Tools 2

Helpful Tools

• Limit checks – find out of bounds conditions

• CAAT Tools – see www.kmworld.com

The OCTAVE Methodology: Structured Risk Determination

• Structured process for assessing RISK Environment Threats Vulnerabilities Risks

• Developed by the SEI Institute at Carnegie Mellon University

Impact vs. Probability

Control

Share Mitigate & Control

Accept

High Risk

Medium Risk

Medium Risk

Low Risk

High

High

IMPACT

PROBABILITYLow

Key Risk Control Matrix

Risks Primary

P D C

Secondary

P D C

Secondary

P D C

Secondary

P D C

Tertiary

P D C

1

2

3

4

N

Controls

Primary & Secondary controls are reliable. P = Preventive, D = Detectable, C = Corrective,

TOWS MatrixInternal Factors

External Factors

Strengths(S)

List primary strengths S1 S2 S3 S4 S5

Weaknesses(W)

List primary weaknesses W1 W2 W3 W4 W5

Opportunities (O) List primary external opportunities

O1 O2 O3 O4 O5

SO Strategies Strategies that use strengths to take advantage of opportunities

WO Strategies Strategies that take advantage of opportunities by overcoming or

mitigating weaknesses

Threats (T) List primary external threats here

T1 T2 T3 T4 T5

ST Strategies Strategies that use strengths to

avoid or mitigate threats

WT Strategies Strategies that minimize

weaknesses and avoid or mitigate threats

The TOWS Model requires the identification of all major Strengths, Weaknesses, Opportunities and Threats, and then requires an analysis of how each strength mitigates entity weaknesses, and threats, and enhances opportunities. This analysis continues offsetting one attribute against all others, and then taking the next. There will not be one to one coverage in enhancing the positives or mitigating a negatives. Address uncovered items.

Pareto’s Rule

• 20% of any set will be responsible for 80% of the effect

• Dr. Juran repostulated this as:

“The vital few and the trivial many”– 20% of customer will generate 80% of the

revenues– 20% of the products will generate 80 of

revenues

Benford’s Law: A Health South Fraud Determinant

• The number 1 appears as the first digit 30.1% of the time, 2 - 17.6%, 9 – 4.6%

• Derived formula to determine occurrence – any number “d” in a system of 1 through 9 being first is log to the base 10 of (1+1/d).

• Dr. Mark J. Nigrini, UTD, developed use of Benford’s Law for the IRS.

Powerful Concept

• Inflection Point Analysis

• Inflection points are points in time where a major change occurs

• Personally, this may be a marriage, birth, divorce, graduation, death, etc.

• For a corporation, it might be a change in market share, profitability, cycle times etc.

Life Cycle Analysis - The Gaussian

Curve - Where Are You?

TIME

Main Street

The TornadoThe Bowling AlleyThe Chasm

Early Market

Technology Visionaries Pragmatists Conservatives Enthusiasts Emerging Rising Cash Sunset Hopeful Stars Cows

TeenAge Years

Mid Life

Old Age

InfantMortality

Height and widthof the curve mayvary dependingon the number of entrants and time periodsinvolved. Also, the curve willusually be skewed at one or both ends.

1st Consolidation

2nd Consolidation

Business Life cycles have 3 major contraction/consolidations points: 1st 5 years of life 85+% of new business fail; firstMajor industry consolidation at approximately 50% market satiation, and 2nd consolidation at 90+% market satiation.

Inflection Point Defined

• A point in time when a major and infrequent event occurs that affects one’s emotions or behavior in either a negative or positive fashion.

• Inflection points identify shifts in leverage between stakeholders (entity, suppliers, customers, competitors, etc.)

Inflection Points

• Personal– Marriage– Divorce– Birth– Death– New Job– Loss of a Job– Purchase of a Home

• Business/Industry– Business

Decline/Incline– Loss of Market

Share/Gain of share– Explosion/Fire– Export Law Changes– Homologation Rule

Changes– Decertification

Inflection Point Determinant

• Use Modified Altman’s Bankruptcy Prediction Model to determine Inflection Points.

• Don’t pay attention to absolute scores as in bankruptcy prediction, rather look only for changes in score.

• Significant changes in score may highlight areas that require further examination

Microsoft, Apple & LotusShareholder Value

1989 1998Microsoft $3 billion $220 billionApple $4 billion $4 billionLotus $1 billion $3 billion

One Apparently “Got it,” and two did not.

Market Value

Cisco vs Bay - Shareholder Value

1993

Cisco $4B

Bay Networks $2B

1998

$76B

$6B

Market Value

Nike vs Reebok - Shareholder Value

1990

Nike $4B

Reebok $3B

1998

$10B

$2B

Market Value

Inflection Points

• Conceptually easy to understand

• Hard to Detect – Need a Tool

• Advanced detection can lead to competitive advantage or highlight a problem

Modified Altman

• Use the Modified Altman algorithm to detect changes in corporate health period over period - Inflection point analysis.

• Verify changes with Chanos’ algorithm

Modified Altman’s Discriminant Function Algorithm

• X1 = Working Capital/Total Assets• X2 = Retained Earnings/Total Assets• X3 = EBIT/Total Assets• X4 = Market Value of Equity/Book Value of Total Debt• X5 = Net Sales/Total Assets• Z = Overall Index of Corporate Health

• Z = (1.2*X1) + (1.4*X2) + (3.3*X3) + (0.6*X4) + (1.0*X5)

See Plan to Win: Analytical and Operations Tools – Gaining Competitive Advantage, 2nd ed., 2003 for the use of this tool. ISBN 0-07-293161-2, John H. Nugent author, McGraw-Hill publishers.

Note: For bankruptcy prediction Altman requires the decimal form of weighting; hence 1.2 above would be represented as .012, etc.

Altman’s tool used for bankruptcy prediction requires the use of the decimal function of his weights; i.e. 1.2 *X1 would be .012*X1. For inflection point analysis this latter use is not required.

AT&T: A Case in Point

Category 1999 1998

Current Assets $14B $14B

Current Liabilities 28B 15B

Working Capital (14B) (1B)

Total Assets 131B 60B

Retained Earnings 9B 8B

EBIT 10B 9B

Equity at Market 161B 134B

Total Debt 82B 34B

Sales 62B 53B

Shares outstanding 3,196436,757@$50 2,630,391,784 @$51

Gross Margin 53.2% 51.5%

AT&T Modified Z Score

Factor 1999 Score 1998 Score

X1 ($14B/131B -.107 ($1B)/60B -.017

X2 $9B/131B .069 $8B/60B .133

X3 $10B/131B .076 $9B/60B .150

X4 $161B/82B 1.960 $134B/34B

3.940

X5 $62B/131B .473 $53B/60B .883

Inflection Point Solution1999: (1.2 X -.107) + (1.4 X .069) + (3.3 X .076) + (.6 X 1.96) + (1 X .473) = 1.87Z1998:(1.2 X -.017) + (1.4 X .133) + (3.3 X .150) + (.6 X 3.940) + (1 X .883) = 3.91Z

AT&T’s Modified Z Score.

ZScore

1997 1998 1999 2000 2001

5+

3.91

1.87

1.1

.8

All leading investment firms were recommending this company during this period Despite the company’s precipitous and monumental decline.

Altman’s Modified Z Score Caveats

• Not a “be all, end all” metric.• Just another data point.• Decent leading indicator/predictor.• The degree of entity asset wealth can mitigate

Altman’s time line.• Should only be used in conjunction with other

tools.• May have to tailor for different industries.

Chanos’ Discriminant Model: A Measure of Changing Financial

Health

Chanos’ Discriminant Weighting Model: Chanos uses certain balance sheet and income statement metrics in order to calculate a score of financial health similar to that of Altman. In the Chanos Model, scores are as follows: Chanos Algorithm: Working Capital + Retained Earnings + 12 Month Trailing EBIT + 12 Month Trailing Revenues ______________________________________________________________________ 12 Month Average Total Assets

Chanos should track Altman relative to trending

Comparative Industry Phased Inflection Points

PHASEONE

PHASETWO

COMPANY A

COMPANY B

INFLECTION POINT

MARKETCAP

TIME

COMPANY A AND B ARE RELATIVELY CLOSE IN PHASE ONE, BUT SUDDENLY ONE GETS IT,AND THE OTHER DOESN’T. AT THE INFLECTION POINT, VALUATIONS DIVERGE significantly.

Unit Price Unit Cost Model

Minute/Margin Squeeze – A Unit Price/Unit Cost Model (PPM = retail cents price per minute: blended rate)

Cents

1990 2000 ? Source: Hilliard Consulting Group, Inc., August 2000

Gross revenue Per Minute

Cost per minute

7-10 CPM

25 PPM CPM

The Profit Zone

Time to Exit

Unit Prices in competitive markets always decline significantly faster That Unit Costs due to competitive pressures.

Average Price/Minute for Mobile Telephone Service

$0.53

$0.58 $0.57 $0.56$0.54

$0.43

$0.35

$0.28

$0.21

$0.45

$0.10

$0.20

$0.30

$0.40

$0.50

$0.60

199119921993199419951996199719981999 2000 2005

Ave

rage

Pri

ce P

er M

inut

e

Source: FCC Annual Report on Wireless Industry, June 2001

$0.10

Bottoms Up Analysis

• 3 requirements

– Determine the size of the investment– Determine the required market acceptable

rate of return on the investment– Determine the estimated number of

customers required to ean this required return

Bottoms Up Analysis• AT&T Acquired Cable Properties for

approximately………………………………………... $120B• AT&T had to make this system2 way at an est. cost of…. …………………………………………...… 20B• AT&T wanted to provide phone Service over this cable net – power conundrum……………………..…. 10B• CAPIAL COST OF OPERATING CABLE INVESTMENT……..

………………………………….$150B

• Market acceptable rate of return @10%…………………………$15B/yr.

• How many customers are needed to yield a $15B return?

• Average bundled rev. per customer $100/mo; $1,200 yr.• Net on bundled Revenue @12% (generous); @ $150• $15B/$150 = 100,000,000 customers needed – only 108 million

U.S. Households - TILT

Relative Mix Shift in Total Communications Components

Year

Service

1985 2015

Voice 90% 10%

Data 10% 90%

Relative Mix Shift

Year

Service

2002 2005 20??

Landline 80% 50% 10%

Wireless 20% 50% 90%

Analytical Relationshipsfor Fraud Detection

• Days Sales in Receivables Index

• Days Sales in Inventory

• Gross Margin Index

• Asset Quality Index

• Sales Growth Index

• Total Accruals to Total Assets

• Inflection Point Analysis

• Horizontal and vertical analysis

7-3

Use in yourFinancialStatementaudits

Fraud Statement Indices

Measure Manipulation Mean

Non Manipulation Mean

Difference % Difference

Days sales in receivables Index

1.460 1.030 .430 42

Gross margin Index

1.190 1.010 .180 16

Asset Quality Index

1.250 1.040 .210 21

Sales Growth Index

1.610 1.130 .480 42

Total Accruals to Total Assets

.031 .018 .013 72

Asset Quality Index = Total Assets – PP&E/Total AssetsSee Messod Beneish at Indiana University

Enron: in Billions $sCategory 2000 1999 1998 1997

Current Assets

30.4 7.3 5.9 4.1

Current Liabilities

28.4 8.8 6.1 3.9

Working Capital

2.0 <1.5> <.2> .2

Total Assets 65.5 33.4 29.4 22.6

Retained Earnings

3.2 2.7 2.2 1.9

EBIT 2.5 2.0 1.6 .6

Equity at Market

62.5 32.1 9.5 6.6

Total Debt[1] 50.7 20.4 19.2 14.8

Sales 100.8 40.1 31.3 20.3

Shares outstanding

752,205,[email protected]

716,865,[email protected]

335,547,276 @28.34

318,297,276 @20.78

Gross Margin in $

2 .8 1.4 0

Beneish’s Fraud Identifiers highlighted Enron as a Likely fraud Long before Others saw this calamity in the making

Porpoising Gross Margin: A la Enron

.

TIME

Porpoising Gross Margins are almost indicative of financial manipulation

Often, when we see a porpoising gross margin – up/down patternperiod over period – this is indicative of fraud.