1 Financial Engineering 4 What’s Financial Engineering? –Mathematical system that integrates the financial performance of the firm –Provides a structured

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Financial Engineering

What’s Financial Engineering?– Mathematical system that integrates the financial performance of the firm– Provides a structured assessment of the firm’s financial position– Allows management to identify the key leverage points in the firm.

Why is it important?– The most critical resource in any firm is management time and attention– Allows management focus initiatives where there is the biggest payoff

Who Cares?– Shareholders, investors– Customers– Employees

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Financial Engineering is not “Cooking the Books”

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Agenda What’s Financial Engineering

Structure analysis – DuPont Formula– Capital markets benchmarks– Financial leverage and risk

Component analysis– Profitability benchmarks– Asset benchmarks

Connection analysis

Summary

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Financial Engineering Structure Analysis - Benchmark Analysis Income Statement $000

Sales 15,000 100% Benchmark Analysis

Materials 3,800 25% Allows ComparisonLabor 2,200 15%Plant overhead 1,800 12% - Prior yearsDepreciation 300 2%Engineering 600 4% - Other firmsOther direct costs 600 4%Shipping 1,100 7% - Industry norms & averagesErection field ops 2,100 14%Total Cost of Goods Sold 12,500 83%

Gross Margin 2,500 17%

Sales, General & Admin 1,000 7%

Earnings on Total Assets 1,500 10% Pretax Profit Margin

Interest costs 500 3 Interest coverage ratio

Profit before Tax $ 1,000 6.7%

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Financial Engineering Structure Analysis - Some Key Ratios

Balance Sheet $000Assets Liabilities & Equity

Cash 300 Accounts Payable 1,000Accounts Receivable 2,400 Accrued Liabilities 400 Quick Assets 2,700Over 90 Receivables 240 Line of Credit 1,300Retainage 1,050Inventory 750Total Current Assets 4,740 Total Current Liabilities 2,700

Quick Ratio 1.0x

Plant cost 8,750 Current Ratio 1.8xDepreciation 4,390Net Plant & Equipment 4,360 Long Term debt 3,000

Land 250 Owners Equity 3,650 Equity ratio 2.56x

Total Assets 9,350 Total Sources 9,350Sales turnover of assets 1.6x Return on total assets (ROI) 16.0%

Return on Stockholders equity (ROE) 27.4%

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Financial Engineering Structure Analysis - DuPont Formula

ROI is the most important benchmark

Formula invented by an engineer at DuPont 80 years ago

ROI = Profit margin x Asset turnover

Profit Profit Sales --------- = ---------- x -------------- Asset Sales Asset

$ 1,000 $ 1,000 $15,000 --------- = ---------- x -------------- $ 9,350 $15,000 $ 9,350

16.0% = 10.0% x 1.60

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What about return on Stockholders Equity (ROE) ?

ROE = ROI x Equity Ratio

Profit Profit Assets --------- = ---------- x -------------- x [1 – recip. Cov. Ratio] Equity Assets Equity

27.4% = 10.7% x 2.56 x [1 – (1/3)]

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Financial Engineering Structure Analysis - Leverage & Risk

Is this magic? ROI of 10.7% becomes ROE of 27.4% - Equity ratio is 2.56 (i.e. about 60% of capital is borrowed)

Borrowing to reduce equity - Works as long as interest cost is less than ROI

Borrowing introduces significant risk - Interest and principal must be paid timely - Lenders typically impose restrictions

Return on Equity (ROE) carries risk proportional to debt

ROE is important to the owner but it is not the best benchmark Borrowing risk varies from firm to firm

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Financial Engineering Structure Analysis - Benchmark Returns

Sales Asset Equity Business ROI Margin Turnover Ratio ROE

Example producer 16.0% 10.0% 1.6 2.6x 27.4%

Typical retailer 16% 4.1% 4.0x 2.5x 27%

Contractor 16% 5.0% 3.2x 2.5x 27%

Heavy Industrial 16% 20% 0.8x 2.5x 27%

Marginal ROI 3% 1.7% 1.8x 2.5x 8%

Excessive Debt 3% 3% 1.0x 5.0x 20%

It’s not magic, its mathematics

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Financial Engineering Structure Analysis - ROI Benchmark ROI Benchmark – what’s the number?

Competitive Return . Owner has a reasonable expectation for a competitive return = Risk free rate + an equity premium . Long term risk free government bonds yield ~ 5.0% today + Historic long term risk premium for stocks ~ 3.5% (40 year ave.) + Premium for cyclical industry ~ 2.5% (beta = 1.75) + Premium demanded for closely held business ~ 2.8% (25%) = All this totals ~ 13.9%

Long term average– ROI should be measured as long term average

– 2002-2003 is below acceptable return for most

– Annual Financial Survey is the best source of peer-group benchmark data

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ROI and Profit Margin - Before tax, after interest expenses

- Ave. All Producers

0.0%

5.0%

10.0%

15.0%

20.0%

25.0%

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

%

PCI ROINPCA ROI

PCI Profit marginNPCA Profit margin

Figure 2

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Sales Turnover of AssetsAve. All Producers

0

0.5

1

1.5

2

2.5

Tu

rno

ver

Figure 3

PCI TurnoverNPCA Turnover

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Leverage Ratio All Producers

$0.0

$1.0

$2.0

$3.0

$4.0

$5.0

$6.0

1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

.

Ind

ust

ry S

ales

($ b

illi

on

s)

0.00

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

Lev

erag

e R

atio

Figure 4

PCI Leverage RatioNPCA Leverage Ratio

Industry Sales

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Financial Engineering Structure Analysis- Benchmark Guidelines

ROI Benchmark Guidelines

1. ROI is the most important benchmark measure for the firm - ROI is key and central to the stockholder’s willingness to invest - ROI can be directly compared because debt is not included

2. ROI benchmark should be at least 13.9% - Risk-free rate + equity premium + other considerations - Long run average

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Financial Engineering Structure Analysis- Key Benchmark Ratios Key Ratio benchmark guidelines

Liquidity Ratios– Quick ratio Stay above 1.0

– Current ratio Guideline above 2.0, stay above 1.5

Equity Ratio (total assets divided by equity)

– Your operations may be undercapitalized if it is more than 3.0x

– There is nothing wrong with borrowing, management is expected to balance risks

Asset Turnover (Sales divided by assets)

– Should be above 1.5x for a typical producer, hard to get much above 2x

– If below 1.0x, you may have too many assets in the business to make a good return.

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Connection analysis

Summary

Annual Survey

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Financial Engineering Component Analysis - Profit Margin

ROI = Profit margin x Asset turnover

Options 1. Improve margin by managing product lines and market segments 2. Reduce costs with capital, worker productivity, and rework reduction

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Financial Engineering Component Analysis - Profit Margin

Progression toward commodities

Profit by Product line $000 Losers Bleeders Cash Cows Stars

Sales 15,000 200 4,300 10,000 500 100% 2% 28% 67% 3%

Total Cost of Goods Sold 12,500 190 3,655 8,280 375

Gross Margin 2,500 10 645 1,720 125 % 17% 5% 15% 17% 25%

Sales, General & Admin 1,000 20 325 600 55Interest costs 500 10 150 300 20

Profit before Tax $ 1,000 (20) 150 820 50

% 6.7% -10% 3.5% 8.2% 10%

Take action benchmark guidelines:1. If Losers exceed Stars2. If Bleeders exceed Cash Cows3. If Cash Cows are less than 50% of all sales

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Financial EngineeringComponent Analysis - Profit Margin Comparison to Annual Financial Survey

$000 Survey Producer Lower Improvement Program

Materials 3,800 25% 23% Reduce mix cost by $5/yard by controls

Labor 2,200 15% 11% Reduce labor 10% with training program

Plant overhead 1,800 12% 9% Depreciation 300 2% 2% Engineering 600 4% 2% Reduce drafting 25% w

computer program

Other direct costs 600 4% 2% Shipping 1,100 7% 4% Erection field ops 2,100 14% 11% Reduce erection 10% by reduced rework

Gross Margin 2,500 17% 20% Improve margin 1% with new product line

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Financial EngineeringComponent Analysis - Profit Margin Comparison to Annual Financial Survey

$000 Survey Producer Lower Improvement Program

Materials 3,800 25% 23% Reduce mix cost by $5/yard by controls Labor 2,200 15% 11% Reduce labor 10% with training program Plant overhead 1,800 12% 9% Depreciation 300 2% 2% Engineering 600 4% 2% Reduce drafting 25% w

computer program Other direct costs 600 4% 2% Shipping 1,100 7% 4% Erection field ops 2,100 14% 11% Reduce erection 10% by reduced rework

Gross Margin 2,500 17% 20% Improve margin 1% with new product line

Take action benchmarks guidelines– Margin differences of >2%– Cost differences of >3%

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Financial EngineeringComponent Analysis - Profit Margin Summary of Profit Margin Component Analysis

All producers can benefit by benchmarking product line profitability– Take action if Losers exceed Stars, Bleeders exceed Cash Cows– Take action if Cash Cows are less than half of total sales– Benchmark product line progress from year to year

Annual Financial Survey is the best source benchmark margin data– Margin differences ≥ 2% have a message worth discovering– Cost differences ≥ 3% should be examined closely– Bid analysis can be used to determine your competitors’ cost

Programs for change should flow from benchmark review– Things don’t change unless something changes– Management by objective → goals & programs

It takes some humility to let the data speak to you

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Financial EngineeringComponent Analysis - Asset Management

Comparison to Annual Financial Survey

Assets $000 Producer Survey Improvement ProgramCash 300 Accounts Receivable 2,400 59 days 45 days Reduce to 45 days with new program Quick assets 2,700Over 90 Receivables 240 6 days Eliminate with new program

Retainage 1,050 26 days 10 days Cut in half with new contract negotiations

Inventory 750 18 days 10 days Cut in half with new contract negotiations

Total Current Assets 4,740

Plant cost 8,750Depreciation 4,390Net Plant & Equipment 4,360Land 250 Land appraised at $3.5 million.

Total Assets 9,350

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Financial EngineeringComponent Analysis - Asset Management

Annual Survey is the best source for benchmark data– Current Assets data is best converted to the days sales format– Land and fixed assets should be analyzed at market price if you have reason to think there is a big

difference between book to current market

Asset management action benchmarks guidelines Collections:

– Get aggressive at 45 days– Computer systems support and training for collections clerk

Inventory: – Keep it to 30 days or less– Get paid for stored materials– Just in time deliveries– Dispose of leftovers

Retainage:– Target 5%, this can be achieved– Include partial or complete retainage return when erection is accepted.– Get it in the contract agreement, get owner buy-in on the front end.

Land Values:– Typically are way undervalued on the books– Easy to ignore, yet can be critical in determination of adequate ROI

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Connection analysis

Summary

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Financial EngineeringConnection Analysis

Results of All Initiatives The most valuable resource is management time and attention Base ROI = 16%

Improvement program Carrot Program ROI Reduce mix cost by $5/yard 125 17.4 % Reduce labor 10% with training program 220 18.4 % Reduce drafting 25% computer program 90 17.0 % Reduce erection 10% by reduced rework 210 18.3 % Improve margin 1% with new product line 150 17.6 % Total Margin Improvement 795 24.5% Reduce A/R to 45 days with new program 810 17.6 % Retainage in half contract negotiations 260 16.5 % Inventory in half contract negotiations 375 16.7 % Total Asset Management 1,445 19.0%

Combined Results 29%– Profit and ROI nearly double

Land appraised at $3.5 million. 3,250 11.9 %

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Connection analysis

Summary

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Financial EngineeringSummary of key points

DuPont Formula– ROI = Profit margin x Asset turnover– ROI is the most important benchmark measure for the firm

Competitive Return is a reasonable owner expectation = Risk free rate + an equity premium- Benchmark ROI = 13% or greater – long run average

Profit Margin action (Product line and cost benchmarks)– Take action at the guideline points

Asset Management benchmarks can help all producers– Take action at the guideline points

Annual Financial Survey is the best source of peer-group benchmark data– Participants benefit by using benchmark analysis– Using % of sales comparisons washes out many regional and product differences– It takes some humility to let the data speak to you

Management time and attention is the most valuable resource in the firm

Things don’t change unless something changes

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Who’s Precast Consulting

We are a general management consulting firm focused only on the Precast Industry

Finance – Acquisitions / dispositions– Financial benchmark analysis

Sales & marketing– New product development– Margin improvement– Profitable sales growth

Operations– Work group productivity improvement– Project management– Quality programs – rework reduction– Manufacturing improvements

Management Professionalism for the Precast industry Contact information [email protected] web site www.precastconsulting.com 770-979-3711

Documents

1 Financial Engineering 4 What’s Financial Engineering? –Mathematical system that integrates the financial performance of the firm –Provides a structured