Financial Engineering

1. 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 Left click to advance - Right click for controls The back arrow will return you to the website

2. Financial Engineering Financial Engineering is not “Cooking the Books”

3. Financial Engineering 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

4. Financial Engineering Structure Analysis- Benchmark Analysis Income Statement$000 Sales 15,000 100% Benchmark Analysis Materials 3,800 25% Allows Comparison Labor 2,200 15% Plant overhead 1,800 12% - Prior years Depreciation 300 2% Engineering 600 4% - Other firms Other direct costs 600 4% Shipping 1,100 7% - Industry norms & averages Erection 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%

5. Financial Engineering Structure Analysis- Some Key Ratios Balance Sheet $000 Assets Liabilities & Equity Cash 300 Accounts Payable 1,000 Accounts Receivable 2,400 Accrued Liabilities 400 Quick Assets 2,700 Over 90 Receivables 240 Line of Credit 1,300 Retainage 1,050 Inventory 750 Total Current Assets 4,740 Total Current Liabilities 2,700 Quick Ratio 1.0x Plant cost 8,750 Current Ratio 1.8x Depreciation 4,390 Net 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 9,350 Sales turnover of assets 1.6x Return on total assets (ROI) 16.0% Return on Stockholders equity (ROE) 27.4%

6. 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

7. Financial Engineering Structure Analysis- DuPont Formula • 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)]

8. 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

9. Financial EngineeringStructure Analysis- Benchmark Returns Sales Asset Equity Business ROIMarginTurnoverRatioROE • 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% 1.8x2.5x 8% • Excessive Debt 3% 3% 1.0x 5.0x20% • It’s not magic, its mathematics

10. Financial EngineeringStructure 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

11. Financial Engineering Structure Analysis- DuPont Formula

12. Financial Engineering Structure Analysis- DuPont Formula

13. Financial Engineering Structure Analysis- DuPont Formula

14. 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

15. Financial EngineeringStructure 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.

16. Financial Engineering 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 • Annual Survey

17. 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

18. 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 55 Interest 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: • If Losers exceed Stars • If Bleeders exceed Cash Cows • If Cash Cows are less than 50% of all sales

19. Financial EngineeringComponent Analysis - Profit Margin • Comparison to Annual Financial Survey • $000 Survey ProducerLowerImprovement 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

20. Financial EngineeringComponent Analysis - Profit Margin • Comparison to Annual Financial Survey • $000 Survey ProducerLowerImprovement 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%

21. 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

22. Financial EngineeringComponent Analysis - Asset Management • Comparison to Annual Financial Survey • Assets $000 ProducerSurveyImprovement Program Cash 300 Accounts Receivable 2,400 59 days 45 daysReduce to 45 days with new program Quick assets 2,700 Over 90 Receivables 240 6 daysEliminate with new program Retainage 1,050 26 days 10 daysCut 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 8,750 Depreciation 4,390 Net Plant & Equipment 4,360 Land 250 Land appraised at $3.5 million. Total Assets 9,350

23. 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

24. Financial Engineering 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

25. Financial EngineeringConnection Analysis • Results of All Initiatives • The most valuable resource is management time and attention • Base ROI = 16% • Improvement program CarrotProgram 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 %

26. Financial Engineering 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

27. 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

28. Financial Engineering 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 billray@precastconsulting.com web site www.precastconsulting.com 770-979-3711