Industry Risk Analysis

Commercial Lending Industry Risk Analysis

Omega Performance Corporation is a global consulting and training firm that increases the profitability of financial services institutions by improving the performance of their people. Omega Performance helps financial institutions reach new levels of performance by integrating intensive skill development, comprehensive learning systems, and a motivational learning environment to create a positive, lasting behavioural change. Since 1976, more than two million financial service professionals from over 2,500 global financial institutions have completed Omega Performance programmes in credit and risk management, and service, sales and sales management. Omega Performance’s clients include financial service organisations of all sizes in North America, Europe, and the Asia/Pacific region.

N

O

T

I

C

E

This publication is protected by copyright and is licensed to be used by a single individual only. It is illegal to reproduce this training system or any part of it in any way, to share these materials, or to lend or rent them to anyone else.

Copyright © 1989–2013 by Omega Performance Corporation. All rights reserved.

Omega Performance 2nd Floor 30-32 Mortimer Street London W1W 7RE United Kingdom

Credit Skills Development Helpdesk

+44 (0)20 7017 7069

+44 (0)20 7017 7065

www.omega-performance.com [email protected]

[email protected]

Available 24 hours a day, 7 days a week

0113 UK-En

Table of Contents Start -------------------------------------------------------- 1 Unit 1: Industries ---------------------------------------- 9 Unit 2: Industry Risk Characteristics-----------------21 Section 1: Cost Structure and Profitability --------- 23 Section 2: Maturity and Technology ----------------- 37 Section 3: Cyclicality and Dependence ------------- 59 Section 4: Globalisation and Vulnerability to Substitutes -------------------------------------------- 71 Section 5: Regulatory Environment and Operations --------------------------------------------- 81 Appendix --------------------------------------------------99 Industry Information: The UK Bicycle Manufacturing Industry ---------------------------- 100 Job Aids ------------------------------------------------- 103 The Decision Strategy -------------------------------- 104 Job Aid: Industry Risk Assessment ----------------- 105 Job Aid: Managing Industry Risks ------------------ 107 Risk Assessment Worksheet ------------------------ 109 Glossary ------------------------------------------------- 111

© Omega Performance Corporation. All rights reserved.

Table of Contents iii

iv Industry Risk Analysis

IRA.0.0113.CSD.IFRS.UK

© Omega Performance Corporation. All rights reserved.

Start Cardboard boxes are ubiquitous. Manufacturers of corrugated and solid fibre boxes operate in a mature industry that has had a traditional dependence on forest products for its supply of material. It is also somewhat subject to economic cycles. The most significant recent trend is the increased use of synthetic-blend and recycled materials. Cody Containers produces a line of standard-size, uncoated boxes at low cost and also offers a line of packing materials. On the opposite side of the city, Cubit Ltd produces boxes that are custom made to client specifications, which include lamination, coating, and printing. Now managers of both businesses are contemplating the opportunity and risks of using new materials in their boxes.

Industry Risk Analysis Industry risks are those that are faced by all businesses operating in an industry. In addition to sharing the same risks, all businesses in a particular industry may also enjoy, or have the potential to take advantage of, certain strengths. Understanding these risks and strengths will help you do several things that are important to making a reliable credit decision about a particular borrower: 

Assess how difficult it is to succeed in this industry, and therefore the management experience and skills and business strategies that are important for success.



Develop expectations about the financial condition and performance of businesses in the industry, especially operating and capital investment cycles, liquidity, gearing, and profitability.



Make an educated guess about the future of the industry and its effects on your customers.

© Omega Performance Corporation. All rights reserved.

Start 1

Industry Risk Analysis and the Decision Strategy Industry risk analysis is the first step in assessing repayment ability. An understanding of the industry is necessary before you can draw conclusions about: 

The appropriateness of a borrower’s business strategy



The quality of its financial performance and cash flow



The outlook for its future performance

Understanding industry risks and strengths also helps lenders early in the opportunity assessment stage, since some lenders by policy or practise minimise their exposure to certain industries or require specialised expertise for lending to some industries. Also, you will still be relying on your industry analysis when you consider how best to structure and manage loans to preserve strengths and guard against risks that could develop in the future. Think of your repayment analysis like this: your borrower is trying to win a game of cards and, if it wins, it will be able to repay your lending facilities. Now imagine that you walk up to the table where the borrower is playing, anxious to decide if it will win or not and if you will be repaid. The first thing you need to know is ‘What game is being played?’ That is the question you answer when you understand the borrower’s industry and its risks – the game and the rules by which that game is played. Only after you understand the game will you be able to evaluate how strong the borrower’s hand is, how well it is playing the game, and whether it is likely to win or lose. Before continuing, review the Decision Strategy job aid on the following page to see where industry risk analysis fits into the lending process. The job aid also appears in the Job Aids section of this module.

2 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

The Decision Strategy Opportunity assessment Prospecting Does the prospect match the institution’s profiles? If the prospect is a current customer, can the relationship be expanded?

Identify opportunities Review the prospect’s strategic objectives and financial structure. What immediate and long-term needs exist for lending or non-lending services?

Preliminary analysis Preliminary assessment What is the specific opportunity? Is the opportunity legal and within your institution’s policy? Are the terms logically related? Do the risks appear to be acceptable?

Identify borrowing cause What caused the need to borrow? How long will the borrowed funds be needed?

Repayment source analysis

Industry and business risk analysis What trends and risks affect all businesses in the borrower’s industry? What risks must the borrower manage successfully in order to repay the lending facility?

Financial statement analysis What do the financial statement trends show about the borrower’s management of the business? What trends will influence the ability to repay?

Cash flow analysis and projections Will the business have sufficient cash to repay the lending facility in the proposed manner? Which risks will have the greatest impact on its ability to repay?

Facility packaging Summary and recommendation What are the major strengths and weaknesses of the lending situation? Should a lending facility be granted?

Loan structuring and negotiation What are the appropriate facility, security, pricing, advance method, documentation, and covenants?

Facility management Facility monitoring Is the borrower performing as expected? What caused variations? What are the risks to repayment? How can you protect the institution’s position?

© Omega Performance Corporation. All rights reserved.

Start 3

You Will Be Able to . . . When you have completed this module, you will be able to: 

Identify basic industry type, market segments within the industry, and affiliated industries.



Identify how each of ten industry characteristics affects your risks in lending to a borrower:          



Cost structure Profitability Maturity Technology Cyclicality Dependence Globalisation Vulnerability to substitutes Regulatory environment Operations

Prioritise the most important industry characteristics for your borrower.

Unit 1, Industries, describes basic types of industries, the significance of market segments within industries, and the concept of affiliated industries. It also introduces industry classifications that help you identify relevant background information and composite financial information. Unit 2, Industry Risk Characteristics, describes the ten industry characteristics and guides you in assessing the importance of each one to your borrower. It summarises the ten characteristics in the Industry Risk Assessment job aid and introduces the Risk Assessment Worksheet for describing and prioritising the characteristics most important to a borrower.

4 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Job Aid: Managing Industry Risks Risk

Page 1 Possible Mitigation Strategies

Cost structure 

High operating leverage

 Lock in volume through long-term contracts  Focus on marketing and selling to keep volume up  Attempt to increase flexibility of costs



Low operating leverage

Profitability

 Implement tight cost control  Identify and meet needs of most profitable groups of customers through

better products and better service  Maximise bargaining power over customers  Pay consistent attention to cost control and revenue expansion

Maturity 

Emerging industries

 Educate and support customers as needed  Finance rapid sales growth  Have flexible production strategies and be able to increase capacity quickly  Be able to obtain sufficient raw materials or components to produce quantity



Mature industries



Declining industries:

Technology

and quality needed  Establish distribution channels and distribute quickly and effectively  Control costs  Focus on product improvements to increase market share  Increase sales to existing customers  Focus on market segments with above-average profitability  Control costs, diversify, and focus on market segments that still provide opportunities  Likely to have some competitive advantages: brand recognition, high cost of switching for customers, strong statement of financial position (high liquidity, low gearing, and high-quality assets)  Budget adequately for important capital expenditures  Invest in new product research and development  Lease computer and telecommunications equipment to manage

obsolescence  Outsource specialised needs such as web site development and hosting

Cyclicality

 Diversify product mix to include more staple items that are sold all year,

through expansions and recessions  Increase flexibility of cost structure to ensure business does not lose money

during recessions when volume declines

Dependence

 Develop additional sources of supply or production  Diversify product mix; develop products or services for other industries  Find additional uses for products outside industries on which there is

dependence

Globalisation

 Develop suppliers who offer suitable combinations of price, quality, and

delivery time  Outsource aspects of the business to benefit from lower costs of production

or shipping  Develop market research and customer preference information to support export sales  Select financial services that minimise exchange and payment risk with global trading partners

© Omega Performance Corporation. All rights reserved.

Start 5

Job Aid: Managing Industry Risks Risk

Page 2 Possible Mitigation Strategies

Vulnerability to substitutes

 Increase switching costs to prevent customers from switching to substitutes  Cut costs to reduce prices; reduce attractiveness of substitutes  Change prices to compete more effectively

Regulatory environment

 Support lobbying efforts to reduce regulatory restrictions or promote

advantageous legislation  Allocate resources to identify the most profitable ways of dealing with the

regulatory requirements, to reduce their impact on profits

Operations

 Conduct stringent employee training and safety programmes  Purchase liability insurance for products  Avoid fixed cost contracts  Monitor estimating and project management to avoid cost overruns

Useful Prior Learning Each module has been designed so that it can be undertaken on a standalone basis. Nevertheless it is recognised that for anyone new to a lending role there is a preferred order of study. In this respect you may find it useful, before beginning this module, to have covered the following skills or knowledge: 

An understanding of basic financial accounting.

Be Aware That . . . The following conventions are used in this module: 

Practise opportunities: Some paragraphs are marked with a question icon (Q) and followed by questions and blank spaces. These are learning and practise opportunities to help you understand and apply the material in this module. Please write your answers in the spaces below the questions, and then compare your responses to the answers that follow the spaces, which are marked with an answer icon (A).



Sidebars: Special boxes offer additional details, background information, and focused examples for those who want more detail than is available in the mainstream content.



Points of emphasis: Essential information is emphasised with the arrow icon.

6 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



Accounting Standards: Reference in these materials to any accounting standard is to International Financial Reporting Standards (IFRS) as implemented in an International Accounting Standard (IAS) as of December 2010, unless the materials, either directly or implied, indicate otherwise. Accounting standards are studied in order to introduce you to the foundations upon which accounting practises and procedures are built. Standards are not studied in detail but rather at a level that allows you to see, in reasonably simple terms, why and how accountants treat various accounting matters as they do. Since any reference in these materials to an accounting standard is to an international standard, the materials can be used in any jurisdiction that has harmonised its accounting standards with international standards.



Financial terminology: As new terms are introduced and defined, the term used in IFRS appears first, in boldface, and other terms commonly used to mean the same thing are also presented. From that point forward in the module, only the preferred IFRS term is used.. The table that follows shows some of the differences in terminology you may encounter. Previous terminology

IFRS terminology used here

Balance sheet

Statement of financial position

Profit and loss accounts

Income statement, or statement of comprehensive income

Cash flow statement

Statement of cash flows

Debtors

Trade debtors or trade accounts receivable

Creditors

Trade creditors or trade accounts payable

Turnover

Sales, revenue, or sales revenue

Glossary A glossary of terms is provided at the end of this module explaining terminology used in this programme that may be unfamiliar to you. Refer to this glossary as needed during your study.

Be Sure to Have . . . Before you begin this module, be sure to have the following items on hand: 

Pencil



Calculator

© Omega Performance Corporation. All rights reserved.

Start 7

8 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

1 U

N I

Industries

T

When you have completed this unit, you will be able to: 

Classify a borrower’s industry according to:   

The customer needs it satisfies Whether it sells a product or a service or some combination Whether it makes the product or service, distributes it to a ‘middleman’, or sells it to a consumer who is the end user

What Is an Industry? An industry is a group of companies supplying products or services that are close substitutes for one another in the eyes of the consumer or purchaser. The products and services supplied by an industry meet a set of customer needs. For example, the automotive industry supplies cars that meet customers’ personal ground transportation needs. The airline industry provides a service that also meets customer needs for transportation, and may sometimes substitute for ground transportation, but airline travel is not a close substitute for personal ground travel, so the airline industry is a separate industry.

Market segments and close substitutes Within an industry, some groups of products or services are closer substitutes for each other than other groups of products or services. For example, cars, HGVs, vans, and 4X4 vehicles are special segments of the automotive industry. They are sometimes close substitutes for one another in meeting customer needs, but they do meet somewhat different customer needs and preferences. Within a market segment such as 4X4 vehicles, competition is among branded products rather than widely different products. Understanding your borrower’s market segment or segments within its industry will help you: 

Identify who the borrower’s competitors are.



Focus on trends in that segment that may help or hurt your borrower’s business.

© Omega Performance Corporation. All rights reserved.

Industries 9

For example, if your borrower processes and packs vegetables for sale in supermarkets: 

You would classify the borrower’s industry as ‘food processing’ with the market segment ‘vegetables’.



You would want to compare your borrower’s strategy and financial performance with other companies in the same market segment. Are competitors larger and perhaps able to spend more for advertising? Do they have lower costs? Are they further away from desirable markets and, therefore, have higher shipping costs?



You would also want to keep an eye on (and expect that your borrower will be keeping an eye on) trends in other foods and the companies that process and package them.

Affiliated industries We refer to separate groupings within a broad industry as affiliated industries. These groupings may be based on product characteristics, called horizontal groups, such as the difference between passenger cars and trucks, or the differences between children’s clothing and men’s and women’s clothing. Or the groupings may be based on whether the businesses in that grouping make the product, distribute the product to others who resell it, or sell it directly to the end user. These groupings are called vertical groups. The automotive industry comprises horizontal affiliated industries along product lines: the passenger car industry, the light goods vehicles industry, the heavy goods vehicles industry, and so forth. It also includes the vertical affiliated industries that make the components of cars, assemble the cars, and sell and service the cars for the ultimate consumer. When a business participates in more than one affiliated industry, we say the business is either horizontally integrated or vertically integrated, or both. Understanding how each kind of affiliated industry performs will help you evaluate the profit potential and risk of your borrower.

Industry Types Globally there are hundreds or thousands of industries. To understand an industry and to evaluate your borrower against its industry, it helps to classify and categorise industries. One way to distinguish between industries is to determine whether the industry sells a product or a service. This distinction is useful because it offers clues as to the nature of the operating and capital investment cycles you should expect, which in turn tells you a great deal about borrowing causes and other financial service opportunities.

10 Industry Risk Analysis

IRA.1.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

Some borrowers have multiple divisions and provide both products and services. You should try to understand the risk characteristics of any division that is material, usually if it comprises 10% or more of the total business revenues, assets, or operating profits.

Product industries Product industries make, distribute, and sell tangible goods such as electronics, cars, clothing, or medical supplies. Some of the products are sold to and used directly by consumers, such as laptop computers. Other products are raw materials or components that are sold to the makers of the laptop computer. Product industries include manufacturers, wholesalers, and retailers; they form the product chain running from purchase of raw materials such as iron ore or timber, to the sale of final products such as steel girders and roof trusses or cars and dining tables.

Service industries Service industries make and deliver activities rather than products, such as medical care, consulting, transportation, or equipment repair. Some service businesses use a high level of land or equipment in their service, such as a bus business or a printing business. Other service businesses use less equipment and more labour, such as an accounting firm. The distinction between service and product industries can sometimes be unclear. Whether they sell to other businesses or to consumers, service industries share some characteristics with manufacturing, wholesaling, and retailing product industries.

Manufacturers Manufacturers are one of the three types of product industries. The economic function of the manufacturer is to add value to raw materials, which it does by applying the services of machines and people to change the raw material into something for which customers will pay considerably more than the cost of the raw materials. The cost of the product is the sum of the costs of the raw materials, machines, and labour. Successful manufacturers get paid a profit for creating the value, managing the complex process, and taking the quality risk.

© Omega Performance Corporation. All rights reserved.

Industries 11

Here are the major characteristics of manufacturers: Manufacturers must manage a relatively complex series of activities including purchasing raw materials, production and quality control of the product, and distribution or sale of the article. Operating cycles for manufacturers are typically longer than for wholesalers or retailers, which places added pressure on expense control for manufacturers. The supporting capital investment cycle is also very important in manufacturing companies, with the consequence that manufacturing management often needs to be sophisticated in financing and planning for the effects of economic cycles. To drill deeper into the complexities that any particular manufacturer must manage, it helps to classify manufacturers into three groups: fabricators, processors, and assemblers. Some borrowers perform all three activities and some provide only one. Understanding which pattern or patterns your manufacturing borrower fits will sharpen your insight about the key success factors for the business, what management must be good at, and the risks the business will face. 

Processors either produce raw materials, such as agricultural crops, timber, and livestock, or take raw materials and refine or modify them, such as refining oil, crushing oranges into juice, and converting timber into planed and shaped wood products. 



These activities tend to require either a relatively long period of time or a high investment in the manufacturing and processing equipment, or both. Typically, processors require the highest investment in long-term assets to generate each £ of revenue. Therefore, one key to success is the ability to generate a high volume to justify the time and investment required.



Fabricators take the processors’ output and convert it or fashion it into usable pieces. For example, a metal fabricating shop might take rolled steel from a steel mill and shape it into sheet steel or wire, which can be used to build something for use by consumers. Other fabricators are makers of hardwood components that are ultimately used in cabinet and furniture assembly, and builders of engines that become part of jet aircraft.



Assemblers usually represent the last stage of a complete manufacturing cycle, in which a final product is put together. A construction business takes fabricated parts such as bricks, cement, pipes, gaskets, boards, screws, nails, and assembles them into a finished product, a house. A computer maker takes circuits, mother boards, switches, and casings and assembles your laptop computer.

12 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.





Assemblers often require the least investment in long-term assets and instead rely on skilled or unskilled labour for the assembly process. The extent to which assemblers can manage labour costs or gain productivity through automation is one key to their success.

Wholesalers Wholesalers are the second type of product industry. Wholesalers buy from manufacturers and sell to retailers. Here are some of the key characteristics of wholesalers: Typically, a wholesaler completes its operating cycle – cash, to goods purchased from manufacturers, to accounts due from retailers, and back to cash – in less time than a manufacturer, sometimes in only a few days or weeks. The wholesaler adds little value to the product, performing only a brokerage or distribution role. Therefore, the operating cycle is more significant to wholesalers than is the capital investment cycle. The profit margin of wholesalers ought, for the above reasons, to be the lowest among the three product industries. However, they are often successful in ‘adding’ value through control of the market and distribution channels and so are often able to achieve returns as high as, or higher than, either retailers or manufacturers. Wholesalers are sometimes described as ‘middlemen’ who are vulnerable not only to competition from other middlemen dealing in the same or similar products, but also to being eliminated altogether by their suppliers or their customers. Suppliers or customers may choose to do business directly with one another rather than pay even a small amount for the services of the middleman. Technology advances such as electronic data interchange (EDI) and the Internet have aggravated this risk for wholesalers because they make it easier for remote parties to do business directly with one another. To avoid being eliminated by customers or suppliers, to gain competitive advantage over other middlemen, and perhaps to improve their own profit margins, many wholesalers seek to become more valuable either to their customers, their suppliers, or both. They do this by: 

Carrying a wider range of products



Adding various services that save time or money for customers



Adding services that increase sales and profits for suppliers

© Omega Performance Corporation. All rights reserved.

Industries 13

Some wholesalers seek to become almost like a purchasing department for their customers or almost like the marketing or sales arm of their suppliers.

Services to customers To increase their value to customers, wholesalers may: 

Receive specifications from the customer and locate and procure for the customer the products that meet the specifications. In this process, the wholesaler may deal with multiple suppliers and serve as a consolidator, saving the customer the time of searching out and dealing with many different suppliers.



Educate the customer on the appropriate use of products that will save the customer money by reducing waste or downtime.



Facilitate communication and purchasing with computerised or online data, so that the customer’s sales and stock levels flow directly to its purchasing department and then to the wholesaler, or directly to the wholesaler.



Provide ‘just-in-time’ deliveries to the customer, thereby removing from the customer some of the risk of the stock holding period and taking that risk upon itself.

Services to suppliers To increase their value to suppliers, wholesalers may: 

Certify or attest to the quality of supplies so that they become more saleable to a wider range of customers or customers with stringent quality standards. Suppliers then seek to become qualified or preferred providers to ultimate customers with whom they would otherwise not be able to do business. This is especially valuable to small businesses that supply large businesses or rapidly growing industries.



Market the products using educational conferences, Web sites, and trade shows, so that the products become better known and better understood by potential customers.



Facilitate packaging, shipping, cross-border issues, currency exchange, and even financing.

True to the fundamental relationship of risk and reward, these added services that have the potential to increase the wholesaler’s value added and therefore its profitability, also have the potential to increase the risks. If you understand how these changes are affecting whole industries and industry segments, as well as how they are affecting individual companies within an industry, you will have taken the first step toward deciding a wholesaler’s ability to repay a loan.

14 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Retailers Retailers are the third and generally least complicated type of product industry. Retailers sell products directly to the public. They compete with one another in the prices they charge, the credit they offer, the convenience of the purchase including location, and the services they may provide during and after the sale. Historically, two keys to success for retailers have been: 

Location, which has affected the volume of potential buyers



Product mix, stocking the products that customers want to buy

Changes in retailing and in consumer preferences have modified the key success factors. With the rise of direct mail catalogues, e-tailing on the Internet, and the network of fast delivery shippers, physical location is less important to retail success. Location is redefined as ‘exposure to potential, qualified customers’, and as such, it is still vital to retail success. Other factors such as price, credit, and the customer experience are important in varying degrees according to the nature of the products sold and the segment of the consuming public that the industry is targeting. To understand the risk faced by a particular business, it is important to find out what is typical for its industry and then to determine how the business is dealing with those industry characteristics. For most retailers: The operating cycle is more important than the capital investment cycle. Within the operating cycle, the dominant asset is stock for most retailers. The holding period can be just a few days for a food supermarket or as long as a year for a retailer of heavy equipment. Most sales are cash or credit card, and many retailers lease their store locations. However, some retailers do offer and finance their own credit terms, and some invest in lavish locations or fixtures that contribute to convenience and the customer experience.

More About the Nature of Products To understand the risks and strengths of product industries, it helps to focus on the nature of the products it sells. The nature of the product, such as microchips, cars, or ice cream, reveals much about how the industry is likely to be affected by the industry characteristics you will study in Unit 2 of this module. For example: 

Original equipment manufacturers (OEMs): Microchips are an example of a product that is sold as a component to other businesses that in turn make the final product. The microchip industry is heavily influenced by the various other industries that use microchips.

© Omega Performance Corporation. All rights reserved.

Industries 15



Consumer durables: Cars are an example of a consumer durable, a relatively high-priced item that consumers purchase only periodically instead of continuously. Purchases of consumer durables can be delayed when consumers are not prosperous, or are not feeling prosperous. Consumer durable sales are also affected by interest rates, since consumers often obtain financing for, or use a large part of their savings to fund, these large purchases. Therefore, industries whose products are consumer durables are more cyclical; they are more sharply and immediately affected by economic cycles and interest rates.



Consumer non-durables: Ice cream is a consumer non-durable, as are clothes, books, and other relatively low-cost items. Consumers do not specifically finance these purchases (although they may use credit cards to finance general spending levels), and they tend to consume about the same amount each year. These products are more subject to changes in consumer tastes and fashion preferences than to economic cycles. If they react to economic cycles, they do so less dramatically than durables.

Service Industries The number and scope of service industries have increased dramatically and now form a substantial market for lenders. Also, many product industries, especially wholesalers and retailers, have expanded their offerings to include services to their customers and suppliers. Therefore, lenders need to understand service industries more than ever before. Service industries include cinemas, consulting firms, restaurants, airlines, schools, hospitals, hotels, package-tour operators, accounting firms, medical service providers, graphic designers, advertising agencies, insurance agencies, entertainers, engineering firms, printers and copy shops, shippers and delivery services, and many more. Service industries can be distinguished according to the cost of the services they provide, whether the services are a necessity or a discretionary purchase, and whether they are purchased by consumers or by other businesses. Those factors affect how the industry performs during various economic cycles, in various regulatory climates, and as consumer demographics and tastes change. When a service industry sells to other businesses, some risks will be similar to risks faced by manufacturers and wholesalers. When service industries sell to consumers, some risks will be similar to risks faced by retailers. Service industries also differ according to the ease or difficulty of getting into the business and performing the activity. Those factors affect how profitable the industry is and how much turnover there is among companies in the industry.

16 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Two ways to classify and understand service industries are particularly helpful in understanding their credit needs, key factors for success, and therefore key risks for the lender: 

Some service industries are capital-intensive and some are labourintensive.



Some rely on highly skilled, knowledgeable labour and some rely on unskilled, relatively low-wage labour.

Capital-intensive service industries Airlines, hotels, and nursing homes are good examples of service industries that require a high investment in long-term assets in order to generate revenue. These industries resemble manufacturers, especially processors, in their large investment in special buildings or equipment. However, their operating cycle is unlike manufacturers because they do not have a substantial investment in stock or debtors. Their ‘holding period’ is the time it takes to perform the service or activity for an average customer – usually very short. Their collection period is very short either because they sell for cash or credit card settlement or because they bill and collect periodically (usually monthly) from long-term or repeat customers, such as the occupants of a nursing home or apartment building. Keys to success for capital-intensive service industries: Efficient use of non-current assets is key. Excess capacity is a serious problem; it cannot be offset by idling a portion of assets and turning over stock more quickly. These service industries generate revenue directly from the use of their non-current assets. Therefore, volume forecasting and managing capacity are essential management skills in these industries.

Labour-intensive service industries Some examples of labour-intensive service industries are consultants, recruitment agencies, accountants, lawyers, stockbrokers, and other professional advisors, and entertainers. The operating cycle is dominant, as large investment in buildings or equipment is usually not required. However, for these service industries, the holding period can be quite long because it takes longer to perform the activity or provide the service. These industries also often sell to other businesses rather than to consumers, and offer credit terms rather than selling for cash or credit card. As a result, the operating cycles can be quite long and require a substantial amount of cash to keep the business operating.

© Omega Performance Corporation. All rights reserved.

Industries 17

Key success factors for labour-intensive service industries: The productivity of employees is one key; recruiting, training, and retaining employees is a crucial management skill. The control of operating expenses is another key; the ability to control staff expenses and expenses for travel, communication, and marketing is a crucial management skill. When the key success factor for a business is the knowledge of its employees, we call that a knowledge-based industry. Increasingly, labourintensive service industries flourish because of the expertise and knowledge of their staff. Consider the success of management consultants, software designers, travel consultants, financial advisors, space planners, and property consultants. Knowledge-based industries present special challenges to lenders. The chief value of companies in such industries is in the heads of their people, not in buildings, equipment, or stock that lenders can physically inspect and perhaps take as security. This removes what lenders often rely on as a strong secondary source of repayment, and makes it very important to assess the ability of the business to prosper and generate strong primary sources of repayment from profitable operations. Consider these things when analysing borrowers in a knowledge-based industry: 

How does it recruit, develop, and retain key staff?



How does it document important experience and processes, in order to improve efficiencies and reduce the dependence on the personal expertise and experience of individuals?



How does it protect its ‘intellectual property’ from appropriation by competitors, customers, or suppliers?



How does its sales volume and profitability, and therefore its cash flow and repayment ability, react to changes in the economy or changes in other industries?



What advantages or weaknesses does this particular business have within its industry?

Sources of Industry Data Sources of industry information (historical statistics of performance, outlook and issues, and composite financial statements) include the following: 

Government statistics and research publications



Private research publications

18 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



Investment analysts’ reports of an industry or major business in an industry



Industry-specific trade associations’ research and compilations



Industry-specific trade journals



Your own employer’s industry files or designated industry specialists



Management of your customers and prospects who are active in an industry

Substantial information is available through the Internet, either free to be viewed online or downloaded, or to be downloaded or shipped to you for a fee. Information is also available in public libraries. Industry managers who may be your customers or prospects are also good resources, either for direct discussion of issues or to suggest trade journals and other sources for you to review.

Summary An industry is a group of companies supplying products or services that are close substitutes for one another in the eyes of the consumer or purchaser. Understanding the industry in which your borrower operates will help you to recognise the economic and competitive pressures it may face, and to find out about its asset conversion cycle and financial service needs. To streamline your understanding of industries, consider two broad types of industries: those that deal in tangible products and those that provide services or activities. Product industries can be further classified as manufacturers, wholesalers, and retailers. Manufacturers are processors, fabricators, or assemblers. Product industry characteristics also vary according to whether the industry deals in a product that is sold directly to consumers or one that is sold to another business as the end user or as a component of that business’s product. Service industries are either capital-intensive, relying on substantial investment in long-term assets for revenue generation, or labourintensive, relying on a mix of skilled and unskilled labour to deliver services to customers.

© Omega Performance Corporation. All rights reserved.

Industries 19

20 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

2 U

N I

T

Industry Risk Characteristics After you identify your borrower’s industry, you are ready to evaluate how each of the ten significant industry characteristics affects your borrower’s industry. Then you can prioritise which characteristics are most important for this industry. You will carry those insights forward as you assess your borrower’s business strategies and financial results and as you develop projections to test future repayment ability. When you have completed this unit, you will be able to: 

Describe how each of the ten industry risk characteristics applies to an industry.



Identify and prioritise the industry risk characteristics most important to an industry.



Complete the industry characteristics portion of the Risk Assessment worksheet for a variety of industries.

In this unit, we will discuss each of the ten industry characteristics. These characteristics are also summarised in the Job Aid: Industry Risk Assessment, portions of which appear in each section. As you read each section, refer to the job aid summary. The entire job aid is in the Job Aids section of this module. Also in the Job Aids section is a blank Risk Assessment worksheet. It provides a format for describing the industry risk characteristics that are most important to a particular borrower’s industry. Throughout the unit, you will use the first column of the Risk Assessment worksheet to identify and describe a particular borrower’s industry risks and then to select the industry risks that are the most important for that borrower. On the job, you can continue your analysis by using the second column of the worksheet to identify the business strategies your borrower is using to mitigate each important industry risk you have identified. Finally, you can use the third column of the worksheet to make notes about the financial impact those industry risks and business strategies are likely to have on your borrower’s future performance. This process of moving from industry risk to business strategy to financial implication will help you in analysing the borrower’s historical financial performance and in forecasting future performance under various conditions.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 21

This unit contains five sections that will help you understand the importance of industry risk analysis: 

In Section 1, we will discuss cost structure and profitability.



In Section 2, we will discuss the risks of maturity and technology.



In Section 3, we will discuss the risks of cyclicality and dependence.



In Section 4, we will discuss the risks of globalisation and vulnerability to substitutes.



In Section 5, we will discuss the risks of regulations and operations.

22 Industry Risk Analysis

IRA.2.0.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

Section 1 Cost Structure and Profitability What Is Cost Structure? Cost structure refers to a business’s mix of fixed expenses and variable expenses. Variable costs are those that vary with sales and production levels. Examples are costs of hourly labour, raw materials, and sales commissions. Fixed costs are those that, in theory, do not vary significantly with the level of sales or production, but vary only when management takes action to increase them or cut them back. Examples include salaries for executive employees, insurance, rent, interest expense on outstanding debt, and depreciation expense.

Operating leverage (also known as operating gearing) An industry that has a high proportion of fixed expenses is said to have high operating leverage. (Leverage is a U.S. term that is now widely used within banking in the UK, but historically this was also known as gearing. Operating leverage is still referred to as operating gearing within certain UK textbooks.) Such an industry can be significantly more profitable when volume of production and sales is high (relative to total industry capacity) than when volume is low. Manufacturing industries that require a high level of investment in property, plant, or equipment in order to generate sales and capital-intensive service industries typically have high operating leverage. This is because cutting back on the expenses associated with fixed assets is difficult – like the assets they are tied to, these expenses tend to be fixed. An industry that has a low proportion of fixed expenses, and a high proportion of variable expenses, is said to have low operating leverage. Such an industry can more easily trim its expenses and maintain profit margins if volume falls, but it does not experience the steep increase in profitability when volume rises. Manufacturing industries that are not highly automated and are, therefore, very labour-intensive and labourintensive service industries tend to have lower fixed costs and higher variable costs. However, even industries with theoretically high variable costs (or low operating leverage) may be slow to cut expenses by laying off staff who may be hard to replace if volume picks up again.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 23

Economies of scale Scale refers to the volume of production or sales activity. If a business increases the scale of its operations, it increases its production or selling capacity. An industry or a single business achieves economies of scale when it is able to increase its production or selling capacity without a proportionate increase in expenses. These businesses are considered to have high operating leverage. Industries that have high operating leverage tend to be very profitable when demand for their products or services is high, and less profitable or prone to losses when demand is low. Within an industry, businesses that have succeeded in achieving both a cost structure that has high operating leverage, and the production and sales volume to lower their costs per unit, are better able to compete on price and gain or hold market share.

Breakeven sales The point at which a business’s sales are just enough to cover all fixed and all variable expenses is its breakeven sales point. In industries whose cost structure is one of high operating leverage, breaking even may require a relatively high sales volume. These businesses must cover high amounts of fixed costs.

How Do You Recognise Cost Structure? Industry composite financial statements and individual borrower financial statements provide clues to the cost structure.

Clues on the income statement A very rough rule of thumb is to assume that most expenses included in cost of goods sold are variable, and most expenses included in selling, general, and administrative expenses are fixed. Closer examination and discussion with the borrower’s management will almost always uncover important exceptions, but the assumption is a useful starting place to investigate potential operating leverage. This means that an industry that typically has a relatively high cost of goods sold as a percentage of sales and a relatively low gross margin probably has lower operating leverage than an industry that has a low cost of goods sold as a percentage of sales and a high gross margin.

24 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Low Operating Leverage

High Operating Leverage

Sales

£100

£100

Cost of goods sold as a % of sales

80%

30%

Gross margin

20%

70%

Clues on the statement of financial position Asset distribution, the proportion of total assets represented by each major asset category, indicates the degree of operating leverage. Industries with high operating leverage tend to have higher percentages of total assets distributed in non-current assets. Industry

Cash

Building materials

2%

Food manufacturing

6

Drinks wholesaler Large department store Car retailer

Debtors

8%

Stock

Noncurrent Assets

Other

Total

4%

60%

26%

100%

20

4

50

20

100

3

14

31

20

32

100

1

1

18

76

4

100

13

12

52

23

0

100

Building materials, large department store and food manufacturing industries have a high proportion of their assets invested in non-current assets – their production capacity. They do have high operating leverage, as their variable costs for providing services are relatively low compared to the fixed costs of their capacity. Therefore, their profitability will vary much more significantly with changes in volume than will the drinks wholesaler and the car retailer, which have much lower proportions of their assets invested in non-current assets and have lower operating leverage.

Operating Leverage Examples Let’s look at some examples.

High operating leverage High Industry consists of businesses that use large machines that cost £500 each day, whether they produce a little or a great deal. Each widget produced requires £10 in raw materials (a variable cost tied directly to the number of widgets produced).

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 25



If a business in High Industry produced only one widget in a day, its total cost for that day would be £510, of which £500 is fixed and £10 is variable.



If the same business produced 100 widgets in a day, its total costs would be £1,500 (£500 fixed cost plus £1,000 variable costs). At the higher volume, the average cost of a widget falls to just £15.



If the same business can make and sell 1000 widgets each day with the same equipment, the total costs would be £10,500, and the average cost of a widget drops to just £10.50.

From management’s perspective, what do you think it is like to compete for customers in High Industry?

Competitors in High Industry, as in any industry whose cost structure is one of high operating leverage, fight aggressively for volume. Smaller businesses are trying to increase their volume so that they can spread their fixed costs over more units produced and sold and, therefore, make a profit or make a higher profit. Larger businesses that have already achieved economies of scale are likely to lower their selling prices to retain and buy market share and try to keep the smaller businesses at low volumes and losses. Therefore, when lending to a business in an industry with high operating leverage, or where most of the key competitors have high operating leverage, you will incur greater risk if your borrower is smaller than key competitors. A smaller business in an industry of high operating leverage may be able to differentiate itself on some basis other than price, but it will not be able to compete on price. The car manufacturing industry is an example of an industry with high operating leverage and high economies of scale. It has high investment in research and development and in production capacity for tools, dies, assembly lines, and so forth. Fixed costs are high relative to labour and materials. The higher the volume produced and sold, the lower the average cost and the lower the price to consumers could be and still generate a suitable profit. As a result, there are strong incentives to raise volume in order to reduce cost per unit and then cut prices and/or increase profit margins, especially if competitors cannot match the lower prices and still make a profit.

26 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Low operating leverage Low Industry uses more labour and less expensive machinery to make its widgets. Its machines cost only £10 per day, but each widget requires £10 of labour and £10 of raw materials. If a business in Low Industry produces just one widget per day, the cost of the widget is £30. £20 is variable (labour and raw materials) and £10 is fixed. If the business produces 100 widgets each day, the total cost is £2,010 and the average cost of each widget is £20.10. If the business produces 1000 widgets each day, the total cost is £20,010 and the average cost of each widget is £20.01. Competitors in Low Industry have low operating leverage and are not very scalable. Their average costs don’t fall much as volume rises because such a high percentage of their total costs each day or period are variable. Sales volume is therefore less of a competitive advantage in an industry with low operating leverage.

So, Where Is the Risk in Cost Structure? An industry with high operating leverage is a higher risk than an industry with low operating leverage. This is a valid generalisation because: 

New and smaller businesses will struggle against older and larger businesses, first to raise the capital needed to establish a high fixed cost business, and then to gain sufficient volume to spread the fixed costs. They are vulnerable to price competition from the larger businesses.



Even the larger businesses must be prepared for periodic price wars, such as you sometimes see in the airline travel industry. Survival (and repayment for the lender) depends heavily on management’s ability to control or cut costs and to market effectively.

Don’t be lulled into thinking that borrowers who operate in industries with low operating leverage always have lower risk. Competitors will be vigilant in finding economies of scale, ways to grow sales without commensurate growth in expenses, thereby either increasing their profits or cutting their prices to take more market share. Industries that experience waves of consolidation often do so because managers are seeking and finding ways to increase operating leverage. Examples are travel agents and bookshops. These examples show that not all economies of scale come from the equipment and automation that we think of in manufacturing businesses. Economies of scale may occur in many areas of operations including advertising, purchasing, selling, marketing, distributing, and customer service, as well as in production.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 27

Ways to Mitigate Cost Structure Risk Job Aid: Managing Industry Risks Risk

Possible Mitigation Strategies

Cost structure 

High operating leverage

 Lock in volume through long-term contracts  Focus on marketing and selling to keep volume up  Attempt to increase flexibility of costs



Low operating leverage

 Implement tight cost control

Interaction of cost structure and other industry risk characteristics A cost structure with high operating leverage is especially risky for the business and its lenders if the industry is also subject to: 

Swings in customer demand (due to economic cycles or vulnerability to substitute products, for example)



Increased competitive threats due to technological advances or globalisation



Low profit margins, even during periods of average sales volume

All of these variables will be discussed in this unit. The Cost Structure portion of the Job Aid: Industry Risk Assessment offers guidelines for assessing the risk due to an industry’s cost structure.

Job Aid: Industry Risk Assessment Industry Characteristic Cost structure

Low Risk Low operating leverage:  Low fixed costs  High variable costs

28 Industry Risk Analysis

Moderate Risk Balance of fixed and variable costs

Moderately High Risk Fixed costs moderately higher than variable costs

High Risk High operating leverage:  High fixed costs  Low variable costs

© Omega Performance Corporation. All rights reserved.

What Is Profitability? Profitability is the ability of an industry or a single business to create value, literally to create through the asset conversion cycles more value than was required to begin with. Profitability is typically measured in two ways: 

Profit as a percentage of sales



Profit as a percentage of total assets

Industries can generate a level of profits that enables them to survive and prosper by making a handsome percentage profit on each £ of sales. Examples are wine and spirits manufacturers. Alternatively, they can generate sufficient profit in pound terms even with a low margin of profit on each unit of sales if they can generate a high sales value for each unit of assets. Examples are food supermarkets and many wholesalers.

What is the risk? Industries that have low profitability tend to be riskier for the businesses operating in them and for their lenders because: 

They are more vulnerable to changes in the economy, new competitive threats, and increases in supply costs.



They often have less cash flow for investment in new technology or marketing, and less cash flow to support debt they may need to incur to remain competitive.

Ways to mitigate profitability risk Job Aid: Managing Industry Risks Risk Profitability

Possible Mitigation Strategies  Identify and meet needs of most profitable groups of customers through

better products and better service  Maximise bargaining power over customers  Pay consistent attention to cost control and revenue expansion

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 29

Interaction between profitability and other industry risk characteristics Before generalising about industry profitability or drawing conclusions about the risk to the industry and to individual businesses in the industry, you should understand the factors actually influencing the particular industry’s profitability. Profitability, almost more than any other industry risk characteristic, is influenced by interaction with the other industry risk characteristics. The Profitability portion of the Job Aid: Industry Risk Assessment summarises the degree of risk based on industry profitability.

Job Aid: Industry Risk Assessment Industry Characteristic

Low Risk

Profitability

Consistently profitable through expansions and recessions

Moderate Risk Consistent but lower than average profitability during recessions

Moderately High Risk  Profitable during

expansions  Mildly unprofitable during recessions

High Risk Unprofitable during expansions and recessions

Factors That Influence Industry Profitability Factors that influence the profitability that is typical of an industry cluster around the concepts of risk and reward and value creation: The greater the risk taken, the higher the reward if the venture succeeds. The higher the perceived value an industry creates, the higher its profit margins. Those factors interact with and are buffeted by other industry risk characteristics, but they tend to produce the following profiles of profitability across industries: 

Industries perceived to create the most value tend to have the highest profits as a percent of sales or as a percent of assets. Generally, manufacturers are perceived to create more value than wholesalers, so the profit margins of manufacturers tend to be higher than the profit margins of wholesalers. Manufacturers of expensive, durable products such as aircraft and refrigerators tend to have higher profit margins than clothing manufacturers because they create more value. Among clothing manufacturers, those that invest in design and high-quality fabric, which conveys higher quality, tend to have higher profit margins than those that make basic T-shirts and tracksuits.

30 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



The more cyclical the industry, the higher its profits need to be during good and average times in order for it to operate during bad times. House builders are subject to swings in demand and must make a higher profit in good times in order to survive when demand falls.



The more difficult or uncertain the process of producing or distributing the product or service, the higher the profit margin needs to be to allow for some failures. Most construction industries involve high operating risk, so the average profit margin for construction industries should be higher than the profit margin for an industry that has low operating risk such as furniture makers. Within construction industries, those businesses that have the hardest time estimating costs, or that require the most novel engineering solutions or the most dangerous physical risk, need a higher profit margin than those that paint stripes on roads or erect simple metal buildings.



The longer the operating cycle, the higher the profitability required to sustain the business. This is in part because the longer operating cycle requires more cash invested, and in part because the longer operating cycle often means the product or service is more complex and has a higher value added. It may also mean a greater risk in accurately forecasting the demand for the product when the cycle is completed.



The higher the barriers to entry, whether from high investment required to generate even the first unit of sales, or from expertise required to satisfy customers, the higher the profit margin. This occurs because of the higher financial risk and typically higher value added. Also if relatively few businesses have surmounted the barriers, there may be little competition to drive prices down.



Cost structure also affects profitability, as industries with high operating leverage in their cost structure can increase their profits substantially when volume rises. These industries are also subject to profit squeezes or losses when volume drops.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 31

Summary Two important risk characteristics to understand about your borrowers’ industries are cost structure and profitability. Industries that have a cost structure with high operating leverage are generally considered riskier (to the businesses and to their lenders) than industries with a cost structure of low operating leverage. Operating leverage refers to the mix of fixed and variable expenses; the higher the fixed expenses as a percentage of total expenses, the higher the operating leverage. Fixed expenses tend not to vary much as sales rise and fall, and may be difficult for management to curtail quickly if sales fall. Variable expenses, such as raw materials and direct labour in production, rise and fall almost automatically with sales and are easier for management to curtail. The actual risk faced by an industry that has high operating leverage depends on how close to its breakeven sales amount it is operating, how likely it is to face unpredictable swings in volume, and how thin its profit margins are during average or good times. Financial statements hold clues to operating leverage: 

A high cost of goods sold as a percentage of sales (low gross profit margin) suggests low operating leverage because most costs of goods sold are usually variable.



Statements of financial position that show a high proportion of assets in fixed assets suggest high operating leverage because the fixed assets are often a sign of automated, fixed cost production capacity.

Profitability (for purposes of identifying industry risk) is measured by profits as a percentage of sales and by profits as a percentage of total assets. Profitability is affected by cost structure, but it is also a separate risk factor that is influenced by the degree of risk the industry takes (and therefore the reward that successful businesses in it must make in order to survive) and the extent of value added perceived (and paid for) by customers. Stemming from those key factors, several profitability profiles emerge: 

Industries perceived to create the most value tend to have the highest profits as a percentage of sales or as a percentage of assets.



The more cyclical the industry, the higher its profits need to be during good and average times.



The more difficult or uncertain the process of producing or distributing the product or service, the higher the profit margin needs to be.



The longer the operating cycle, the higher the profitability required to sustain the businesses.



The higher the barriers to entry, the higher the profit margin.

32 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Practise Exercise Directions: Study the information about the bicycle manufacturing industry in the Appendix of this module and use it to assess how each of the two industry risk characteristics discussed in this section affect the industry. You may find it helpful to make notes below before completing the first two boxes of the Risk Assessment worksheet that appears on the following page. Refer to the Cost Structure and Profitability sections of the Job Aid: Industry Risk Assessment if you have difficulty identifying how each characteristic affects the bicycle industry or how important that effect is. Cost Structure and the Bicycle Manufacturing Industry

Profitability and the Bicycle Manufacturing Industry

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 33

Risk Assessment Worksheet Industry Characteristics

Business Characteristics and Strategy

Relevant Future Scenarios and Assumptions

 Cost Structure  Profitability  Maturity  Technology  Cyclicality  Dependence  Globalisation  Vulnerability to Substitutes  Regulatory Environment  Operations Which characteristics have affected and will most significantly affect all businesses in this industry?

       

   

For each significant characteristic in column 1, what is this business’s business strategy for mitigating risk or capitalising on opportunity?

How should the impact of this characteristic and strategic response (or lack of response) be anticipated in scenarios of future performance?

Characteristic: Cost Structure

Business Strategy:

Future Impact:

Characteristic: Profitability

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

34 Industry Risk Analysis

General ProductMarket Match Supply Production Distribution Sales Management Overall Strategy



Economic Industry Strategic Management Control, Action, and Reaction Financial Performance Hypotheses − Most Likely − Downside − Sensitivity

© Omega Performance Corporation. All rights reserved.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 35

Answers Cost Structure and the Bicycle Manufacturing Industry While the bicycle manufacturing industry has some fixed costs, most are variable. The industry is generally labour-intensive, except in the largest, most automated companies. Smaller manufacturers are making or importing the frames and purchasing components to add to the bicycles and are therefore acting in more of an assembler capacity. As an industry, operating leverage is low. Profitability and the Bicycle Manufacturing Industry Profitability is under some pressure due to the maturity and somewhat cyclical nature of the industry and to the relative ease of new entrants who are willing to start small in local, niche markets. Profitability in the bicycle manufacturing industry differs by market segment. High-end and specialised bikes including racing bikes, hybrid commuter bikes, and mountain bikes have a much higher profit margin than do children’s bicycles and tricycles.

36 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Section 2 Maturity and Technology What Is Industry Maturity and How Does It Affect Risk? Industry maturity refers to the stage in the industry life cycle, defined by: 

The growth rate of industry sales, year on year



The rate at which businesses are closing or leaving the industry

Industry maturity affects the risk to businesses in the industry and their lenders because: 

Businesses encounter different challenges and opportunities depending on the maturity stage of their industry.



Critical management experience and skills typically differ according to the maturity of the industry.



Some industries in the riskier maturity stages have so many other risk characteristics that the combination makes them an unacceptable credit risk.



Maturity stage alone may introduce so much risk that lending is not safe.

Knowing the maturity stage of your borrower’s industry can help you understand its business strategy and anticipate not only its financing needs but also its needs for other financial services. Individual businesses also have maturity stages, as do products within businesses. This section focuses on the maturity stages of industries.

Three Stages of Maturity To understand some of the risks and opportunities of lending in various industries, think about industries as experiencing three stages of maturity: emerging, mature, and declining. Emerging industries grow very rapidly, perhaps 20–100% annually. Changes in competition seem to happen every day, demanding flexibility and innovation to be successful. Emerging industries may be new, or recently revitalised as a result of changes in technology, customer needs and preferences, cost structure, or regulation.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 37

Mature industries grow more moderately, usually only at the rate of general population or economic growth, and definitely not more than 20 percent annually. Mature industries have more stable products and services and launch new products much less frequently. Mature industries may stay in the mature stage for many years, or they may be revitalised and re-enter the emerging stage, or they may decline. Mature industry success demands focus and attention to details and cost control, since replacing a lost customer is not easy. Declining industries experience a decline in unit sales over a long period of time. If sales dollars increase at all, they do so at less than the rate of inflation. Management in declining industries may preside over the decline by carefully controlling costs, or they may attempt to reinvigorate the industry with new products or services, perhaps to the extent of creating a new industry. The following graph depicts the growth rates of each industry stage.

It can be safe to lend to businesses in any of the three stages. However, you must understand the particular risks and success factors of each.

Consumer Preferences: A Special Aspect of Maturity A change in consumer preferences, such as fashion trends, can present even mature industries with some of the challenges of an emerging industry. The overall level of demand may rise or fall, and the particular style of items consumers want to buy within a stable level of demand definitely change. Production and distribution processes may be mature. But the product itself is periodically emerging. Do consumers prefer mauve or yellow, sandals or boots, wood furniture or plastic and glass, suits and ties or sweaters, vans or 4X4 vehicles? When industry sales depend on consumer preferences, you need to: 

Be sure your borrower has reliable techniques for meeting consumer preferences



Be sure your borrower’s financial condition allows for continued operations and loan repayment even when there is a temporary mismatch of product and consumer preference

38 Industry Risk Analysis

IRA.2.2.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

Ways to Mitigate Maturity Risk Job Aid: Managing Industry Risks Risk

Possible Mitigation Strategies

Maturity 

Emerging industries

 Educate and support customers as needed  Finance rapid sales growth  Have flexible production strategies and be able to increase capacity quickly  Be able to obtain sufficient raw materials or components to produce quantity

and quality needed  Establish distribution channels and distribute quickly and effectively



Mature industries

 Control costs  Focus on product improvements to increase market share  Increase sales to existing customers  Focus on market segments with above-average profitability



Declining industries:

 Control costs, diversify, and focus on market segments that still provide

opportunities  Likely to have some competitive advantages: brand recognition, high cost of

switching for customers, strong statement of financial position (high liquidity, low gearing, and high-quality assets)

The Maturity portion of the Industry Risk Assessment job aid summarises the degree of risk according to the industry’s maturity stage.

Job Aid: Industry Risk Assessment Industry Characteristic Maturity

Low Risk Mature industry – sales and profits still increasing at reasonable rate

Moderate Risk

Moderately High Risk

Maturing industry – beyond major growth problems and shakeout of weak competitors

Emerging industry – still growing rapidly; weak competitors just beginning to drop out Or highly mature industry – just on verge of decline

High Risk Emerging industry – growing at explosive rate Or declining industry – sales and profits decreasing

When evaluating the risk of a particular industry, you should understand not only its maturity but how the particular risk and success factors of that stage are affecting the particular industry as well.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 39

Risk and Success in Emerging Industries Emerging industries present the highest risk to lenders because there is no track record for businesses or managers and because competition and products change daily. Some emerging industries present so much risk that financing for businesses in the industry comes almost entirely from equity. However, if you can identify that your potential borrower has significant success factors and you can mitigate the risks, you may be able to establish a relationship that will be profitable over a number of years.

Key risks No clear winning product: New product or service functions and features have captured the imagination (and wallets) of customers, but much innovation and variation in products carries risk. One business may have the best combination one day, and another business’s product launch captures all the attention the next day. Businesses have to have the financial capital and intellectual capital to innovate continuously and bring new products or new versions to market. No clear winning strategy: Businesses experiment with production,

marketing, sales, distribution, and customer service strategies. Some strategies don’t work at all; some work briefly and then are surpassed by a competitor’s experiment; a very few succeed. No sure blueprint for success exists because nobody knows what customers will do or prefer.

Uncertainty about technology: Rapid advances in technology are often

the key to product features, but businesses risk getting ahead of or falling behind the technology. The best idea may turn out to be months or years ahead of its time in terms of the ability of available technology to deliver a reliable product. Today’s innovation, and the heavy investment in research and development and production capacity, may be obsolete tomorrow.

High initial costs followed by steep reductions: Businesses need large amounts of capital and expertise to bring a new product to market. Getting to market even a few weeks ahead of a competitor can earn the winner a large enough market share to drop its unit costs dramatically. However, when several competitors launch similar products about the same time, the drop in sales prices can keep everyone from recovering initial costs before new product variations capture the market.

Inexperienced management: Nobody has a strong base of experience because so much of what is happening happens for the first time. Managers are learning as they go. No standard formulas for customer behaviour or for pricing, packaging, or distribution exist. Some managers are trying to apply lessons from other industries to the new industry; some have little experience in any industry.

40 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

New competitors: Many people are trying to get into the rapidly expanding market. New businesses are formed and established businesses start new divisions or subsidiaries. High growth and profit potential attracts competitors globally. All new entrants fuel the innovation and uncertainty. Cost control is not as important in emerging industries as in mature or declining industries, because customer demand in emerging industries is still growing fast. Customers purchase more based on availability and product features than on price. They want the ‘new new thing’. However, the ability to gain enough market share quickly, cover fixed costs, and simultaneously earn substantial profit while cutting prices is quickly followed by the need to control costs. When that happens, the industry or at least the product is moving from emerging to mature.

Key success variables An emerging industry has no blueprint for success. Strategies turn out to be successful; they aren’t known to be successful beforehand. However, patterns from other emerging industries and a review of the risks that winners will overcome provide some useful insights about what it takes to succeed in an emerging industry. Keep in mind that much of your assessment will be based on what the business tells you it is going to do or what it tells you and you observe that it is now doing, rather than what it has done that worked in the past.

Innovation: Businesses that have the expertise, creativity, and capital to innovate are more likely to succeed. To evaluate a potential borrower’s ability to innovate: 

Look for spending on research and development.



Ask about the product design process, both idea generation and the time it takes to bring a product to market.



Find out who the ‘brains’ or talent is in the business.

Marketing and customer support: Businesses that are able to get the word out to potential customers about their products and services, and to educate and support customers as needed, have an advantage over businesses that have a great product that no one knows how to use. In an emerging industry, products are new; effective customer education can greatly expand the market. To evaluate this success factor: 

Ask about the amount and type of marketing, sales, or advertising, and decide how well it seems to fit what the business tells you is its target market.



Ask if sales staff or others are well prepared to educate customers about product features and benefits, and to provide help after the sale if customers need it.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 41

Production capacity: When a product ‘catches on’, the next hurdle is to produce enough to satisfy the demand before a competitor does. Businesses that have flexible production strategies and are able to increase capacity quickly (without incurring too much financial risk if sales drop) have a strong advantage. To evaluate the production strategy: 

Find out what the business’s current production capacity is and how quickly and at what cost can it be expanded.



Ask whether they are using, or could be using, outsourcing as part of the solution.

Supply sources: Closely related to production capacity is the business’s ability to get enough raw materials or components to produce the quantity and quality it needs. The challenge multiplies because in an emerging industry, suppliers are likely to be new and coping with emerging issues as well. Some suppliers will fail or fade away. The growing market may attract suppliers from longer distances, adding political and currency issues for managers to deal with. When a business is forced to use many different suppliers to meet its demand, issues of consistency and quality mushroom. To evaluate supply sources: 

Ask how the business identifies, selects, and coordinates with suppliers.



Ask how the business manages supplier quality.



Ask if the business works with any supply brokers or devotes any of its own resources to supply-chain management (such as working with a consolidator who in turn locates many individual, small suppliers).

Distribution: Just as lack of production capacity can kill off sales growth, so can the ability to get the product into the hands of the customer. The ability to distribute quickly and cost effectively to meet demand is a key success factor. This includes aspects of sales, wholesaling and retailing networks, and shipping and delivery. To investigate distribution: 

Ask how the product is sold. If third parties are involved, do they have appropriate knowledge of the product (and the customer) to sell it effectively?



Consider what value wholesalers or retailers add in the sales process.



Ask if shipping and delivery capacity keep up with actual sales.

42 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Shaping the industry: The businesses that tend to be the most successful in an emerging industry are the ones that succeed in setting the standards that actually shape customer expectations and what other competitors must do to meet them. These standards can include technical features of the product or service, pricing, and timeliness of delivery or service. This leadership reduces the opportunity for followers to introduce new ideas that would work to their own advantage. To understand the potential a business has for industry leadership: 

Identify what, if any, standards or variations exist in the industry today.



Ask management what standards they believe will most likely be set for the industry, and how and when that may happen.



Ask what the business is doing to establish standards, and what risks if any the business sees in doing that.

Quality is somewhat less important in an emerging industry than in a mature or declining industry. Customers are somewhat more tolerant of minor bugs as a trade-off for early availability. However, serious quality problems can undermine sales and sometimes even cool an entire market. As the industry moves towards maturity, quality becomes more important. Customers know what the product should do, and they have less tolerance for defects or mistakes.

Risk and Success in Mature Industries Mature industries can present the lowest risk because they have been around long enough to have a track record. Products and services are more stable and some strategies are proven winners. Management can be very experienced, and surprises are less common than for emerging industries. Yet demand for the industry’s products and services is still growing, so businesses in the industry have a reasonable chance of success over the next few years. Much of your market opportunity will consist of businesses in mature or maturing industries. These businesses often have borrowing needs and can present sound lending and relationship opportunities. However, you are not assured of a particular business’s success, just that of the industry as a whole. You will need to identify the businesses that are dealing well with the risks and taking best advantage of the success variables.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 43

The risks and success variables in mature industries stem from the following changes in markets and competition as compared to emerging industries. As the rate of growth in demand slows: Competition for market share increases. There is no longer room for everybody; one business’s increase in sales becomes another business’s market share loss. Businesses compete directly for the same customers. Customers become more knowledgeable. They have purchased these products before. They know what they are looking for and how to buy. They are more interested in price and less tolerant of defects than they were when products were novel. The focus of competition shifts. Businesses promote their products on the basis of low price and service provided with the purchase. They focus less on new features and benefits or new technology. Product standards emerge. Product features, pricing, and service standards become more consistent because businesses have enough experience to know what works best. As a result, new products are introduced less often. Changes tend to be small, incremental improvements rather than major breakthroughs. As a result of those four trends, you will observe the following in mature industries: 

The rate of plant and personnel expansion slows.



Industry profitability declines.



Spending on research and development as a percentage of revenues declines.



Very few new businesses are formed.



The network of suppliers and distribution channels is well established.



Management teams focus on reducing production and operating costs.



Long-range planning and budgeting receive more attention.



Businesses market service and convenience to try to differentiate themselves from competition.

44 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Key risks The following lapses can be very damaging to the individual businesses in a mature industry:

Inappropriate cost structure: If cost structure has too little operating leverage, other competitors will have lower costs per unit and can make more profit, or lower prices, or both. With cost as the most important competitive tool, the businesses with lower unit costs have an advantage. If cost structure has too much operating leverage, especially if the industry is also cyclical, red ink will flow when sales dip. Slowly growing mature industries cannot fall back on overall market growth to soften the impact of an economic downturn. Failure to control expenses: With price as the principal competitive tool, controlling costs of goods sold and operating expenses is very important. Labour costs that are higher than those of the competition, waste in production, higher than average cost of production facilities, too much corporate overhead – any of those things can be fatal.

Encroachment of substitutes: When product innovations are modest, industries selling products that are different, but which might be acceptable substitutes, may begin to target the same customers. Demand for breakfast cereals, which was once stable, can be eroded by alternative breakfast foods.

Ineffective marketing: When product features are similar across brands, and businesses try not to reduce prices any further, the businesses can attract or repel customers through advertising, sales campaigns, and promotions. A business that lacks well-planned marketing, or one that spends too much on marketing that fails to motivate customers, will lose market share to the business doing a better job of influencing customers. And customers are hard to acquire in a mature market.

Key success variables Success variables in mature industries are related to fine-tuning production and marketing.

Cost control: Businesses that are best able to control both production and operating costs are better able to compete on price. To evaluate cost control: 

Look for stability or improvement in the gross profit margin.



Ask about strategies for managing labour costs and costs of supply.



Look for the ability to maintain or reduce selling, general, and administrative costs as a percentage of sales.

Innovation in production: Instead of innovations in product features, mature industries need to innovate in production to reduce costs per unit to lowest possible levels. To evaluate production costs:

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 45



Ask about the effect on unit production costs when businesses purchase new long-term assets.



Tour facilities to observe and ask about production methods, capacity, and opportunities for automation or other possible savings.



Find out if products can be or are being redesigned for cheaper manufacturing or service delivery without loss of significant features and benefits.

Effective marketing: Success in mature industries demands careful attention to three areas of marketing. 

Increasing sales to existing customers. Because the market growth is slow and acquiring a new customer is difficult and expensive, the best chance for sales growth is often to increase sales to existing customers. The maker of breakfast cereal devotes as much or more attention to getting each customer to eat more (or, at least, the same amount of) corn flakes than to getting more people to eat some corn flakes. Find out what your borrower is doing to encourage and monitor customer satisfaction and make it easy for customers to buy more.



Selecting customers more precisely and more knowledgeably. The trick is to find market segments that the business is particularly able to serve and that are above average in profitability. Businesses must know which customers and products are most profitable, and pay less attention to segments that are not good long-term prospects.



Selling globally. Businesses that are successful in expanding their potential market and their actual sales by consistently selling in global markets have higher growth and profit potential than businesses that are restricted to smaller markets or who think of global markets only as an afterthought. Find out your borrower’s global strategy and look for signs that it begins with product design and market research, rather than treating global markets as occasional outlets for excess product.

Planning and budgeting: Decisions are based on hard study and accumulated data. Because the industry moves more slowly, success depends more on the quality of the strategy than the speed of its execution. To assess your borrower in this area: 

Learn how the business makes advertising and marketing decisions.



Find out how well the business understands the profitability of its product lines and market segments or key customers, and how well it uses those insights to make decisions.



Observe how the business keeps track of competitors, especially pricing and production methods.



Be sure the business has a plausible business plan and budget and that you know how successful it is in sticking to the plan.

46 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Risk and Success in Declining Industries Declining industries present more risk than mature industries, but some can offer profitable, safe, and possibly even sound lending opportunities. However it is more likely that the interest of the lender will be centred on the need to protect the bank from potential losses, rather than to grow the relationship. Deciding whether and how long it may be safe to continue lending to businesses in a declining industry involves understanding the reasons for the decline, the speed of the decline, and how far it has already progressed. Because the backdrop of a declining industry is relatively high risk, the impact of all other industry risk characteristics is magnified. Declining industries have falling sales: they may still be profitable, or may already be losing money, especially during periods of lower than average growth in the economy as a whole. Survival is the highest priority. Often businesses are shutting down their operations or agreeing to be acquired. Because cash flow from profits is uncertain, more lending is secured or short-term, and repayment is often dependent on converting assets to cash as the business shrinks.

Key risks Falling profits: As profits fall or losses occur, not only is cash flow for debt repayment impaired, but the business is less able to spend for staff development, facilities maintenance or upgrading, and marketing. These deferrals of expenditure, which may become urgent, will aggravate the business’s ability to satisfy customer needs and accelerate the decline.

Obsolete assets: The recognition by management and the business’s lenders that the industry is in decline may follow a period of very slow growth during which businesses in the industry may pay insufficient attention to their facilities. They focus less on supplier quality in an effort to find lower costs. They may tolerate lower credit standards from their customers in order to preserve sales. Just when owners and lenders may most need to rely on asset values because profits are gone, those values are impaired.

Key success variables Because the risk is so high in declining industries, the lender’s best hope for finding safe lending opportunities lies in finding other industry risks that are very low and selecting only those businesses that have very strong business strategies and management. Even then, a strong statement of financial position or outside support for the loan may be necessary.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 47

Strong management: Management must be exceptionally good at cost control and successful at either diversifying (into industries with higher growth and profit potential) or focusing on market segments that may still provide opportunities. Finding management teams that are good at trying new ideas to improve revenues and reduce costs is difficult, because creative, enthusiastic managers will find growing businesses and industries both more attractive and easier sources of profit. One of the most likely attractions to effective management in a declining industry is the possibility of ‘asset stripping’ as a means of realising profits and cash from the sale of undervalued assets – and this may not be in your best interests as a lender. Investigate both skill sets and activities and be the best judge you can be. Also bear in mind the real (and not necessarily just the stated) intentions of managers and owners when structuring facilities, negotiating security, etc. so that you can have as much access and control as feasible over those parts of the business that are important to the managers. The more distant your sources of cash flow and security are from the real interests of management, the more you need to monitor performance and values. Favoured or proprietary product: Even in a declining industry, the fittest businesses and products may survive. As demand shrinks, some customers will remain, and they will gravitate to the brand or specific product that best combines features, price, and service. Know your borrower’s market share and brand recognition or customer loyalty measures. Look for products or services that are expensive for customers to drop or switch. These advantages may be sufficient to keep your borrower operating successfully for a long time, or they may give it the financial flexibility to enter new industries. Strength in a market niche: Businesses in a declining industry may survive and prosper by retreating to a narrower market segment or focusing on a narrower product line. To evaluate their ability to do this well for several years or longer, look at historical product line trends including profitability. Find out what the business knows about the niche or niches it intends to focus on. Be aware that success in a niche is likely to require deep knowledge of customer needs and preferences, and that there may only be room for one profitable business in the niche. Strong statement of financial position: A strong statement of financial position (balance sheet) – one that has high liquidity, low gearing, and high quality assets – is sometimes called a fortress balance sheet because it provides the business with the means to withstand a prolonged siege. The strong statement of financial position may enable the business to emerge the survivor in a shrunken market, even if it did not have the best product or a proprietary product when the industry decline began. Or, it may provide the business with financing flexibility to try to enter a new industry.

48 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

The Impact of Technology on Industry Risk Technology is a key element of industry maturity because changes in technology often initiate, accelerate, or halt growth of an industry. However, the impact of technology goes beyond industry maturity and impacts industries in three ways: 

Creates the possibility of new products. Technology literally changes what customers demand and what they perceive they need. Mobile phones can replace traditional phone service and pave the way for instant, mobile personal communications in a new format (text messaging, for example) or create a need that was not perceived before – few people in 1990 would have worried about the fact that they did not have a mobile phone when leaving the house. Microwave technology creates the possibility and the demand for new lines of prepared foods.



Changes the way products are produced and services are delivered. Technological change affects the cost structure of entire industries and enlarges the playing field, making new winners and losers. Containerised shipping technology makes global competition feasible for more products than ever before. Robotics, and the use of new plastics, changes the way cars are made and reduces (or at least changes the structure of) their costs, modifying the balance of risk factors and creating new ones, for example by adding to the fixed costs in exchange for other advantages. In the case of robotics it would replace more-or-less variable labour costs by fixed capital costs but, at the same time, give more reliable quality, higher volume, and more flexible production schedules.



Changes the way businesses conduct business and how they are managed. The potential to use new technologies to reach new markets, access new labour sources, and reduce purchasing costs creates new opportunities for competitive advantage. When such technologies begin to be adopted in an industry, new business strategies become both possible and necessary. Businesses that successfully adapt will succeed over those that do not, or cannot, take advantage of the new potentials.

For example: 



Internet bookselling took significant market share from local book shops; now, e-book readers are taking market share from book publishing in general. Telecommuting allows labour-intensive industries to operate with less space and to overcome labour shortages in an immediate area.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 49





Database management may be used to document and exchange corporate experience and knowledge, and so accelerate the development of new employees and reduce the risk of losing expertise through employee turnover. Customer relationship management software systems allow industries that may once have relied on personal knowledge of customers and face-to-face dealings to be successful across national markets without in-person contact.

Each of the three kinds of impacts that technology has on an industry can happen quickly and with dramatic consequences. Therefore, understanding how technology is affecting and may be likely to affect your borrowers’ industries is important. You will then be able to assess how the individual borrower is likely to be helped or hurt, and what new business skills and strategies it may need.

Technology is not just computers Think broadly about technology. It is more than just computers, although computer technology is at the heart of many other technological advances. Examples of technology include disposable nappies and syringes, pharmaceuticals, laser-cutting devices, and digital video discs as much as they include fibre optics, the Internet, and global positioning systems.

So, what’s the risk? New technology always means change, and change usually means risk. Industries in which technology is significant to the product features or to the cost of producing the product are often considered riskier than industries in which technology is less significant. This is especially true when the technology is rapidly evolving. New technology means uncertainty about what competition will do, uncertainty about what management will do and whether their decisions will turn out to be smart, and uncertainty about how customers will react. Even when technology leads to successful new products or production processes, the change may require substantial additional capital. This creates opportunity for the lender, but may also increase financial risk to the business and the lender. If the technology changes again, weaker businesses may not have the capital to keep up. But if they wait until the technology stabilises, they may be out of business. Surviving in an industry in which technology is a significant factor, especially if that technology is changing, requires management skills, a technology plan, and a sufficient budget.

50 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Ways to mitigate technology risk Job Aid: Managing Industry Risks Risk

Possible Mitigation Strategies

Technology

 Budget adequately for important capital expenditures  Invest in new product research and development  Lease computer and telecommunications equipment to manage

obsolescence  Outsource specialised needs such as web site development and hosting

To support your assessment of technology risk for a particular industry, it is important to understand how technology is actually affecting that particular industry – its products, its production methods and costs, and its operations and management – and to remember that the technology risk in any given industry may change from year to year. That is, after all, the nature and purpose of technological development. The Technology portion of the Job Aid: Industry Risk Assessment offers guidance for assessing the industry risk due to technology.

Job Aid: Industry Risk Assessment Industry Characteristic Technology

Low Risk

Moderate Risk

Technology is stable and has little impact on products, production processes, or business practises

Technology change is gradual and has some impact on either products, production processes, or business practises

Moderately High Risk

High Risk

Technology change is gradual and is impacting several aspects of products, production processes, or business practises

Technology advancement is rapid; products, production processes, or business practises are changing swiftly and substantially

Technology, new products, and new ways to make and deliver products To understand how changes in technology may create new product possibilities and change customer demand is most difficult. You are not an expert in the technology, and neither you nor your borrower can predict the future. Here is what you can do: 

Assume that the higher the growth rate of sales in the industry and the more new businesses entering the market, the faster the rate of product innovation and technology change will be.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 51



Ask the management of your borrower and management of similar businesses what they think the life span of current products will be and what technology advances will result in improved or new products.



Ask what factors, milestones, or breakthroughs will trigger the most change and growth. Look out for regulatory changes and approvals pending, as well as technological change driven by research and development expenditures.



Ask what impact the technology changes that are most likely to occur in the next few years will have on your borrower’s products and services; what new features may become possible; and what features may become obsolete.



Consider how the technology changes may bring new competitors into the field, from different industries or geographies or from new start-ups.



Ask what aspects of the production process now cost the most, take the most time, and involve the most waste, and ask what your borrower is doing to improve those parts of the process and cut costs.



Ask if the change in technology will give a competitive edge to the already strong business – for example, where the capital cost of change is high – or will it enable weaker businesses to produce more at a lower cost?



Ask what new technologies are being exhibited at trade shows for the industry. How expensive are they? How reliable? How widely adopted by the industry?

Technology and new ways of doing business To assess the impact of technology on how an industry sells and manages aspects of the business other than production, learn about the following: 

Ask what new sales and distribution methods are being used in the industry. Will these reduce (or increase) barriers to new entrants in the market?



Ask what new information management or decision-making systems are available. Who will benefit, and why?



Ask what new methods of purchasing are available, and what difference this will make.



Understand how the industry is using technology to communicate with employees, customers, and suppliers.



Ask how the industry documents and manages its product information and knowledge of customers. How does the business compare with industry averages?

52 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



Ask how widely the potential technologies are being used and how fast they are being adopted.



Consider how the industry is changing or likely to change as a result. Which businesses are best suited to these changes? What impact (if any) will they have on the average financial profile of businesses in the sector?

Summary Industry maturity is defined by the rate of growth of demand for the industry’s products and services. Changes in demand are driven by new products, new marketing techniques, different cost structures, or a mixture of these influences. An industry, or a business, may have to deal with different stages of maturity for individual items within its product range. 

In the emerging stage, high growth attracts new competitors and results in rapid change and product innovations. Management experience is often not directly relevant to the challenges the new industry faces, and risk is therefore high.



Mature industries experience slower growth and less change. Customer buying is based more on price and service than on product features and availability. Product standards and blueprints for success make management’s task somewhat easier.



Declining industries experience no real growth and may experience falling sales and losses. Businesses with the strongest management, the most preferred (by customers) and lowest cost products, and the strongest statements of financial position will survive the longest. Some may survive indefinitely in a niche market or may reinvent themselves in an emerging industry.

Technology is often a factor that accelerates change in an industry, triggering shifts in growth rates and maturity. However, technology is an important industry risk characteristic independent of industry maturity because it has the capacity to: 

Change what is possible to produce or deliver



Change the method and therefore cost structure of producing and delivering, even when the product itself does not change



Change the way businesses manage information, customers, suppliers, and employees

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 53

Investigate how changes in technology have affected, are affecting, and are likely to affect the industry and your borrower by talking to your borrower and to other sources knowledgeable about an industry. You should explore: 

Its products and services and the demand for them



Its production or delivery processes



Its operating efficiencies, client base, and management processes

54 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Practise Exercise Directions: Study the information about the bicycle manufacturing industry in the Appendix of this module and use it to assess how each of the two industry risk characteristics discussed in this section affect the industry. You may find it helpful to make notes below before completing the first two boxes of the Risk Assessment Worksheet, which appears on the following page. Refer to the Maturity and Technology sections of the Industry Risk Assessment job aid if you have difficulty identifying how each characteristic affects the bicycle manufacturing industry or how important that effect is. Maturity of the Bicycle Manufacturing Industry

Technology and the Bicycle Manufacturing Industry

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 55

Risk Assessment Worksheet Industry Characteristics

Business Characteristics and Strategy

Relevant Future Scenarios and Assumptions

 Cost Structure  Profitability  Maturity  Technology  Cyclicality  Dependence  Globalisation  Vulnerability to Substitutes  Regulatory Environment  Operations Which characteristics have affected and will most significantly affect all businesses in this industry?

       

   

General ProductMarket Match Supply Production Distribution Sales Management Overall Strategy



Economic Industry Strategic Management Control, Action, and Reaction Financial Performance Hypotheses − Most Likely − Downside − Sensitivity

For each significant characteristic in column 1, what is this business’s business strategy for mitigating risk or capitalising on opportunity?

How should the impact of this characteristic and strategic response (or lack of response) be anticipated in scenarios of future performance?

Characteristic: Maturity

Business Strategy:

Future Impact:

Characteristic: Technology

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

56 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 57

Answers Maturity of the Bicycle Manufacturing Industry Demand for bicycles globally has grown slowly. However, the UK’s Cycle to Work initiative, Britain’s success in spring events in Beijing, and global interest in the Tour de France have renewed some interest in bicycles, especially in the high end of the market, including toad bikes and hybrid commuter bikes. Overall, established markets are mature. Technology and the Bicycle Manufacturing Industry Technology can cause changes to the product and make certain frames and components obsolete, especially in the high end of the market. High performance bike manufacturers are always looking to improve frames and make them lighter weight yet durable. Component manufacturers are also looking to improve products. One such example is the current improvement in variable shocks.

58 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Section 3 Cyclicality and Dependence What Is Cyclicality? Cyclicality is the tendency of industry sales and profits to rise and fall in line with changes in economic activity. These changes in the economy may be driven by changes in interest rates or government fiscal policy, by conditions in foreign markets or exchange rates, by changes in the supply of critical resources (including energy and labour) and other factors, which may have a direct effect on the demand for goods and services, or may change demand indirectly through their impact on business confidence. Cyclical industries are ones in which profits and sales tend to rise and fall with the economy. Some industries are highly cyclical, experiencing such wide swings that a recession may virtually bankrupt an industry and an expansion of the economy may produce an industry boom. Automotive, airlines, and property are highly cyclical industries. Other industries are more mildly cyclical, with less dramatic peaks and valleys of performance. Some industries may find it difficult or impossible to recover business lost in a recession – for example if production is driven offshore to cheaper areas of production, which then develop experience in the industry and are able to profit from the increasing globalisation of trade. Counter-cyclical industries experience cycles, but the timing of the cycle is opposite the economic cycle. A recession actually stimulates growth in the industry, while an economic expansion may dampen demand for the industry’s products or services. Shoe repair businesses and do-it-yourself home repair or improvement products are examples. Non-cyclical industries are relatively unaffected by economic cycles. Demand for their products and services is fairly stable in good times and bad. Basic food products and food retailers are good examples. The following graphs show the difference between cyclical, countercyclical, and non-cyclical industries.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 59

Degree and Timing Two aspects of cyclicality are important to understand in order to assess the risks to the businesses in the industry and to their lenders.

Degree By degree, we mean the magnitude of the swing in industry sales and profits. The highest risk to lenders is in industries that have steep and deep swings. They are highly cyclical, reacting strongly to changes in the economy. The more sensitive an industry’s demand is to changes in interest rates, the more likely that it is highly cyclical. Domestic mortgage lending is very highly cyclical: when interest rates rise, the volume of customers purchasing or refinancing homes may drop sharply. When interest rates fall, the volume of purchases and refinancing rises. The rise is usually less sharp than the decline because some of the demand for purchase financing must await the resurgence of new home building. By contrast, the demand for furniture and domestic appliances is also cyclical, but the swings are less extreme than the swings in mortgage financing. Similarly some industries (or certain businesses within a given industry) may be more sensitive to exchange rates, or commodity prices, than their competitors. The impact of exchange rate changes may be on the ‘demand’ side, making their established market price for products more (or less) competitive, or on the ‘supply’ side through its effect on the business’s cost base. Which businesses in an industry are best able to withstand such trends? Will the whole industry be affected by the changes – possibly being driven offshore or, alternatively, finding itself joined by new competitors from abroad?

60 Industry Risk Analysis

IRA.2.3.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

Timing By timing, we mean the sequence of changes in the economic cycle compared with changes in the industry demand. Again, the industries that are the most immediately affected by interest rates, and have the shortest operating cycles, react the most quickly. Those that react more quickly are riskier because they have less time to anticipate and prepare, and because they are more certain to be affected. Industries that react slowly to a recession have more time to prepare, and the recession may be over before sales fall to the point of endangering loan repayment. Consider the estate agent, the house builder, and the furniture manufacturer. 

The estate agent’s business can shift from boom to bust in a very short time when interest rates rise. Even a relatively short period of higher interest rates may drive some firms out of business.



The house builder is also sharply affected if housing starts drop sharply, but may be able to continue working to build houses in progress, especially if they are pre-sold. If homes in progress are not pre-sold, or if financing falls through due to the higher rates, construction stops. The stronger house builders may be able to finish work in progress; the weaker ones may not.



Furniture manufacturers are next to be affected. They continue at a higher volume, as people who bought homes before the rise in rates continue to furnish their homes although they may leave the purchase of the new dining room suite until the outlook is better. A very short recession may not affect furniture manufacturers much at all, while a long one will eventually cause layoffs, shutdowns, business failures, and forced consolidations.

Coming out of an economic downturn or recession, the order is the same. The estate agent’s business picks up quickly as rates fall, first with new demand for refinancing. Then housing starts increase and further fuel the sale and purchase of houses. Lastly, furniture sales rebound as optimistic consumers move into the first wave of new homes to be completed.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 61

Identifying and Evaluating Cyclical Risk To determine whether your borrower’s industry is cyclical, and then to assess the degree and timing of that cyclicality: 

Study the patterns of industry performance in prior economic cycles. Bear in mind that emerging industries may not have this history, which is one of the things that makes them riskier; managers and others may not agree on how the industry will react to economic changes. Declining industries may be unable to weather the effects of a cyclical downturn, although the industry survived recessions when it was mature.



Understand how the industry is affected by changes in interest or exchange rates. Be sure to focus on the impact of interest and exchange rates on customer demand and customer ability to pay, not just on the interest expense and debt repayment burden.



Find out if the industry sales are highly vulnerable to the availability or price of raw materials, especially when those raw materials’ prices are influenced or determined by factors outside the industry you are evaluating. For example: 



The house-building industry has some effect on land prices, since high demand for building land will drive up the price. But other factors including interest rates and demographic changes are likely to have a bigger impact. Industries that are affected by changes in oil and gas prices are especially important to identify and understand. Higher cost of aviation fuel may cut into airline profits or demand for travel, or both. Plastics manufacturers, which rely on petroleum-based raw materials, may experience disruptions of supply or spikes in price that hurt their profits, or drive away their customers if there are alternative products available.



Find out how the industry will be affected by a shortage of labour. Will the entire industry be stifled? Will there be pressure on wages, or to relocate to other areas? Will recruiting and training become key success factors, when before they were less important?



If an industry is cyclical, find out how businesses have adapted to deal with this. If the industry is sensitive to cyclical changes in demand or supply, it will (or should) have developed safeguards, and ways of working, to deal with this. For example airlines will lease a certain proportion of their aircraft capacity, and house builders will tend to build up a stock of development land when prices are cheap, provided they are reasonably confident of the timing of the next upturn in the economy. This information will give a ‘benchmark’ of how supply and demand factors are normally managed in that industry, and so help to provide an objective comparison of

62 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

management quality for individual businesses. In some cases, as noted above, the industry may have no long-term remedy to a cyclical downturn, and so may be forced to close or locate its production facilities overseas in order to maintain profits, or prevent losses.

Ways to mitigate cyclicality risk In looking at the ability to weather an economic downturn, you should review the business’s financial information and remember the following: 

The lower the operating leverage, the better able the business can adjust to a downturn in sales.



The more cash and liquidity a business has on its balance sheet, the better able it can survive when profits are low.



The higher the profit margins, the more cushion a business has during an economic downturn.

Job Aid: Managing Industry Risks Risk Cyclicality

Possible Mitigation Strategies  Diversify product mix to include more staple items that are sold all year,

through expansions and recessions  Increase flexibility of cost structure to ensure business does not lose money during recessions when volume declines

Refer to the Cyclicality portion of the Industry Risk Assessment job aid for a summary of low, moderate, moderately high, and high risk due to cyclicality.

Job Aid: Industry Risk Assessment Industry Characteristic Cyclicality

Low Risk

Moderate Risk

Not affected by business cycle

Sales rise and fall mildly, reflecting expansion and recession

Moderately High Risk Sales moderately affected by expansion and recession

High Risk Highly cyclical or counter-cyclical

What Is Dependence? When Industry A’s sales and profits are significantly affected by volume and prices in Industry B, Industry A is said to be dependent on Industry B. The more dependent your borrower’s industry is on any other

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 63

industries, the higher the potential risk of lending to the industry because more factors outside its control will have an effect on its level of activity. In a sense, all industries are dependent on their suppliers and their customers, but dependence as an industry risk characteristic is not always (or even usually) symmetrical. For example: 

Sales in the furniture industry are dependent on activity in house building, yet house builders are neither the suppliers nor the customers of furniture manufacturers.



Profits of plastics manufacturers are dependent on the price of oil, yet the plastics industry is not a major determinant of oil prices.



Internet retailers may be dependent on the logistics industry’s capacity and pricing.

When you find that your borrower’s industry is dependent on another industry, you need to analyse not only your borrower’s industry risk characteristics but also the risk characteristics of the industry or industries on which it is dependent. Be sure to consider dependencies on the supply side (which affect the cost of production, or availability of raw material and other inputs, but may not necessarily change the level of sales, at least in the short term) and the demand side, which directly change the volume or price (or both) of sales. It is also important to check that an apparent diversity of supply and demand is not, in fact, hiding a strong reliance on a more concentrated range of factors. For example food producers are not affected by the demand from any one consumer, but each individual consumer’s demand is likely to be affected by the same factors as all others – the weather, availability of fresh seasonal produce, economic activity, and so on. 

Supply side dependence examples are:  



An airline’s profit dependence on the price of jet fuel A food producer’s dependence on the price of commodity inputs, for example grain, cocoa, and vegetables

Demand side dependence examples: 

 

Airline passenger volumes are affected by business confidence and consumer spending. Demand for ice cream depends on the weather. Demand for steel is affected by volume in the construction, civil engineering, and other heavy industries.

Ways to mitigate dependence risk Job Aid: Managing Industry Risks Risk

64 Industry Risk Analysis

Possible Mitigation Strategies

© Omega Performance Corporation. All rights reserved.

Dependence

 Develop additional sources of supply or production  Diversify product mix; develop products or services for other industries  Find additional uses for products outside industries on which there is

dependence

The following portion of the Industry Risk Assessment job aid gives you some guidelines for evaluating the risk of dependence.

Job Aid: Industry Risk Assessment Industry Characteristic

Low Risk

Dependence

Highly diversified customer or supplier base

Moderate Risk

Moderately High Risk

Customers or suppliers limited to several industries, but none represent more than 10% of sales or purchases

Customers or suppliers limited to a few industries: some represent 20–30% of sales or purchases

High Risk Highly dependent on one or two other industries or customer groups

Summary Industries are cyclical, counter-cyclical, or non-cyclical according to whether or not their sales and profits are subject to swings in line with changes in the level of overall economic activity. Cyclical industries, especially those that react the fastest and most to changes in economic activity, present the greatest risk to lenders. This is because they have the least time to prepare and they may have to weather prolonged periods of lower sales, perhaps wiping out repayment ability or even forcing the business to shut down. To identify cyclicality, look for these patterns in the past and discuss with management their outlook for the future impact of: 

Changes in interest or exchange rates



Availability and price of critical raw material or other production inputs



Cost or availability (including special skill needs) of labour

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 65

When one industry’s volume or profits are significantly affected by the volume and prices in another, we describe this as dependence. Dependence can occur on the supply side, disrupting production or raising costs, or on the demand side, disrupting consumers’ desire to buy or ability to pay. An industry can be thrown into a cyclical downturn or a permanent decline as a result of changes in the industry on which it is dependent. When an industry is seen to be subject to cyclical changes, it will have found ways of dealing with these. Try to understand how this is achieved, and use this knowledge to ‘benchmark’ the capability of individual businesses within the industry.

66 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Practise Exercise Directions: Study the information about the bicycle manufacturing industry in the Appendix of this module and use it to assess how each of the two industry risk characteristics discussed in this section affect the industry. You may find it helpful to make notes below before completing the first two boxes of the Risk Assessment Worksheet that follows. Refer to the Cyclicality and Dependence sections of the Industry Risk Assessment job aid if you have difficulty identifying how each characteristic affects the bicycle manufacturing industry or how important that effect is. Cyclicality of the Bicycle Manufacturing Industry

Dependence of the Bicycle Manufacturing Industry

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 67

Risk Assessment Worksheet Industry Characteristics

Business Characteristics and Strategy

Relevant Future Scenarios and Assumptions

 Cost Structure  Profitability  Maturity  Technology  Cyclicality  Dependence  Globalisation  Vulnerability to Substitutes  Regulatory Environment  Operations Which characteristics have affected, and will most significantly affect, all businesses in this industry?

       

   

For each significant characteristic in column 1, what is this business’s business strategy for mitigating risk or capitalising on opportunity?

How should the impact of this characteristic and strategic response (or lack of response) be anticipated in scenarios of future performance?

Characteristic: Cyclicality

Business Strategy:

Future Impact:

Characteristic: Dependence

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

68 Industry Risk Analysis

General ProductMarket Match Supply Production Distribution Sales Management Overall Strategy



Economic Industry Strategic Management Control, Action, and Reaction Financial Performance Hypotheses − Most Likely − Downside − Sensitivity

© Omega Performance Corporation. All rights reserved.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 69

Answers Cyclicality of the Bicycle Manufacturing Industry Bicycle manufacturers must contend with changes in consumer demand for bicycles based on changes in the economy. More bicycles sell when the local economy is strong. In a downturn, a purchase as a recreational item in any market or as a transportation necessity in a developing country may be deferred. Dependence of the Bicycle Manufacturing Industry Bicycle manufacturers have some dependence on the supply side to wellestablished, global makers of brand-name component parts. Only the very largest cycle makers can afford a strategy to make their own components.

70 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Section 4 Globalisation and Vulnerability to Substitutes What Is Globalisation? Globalisation is the phenomenon of the increased interaction of economies and industries around the world that once operated and behaved more independently. Its importance to businesses and lenders lies in: 

How it affects the risks of particular industries



How it affects the range of business strategies that individual firms have for dealing with industry and financial risks

The Impact of Globalisation on Risk Globalisation can increase or reduce the risk of lending to various industries. It has the following impacts on industries, which tend to increase the risks of businesses in the industry: 

Increases competition. Advances in communication and shipping technologies have made it feasible for businesses all over the world to participate in manufacturing industries (from heavy equipment and telecommunications equipment to clothing and furniture) that once were national or regional. Appliances are made in low-cost areas (for example, Asia), as savings in manufacturing cost outweigh the higher transport costs.



Changes profitability. When globalisation introduces competitors that have different labour or raw materials costs, businesses with higher cost labour or raw materials are under pressure. The UK silk textile manufacturing industry first experienced ‘globalisation’ in the 1920s when businesses in the North West were no longer able to compete against the cheaper production methods of Japanese producers. This pattern has been repeated, as manufacturers in developing countries in Asia, Latin America, and South America are able to produce suitable-quality garments at lower prices.



Introduces more substitute products. Allied to increased competition, the potential access to worldwide markets (provided that customs tariff, legal, and other similar barriers to trade permit) and the easier transfer of technologies across economies mean that consumers have easier access to substitute products. Mobile phone technology grew earlier in Europe than in the United States (in part because traditional telephone services in Europe were not as widely entrenched or as cheap as in the U.S.); it quickly developed in other areas, particularly in Asia, and offered consumers a substitute, first for

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 71

local phone service and then for international long-distance services. It also meant that many countries avoided the need to expand fixedline services which had been held back in many cases by difficult terrain, high fixed costs of installation, and low population densities, all of which were less important in mobile technology. At least two impacts of globalisation – the opportunity to diversify sales and sources of supply, including materials and labour – have the potential to reduce risk, at least for those firms that take advantage of it. If your particular borrower does not take advantage of the new supply and labour strategies, your risk in lending to that borrower may actually go up. However, the diversification of sales or supply across political boundaries and long distances introduces new risks including currency fluctuation and sometimes the ability to move cash as well as potential difficulties with transportation, collections, consistent quality, and cultural differences in expectations. Diversifying sales across more geographies reduces the risk of cyclicality, since various regional or national economies may not be affected in the same way, or at the same time, by economic cycles. However, it is important to understand that as this global diversification of sales (and supply) increases, economic cycles can affect more of the world’s economies at the same time. The attractions of alternative source locations may include lower costs, more favourable regulations, or availability. For example: 

Northern hemisphere food retailers in December and January may purchase fruits and vegetables grown in the southern hemisphere, rather than rely on very limited and more costly supplies that are locally grown.



High technology or heavy equipment manufacturers may locate fabrication or assembly plants where there is available skilled labour, low cost unskilled labour, or proximity to customers.



Financial service firms may obtain charters or licences in jurisdictions that permit businesses in which they can be profitable, due to less onerous regulation or lower taxes.

To understand the effects of globalisation on your borrower’s industry, be sure to find out how diversified geographically the industry’s sales are. The more diverse, the lower the risk of cyclicality. However, new risks such as disruption of supply or product quality may be introduced. You should also ask these questions: 

How much use does the industry make of global sources of supply? What motivates this? How well is it working?



What new competition does the local or national industry face as a result of globalisation? Are new competitors substantially larger or stronger financially than old, local or national competitors?

72 Industry Risk Analysis

IRA.2.4.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.



What, if anything, protects the industry from global competition? Regulations? Scarce raw materials? Proprietary technology? Perishable product? High shipping costs?



How likely is it that those protective barriers might be eliminated?



To what is the industry most vulnerable from global competition? Cheaper labour? Better or cheaper raw materials? Scientific or technology breakthroughs?

The consequences of globalisation may not be obvious, but remember, anything that introduces change is likely to change the competitive landscape and produce new winners and losers.

Ways to mitigate globalisation risk Job Aid: Managing Industry Risks Risk Globalisation

Possible Mitigation Strategies  Develop suppliers who offer suitable combinations of price, quality, and

delivery time  Outsource aspects of the business to benefit from lower costs of production

or shipping  Develop market research and customer preference information to support export sales  Select financial services that minimise currency and payment risk with global trading partners

The following portion of the Industry Risk Assessment job aid summarises ways of thinking about the risks of globalisation.

Job Aid: Industry Risk Assessment Industry Characteristic Globalisation

Low Risk Not affected by global competition

© Omega Performance Corporation. All rights reserved.

Moderate Risk Able to source and sell globally but relatively unaffected by global competition

Moderately High Risk Global competition is a factor in industry profitability

High Risk Global competition is very strong and causing consolidations, failures, or new business strategies in the industry

Industry Risk Characteristics 73

Vulnerability to Substitutes Substitutes come from outside the industry or from other segments within an industry but provide customers with an acceptable alternative to the products of the industry or segment being analysed. For example, in the very broadest sense if food is considered as an industry, there is no substitute for it. But if the definition is narrowed to meat production as an industry, then seafood is a substitute. Soya products or other vegetarian alternatives may also be substitutes. Substitutes sometimes completely replace a product and sometimes simply compete for market share. Digital video discs (DVDs) may be a substitute for CD-ROM, as CD-ROM was for floppy discs and cassettes. Each new product substitute substantially reduces the market for the older products. Sliced bread is a substitute for unsliced. One brand or type of breakfast cereal, dishwasher tablet, or soft drink will always be a threat to another brand. Large numbers of customers will continue to have definite preferences based on price, quality, or other criteria, but many will be largely indifferent and will simply take the most convenient or the most heavily advertised. Substitutes may gain customer acceptance due to: 

Favourable price. If beef prices rise, consumers turn to pork or chicken. Budget airlines will attract customers from the more expensive, established carriers – as long as safety is seen to be equivalent.



Technology. Improvements in the performance of diesel cars have made them an attractive substitute for petrol-engined ones.



Fashion trends and changes in consumer tastes. Mix-and-match ‘business casual’ clothing is a substitute for formal suits.



Temporary scarcity of or alarm about the product that forces consumers to seek alternatives. If the government advises against pork products from another country, some consumers will be lost in the short term; others will develop a taste for other types of meat that are deemed safe.



Changes in regulations. Nicotine patches may be a substitute for cigarettes; if cigarette duty is increased, they may become more popular.

The lower the barriers (in whatever form – price, quality, taste, regulation, etc.), the higher the risk of substitutes and the riskier the industry because: 

Sales volume may fluctuate and be harder to predict.



Sales may decline on a long-term basis.

74 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



Sensitivity to price pressure will increase and margins are likely to be squeezed.



Cost of marketing and advertising, or of research and development, may increase as the industry tries to maintain customer loyalty.

Ways to mitigate vulnerability to substitutes risk Job Aid: Managing Industry Risks Risk

Possible Mitigation Strategies

Vulnerability to substitutes

 Increase switching costs to prevent customers from switching to substitutes  Cut costs to reduce prices; reduce attractiveness of substitutes  Change prices to compete more effectively

The following portion of the Industry Risk Assessment job aid summarises guidance for assessing the risk of vulnerability to substitutes.

Job Aid: Industry Risk Assessment Industry Characteristic

Low Risk

Vulnerability to substitutes

No substitutes available or likely

Moderate Risk Few substitutes available, or high switching costs

Moderately High Risk Variety of substitutes available, or moderate switching costs

High Risk Many substitutes easily accessible; no switching costs

Summary Globalisation is the increased interaction of economies and industries around the world. It can increase risk (for example, by increasing potential competition) or reduce it (for example, by giving access to a wider range of customers and reducing dependence on any one economy). The balance of risks and advantages will not be fixed and should be analysed to understand how it affects a particularly industry and how the businesses within the industry react to, and take advantage of, the effects and what is likely to change in the future. To assess the impact of globalisation on an industry, be sure to ask: 

How is the industry connected to other economies and industries, either through supply or sales?



Has competition increased? What advantages does new competition have?

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 75



Have options for sourcing materials, labour, and production increased? To what extent is the industry taking advantage of these new options?



Where might the industry be vulnerable to or able to take advantage of globalisation in the future?

Substitutes are products and services from another industry, or industry segment, that the customer perceives as meeting roughly the same needs as the products of the original industry. The more vulnerable an industry is to substitutes, the higher the risk in lending to that industry. Therefore, it is important to consider: 

What kinds of products may be substitutes?



What factors, such as price and availability, may cause them to gain favour with customers?



What costs will the industry incur in defending against substitutes?



Do the substitutes have the potential to replace the original products entirely, or almost entirely?

76 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Practise Exercise Directions: Study the information about the bicycle manufacturing industry in the Appendix and use it to assess how each of the two industry risk characteristics discussed in this section affect the industry. You may find it helpful to make notes below before completing the first two boxes of the Risk Assessment Worksheet that follows. Refer to the Globalisation and Vulnerability to Substitutes sections of the Industry Risk Assessment job aid if you have difficulty in identifying how each characteristic affects the bicycle manufacturing industry, or how important that effect is. Globalisation of the Bicycle Manufacturing Industry

Substitutes and the Bicycle Manufacturing Industry

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 77

Risk Assessment Worksheet Industry Characteristics

Business Characteristics and Strategy

Relevant Future Scenarios and Assumptions

 Cost Structure  Profitability  Maturity  Technology  Cyclicality  Dependence  Globalisation  Vulnerability to Substitutes  Regulatory Environment  Operations Which characteristics have affected, and will most significantly affect, all businesses in this industry?

       

   

For each significant characteristic in column 1, what is this business’s business strategy for mitigating risk or capitalising on opportunity?

How should the impact of this characteristic and strategic response (or lack of response) be anticipated in scenarios of future performance?

Characteristic: Globalisation

Business Strategy:

Future Impact:

Characteristic: Substitutes

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

78 Industry Risk Analysis

General ProductMarket Match Supply Production Distribution Sales Management Overall Strategy



Economic Industry Strategic Management Control, Action, and Reaction Financial Performance Hypotheses − Most Likely − Downside − Sensitivity

© Omega Performance Corporation. All rights reserved.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 79

Answers Globalisation of the Bicycle Manufacturing Industry Bicycle manufacturers increasingly face the risk of larger competitors who use high market share in other parts of the world to achieve marketing or production economies of scale when they choose to broaden their market reach. This contributes to consolidations and more large competitors. Successful bicycle manufacturers must have sophisticated global marketing/distribution strategies as well as global sourcing networks. The majority of the manufacturing globally takes place in Asia, specifically Taiwan and China. Vulnerability to Substitutes and the Bicycle Manufacturing Industry Bicycles are products that are not easily replaced. However, there are alternative products such as skateboards that may substitute for the recreational/movement activities as well as alternative products for transportation such as cars.

80 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Section 5 Regulatory Environment and Operations How Regulations Affect Risk Regulations impact industry risk in two ways: 

They expose an industry to, or protect it from, some aspect of competition, such as abolishing (or permitting) a minimum market price, encouraging (or protecting against) price competition, or blocking competition from companies outside the political borders covered by treaties and similar accords such as the free market rules of the EU or agreements with the WTO.



They impose some sort of requirement on the industry, either requiring it to do certain things or limiting it from doing certain things.

Whether regulations increase or decrease the risk of a particular industry depends on the particular regulation. However, keep one important generalisation in mind: whenever regulations are changing, either increasing or decreasing, the resulting changes are likely to shift some competitive advantages within the industry and create new winners and losers. Management teams may need to develop new strategies and skills to be successful in the new environment. This is particularly true when an industry undergoes substantial regulation or deregulation. 

Deregulation: In the United Kingdom, for example, deregulation of the financial services industries occurred in 1986. The result was sometimes more profit, sometimes less, but it always led to new products and services, new leaders, and new failures.



Regulation: Segments of the health care industry have increasingly been affected by regulation, including prescription drug approval processes and nursing home regulations. New rules call for new management skills and new strategies and inevitably produce new winners. Regulation of the tobacco industry, with restrictions against advertising and sales, produces sweeping changes as the industry simultaneously seeks to diversify geographically to places with less regulation, to diversify into new products, and to modify the core product to comply with, or avoid, regulation.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 81

Ways to mitigate regulatory environment risk Job Aid: Managing Industry Risks Risk

Possible Mitigation Strategies

Regulatory environment

 Support lobbying efforts to reduce regulatory restrictions or promote

advantageous legislation  Allocate resources to identify the most profitable ways of dealing with the regulatory requirements, to reduce their impact on profits

The Regulatory Environment portion of the Industry Risk Assessment job aid summarises how to evaluate industries on a scale of regulatory risk.

Job Aid: Industry Risk Assessment Industry Characteristic Regulatory environment

Low Risk

Moderate Risk

Friendly regulatory environment protects or enhances industry health; change in environment highly predictable

Unregulated or slightly regulated; regulatory changes highly unlikely or predictable

Moderately High Risk

High Risk

Regulations have noticeable adverse impact on revenues or costs; predictable and manageable impact

Regulations have significant chronic adverse impact on industry health; regulations subject to sudden change

Categories of Regulatory Risk To assess how the variety of regulations that may influence an industry affects your risk of lending in the industry, it helps to consider regulations in several categories: 

Regulations affecting trade and price



Regulations affecting employee rights, opportunity, and health and safety



Regulations affecting product safety and consumer rights



Regulations affecting environmental safety and preservation



Regulations of financial reporting and disclosure

82 Industry Risk Analysis

IRA.2.5.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

In each of those categories, consider the following: 

If the industry has a powerful lobbying group in parliament, understand the issues and the lobby’s success in protecting the industry. The friendlier the regulatory environment and the more effective the lobby, the lower the risk of lending to companies in the industry.



Trends in public opinion and litigation, as well as specific regulations on the books or pending. Litigation is usually expensive and can be very damaging to financial health or to reputation. Public opinion can foreshadow changes in regulation.

If you use the five categories as a mental checklist and ask the following questions of management, you will be well prepared to assess the regulatory risk: 

How is your business regulated in each area, and what effect do the regulations have on the business?



Have you allocated resources to identify the most profitable way of dealing with the regulatory requirements?

Regulations affecting trade and price It is important to understand the current and future impact of trade agreements such as the North American Free Trade Agreement (NAFTA) and the Trade and Development Act of 2000 (TDA), as well as global developments such as the European Union. 

The European Union requires free trade within the Union and limits some trade between EU countries and those outside. It creates a trading block that can be a more important trading partner, and therefore has more negotiating power, with multilateral organisations such as the WTO and with individual countries outside the EU.



NAFTA generally reduces restrictions on trade between Canada, the United States, and Mexico.

Even if there has been a trend towards freer movement of goods and services between most countries, the actual quotas, tariffs, and requirements vary by country and by industry, and sometimes by narrowly defined product types within industries. When new laws are enacted, some changes are immediate while others are phased in over many years. Disputes such as those which occur from time to time between the U.S. and the EU (e.g. over bananas or steel) can have a more or less immediate impact on the ability of companies to sell in those markets, and, even if the dispute is only short-lived, the impact on the cash flow of individual businesses can be significant.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 83

Trade regulations can affect industries within the United Kingdom. For example, telecommunications, radio and television broadcasting, and railways are examples of industries that are regulated as to where they can operate and the services they can provide. Learn what you can from industry resources and then ask the management of your borrowers, or potential borrowers, in an industry these kinds of questions: 

What trade regulations most affect the industry, and how?



What changes, if any, are in process or under consideration, and how will they impact the industry?



What regulatory factors affect the supply and price of the products and services this industry sells?



What regulatory factors affect the demand for this industry’s products and services?



What countries or parts of the world are increasing their imports (of your type of products) to the United Kingdom or the EU? Why is this happening, and how is the UK/European industry reacting?



What countries or parts of the world are attracting more exports from your industry? Why?

Regulations affecting employee rights, opportunity, and health and safety The Department for Business Innovation and Skills (BIS) is the government department principally involved in regulating these areas of corporate life through the following regulations. Consider how these landmark regulations are affecting the industry: 

The Equal Opportunities Act generally prohibits discrimination according to race, gender, and ethnic origin in decisions of hiring and promotion.



The Occupational Health Acts generally make employers responsible for workplace safety standards.



The Working Time Directive and Minimum Wage legislation aims to provide employees with protection against ‘sweat shop’ practises.

Generally, compliance with these regulations has the near-term effect of increasing the cost of doing business or requiring additional capital investment, or both. This is not a comment on their social benefit. Recruiting and record-keeping costs may increase. Industries may need to increase spending for employee training and safety programmes, as well as to improve the accessibility and safety of the physical facilities. This expenditure may be necessary to comply with the existing laws, or it may exceed minimum legal requirements but be made to reduce the likelihood of litigation, or to provide a better service to employees or customers. 84 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

This can range from the costs incurred by a small shop to install wheelchair-accessible doors to its toilets, to a food producer that reengineers its entire assembly line to minimise repetitive strain injuries to workers. While these kinds of expenditures may ultimately allow greater access to needed labour, broader customer markets, or reduced sick time or employee health care costs, the immediate impact is increased spending. The consequences of non-compliance can be legal expenses, management time, and fines or penalties. To understand the impact of these kinds of regulations on an industry, ask the following kinds of questions: 

How does regulation help or hinder in the recruitment and selection of an adequate supply of qualified workers?



What is the impact of immigration regulations on your workforce availability and cost?



What workplace safety requirements are common in the industry?



What new requirements are most likely in the future?

Regulations affecting product safety and consumer rights When evaluating this category, it is important to consider trends in public opinion and litigation as well as actual regulations already in effect. To understand the risk to an industry, consider the following: 

What regulations affect product standards or approvals?



What licensing is required for staff?



What are the costs of complying?



What are the benefits to companies that comply?



What are the consequences of non-compliance?



What product liability risks does the industry encounter through lawsuits?



What kinds of product liability risks do companies in the industry typically insure against?



What product recalls or litigation may provide indications of product safety issues?



What consumer disclosures are required, and how costly are they to provide? What impact do they have on industry operating expenses or investments?

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 85

Regulations affecting environmental safety and preservation Regulations to protect the environment and natural resources affect most industries. Generally, these regulations tend to: Lengthen and increase the cost of building new plant and equipment, because various planning and environmental impact studies must be completed and found acceptable. Increase the cost of operations or production, such as ones that may require pollution or emission controls, or substitution of cleaner burning fuels. Limit the availability or raise the cost of raw materials, such as restrictions on mineral extraction or commercial fishing. Among the many environmental statutes are these: 

The Environmental Protection Act 1990, which makes wide-ranging provisions for the improved control of pollution arising from certain industrial, domestic, and other processes including hazardous waste disposal.



The Special Waste Regulations 1996, the purpose of which is to provide an effective system of control for wastes that are difficult to handle. The regulations ensure that dangerous wastes are soundly managed from their production to their final destination for disposal or recovery.



In February 2002 the European Commission published a Proposal for a Directive on environmental liability with regard to the prevention and remedying of environmental damage (‘the Environmental Liability Directive’). The basis of the proposed Directive is the ‘polluter pays’ principle, and the introduction of an EU-wide regime is intended (upon implementation) to ensure that those who cause significant environmental damage are responsible for remedying it.

Industries on the high end of the environmental risk scale include: 

Industries that depend, for their raw material or source of supply, on natural resources that are subject to regulation. They are subject to loss of sales if resources cannot be harvested or mined at reasonable cost in reasonable quantities.



Industries in which expansion of physical capacity may have significant environmental impact. They are subject to long planning delays or increased design and development costs before they can build needed capacity. They may potentially affect nearby residential or commercial property, and may include activities such as power generation plants, landfills, scrap metal, or tyre recycling.

86 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



Industries that handle toxic materials or generate toxic waste as a result of their manufacturing processes. The potential for liability extends to its distributors and transporters of hazardous material and to the owners of property on which the hazardous material is located.

To identify and understand environmental risk, ask these kinds of questions: 

What environmental regulations affect the industry and how?



Is the industry dependent on a continuing supply of a natural resource to which there may be restricted access?



Does the industry handle or produce toxic waste?



Will expansion of capacity be affected by environmental requirements?

General and industry specific regulations of financial reporting and disclosure Required disclosures and reporting, whether general or specific to the industry, are important to understand because they can affect both decisions made by companies in the industry and public opinion of the industry. Be sure you understand the most important reporting requirements and how they may be influencing behaviours, such as: 

General reporting and disclosure regulations under the Companies Act 1985 or the listing requirements of the Stock Exchange and the FSA or similar bodies in other countries, if applicable, such as the Securities and Exchange Commission, on the financial condition of the business.



Apart from the financial information that must be included in the annual report, the Companies Act also requires information on such areas as these: 



 

Employee average numbers, aggregate wages, social security costs, and pension costs. With regard to pension liabilities, the shortfalls and/or reductions in pension funds seen in recent years will increasingly focus attention on companies’ obligations in this respect. Policy on employment, training, career development, and promotion of disabled employees. Political and charitable donations. Employee involvement initiatives.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 87

Many industries have special reporting and disclosure regulations. You are not likely to be an expert in regulations for an industry, but you must be aware of their impact on the business and the consequences of noncompliance. For example: 

The banking industry has disclosure and performance requirements required by the FSA and the Bank of England.



The insurance industry has capital and reserve requirements.

Make it a point to learn about the most significant reporting and disclosure requirements that affect an industry with which you do business. In some cases, you need to understand those regulations to evaluate a borrower’s financial performance and condition.

What Is Operating Risk? Day-to-day operations also pose unique risks. Operating risk is the term we use to describe these risks inherent in the very nature of what a business does. The higher the operating risk, the higher the risk to the business and the lender and the more important it is that management and employees be skilled and experienced and that the business have proper quality controls and insurance. Operating risk includes: 

Physical danger to the employees, such as commercial fishing, construction, and, to a lesser extent, factory work and mining



Physical danger to customers, such as medical practises, makers of infant car seats, and drug manufacturers



Financial risk of making a mistake, such as banks paying out too much money, or a civil engineer’s or quantity surveyor’s underestimating the cost of construction work or providing an inadequate specification for the quality required



Financial risk of disruption of the business, such as a computer failure that delays or causes errors in posting share transactions, spoilage of food items if refrigeration fails, or lost advertising revenues if broadcast transmissions fail

Physical dangers usually result in financial loss, either from lost reputation and revenues or from litigation and penalties. To assess the operating risk in an industry, the best approach is to be sure you understand what the business actually does and what can go wrong. 

Start by understanding the operating cycle, how difficult it is, and where it has broken down in the past.



Ask management what the hardest part of their business is, and how they manage it.

88 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.



Ask what kinds of insurance they carry, and why they carry it, and what risks they find it impossible (or uneconomic) to insure against.



Ask about the reasons for the periods of best financial performance, as well as the reasons for periods of worst financial performance.



Ask about employee training and safety programmes

Look for two things as you make your assessment of operating risk: 

How easily can companies in the industry keep the risks or mistakes from happening?



How well can companies in the industry contain the costs of risks or mistakes when they do happen (for example, are contracts in the industry typically fixed price, and what is the likelihood of cost overruns)?

Ways to mitigate operations risk Job Aid: Managing Industry Risks Risk Operations

Possible Mitigation Strategies  Conduct stringent employee training and safety programmes  Purchase liability insurance for products  Avoid fixed cost contracts  Monitor estimating and project management to avoid cost overruns

The following portion of the Industry Risk Assessment job aid offers guidance for assessing operating risk.

Job Aid: Industry Risk Assessment Industry Characteristic Operations

Low Risk

Moderate Risk

Business activities are easy to predict and control and are not dangerous to employees; product defects are not dangerous to customers

Predicting and controlling business activities requires normal routines and care by managers and employees; product defects are an inconvenience rather than a danger to customers

© Omega Performance Corporation. All rights reserved.

Moderately High Risk Predicting and controlling business activities require special knowledge and skill to avoid loss and special employee precautions to avoid danger; defects are sometimes dangerous to customers

High Risk Business activities are very difficult to predict or control and are dangerous to employees; even small product defects are dangerous to customers

Industry Risk Characteristics 89

Summary Regulations impact industry risk in two ways: 

They control some aspects of competition, usually promoting it but sometimes protecting against competition from companies outside the political borders.



They impose some sort of requirement on the industry, either requiring it to do certain things or limiting it from doing certain things.

When the regulatory environment is uncertain or unfriendly, the risk of doing business is higher. Uncertainty is introduced whenever an industry is being deregulated or is experiencing new regulations, so the risk is likely to be higher during those periods. In addition to regulations already in force, consider carefully the trends in public opinion and litigation which can foreshadow regulatory change. Use the following five categories as a checklist to consider about each industry in which you lend: 

Regulations affecting trade and price supports



Regulations affecting employee rights, opportunity, and health and safety



Regulations affecting product safety and consumer rights



Regulations affecting environmental safety and preservation



Regulations of financial reporting and disclosure

Operating risk includes physical danger to employees or customers and the financial risk of making a mistake or of a disruption of business. The higher the operating risk, the higher the risk to the lender, and the more important it is that the business has management that is skilled in successfully handling the risks.

90 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Practise Exercise, Part A Directions: Study the information about the bicycle manufacturing industry in the Appendix section and use it to assess how each of the two industry risk characteristics discussed in this section affect the industry. You may find it helpful to make notes below before completing the first two boxes of the Risk Assessment Worksheet that follows. Refer to the Regulations and Operations sections of the Industry Risk Assessment job aid if you have difficulty identifying how each characteristic affects the bicycle manufacturing industry or how important that effect is. Regulations in the Bicycle Manufacturing Industry

Operations in the Bicycle Manufacturing Industry

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 91

Risk Assessment Worksheet Industry Characteristics

Business Characteristics and Strategy

Relevant Future Scenarios and Assumptions

         

       

   

Cost Structure Profitability Maturity Technology Cyclicality Dependence Globalisation Vulnerability to Substitutes Regulatory Environment Operations

General ProductMarket Match Supply Production Distribution Sales Management Overall Strategy



Economic Industry Strategic Management Control, Action, and Reaction Financial Performance Hypotheses − Most Likely − Downside − Sensitivity

Which characteristics have affected and will most significantly affect all businesses in this industry?

For each significant characteristic in column 1, what is this business’s business strategy for mitigating risk or capitalising on opportunity?

How should the impact of this characteristic and strategic response (or lack of response) be anticipated in scenarios of future performance?

Characteristic: Regulations

Business Strategy:

Future Impact:

Characteristic: Operations

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

92 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 93

Answers, Part A Regulations in the Bicycle Manufacturing Industry International trade restrictions may affect the cost and availability of components or the opportunity to distribute the product. Operations in the Bicycle Manufacturing Industry Although some care and quality control are required, the design and assembly of a bicycle is not so difficult that it poses great operations risk.

94 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Practise Exercise, Part B Directions: Review your analysis of each of the 10 industry risk characteristics for the bicycle manufacturing industry. Consider each risk individually as well as how the various risk characteristics interact with each other to reduce or increase the risk of doing business in the bicycle manufacturing industry. 1. Select the industry risk characteristics that you think are the most significant for a lender to understand about the bicycle manufacturing industry. Which characteristics will have the most significant impact on a business’s chances for success? Which are the most important for management to have a strong strategy for dealing with? Why?

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 95

2. Which industry risk characteristics present a medium degree of risk to the bicycle manufacturing industry?

3. Which industry risk characteristics present the least risk or greatest strength to the bicycle manufacturing industry? In other words, the industry’s risk in this area is low, and the low risk is an advantage for the industry.

96 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

© Omega Performance Corporation. All rights reserved.

Industry Risk Characteristics 97

Answers, Part B 1. Highest industry risk characteristics: 

Globalisation



Cyclicality



Dependence



Maturity

2. Moderate industry risk characteristics: 

Profitability



Technology

3. Lowest industry risk characteristics: 

Operations



Cost structure



Vulnerability to substitutes



Regulatory environment

98 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Appendix This section contains: Industry Information: The UK Bicycle Manufacturing Industry

© Omega Performance Corporation. All rights reserved.

Appendix 99

Overview of the Bicycle Manufacturing Industry Global characteristics The bicycle manufacturing industry is global. The global bicycle industry, including bicycles, parts, and accessories, is estimated to have total retail sales in excess of £20 billion. The bicycle manufacturing segment of the industry produces approximately 100 million units per annum. The industry is dominated by companies based outside the United Kingdom, such as Giant Manufacturing Co. Ltd. (Taiwan), with annual sales of approximately 800 million pounds, Cannondale, Trek (U.S. based with production in Asia), and Bianchi of Italy, now part of Cycleurope. Giant is the world’s largest bicycle maker followed by Trek. Bianchi is one of the oldest companies still operating in the industry. Founded in 1885, it was making 70,000 bicycles in 1935 and claims that its ‘Army Bike’ was the world’s first mountain bike, tested in the Alps and Africa during World War I. Raleigh bicycles were originally manufactured in the UK, but the company was sold a few years ago to the U.S. management team. The strength of global companies in the industry is due in part to the longer period of time in which cycling has been both a favourite sport and a widespread means of transportation in all parts of the world. The Bianchi history and stature is an example. A visit to the www.bianchi.com Web site yields a vivid picture of the proud history of this company and its association with famous racers who have inflamed the passions of generations of avid cyclists. That passion, along with its reputation for high-quality design, supported by the philosophy that ‘At Bianchi’s factory, everything is homemade’, has established a very strong brand. Giant is an example of another reason for strength of bicycle manufacturers: highly efficient production with good quality. Giant began as an OEM, originally manufacturing 80% of its output for Schwinn. When Schwinn moved suppliers to China, Giant began manufacturing its own brand as well as continuing in its OEM role. The majority of bike frames globally are produced in Taiwan and China. This is due not only to lower-cost labour but also to the fact that China is the world’s largest bicycle market. In its most recent year, Giant’s four manufacturing plants produced 5.6 million bicycles. Approximately half were sold to mainland China. About 30 percent were produced for other companies in other countries, who seek to maintain their own brand while taking advantage of Giant’s economies of scale. Giant’s own brand models retail for £200 to £4,000 through independent bicycle shops in 50 countries and a few company-owned shops.

100 Industry Risk Analysis

IRA.APP.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

United Kingdom industry characteristics The UK bicycle manufacturing industry has flowered in the past 30 years and now boasts about 50 smaller sized manufacturing firms. Total sales of these UK-based bicycle manufacturing companies were about £500 million in the most recent year. Revenue growth has been driven by the rise in popularity of biking as a transportation mode as well as increased focus on healthy lifestyles. In addition, the popularity of the Tour de France and the UK triple medal win by Chris Hoy at the Beijing Olympic games have helped stimulate sales and interest in cycling. Chris Hoy was voted the BBC Sports Personality of the Year – a big deal in the sportsmad UK – and just days later the Queen knighted him, turning the Edinburgh sprinter into one of the most recognised celebrities in Britain. With fame have come lucrative endorsement deals which benefit cycling as a whole. When Sir Chris is used in TV advertisements, he’s always shown on his bike. The value of shipments was as high as £1.3 billion five years ago; however, in the past three years, overall revenues have been down. Yet there have been continued new entrants into the industry, so that average revenues per company have fallen from about £10 million two years ago to just £5.2 million last year. The industry is generally low-wage, with the cost of materials absorbing as much as 60% of the total value of shipments. The low wage reflects to some extent the low complexity of some production tasks, but also to some extent the often young age and short tenure of many production workers. The industry is not very capital intensive. Non-current assets make up only about 25% of total assets, and in some years, capital spending is as low as 2% of sales. The industry as a whole lost money in the most recent year. These figures are the result of general malaise due to the economic downturn and flat sales in some segments, but they also reflect the disproportionate effect of several very large financial failures of biking companies. Profitable companies remained, especially those with strong dealer networks and a substantial portion of sales to international distributors. Most manufacturers are believed to generate higher profits from their international sales than from domestic sales.

© Omega Performance Corporation. All rights reserved.

Appendix 101

Government support for cycling Cycling gets a lot less money from central Government than it would like, but a lot more than it used to get. In the most recent year, the Department for Transport pumped in a record £140 million investment to support its Cycle to Work scheme. The scheme provides vouchers for those using bicycles to commute to and from work. Cycling England had requested £250 million .Cycling England is an independent body funded by the Department for Transport to promote cycling in England. In support of cycling as a mode of transportation, Phillip Darnton, Chairman of Cycling England, stated: ‘Cycling England produced compelling evidence to show that increased and sustained levels of investment in cycling can make a substantial impact. The bicycle really does have a role in helping meet England’s transport challenges. It is now taking its place as a proper mode of transport.’ Source: ‘Global Bicycle Stats’, http://quickrelease.tv/?p=279

102 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Job Aids

© Omega Performance Corporation. All rights reserved.

Job Aids 103

The Decision Strategy Opportunity assessment Prospecting Does the prospect match the institution’s profiles? If the prospect is a current customer, can the relationship be expanded?

Identify opportunities Review the prospect’s strategic objectives and financial structure. What immediate and long-term needs exist for lending or non-lending services?

Preliminary analysis Preliminary assessment What is the specific opportunity? Is the opportunity legal and within your institution’s policy? Are the terms logically related? Do the risks appear to be acceptable?

Identify borrowing cause What caused the need to borrow? How long will the borrowed funds be needed?

Repayment source analysis Industry and business risk analysis What trends and risks affect all businesses in the borrower’s industry? What risks must the borrower manage successfully in order to repay the lending facility?

Financial statement analysis What do the financial statement trends show about the borrower’s management of the business? What trends will influence the ability to repay?

Cash flow analysis and projections Will the business have sufficient cash to repay the facility in the proposed manner? Which risks will have the greatest impact on its ability to repay?

Facility packaging Summary and recommendation What are the major strengths and weaknesses of the lending situation? Should a facility be granted?

Facility structuring and negotiation What are the appropriate facility, security, pricing, advance method, documentation and covenants?

Facility management Facility monitoring Is the borrower performing as expected? What caused variations? What are the risks to repayment? How can you protect the institution’s position?

104 Industry Risk Analysis

IRA.JA.0113.CSD.IFRS.UK.doc

© Omega Performance Corporation. All rights reserved.

Job Aid: Industry Risk Assessment Industry Characteristic

Low Risk

Moderate Risk

Page 1 Moderately High Risk

High Risk

Cost structure

Low operating leverage:  Low fixed costs  High variable costs

Balance of fixed and variable costs

Fixed costs moderately higher than variable costs

High operating leverage:  High fixed costs  Low variable costs

Profitability

Consistently profitable through expansions and recessions

Consistent but lower than average profitability during recessions

 Profitable during

Unprofitable during expansions and recessions

Maturity

Mature industry – sales and profits still increasing at reasonable rate

Maturing industry – beyond major growth problems and shakeout of weak competitors

Emerging industry – still growing rapidly; weak competitors just beginning to drop out

expansions  Mildly unprofitable during recessions

Or highly mature industry – just on verge of decline

Emerging industry – growing at explosive rate Or declining industry – sales and profits decreasing

Technology

Technology is stable and has little impact on products, production processes, or business practises

Technology change is gradual and has some impact on products, production processes, or business practises

Technology change is gradual and is impacting several aspects of products, production processes, or business practises

Technology advancement is rapid; products, production processes, or business practises are changing swiftly and substantially

Cyclicality

Not affected by business cycle

Sales rise and fall mildly, reflecting expansion and recession

Sales moderately affected by expansion and recession

Highly cyclical or counter-cyclical

Dependence

Highly diversified customer or supplier base

Customers or suppliers limited to several industries, but none represent more than 10% of sales or purchases

Customers or suppliers limited to a few industries: some represent 20–30% of sales or purchases

Highly dependent on one or two other industries or customer groups

Globalisation

Not affected by global competition

Able to source and sell globally but relatively unaffected by global competition

Global competition is a factor in industry profitability

Global competition is very strong and causing consolidations, failures, or new business strategies in the industry

© Omega Performance Corporation. All rights reserved.

Job Aids 105

Job Aid: Industry Risk Assessment Industry Characteristic

Low Risk

Moderate Risk

Page 2 Moderately High Risk

High Risk

Vulnerability to substitutes

No substitutes available or likely

Few substitutes available, or high switching costs

Variety of substitutes available, or moderate switching costs

Many substitutes easily accessible; no switching costs

Regulatory environment

Friendly regulatory environment protects or enhances industry health; change in environment highly predictable

Unregulated or slightly regulated; regulatory changes highly unlikely or predictable

Regulations have noticeable adverse impact on revenues or costs; predictable and manageable impact

Regulations have significant chronic adverse impact on industry health; regulations subject to sudden change

Business activities are easy to predict and control and are not dangerous to employees; product defects are not dangerous to customers

Predicting and controlling business activities requires normal routines and care by managers and employees; product defects are an inconvenience rather than a danger to customers

Predicting and controlling business activities require special knowledge and skill to avoid loss and special employee precautions to avoid danger; defects are sometimes dangerous to customers

Business activities are very difficult to predict or control and are dangerous to employees; even small product defects are dangerous to customers

Operations

106 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Job Aid: Managing Industry Risks Risk

Page 1 Possible Mitigation Strategies

Cost structure 

High operating leverage

 Lock in volume through long-term contracts  Focus on marketing and selling to keep volume up  Attempt to increase flexibility of costs



Low operating leverage

Profitability

 Implement tight cost control  Identify and meet needs of most profitable groups of customers through

better products and better service  Maximise bargaining power over customers  Pay consistent attention to cost control and revenue expansion

Maturity 

Emerging industries

 Educate and support customers as needed  Finance rapid sales growth  Have flexible production strategies and be able to increase capacity quickly  Be able to obtain sufficient raw materials or components to produce quantity



Mature industries



Declining industries:

Technology

and quality needed  Establish distribution channels and distribute quickly and effectively  Control costs  Focus on product improvements to increase market share  Increase sales to existing customers  Focus on market segments with above-average profitability  Control costs, diversify, and focus on market segments that still provide opportunities  Likely to have some competitive advantages: brand recognition, high cost of switching for customers, strong balance sheet (high liquidity, low gearing, and high-quality assets)  Budget adequately for important capital expenditures  Invest in new product research and development  Lease computer and telecommunications equipment to manage

obsolescence  Outsource specialised needs such as web site development and hosting

Cyclicality

 Diversify product mix to include more staple items that are sold all year,

through expansions and recessions  Increase flexibility of cost structure to ensure business does not lose money

during recessions when volume declines

Dependence

 Develop additional sources of supply or production  Diversify product mix; develop products or services for other industries  Find additional uses for products outside industries on which there is

dependence

Globalisation

 Develop suppliers who offer suitable combinations of price, quality, and

delivery time  Outsource aspects of the business to benefit from lower costs of production or shipping  Develop market research and customer preference information to support export sales  Select financial services that minimise exchange and payment risk with global trading partners

© Omega Performance Corporation. All rights reserved.

Job Aids 107

Job Aid: Managing Industry Risks Risk Vulnerability to substitutes

Page 2 Possible Mitigation Strategies

 Increase switching costs to prevent customers from switching to substitutes  Cut costs to reduce prices; reduce attractiveness of substitutes  Change prices to compete more effectively

Regulatory environment

 Support lobbying efforts to reduce regulatory restrictions or promote

advantageous legislation  Allocate resources to identify the most profitable ways of dealing with the

regulatory requirements, to reduce their impact on profits

Operations

 Conduct stringent employee training and safety programmes  Purchase liability insurance for products  Avoid fixed cost contracts  Monitor estimating and project management to avoid cost overruns

108 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Risk Assessment Worksheet Industry Characteristics

Business Characteristics and Strategy

Relevant Future Scenarios and Assumptions

 Cost Structure  Profitability  Maturity  Technology  Cyclicality  Dependence  Globalisation  Vulnerability to Substitutes  Regulatory Environment  Operations Which characteristics have affected and will most significantly affect all businesses in this industry?

       

   

For each significant characteristic in column 1, what is this business’s strategy for mitigating risk or capitalising on opportunity?

How should the impact of this characteristic and strategic response (or lack of response) be anticipated in scenarios of future performance?

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

Characteristic:

Business Strategy:

Future Impact:

© Omega Performance Corporation. All rights reserved.

General ProductMarket Match Supply Production Distribution Sales Management Overall Strategy



Economic Industry Strategic Management Control, Action, and Reaction Financial Performance Hypotheses − Most Likely − Downside − Sensitivity

Job Aids 109

110 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

Glossary This glossary is an alphabetical cross-reference of the IFRS terminology and other terms used throughout the Credit Skills Development programme to the alternate terminology with which you may be more familiar. IFRS or standard term

Alternate term(s)

Definition or explanation (if required)

Accounts payable

Creditors*

Amounts owed to suppliers

Accounts receivable

Debtors*

Amounts due from customers

Aged debtors list

Ageing, debtors ageing, A listing of debtors and accounts receivable invoices outstanding, ageing usually sorted by days from date of invoice

Borrowing request

Credit application

Business

Firm, Company, etc.

In CSD, the term “business” is used generally for all types of business without regard to legal structure.

Cash cost of goods sold (Cash COGS, CCOGS)

Cash cost of sales

Cost of goods sold, less any depreciation or amortisation that is included in the account.

Collection period

Debtors days on hand

The average number of days to collect debtors accounts

Company

Corporation, Limited Company, Firm (Partnership)

IFRS often uses “company” as a synonym for “business”, including all legal forms of business.

© Omega Performance Corporation. All rights reserved.

Glossary 111

IFRS or standard term

Alternate term(s)

Definition or explanation (if required)

Core current assets

Permanent current assets

Current asset amounts at the low point in the business’s operating cycle

Core trading assets

Permanent trading assets

Trading asset amounts at the low point in the business’s operating cycle

Cost of goods sold (COGS)

Cost of sales

Total cost of all stock sold during the period

Creditors days on hand (CDOH)

Payment period

The average number of days between the purchase of stock and the sale of that stock. Calculated as follows using annual financial statements: creditors divided by cost of goods sold, times 365 days.

Current portion of long-term debt (CPLTD)

Current maturities of long-term debt

The amount of longterm debt that is due within the 12 months following the statement date

Debtors days on hand (DDOH)

Collection period

The average number of days between a sale on credit and collection of cash from that sale. Calculated as follows using annual financial statements: debtors divided by net sales, times 365 days

Facility, lending

Credit facility, offering, loan type

Encompasses all types of lending: loan, overdraft, revolver, etc.

112 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.

IFRS or standard term

Alternate term(s)

Definition or explanation (if required)

Financial statement

Statement of accounts

Group of statements designed for the use of interested parties outside the business, such as lenders and investors. In IFRS, a complete set of financial statements includes:

Financing need



Statement of financial position



Statement of comprehensive income



Statement of cash flows



Statement of changes in equity



Notes

A requirement for financing over and above what is provided by the spontaneous financing sources, creditors and accrued expenses.

Fixed assets

Non-current assets

Holding period

Stock days on hand, The average number of inventory days on hand days between the purchase of stock and its sale to customers

© Omega Performance Corporation. All rights reserved.

Assets with an expected useful life or term of more than one year. In UK, synonymous with non-current assets; in other countries, the term fixed assets may apply only to tangible noncurrent assets used in operation of the business.

Glossary 113

IFRS or standard term

Alternate term(s)

Income statement

Profit and loss accounts, P&L

Definition or explanation (if required)

See also: Statement of comprehensive income Inventory

See: Stock*

Lending

Credit

Lending facility

See: Facility

Loan term

Non-current assets

The length of time between the provision of financing and the date on which the financing must be repaid. Fixed assets, long-term assets

Assets that have a useful life of more than one year. Includes land, buildings, equipment, machinery, vehicles, intangible assets, and financial assets. Also the name of the category in the balance sheet or statement of financial position in which are lists assets that do not qualify as current assets. See Fixed assets for additional information

Non-current liabilities

Long-term liabilities

Payment period

Creditors days on hand, accounts payable days on hand

Profits

Income, net income

Relationship manager

Credit officer, loan officer, lender

Sales

Turnover, revenue, sales revenue

114 Industry Risk Analysis

The average number of days taken to pay creditors

© Omega Performance Corporation. All rights reserved.

IFRS or standard term

Alternate term(s)

Definition or explanation (if required)

Sole trader

Sole proprietor

A business with one owner who is legally indistinguishable from the business

Spontaneous financing

Creditors and accrued expenses

Forms of financing that occur spontaneously in the course of doing business, as distinguished from more formal debts such as overdrafts or long-term lending

Statement of cash flows

Cash flow statement

Statement of comprehensive income

Income statement, profit and loss accounts, P&L

Income statement plus a statement of comprehensive income other than operating income

Statement of financial position

Balance sheet

Statement of the business’s assets, liabilities, and equity at a specific point in time

Stock days on hand (SDOH)

Holding period

The average number of days between the purchase of stock and the sale of that stock. Calculated as follows using annual financial statements: Stock divided by cost of goods sold, times 365 days.

Stock slowdown

Increase in stock days on hand

A lengthening of the time between the purchase of stock and its sale

Trade debtors

Debtors

Trade creditors

Creditors

© Omega Performance Corporation. All rights reserved.

Glossary 115

IFRS or standard term

Alternate term(s)

Definition or explanation (if required)

Trading asset financing need

Working investment

The amount of trading assets (debtors and stock) that is in excess of the amount of spontaneous financing provided by creditors and accrued expenses; a need for financing of trading assets

Trading assets

Debtors and stock

Debtors and stock are considered to be trading assets because they are an integral part of a business’s trading (sales) activities

*   This term is used throughout the programme instead of the preferred  IFRS terminology. 

116 Industry Risk Analysis

© Omega Performance Corporation. All rights reserved.