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
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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, % Benchmark Analysis
Materials 3,800 25% Allows Comparison
Labor 2,200 15%
Plant overhead 1,800 12% - Prior years
Depreciation %
Engineering % - Other firms
Other direct costs %
Shipping 1, % - 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, %
Earnings on Total Assets ,500 10% Pretax Profit Margin
Interest costs Interest coverage ratio
Profit before Tax $ 1, %

5. Financial Engineering Structure Analysis - Some Key Ratios
Balance Sheet $000
Assets Liabilities & Equity
Cash Accounts Payable 1,000
Accounts Receivable 2,400 Accrued Liabilities
Quick Assets 2,700
Over 90 Receivables Line of Credit 1,300
Retainage 1,050
Inventory
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 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% = % 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% = % x 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 (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 Engineering Structure Analysis - Benchmark Returns
Sales Asset Equity
Business ROI Margin Turnover Ratio ROE
Example producer 16.0% 10.0% x 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

10. 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
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 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.

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 $ Losers Bleeders Cash Cows Stars
Sales 15, ,300 10,
100% 2% 28% % 3%
Total Cost of Goods Sold 12, , ,
Gross Margin 2, ,
% % 5% 15% % 25%
Sales, General & Admin 1,
Interest costs
Profit before Tax $ 1,000 (20)
% % -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 Engineering Component Analysis - Profit Margin
Comparison to Annual Financial Survey
$ Survey Producer Lower Improvement Program
Materials , % % Reduce mix cost by $5/yard by controls
Labor 2, % % Reduce labor 10% with training program
Plant overhead 1, % %
Depreciation % %
Engineering % % Reduce drafting 25% w computer program
Other direct costs % %
Shipping 1, % %
Erection field ops 2, % % Reduce erection 10% by reduced rework
Gross Margin 2, % % Improve margin 1% with new product line

20. Financial Engineering Component Analysis - Profit Margin
Comparison to Annual Financial Survey
$ Survey Producer Lower Improvement Program
Materials , % % Reduce mix cost by $5/yard by controls
Labor 2, % % Reduce labor 10% with training program
Plant overhead 1, % %
Depreciation % %
Engineering % % Reduce drafting 25% w computer program
Other direct costs % %
Shipping 1, % %
Erection field ops 2, % % Reduce erection 10% by reduced rework
Gross Margin 2, % % Improve margin 1% with new product line
Take action benchmarks guidelines
Margin differences of >2%
Cost differences of >3%

21. Financial Engineering Component 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 Engineering Component Analysis - Asset Management
Comparison to Annual Financial Survey
Assets $000 Producer Survey Improvement Program
Cash
Accounts Receivable 2, days days Reduce to 45 days with new program
Quick assets 2,700
Over 90 Receivables days Eliminate with new program
Retainage 1, days days Cut in half with new contract negotiations
Inventory days 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 Land appraised at $3.5 million.
Total Assets 9,350

23. Financial Engineering Component 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 Engineering Connection 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 %
Reduce labor 10% with training program %
Reduce drafting 25% computer program %
Reduce erection 10% by reduced rework %
Improve margin 1% with new product line %
Total Margin Improvement %
Reduce A/R to 45 days with new program %
Retainage in half contract negotiations %
Inventory in half contract negotiations %
Total Asset Management 1, %
Combined Results 29%
Profit and ROI nearly double
Land appraised at $3.5 million. 3, %

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 Engineering Summary 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
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 web site