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

May 2013 Florida RMA Lending School 1
INDUSTRY AND
MANAGEMENT
EVALUATION
Dev Strischek
SVP & senior credit policy officer
404-230-5242
Dev.strischek@suntrust.com
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?
• LFdebt/equity balance
• How easy is it to borrow or raise equity for this management in this
industry?
• IFinterest/dividend balance
• Which is more advantageous for this management in this industry, to
pay 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 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 potential
Sales growth
Profit margins
Marketing strategy
Credit strategy
Operating strategy
Collateral Goods or services
Trade credit terms
Value stability
Inventory a/o
Receivables
Purchasing
Warehousing
Guarantees Access to capital
Scale
Leverage
Public vs.. private
Competitive strategy
Risk 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 Sufficient
CF > (P+i)
Insufficient
Collateral Secured
Coll > (P+i)
Unsecured
Guarantees Guaranteed
Guar > (P+i)
Unguaranteed
(non-recourse)

So let’s build the box--cash Flow
Positive Cash
Flow (+)
Negative Cash
Flow (-)

Building the box--cash flow and
collateral
Positive Cash
Flow (+)
Negative Cash
Flow (-)
Unsecured (-) Secured (+)

Building the box--cash flow, collateral,
and guarantees
Positive Cash
Flow (+)
Negative Cash
Flow (-)
Unsecured (-) Secured (+)
Guaranteed (+)
Non-recourse (-)

An axis to grind . . .
Which box is better?
Cash
Flow
(+)
Cash
Flow
(-)
Secured
(+)
Unsecured (-)
Guaranteed
(+)
Unguaranteed
(-)

An axis to grind . . .
Other options?
Cash
Flow
(+)
Cash
Flow
(-)
Secured
(+)
Unsecured (-)
Guaranteed
(+)
Unguaranteed
(-)

Possible Options
1 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 boxes Options 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
• 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?
1. Competitive position
• How can firm be successful?
1. 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 Assets
TA = Total Assets
Rev = Revenue
GP = Gross Profit
AP = Accounts Payable
TO = Turnover

Structural Differences among 4 Firms
Financial 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?
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?
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 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

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 Forces
How the forces drive competition
Competitive
rivalry 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
• 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
• capacity augmented in large increments
• buyers’ switching costs
• diversity of competitors
• exit barriers
• strategic stakes

Porter’s Five Forces: Example
Beer producer (brewery)
Competitive
rivalry 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
C
O
S
T
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
P
R
O
D
U
C
T
L
I
N
E
MARKET BREADTH

Maintain Competitive Position
by 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
P
R
D
C
T
M
K
T
S
C
O
P
E
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
P
R
D
C
T
M
K
T
S
C
O
P
E
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 drivers
Value 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 Period
2003 2004 2005 2005 2007
Residual Period
2008 . . . . . . . . . . . . . . .
PV of
Residual
Value
Non-
operating
assets
+
+
=
Corporate
Value -
Mkt Value of
Debt & 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=>$35.66
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 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 2007
cash csh/total assets % 6.1 6.5 7.7 5.8
Accts receivable AR/TA % 18.5 15.4 14.7 15.0
Inventory Inv/TA % 24.0 27.6 28.6 28.1
Current assets Tot CA/TA % 50.6 50.8 54.8 52.4
Accts payable AP/TA % 9.0 9.5 11.0 10.3
Notes payable NP/TA % 14.4 13.3 11.4 11.3
AR turnover days receivable 37 29 26 25
Inventory turnover days inventory 68 76 90 92
Payables turnover days payable 23 25 26 23
WC 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. Performance
2. Experience
3. Education & training
4. Skills
5. Organization
6. Compensation
7. Board of directors
8. 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?

 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

 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

 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?
• LFdebt/equity balance
• How easy is it to borrow or raise equity for this management in this
industry?
• IFinterest/dividend balance
• Which is more advantageous for this management in this industry, to
pay 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 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

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

Recommended

Recommended

More Related Content

What's hot

What's hot (8)

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

Similar to RMA-SOCL: Industry & Management Evaluation (Dev Strischek) (20)

More from UCF Continuing Education

More from UCF Continuing Education (9)

Recently uploaded

Recently uploaded (20)

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

Editor's Notes