalesW = change in working capital/change in salesCost of capital (K) Weighted average return that acompany’s debt and equity holdersrequire given the levels of risk in theirrespective investmentsK = [cost of equity X (equity/(equity+debt))] + [costof debt X (1 – T) (debt/(equity/equity+debt))]Where T = cash tax rate
  • 76. May 2013 Florida RMA Lending School 76Impact of Industry on ValueDrivers Averages and norms tend to defineranges of acceptable performance andoperating limits So look at Industry norms for• Sales growth rate• Capital expenditures• Profit margins• Working capital . . .
  • 77. May 2013 Florida RMA Lending School 7710% WC/Sales=>$35.66Year 2007 2008 2009 2010 2011 2012Sales 1648.0 1895.2 2179.5 2506.4 2882.4 3314.7Operating Costs 1635.6 1880,9 2163.0 2487.5 2860.6Operating Profit 259.6 298.6 343.4 394.9 454.1Taxes 106.5 122.4 140.8 161.9 186.2NOPAT 153.2 176.2 202.6 233.0 267.9F 61.8 71.1 81.7 94.0 108.1W 24.7 28.4 32.7 37.6 43.2Cash Flow (CF) 66.7 76.7 88.2 101.4 116.6Discount Factor for K @ 10% 0.9091 0.8264 0.7513 0.6830 0.6209PV of CF 60.6 63.4 66.2 69.3 72.4Cum PV of CR 60.6 124.0 190.2 259.5 331.9Residual Value 1531.9 1761.7 2025.9 2329.8 2679.3PV of perpetuity 1392.6 1455.9 1522.1 1591.3 1663.6Mkt Securities 10.0 10.0 10.0 10.0 10.0Corp Value 1463.2 1589.9 1722.3 1860.8 2005.5 2156.8Mkt Vale of Debt 1007.0 1007.0 1007.0 1007.0 1007.0Shhldr Value 456.2 582.9 715.3 853.8 998.5Share Price 16.29 20.82 25.55 30.49 35.66
  • 78. 13.8% WC/Sales=>$33.99May 2013 Florida RMA Lending School 78Year 2007 2008 2009 2010 2011 2012Sales 1648.0 1895.2 2179.5 2506.4 2882.4 3314.7Operating Costs 1635.6 1880,9 2163.0 2487.5 2860.6Operating Profit 259.6 298.6 343.4 394.9 454.1Taxes 106.5 122.4 140.8 161.9 186.2NOPAT 153.2 176.2 202.6 233.0 267.9F 61.8 71.1 81.7 94.0 108.1W 34.1 39.2 45.1 51.9 59.7Cash Flow (CF) 57.3 65.9 75.7 87.1 100.2Discount Factor for K at 10% 0.9091 0.8264 0.7513 0.6830 0.6209PV of CF 52.1 54.4 56.9 59.5 62.2Cum PV of CR 52.1 106.5 163.4 222.9 285.1Residual Value 1531.9 1761.7 2025.9 2329.8 2679.3PV of perpetuity 1392.6 1455.9 1522.1 1591.3 1663.6Mkt Securities 10.0 10.0 10.0 10.0 10.0Corp Value 1463.2 1454.7 1572.4 1695.5 1824.2 1958.7Mkt Vale of Debt 1007.0 1007.0 1007.0 1007.0 1007.0Shhldr Value 447.7 565.4 688.5 817.2 951.7Share Price 15.99 20.19 24.59 29.19 33.99
  • 79. May 2013 Florida RMA Lending School 79Consequences of overinvestment inWC investment Too much working capital investmentcan reduce shareholder value . . .ShareholderComparisonCum NWInvestmentCum ValuePV of CashFlowShareholderValueShare Price10% NWC $1,666 $331.9 $998.5 $35.6613.8% NWC $2,300 $285.1 $951.7 $33.99Consequences of38% more NWC$634 or 38%more spenton WC$46.8 or14.1% lesscash flow$46.8 or 4.7%less SV$1.67 or 4.7%less share price
  • 80. May 2013 Florida RMA Lending School 80Changes in working capital assets and liabilitiescause 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 otherpurposes• Pay creditors• Reward owners• Pay dividends• Build shareholder value
  • 81. May 2013 Florida RMA Lending School 81Some 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%
  • 82. May 2013 Florida RMA Lending School 82Industry Measures of WorkingCapital AppropriatenessSome industry measures of working capital (WC) appropriatenessGreen 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
  • 83. May 2013 Florida RMA Lending School 83Industry 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
  • 84. May 2013 Florida RMA Lending School 84Working capital asset conversion cycle How long does it take for cash to cycle through a business? Example SLOGO FUEGODays cash 10 15Days receivable 60 30Days inventory 90 60Sub-total 160 105Days payable -40 -30Asset Conversion cycle 120 75 Faster cycling allows lower level of WC to support sales
  • 85. May 2013 Florida RMA Lending School 85Working capital asset conversion cycle If faster cycling allows lower level of WC to support sales, what strategies wouldaccelerate 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?
  • 86. May 2013 Florida RMA Lending School 86Industry 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
  • 87. May 2013 Florida RMA Lending School 87A 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?
  • 88. May 2013 Florida RMA Lending School 88Working capital differences amongdifferent lines of businessWorkingcapitalcomponentBeer brewery Beer wholesaler Package Store TavernCashReceivablesInventoryPayables
  • 89. May 2013 Florida RMA Lending School 89Working capital strategy optionsfor management Working capital options• Match competitors in inventory breadth anddepth—impact on inventory turnover?• Match competitors in customer-friendly creditterms—impact on receivables turnover?• Match competitors in favorable terms fromsuppliers—bulk purchases, consignmentinventory?
  • 90. May 2013 Florida RMA Lending School 90Industry consequences andmanagement decisions . . . A firm’s ability to survive, grow, andprosper depends on its management’sability to make the right decisions at theright time Now we should learn how to assessmanagement’s ability to do the right thing. . .
  • 91. May 2013 Florida RMA Lending School 91Content 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
  • 92. May 2013 Florida RMA Lending School 92I. Management Evaluation Can management make the firm successful—repay thecreditors 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
  • 93. May 2013 Florida RMA Lending School 931. Performance Successes• Revenues or profits? Failures• What was learned?• Were mistakes repeated? Competence• Ability to repay Character• Willingness to repay
  • 94. May 2013 Florida RMA Lending School 942. Experience Relevance• Industry• Job Currency• Recent?• Skills up to date?
  • 95. May 2013 Florida RMA Lending School 953. Education & Training Relevance• Formal• Informal Currency• Recent?• Knowledge up to date?
  • 96. May 2013 Florida RMA Lending School 964. Skills Technical Interpersonal Managerial• Planning• Organizing• Staffing• Directing• controlling
  • 97. May 2013 Florida RMA Lending School 975. Organization Functional• Production• Marketing• Financial Geographic• Local• Regional• national Line of business• Product• service
  • 98. May 2013 Florida RMA Lending School 986. compensation Tied to performance?• Of sales• Of profits• Other? Form of compensation• In-kind• Stock• Cash• other
  • 99. May 2013 Florida RMA Lending School 997. Board of directors Knowledge Skills Experience Control• Internal• external
  • 100. May 2013 Florida RMA Lending School 1008. Management Depth & Succession Depth• Cross-training• Rotation• Assistant managers? Succession• Formal plan?• Buy-out plan• Will• Trust• Key person insurance?• Disability• life
  • 101. May 2013 Florida RMA Lending School 101Content 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
  • 102. May 2013 Florida RMA Lending School 102II. Management evaluationAnalyzing key managers:KEY FACTORS(FUNCTIONAL MGR’SNAME)TECHNICAL( )PRODUCTION( )MARKETING( )FINANCIAL( )EXECUTIVE( )PERFORMANCEEXPERIENCEEDUCATIONSKILLSCOMPENSATION
  • 103. May 2013 Florida RMA Lending School 103Management Analytical SummaryTypical Management SummaryPosition Title/ResponsibilitiesName Age Education andExperienceOwnership#shares/%Compensation Outside Affiliation,RemarksPresVP-productionVP-marketingVP-financeTreasSec’yDirectorDirectorTotals # /100% $
  • 104. May 2013 Florida RMA Lending School 104Management OverviewSummary: Rocking Chair Rollers, Inc.Position Title/ResponsibilitiesName Age Education andExperienceOwnership#shares/%Compensation($MM)Outside Affiliation,RemarksPres Mick Jagger 68 London School/50 yrs rock band250/25% 1,000 Knight of EnglandVP-production Keith Richards 68 School of HardKnocks/50 yrs250/25% 1,000 AAVP-marketing Charlie Watts 75 Drum School/50 yrsrock band100/10% 500 AARPVP-finance Jack Wyman 77 Art School/50 yrsRock band100/10% 500 Stage Design LtdTreas-Secy Ron Wood 66 Oxford/40 yrs rockband100/10% 500 Maggie May School forRetired RockersDirector Jack Nietsche 70 London School/ 50 yrsproducer100/10% 400 BMI ProductionsDirector Mick Taylor 60 UCLA/40 yrs rockbands100/10% 200 Surfing SafarisTotals 1000 /100% $4,100
  • 105. May 2013 Florida RMA Lending School 105Content 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
  • 106. May 2013 Florida RMA Lending School 106III. What raises managementred flags--7 D’s of Desperation?1. Disability2. Disease3. Death4. Divorce5. Debts6. Drugs7. Denial
  • 107. III. Typical Management Red FlagsMay 2013 Florida RMA Lending School 107Flag Able to do right? Willing to do right?1. Highly domineering senior management2. Highly pressured business conditions3. High turnover in financial positions4. Premature announcements/retractions of profits5. Deterioration in quality of earnings6. Slowdown in delivery of interim financial statements7. Unusual fluctuations in financial statement components8. Unexpected year-end transactions9. Frequent changes in auditors & lawyers10. Uncorrected internal control weaknesses11. Related party transactions12. Compensation out of line with performance13. Widely dispersed business locations14. Complex corporate structure15. Diminishing communication—unreturned phone calls,unanswered e-mails, returned mail16. Declining civility—uncooperative, rude, argumentative, impolite
  • 108. Character RedFlag—willing to repay?An affirmative answer to one or more of these questions raises a red flag warning ofquestionable 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 functionalresponsibilities?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 orcovenants?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 andobjectives?12. Are the principals unwilling or unable to provide references from colleagues, competitors, suppliers, lenders,customers, lawyers, accountants, etc.?May 2013 Florida RMA Lending School 108
  • 109. May 2013 Florida RMA Lending School 109Management Assessment—Desirable andUndesirable AttributesEvaluation Point Desirable Attributes/Strengths (+) Undesirable Attributes/Weaknesses (-)1. Organization Organization is grouped around some basic factor—geography, product,process; sense of integration, teamworkOrganization lacks coherence; sense of disorder, chaos, anarchy2. Board of directors Independent outside directors w/professional expertise not in firm Internal board dependent on principals, no impartial, objectiveadvisors3. Principals broad ownership base with written plan for transfer of ownership andmanagement successionControl vested in one individual; no succession plan or transfer ofownership in place4. Managers All positions are filled; no one person wears more than one hat Numerous vacancies; multiple responsibilities concentrated in oneor two people5. Education &trainingEducation & training relevant to responsibilities and tasks; managementkeeps up with industry innovationsLittle or no formal education or training; frequent references to“street smarts” and “school of hard knocks;” no indication ofattention to industry changes6. Experience Experience relevant to company; steady progression up the organizationalladder; years at firm and in industry indicating commitment to both firm andits line of businessJob hopping; extremely rapid advancement with little depth ofexperience; previous jobs have little relevance to current position7. ManagementplanningWritten annual plan & budget; 5-year strategic plan; regular managementteam meetingsNo written plan, conflicting “hidden agendas,” inability to forecastor adjust plans for changes in marketplace8. ManagementorganizingOrganization chart, divisions, departments, units; job descriptions, jobcontentInformal organizations, job assignments change frequently; nochain of command9. ManagementstaffingLow turnover, much cross-training; educational reimbursement programs,human resources function, promotion from withinHigh turnover and absenteeism; no training “troops hired to hit thebeaches running;” relies on outside to management positions10. ManagementdirectingRegular, frequent communication between management and workforce;declines met, promises kept, “get-it-done” attitudeDeadlines missed, promises forgotten, messages unanswered;crisis atmosphere, “putting out fires”11. ManagementcontrollingRoutine actual-budget comparisons; actions taken with deadlines forcompletion; financials provided to bank promptly along with explanationsAlways behind target with no explanation; budget disregarded;cost overruns and unexpected expenses common
  • 110. May 2013 Florida RMA Lending School 110Fraud? As we compete harder for customers, we are being asked to respondfaster 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
  • 111. May 2013 Florida RMA Lending School 111Fraud—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 stateto state• Non-public criminal records are available only toapproved law enforcement agencies• Besides, what crook is going to use the nameunder which he was convicted again? So how do we look for crooks?
  • 112. Fraud Prevention andCharacter ProtectionFraud Control CIP ($M) CNIP ($M) % reduced1. Hotline 100 245 59%2. Employee support program 100 244 593. Surprise audit 97 200 524. Fraud training for employees 100 200 505. Fraud training for management 100 200 506. Job rotation/mandatory vacation 100 188 477. Code of conduct 140 262 478. Anti-fraud policy 120 200 409. Management review 120 200 4010. External audit 140 215 3511. Internal audit 145 209 3112. Independent audit committee 140 200 3013. Management certification of financial statements 150 200 2514. External audit of financial statements 150 200 2515. Rewards for whistle blowers 119 156 23Source: Association of Certified Fraud Examiners Legend: CIP=control in place; CNIP=control not in placeMay 2013 Florida RMA Lending School 112
  • 113. Example of Borrower ActionPlan for Fraud Prevention Borrower Action Plan*1. start at the top with executive management2. Educate employees3. Change corporate culture fast4. Conduct surprise audits5. Check employee backgrounds6. Prepare data breach plan7. Ensure board of directors is involved in risk management andresults reviews*Remember--Audits don’t work by themselves—you needmanagement review, job rotation, hotlines, surpriseaudits, etc.May 2013 Florida RMA Lending School 113
  • 114. May 2013 Florida RMA Lending School 114Summary The industry does shape the firm In order to increase its value, a firm must evaluate theindustry structure, its own competitive position, and itsresources and capabilities Basic drivers of shareholder value• Sales growth• Profit margins• Working capital investment• Fixed asset investment• Tax rate• Cost of capital
  • 115. May 2013 Florida RMA Lending School 115Summary (continued) Purpose of industry evaluation is to determine thefirm’s potential for value creation within its industry Purpose of management evaluation is to assess theability of the firm’s management to increaseshareholder 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
  • 116. May 2013 Florida RMA Lending School 116Summary (continued) Ultimately, management’s job is to figureout how to maximize its value driverswithin the constraints of its industry inorder to increase shareholder value Your job is to figure out if managementhas the ability and the willingness to besuccessful within its industry and repayyou for your financial support!
  • 117. May 2013 Florida RMA Lending School 117Related publicationsby Dev Strischek “Airing out Revenue Projections: Letting the Wind Out of Sales Projections,” RMA Journal, Nov2010, pp. 40-5. .“Assessing Creditworthiness: Importance of Evaluating Company Management,” Journal ofCommercial 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, April2003, pp.48-55 “Industry Analysis: Keys to Similarities of Different Lines of Business,” Journal of Credit RiskManagement, 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 ofCommercial Bank Lending, March 1989, p. 4-14.
  • 118. APPENDICES App A: ROE –ROA App B: GlossaryMay 2013 Florida RMA Lending School 118
  • 119. May 2013 Florida RMA Lending School 119App A-1: Borrower’s Goal Maximize return on equity (ROE=profit aftertaxes/net worth= PAT/NW) to increaseshareholder 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 $$
  • 120. May 2013 Florida RMA Lending School 120App A-2: ROE > Cost of Capital? Points to ponder• Borrowers want high ROE• Growing the firm is usually the road to success, but howeasy is it to grow in the borrower’s industry?• Growth requires funding from lenders and/or investors, but isthe 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 itsindustry and repay your loan?
  • 121. May 2013 Florida RMA Lending School 121App A-3: ROE > Cost of Capital? EBIT/TA• Good measure of how profitably a company hasmanaged 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 bothinterest to debt holders and dividends to stock holders• Comparing companies’ EBIT/TA eliminates potentialdistortions among firms caused by differences infinancing sources and by differences in sales size:• Debt/equity mix• Revenue size
  • 122. May 2013 Florida RMA Lending School 122App A-4: ROE > Cost of Capital? So how do we reconcile these two points ofview?• 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
  • 123. May 2013 Florida RMA Lending School 123App A-5: ROE > Cost of Capital? 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 . . .
  • 124. May 2013 Florida RMA Lending School 124App A-6: ROE > Cost of Capital? 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 ROE200 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, respectivelyT rate = 40%, 30%, 25% for 90, 70, 36 in PBT, respectively
  • 125. May 2013 Florida RMA Lending School 125App 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%
  • 126. May 2013 Florida RMA Lending School 126App A-8: ROE-ROA Dilemma How to bridge the gap between ROE and ROA?• LFdebt/equity balance• How easy is it to borrow or raise equity for this management in thisindustry?• IFinterest/dividend balance• Which is more advantageous for this management in this industry, topay interest or pay dividends?• TFtax-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 helpshape both the industry environment and the industrymembers . . . So how does management satisfy both lenders and investorsin repaying debt and paying dividends?
  • 127. 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 capitalMay 2013 Florida RMA Lending School 127