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Traffic Lights & Threat Levels
- 1. Traffic Lights and Threat Levels An In-House Tool for Consistently Assessing Vendors’ Financial Health Matthew Eckman
- 2. Disclaimer The views expressed in these slides and the accompanying discussion are my own and do not necessarily reflect the views of—and should not be attributed to—Genentech or any other entity associated with the Roche Group. 2
- 3. Why is it Important to Analyze Vendors’ Health? Problems abound for sponsors, vendors alike Persistent economic troubles Drug development challenges Billions at stake Outsourcing on the increase Industry pain points Irrational competition Private equity involvement 3
- 4. Why is it Important to Analyze Vendors’ Health? “Controversial financing strategy” hurts acquired firms “Dividend recapitalization, which is legal, is a shortcut…Instead of waiting to take profits when an acquisition is resold, the private equity firm arranges for the company to borrow money…then channels the proceeds to itself and its investors through a dividend…Some have criticized the dividend recap strategy for saddling companies with debt and for the 15 percent U.S. tax treatment often applied to the payouts, which is far below the 35 percent top individual income tax rate.” Reuters analysis, December 6, 2012 Link: 4
- 5. Advantages of an In-House System Recommended Inputs Translating Data into Action Visually Communicate Financial Data Tying Financial Health Assessments to Decision-Making 5
- 6. Comparing In-House Versus Third-Party Tools After initial investment, advantages favor in-house Criterion In-House Third-Party Tools Source of data (public companies) Vendor Published financials Newsfeeds Public, subscription data feeds Published financials Newsfeeds Public, subscription data feeds Source of data (private companies) Vendor Indirect benchmarks None Customization/ prioritization Complete Limited to none Resource intensiveness Significant (upfront) Moderate (ongoing) Minimal Cost intensiveness None (spreadsheet) Minimal (database) Moderate to significant (per-use and subscription) 6
- 7. Ramifications Of In-House Vs. Third-Party Tools Significant differences exist Financial preferences and concerns • Vendors are business partners, not investments • GAAP*/IFRS* vs. non-GAAP*, EBITDA*, net debt, etc. Increased importance and attention • Finance, risk professionals joining outsourcing, procurement groups • Risk-based award, book-of-business decisions Visibility into tool construction, output • Internal consistency vs. what’s “most accurate” • Redirects nature of dialogue with vendor 7 * See glossary at end of deck
- 8. Advantages of an In-House System Recommended Inputs Translating Data into Action Visually Communicate Financial Data Tying Financial Health Assessments to Decision-Making 8
- 9. Recommended Inputs for an In-House Tool Simple concepts to consider Use multiple facets of financial performance Emphasize ratios and two-step tests Avoid using too many market-based measures 9
- 10. Recommended Inputs for an In-House Tool Simple concepts to consider Use multiple metrics in the same family Emphasize common financial line items Exploit forward-looking measures picture placeholder picture placeholder picture placeholder 10
- 11. Possible Inputs for an In-House Tool Many options exist Financial Integrity • Independent auditor opinion Bankruptcy Prediction • Altman Z Score • Morningstar Solvency Score • Morningstar’s Distance to Default Score Customer Concentration • % of revenues from top-1/3/5 customers (particular service and/or overall) Profitability • Sales & income trends • Operating, profit, FCF* margins • ROA*, ROE*, ROIC* • Retained earnings, EBIT*, revenues/total assets • FCF*/total revenue Liquidity • Cash, current, quick (i.e., acid test) ratios • Net working capital/total assets Denotes forward-looking metrics 11 * See glossary at end of deck
- 12. Possible Inputs for an In-House Tool Many options exist Financial Leverage • Operating cash flow vs. current, long-term liabilities • Interest coverage ratio • FCF* to interest expense • Morningstar's Cash Flow Cushion • Total liabilities/total assets • Total liabilities/total equity • Total liabilities/total capital Financial Leverage (continued) • Net debt/total capital • Total assets/total equity • FCF*/total liabilities Operating Ratios • Backlog and backlog conversion trends • Receivables turnover • % of receivables from top-1/3/5 customers • % repeat clients Denotes forward-looking metric 12 * See glossary at end of deck
- 13. Advantages of an In-House System Recommended Inputs Translating Data into Action Visually Communicate Financial Data Tying Financial Health Assessments to Decision-Making 13
- 14. Methods For Translating Data Into Action What’s the key? Simplify, Simplify! Simplify, 14
- 15. Methods For Translating Data Into Action Be particular about text Use enough… …but don’t use too much. Customize some text… …but focus on boilerplate language. Avoid financial jargon… …in favor of layperson descriptions. 15
- 16. Methods For Translating Data Into Action Composite scores can facilitate understanding Singular output Audited financial statements 36.7% bankruptcy probability 4.8% profit margin 63.9% sales among top 3 customers 89.1% FCF/liabilities 1.32 current ratio 70.4% receivables among top 3 customers 6.4/10 Numerous inputs 16
- 17. Methods For Translating Data Into Action What can composite scores tell you? Clear scale and relativity Current, historical, and average scores over time Can be tied to explicit risk levels 17
- 18. Advantages of an In-House System Recommended Inputs Translating Data into Action Visually Communicate Financial Data Tying Financial Health Assessments to Decision-Making 18
- 19. Visually Communicate Financial Data Color can supplement text, numbers ??/10 Risk Level: Sponsor Choice 2.5/10 Risk Level: High 5.8/10 Risk Level: Medium 9.7/10 Risk Level: Low 19
- 20. Visually Communicate Financial Data Radar plots are compact and information-dense Financial Integrity Bankruptcy Prediction Customer Concentration ProfitabilityLiquidity Operating Ratios Financial Leverage 20
- 21. 21 Visually Communicate Financial Data Composite scores can be graphed Low Risk Medium Risk High Risk 0 1 2 3 4 5 6 7 8 9 10 201320122011201020092008
- 22. Low Risk Medium Risk High Risk 0 1 2 3 4 5 6 7 8 9 10 201320122011201020092008 Visually Communicate Financial Data Composite scores can give historical context What’s typical for this vendor over business cycles? How does the latest score compare to its historical average? Vendor 22
- 23. Low Risk Medium Risk High Risk 0 1 2 3 4 5 6 7 8 9 10 201320122011201020092008 Visually Communicate Financial Data Composite scores can give relative context How well does the vendor’s plight track that of a market index? How does the vendor compare across similar vendors in the sponsor’s own tool? 23
- 24. Visually Communicate Financial Data Traffic lights are simple and powerful 24
- 25. Visually Communicate Financial Data Combine multiple approaches for greatest effect 25
- 26. Advantages of an In-House System Recommended Inputs Translating Data into Action Visually Communicate Financial Data Tying Financial Health Assessments to Decision-Making 26
- 27. Tying Financial Assessments to Decision-Making Key Considerations Proximity of assessor and decision-maker Prioritize efforts and areas of focus Risk-based monitoring, mitigation efforts Integrate with operational, quality checks Communication with vendors 27
- 28. Tying Financial Assessments to Decision-Making Incorporate into vendor selection process RFI/RFP Assessment Lower-Risk Alternatives? Risk Mitigation Ineligible? Eligible? Low Risk Unavailable Medium Risk High Risk No Recommended Required Yes No 28
- 29. Tying Financial Assessments to Decision-Making Risk mitigation tool Make it easy to use Make it versatile and flexible Provide a framework, not a mandate Emphasize “living documents” over plans set in stone Incorporate risk management concepts 29
- 30. Tying Financial Assessments to Decision-Making Risk maps can put activities in context Negligible Low Extreme High Medium Rare Unlikely Certain Likely Moderate Likelihood Impact 30
- 31. Tying Financial Assessments to Decision-Making Approach risk mitigation from multiple angles Action Responses: • One-time activities that reduce the sponsor’s level of risk once they have been completed Control Responses: • Persistent mechanisms and procedures that are collectively intended to reduce— or at least maintain—the sponsor’s level of risk; they are typically effective after being implemented and while being operated Fallback Responses: • Contingency plan: a detailed mitigation plan in the event that actions and/or controls fail to prevent the risk(s) to sponsor that had been identified via the financial assessment 31
- 32. Traffic Lights And Threat Levels Conclusion • Industry challenges compounded by irrational competition, private equity • After an initial investment, in-house tools are powerful, cost-effective • Six simple concepts can guide selection of a custom array of inputs • Composite scores can facilitate understanding • Visual cues can be combined with numbers, text to enhance communication • Assessments should accompany risk mitigation for maximal effect • Risk maps and response categories can frame mitigation efforts 32
- 33. Doing now what patients need next 33
- 34. Glossary Explanation of abbreviations EBITDA • Earnings before interest, taxes, depreciation, and amortization EBIT • Earnings before interest and taxes FCF • Free cash flow GAAP • Generally accepted accounting principles IFRS • International Financial Reporting Standards ROA • Return on assets ROE • Return on equity ROIC • Return on invested capital
Editor's Notes
- Persistent economic troubles—a holdover from the global economic crises of the late 2000s—continue to plague many of the largest markets in which sponsors and vendors alike do business…The increasingly-challenging drug development landscape is affecting the industry’s productivity and profit…R&D budgets—a significant source of our costs--reach into the billions for many firms…Sponsors are increasingly reliant on outsourcing to stretch those R&D budgets…Our vendors face significant challenges in their industries as sponsors reduce their slates of preferred vendors, sponsor alliances are not the fiscal windfalls they were hoped to be, and the preclinical and Phase I business segments stagnate in the doldrums of a demand trough…Increasingly-generous signing bonuses are leading to a war of attrition, constraining profits and leading to higher employee turnover that could threaten performance on outsourced studies… The go-to methods of private equity firms are draining cash off the balance sheets, shifting unsustainable debt onto our vendors, and increasing the cost of that debt via high interest rates and credit downgrades. This has, in some cases, led to lawsuits against the private equity firms. And while the recent and debated changes to the US tax code have not lessened their reliance on these tactics, some organizations are predicting moderate returns and a more competitive landscape for PE that could see their use increase.These factors and more are impacting the financial performance of many companies that rely on our industry, leading some to fail. Roche and Genentech have both experienced the sudden failure of vendors in the midst of studies. These failures can result in cost overruns, quality issues,product development delays, and lost revenues.It is important to note that financial, operational, and quality risks with vendors are independent types of risk that are intertwined and, in some cases, predictive of one another. [Explain with an example.] While we are discussing financial risk in this presentation, I will point out that Roche assesses the performance of its vendors across a variety of dimensions (sustainability, operation, quality, etc.) of which financial risk is but one component.
- By now, you have an appreciation for the importance of evaluating your vendors’ financial health. Now let’s take a look at the arguments in favor of doing it yourself…
- Indirect benchmarks also refers to the use of sector averages in the absence of specific information…can be totally irrelevant and/or misleading
- Sponsors view vendors as business partners, not as investmentsFinancial concerns are resultantly differentVendor financial data provided to sponsors should reflect this distinctione.g., avoid non-GAAP/EBITDA figures, don’t downplay debt and debt service, etc.Don’t downplay sponsor requests for financialsFinance professionals joining outsourcing, procurement groups…part of the ‘professionalization’ of new procurement organizations: not only deal cutters anymore, but part of an overall solutions strategy development…also provides greater job security than the tumultuous financial services industryRisk management efforts intensifying (DJSI also asks increasingly about comprehensive risk management)Can impact individual awards and total book of businessSpecifics (construction, final scores) withheld from vendorsPrevents unproductive debates on methodology and the possibility that knowledge could influence vendor behavior, performanceAllows sponsors to use one tool consistently, as opposed to customizing for each vendor (time-saving and focuses attention on items important to sponsor)
- At this point, perhaps I’ve convinced you to create your own in-house tool for vendor financial assessments, in place of or in combination with an external service…so let’s now discuss what inputs might comprise a first-in-class financial assessment tool…
- Use multiple metrics in the same family: No one metric is perfect, as each has its limitations and idiosyncrasies; multiple indicators lend greater weight to conclusionsEmphasize common financial line items: Esoteric inputs can impact timeliness of vendor responses and inject unwanted variation in calculationsExploit forward-looking measures: Elevates tool from an historical snapshot and better aligns risk assessment with timeline of outsourced work
- Can mention that other common financial metrics have some success at being used to predict bankruptcy
- At this point, you’ve decided what inputs will comprise your in-house tool for vendor financial assessments…now let’s discuss how you translate those data into actionable recommendations…
- Talk about the relative numbers of ENIACs, PCs, and iPads in their first years of availability…emphasize that ease-of-use and visual appeal were key to their understanding and adoptionConcentrate on the broad themesUse layperson language to explain financial concepts
- Regardless of how you construct your tool, it’s bound to have text. Here are some recommendations on the use of text in your tool.Use enough text to provide a description and appeal to those who learn via reading, but don’t use too much.Customize some text for the specific vendor you’re evaluating, but focus on boilerplate language so that there’s consistency and end-users get comfortable with the text on the tool.Avoid financial jargon in favor of layperson descriptions that can be understood by anyone, regardless of background and education.
- So what do you do with all the inputs you selected and the metrics you’ve calculated? How many of your colleagues would understand these data well enough to make a decision based on them?In order to do this, will have to decide, as a company, thresholds for each metric individually and for each metric’s contribution to the whole weighted composite scoreComposite scores could be additive or subtractiveIn the absence of enough information to determine a score, suggest you act conservatively and rate accordinglyValuable shortcut:When constructing your tool, you can align it with the vendor RFI to enable cut-and-paste entry of the raw financial data. The tool can then automatically calculate all selected metrics, then rate and weight the metrics into the composite score. Microsoft Excel and secure, web-based interfaces are both viable options for doing this.
- Provides consistent interpretation of multiple componentsEases the exercise of financial analysis by offering automatically-computed, meaningful, and easy-to-read output derived from relatively simple inputClear scale and relativity (intra- and inter-company) ---Pay attention to the gradation of your scale: a 0-5 scale may be too blunt, 0-10 through 0-100 scales can provide enough room, while round numbers may hold appealCan be compared to most recent composite score to judge relative financial health of lateScores can dictate risk level and suggest whether risk mitigation warranted
- So now you’ve opted to create an in-house tool…You’ve sat down with Finance to compile the desired inputs and rate and weight them accordingly…You’ve figured out how to distill the text and numbers down to a meaningful few…But how do you make sure that you’ve unambiguously made your point to a non-financial audience?People learn and understand things in different ways: some by reading, some by seeing. Some people prefer text to numbers; others take in data from pictures best. We’ll look at ways in which we can try and tackle each of those scenarios.
- The simplest first step is to add color. In this case, we can overlay color on text and/or numbers.Note that the score is prominent in all cases. The scale is also mentioned. At bottom, the risk level is correlated to the score. The color is, in turn, correlated to the risk level.When looking at the box on the left, it is important to note that sponsors can choose a default for overall scores or individual components in the absence of data…medium- or high-risk, for example…this still allows it to be incorporated with risk management process and hopefully discourages vendors from withholding information…also allows for conservative stance as a default
- Radar plots are another visual way to communicate several pieces of data at once:The shape can accommodate many different facets of analysis, simply by adding another sideThe radii convey the scale for the individual scoresThe colors and dotted polygons convey the risk levelsTwo potential setbacks of the radar plot:Can be difficult to reflect an overall score and risk levelComparisons to other benchmarks may be difficult to comprehendCould alter color of the lines to reflect overall risk level of vendor
- If we instead focus on a composite score, then we can use a plot such as this to visually communicate key data.Risk levels are demarcated, colored and named against a clear scale that situates the highest scores at the topThe horizontal axis shows the annual composite score of current and historical financial data
- Higher lifetime average suggests recent financial challenges (could be unique to firm or reflective of industry/economy)
- A graph such as this could show that—while the market index has performed better than a vendor and its cohort—the vendor in question better handled the downturn and has improved at a faster rate than its cohort.
- Traffic lights are interpretable under many scenariosSymbol is recognizable, if not identical, in all developed countriesColors can be consistent with other risk level depictions in your toolSuperimposition of symbols onto traffic lights aids B&W printing and those with red/green color blindnessUse of symbols instead of abbreviations (e.g., R, Y, G) or pictures (e.g., “thumbs up”, “thumbs down”) intended to avoid cultural and language differences in a global companyBy default, lack of data for a traffic light could result in a blank traffic light, which would not count toward a vendor’s score
- Here we see several of the items previously discussed being used in combination with one another: numbers, boilerplate layperson text, graphs, and traffic lights. This combination should appeal to a broader audience given the redundant signalsAll four variations of a bankruptcy prediction score box shown with sample data…can be used for additional detail on your tool’s major families of metrics By default, lack of data for a traffic light results in a blank traffic light with explanatory text Helps end-users identify particular areas of concern and strengthNote changes in traffic light color and symbol, as well as corresponding textBoilerplate layperson text inputs and traffic light automatically triggered by risk level; risk level automatically triggered by score
- Great. You’ve created a powerful, first-in-class, in-house tool to assess your vendors’ financial health…and even better, your colleagues understand it. How do you tie financial health assessments to decision-making and clinical development activities?
- Proximity of assessor and decision-makerInvolve end-users in process: Get buy-in and support from top management, emphasize its place as an additional decision-making tool, designate process SMEs, conduct global trainings (VC, TC, in-person, and online) for outsourcing and clinical development colleaguesAssessments and risk mitigation plans without proper context from involved parties could lead to misinterpretation and misunderstandingMost appropriate study team SMEs dictate risk mitigation plans on particular studies; outsourcing relationship managers dictate vendor- or service area-wide RMPs; contract negotiators facilitate study team education and adherence to processPrioritize efforts and areas of focusDevelop eligibility requirements to help focus assessment effortsRisk-based monitoring, mitigation effortsText recommendations automatically triggered based on risk level implied by composite scoreRisk levels can be linked to the performance and extent of risk mitigation activities, ensuring concerning eligible vendors command the most attentionIntegrate with operational, quality checksAlthough financial risk can be independent from operational and quality risks, it should be part of the overall battery of risk assessments you systematically conduct for a holistic approachCommunication with vendorsKnowledge of FHAT methodology, results, or FRMP components could influence vendor behavior, performance
- How might vendor financial assessments be incorporated into decision-making? It can be used for the selection of vendors at the RFP stage, for example…Eligibility criteria can include such considerations as:Preferred/prequalified vendorsKey service area vendorsVendors comprising a majority of overall spendVendors with contracts above a minimum thresholdVendors requested by managementDoes sponsor have to work with vendor identified as medium- or high-risk? If not, look for lower-risk alternative vendors with comparable capabilities.Internal customers involved in determining whether a particular vendor is critical, whether there are viable alternatives with lower risk ratings, and what actions will comprise a risk mitigation plan.Also need to mention that risk mitigation activities continue for duration of project/contract…not a one-time exercise
- What characteristics should a risk mitigation tool exhibit?Not overly cumbersome:Goal: Create a tool that the business will want to useVersatile:Built-in flexibility for tool to be relevant for all different studies and servicesSuggestive aid:Does not “mandate” activity, rather provides framework for guidanceAccountability:“Living document” that can evolve, record efforts, and proactively describe a backup plan…not a one-time activity!Familiar:Align with risk management processes: Risk map, response categories
- Risk Map – Likelihood AxisThis parameter refers to the likelihood of the vendor experiencing a financial issue (e.g., bankruptcy, insolvency, etc.).Could be assigned by the result of the financial assessment or a forward-looking metric within it (e.g., bankruptcy prediction). Sponsors could decide that a vendor lacking an assessment would default to a medium likelihood unless attainable evidence suggests otherwiseRisk Map – Impact AxisThis parameter assesses the impact to the sponsor in the case of a disruption to project(s) due to financial issues with the vendor.Could be assigned by the plan owner after consulting relevant stakeholders.Considerations might include:Critical nature of work to project timelines (e.g., retrospective analysis vs. registration study, primary endpoint vs. secondary endpoint)Total budget of contractRoche example: Any disruption causing delay in project timelines—or directly affecting the well-being of patients—is considered to be high impact to Roche.
- Examples of action responses: MSA and contract language Payment terms Preliminary audit Initial communicationExamples of control responses: Repeat financial assessments Performance, operational monitoring Ongoing communicationExamples of fallback responses: Alternate vendors assessed and, if necessary, prepped Vendor transition plans Safeguards to minimize project disruptions at time of failure