Right now we're going to cover the fifth part of every business, which is finance. And finance is the part of business that people start to get really intimidated by, or kind of freak out a little bit because there are numbers involved. Right? It seems scary, it seems intimidating. It seems complicated. It's really not. Beyond the spreadsheets, beyond the formulas, beyond the equations, there are very, very simple things that we need to make sure that we think about in running a business to make sure that we get to keep doing what we've been doing the first four parts of every business, which is serving more customers, making them happy, and making sure it's worth our time to keep going. So we're going to define the fifth part of every business. The finance process is answering two very important questions. So you analyze the first four parts of every business and try to answer two questions, number one, am I bringing in more money than I am spending? Necessary criteria of staying in b...
usiness, right? And number two, is it enough? Is it enough for me to compensate for the time and energy and everything that you are invested keeping this business going? Because it's perfectly possible to have more money in your bank account when you started. But if you're investing so much time and energy and so much of yourself in making a business go, and you're not being rewarded appropriately for that, or if it's possible for you to quit doing what you're doing, and go work for another company and be rewarded better for that the business will cease to exist, right? So finances, just the process of looking at everything that we're doing in the first four parts of every business, and answering those two very important questions, bringing in more money than we're spending and is it enough to make it worthwhile to keep going? So some very simple definitions here. And this is about as basic as it gets. Profit, profit is bringing in more money than you spend. That's it. So I have a fun little quote by Scott Adams, who created the Dilbert cartoon, it's like remind people that profit is the difference between revenue and expense, because that makes you look smart. (audience laughing) It's pretty basic right? How much money did you bring in, minus how much money did you spend in the process of bringing in that money? What is left over is your profit. Pretty simple. And what's nice about having high amounts of profit, so spending just a little bit amount of money to bring in a lot more is it helps make sure that your time and energy is worth it. It also very importantly, provides a cushion against unexpected events. So if your raw materials suddenly become way more expensive, that's not a super a traumatic thing if you have a huge amount of profit coming in, or if what you're doing is very, very profitable, right, you can absorb some of those increased costs and it's not a big deal. If you're running a commodity business where the profit you're bringing in for each transaction is really, really low, a change in some of the costs of doing business can make you unprofitable, in the blink of an eye, right? So higher profits are good because they reward you better for the work that you're doing. They also make it much more, make your business much more resilient to unexpected things changing in the market. Okay? So, what's interesting is that profit has often been taught as the point of business, right? Every business is in business to make a profit. And some people believe that the responsibility of a business owner is to make the business as profitable as it possibly can be. Right, maximize profits at all costs. Not true. Not true. So improving your profitability in most cases is a grand thing. But if you're running your own business, if you own your business and you control what your business does, profit does not have to be the only criteria you use to make decisions. So, for example, one of the things, I own my own business, I don't have any investors, I am not a publicly traded company, thank goodness, I run my own business, if I want to take off a day to spend time with my daughter, that is an executive decision that I can make at any point. And I may be legitimately giving up profit to do that, I could make more money if I work more. But that's not the only criteria that I use to judge the success of the business. So it is a criteria. It's an important one. It's not the only one. Does that make sense?
Thanks. Yeah, continuing with the discussion of profit. A lot of times, you can talk about profit, (clearing throat) excuse me. In terms of the number of dollars each transaction brings you extra above and beyond what you've spent, you can also talk about it as a percentage. And this is called profit margin. So it's the percentage of the transaction that you get to keep after you take all of your expenses. And the equation is really simple. It is present margin equals the profit from the transaction divided by the revenue, or the absolute size of the transaction that takes place, right? It's just taking that profit number and turning it into a percentage. Value capture is a way of analyzing how much of the value you create for your client or your customer that you get to keep as profit. And so, you know, if you bring in a million dollars of revenue to a client based on something you did, like say as a consultant or as advisor, your client has an extra million dollars in the bank account and you charge $100,000 for your advising service, you're capturing 10% of that value. Does that make sense? Very basic comparison. Now, the more value you capture in a transaction, the less attractive your offer becomes. So let's say continuing the consultant advisor example, if you create a million dollars worth of value to a company, but you charge $999, to create that value, it's not worth it for the company to even talk to you. Right? If you capture too much, it becomes much less attractive. If you capture less, bless you, if you capture less, it becomes more attractive for the company to get that thing because they have to give up a smaller percentage of the value of the transaction in order to get the result, right? So, sufficiency is the point where you could call a business solid and sustainable, right? And sufficiency is not necessarily what what we'll call breakeven, right? The point where revenue equals expenses. It's not that, it's the point where the owners or the operators of the business, don't have the next best alternative that would be better to stop doing this business and go to, right? Now, the important point about sufficiency is that it is an entirely subjective personal decision. Right? There's no number that says, when you get to this point of profitability, you are now sufficient. It's different for everybody. But what's nice is based on your personal needs, based on your personal desires, you get to decide what the sufficiency number is for you. An idea we talked about yesterday, well, let's define it completely here, is valuation. And valuation is an estimate of the total worth of a company. You can think about it this way. If you're running a company and another business came up to you, another individual came up to you and said, I would like to buy your company flat out, I'll write your check right now, what would that number need to be in order for you to have some common ground there, for you to be interested in selling the company and for them to be interested in buying it from you? Your best estimate of that number is a good estimate of the worth of the company as a whole. It's called a market valuation. Right? Big public companies have something called a market capitalization, right? It's the worst of the entire company when you look at the value of the entire company's stock. Valuation is something that applies to every business, every business has some worth attached to it. Right, and valuation is just an estimate of what that might be at a point, at a moment in time. And the higher the business's revenues, the stronger the company's profit margins, the higher its bank cash balance and the more promising its future by the valuation, the better the business, the more that business is worth, and the more other people might be willing to pay for that. And the higher the business's valuation, the easier it is to do lots of different things. You can borrow money from banks or other forms of lending. Way easier if you have a high valuation than a low one, right? If your public your share price is higher because the business is worth more, if you are interested in attracting outside investors, you get more in investment and you have to give up less ownership of the company if the valuation is high. Right? So having a high valuation is a super good thing. Okay? Now, it's also important, so if you are planning to have a public company, or a company that is going to be acquired, your business's valuation is something that you will probably think about on a daily basis and make decisions based on, right? If we buy this equipment, is it likely to lead to a higher valuation for the company? How will this product line or whatever it is that you do in the business, how is it going to affect the company's valuation, is going to increase it or decrease it? If you run a private company by yourself and you have no intention of ever selling it ever, your valuation really doesn't matter. You probably could calculate it if you really wanted to, but you probably don't need to, because it's not relevant. But it is. If you have investors, if you plan on potentially being acquired in the future, or you want to build up to an initial public offering, whatever, you will think about valuation decisions every single day. Make sense? Okay. Now, now we get into fun things. So, when people think of finance and they've had any exposure to it whatsoever, they usually think of these really boring looking pages of lots of different numbers with, you know, cash imbalances and lots of really geeky accounting terms. And there are a bunch of different types of financial reports. There are a bunch of different ways that you can analyze a company's finances, but there are three big ones. And so we're going to talk about those now. So the cash flow statement, the income statement, and the balance sheet. And there are entire, like 500 page books that have been written about some very small segment of each of these things. There's a lot of knowledge out there. What we're going to do today is understand what they are, why they are important, so why do you do this in the first place, and how these things help you make better decisions, right? So there are a bunch of books that can help you dig more into this if this is something that you find fascinating or useful, Financial Intelligence for Entrepreneurs is the book that I recommend reading first. It can give you a really deep overview about all of this stuff. So you can go deep into this, if you like, we're just going to do a basic overview of it now. Okay? So the cash flow statement is an examination of a company's bank account. So think of, we all probably have a checking account, right? Most of us can check our checking account online at this point. So imagine logging into your bank online and seeing what it tells you, right? And it's just a list. Here are all of the things that money has gone out for, here are all of the places or times money has gone in, and why. And when you add and subtract, you have a nice number at the bottom that says this is how much cash you have right now. Right? Congratulations. You've just looked at a Cash Flow Statement. That's it. It's a ledger, how much money is going in, how much goes is going ou,t how much you have leftover. And that is the cash that you have at any given point in time. And it's important to know that a cash flow statement covers a specific period of time, from this day to this day at this time to this time, okay? And cash, at least in the business tends to come from three primary sources. The first source is operations. So selling offers, buying inputs, cash from operations, investing is let's say you invest in something else that's not related to your direct business, but you're getting some cash from the sale or appreciation of that. That's cash flow investing. And financing is cash that you would get from a loan that you take out, right? You borrow $100,000, you have $100, of cash flowing into your account. So cash is great. Cash is not profitability. And if you run your business on credit, or you have an inventory or there's something complicated or there's a lag time between when you bring in your revenue, and when you pay for your expenses, you need to have some way of bringing those numbers together as quickly as possible to figure out am I really making money or not? And that's what the income statement is. Income Statement is matching sales. So matching revenue with the expenses that are incurred in the bringing in of that revenue to get a more accurate estimate of profit. So if you've ever wondered what accountants do all day, this is what they do. They make estimates and try to match as accurately as possible when revenue is coming in, where it's coming from, what expenses are associated or matched with that revenue coming in to get a more accurate picture of the actual profitability of a company. Does that make sense? Now, in order to do this, and to do this well, you have to account for things on a slightly different basis. So if you're running your own company, you don't have it inventory, you don't have a lot of matching to be done. You can manage your entire business on cash, right, just out of a check checking account. And that's probably what you do. That's what I do. I don't have any inventory, any stock. It's not complicated. So I don't make my business complicated. If you have inventory, you have to figure this stuff out. And so you account for revenue and expenses in a slightly different way. If you're cash accounting, it's not income until the cash is in your bank account. Right? When you have inventory or things that require an accurate income statement, you use what's called accrual accounting, which is you recognize revenue immediately when a sale is made. So products purchased, services rendered, whatever, you recognize that income immediately. And the expenses with that sale are associated in the exact same time period, even if you pay for them before, so you prepay, or even if they're postpaid, they're all matched. And with a business of any size, you can see how that could become a really complicated job very, very quickly. There's an enormous amount of expertise and judgment that's required in matching the revenue and matching the expenses. Now, the third financial statement is the balance sheet. And a balance sheet is a snapshot of what a business owns and what it owes at a particular moment in time. So you can think of it as an estimate of the net worth of a company at a certain date at a certain time. Here are all of the assets so the things that the business owns that are valuable, here all the businesses liabilities. So the things that it owes to other people that have not been paid yet. And assets minus liabilities equals what the business is worth, when all of those liabilities are discharged, assuming they're paid back, right? So what makes the balance sheet balance is a interesting kind of a rearrangement of that question. So, assets minus liabilities equals what's left over, which is sometimes called owner's equity. You can using very basic algebra, rearrange that equation to be assets equals liabilities plus owner's equity. So your assets and what it's worth, after all the liabilities are discharged are always going to be equal. Right? They have to be, basic math. What that gives you if you're analyzing a company, or if you're analyzing your own company, is a very useful check. Because if assets does not equal liability plus owner's equity, there's a mistake that's been made. Somebody is stealing money from you and you don't know it. It's a really nice canary in the coal mine that something is not quite right. Okay, so it's a very basic check step to find an error or to find something that is happening that shouldn't be. Does that make sense? Okay. That's not so hard, right? It's just math. It's just a very structured way of thinking through some common sense things like is your business actually working? And putting it in a form that it's really easy to see where the money's flowing in, where the money's flowing out, and if it's worth it or not. Cool?
Way to simplify it.
Thanks. You know what, we haven't we've actually up to this point, we've covered what would be covered in a college like Managerial Accounting 101 class, and we just happened to do it in two 15 minutes instead of six weeks. Okay? Now, one of the things that you can do, when you have these really nice financial statements is the statements are only as good as your ability to look at the numbers and use that information to make better decisions that improve the business, right? We're not just making spreadsheets to make spreadsheets, we're going to use them for some important things. And one of the ways that you can use these documents to give you an idea that something needs to be looked at, is to calculate what's called a financial ratio. And a ratio, very basic mathematical concept. One number divided by another number equals a ratio. Right? That's it, pretty basic. And there are a couple of different ratios. We're not going to talk about very many specific ones here, we'll talk about the types of ratios that you can calculate. The types are really important, right? So one type of ratio is a profitability ratio, which indicates a business's ability to generate profit. So how profitable is this company? And when you calculate a ratio, and you calculate the ratios of other companies or other products, and you start comparing those, you can use the ratio as a very quick way of measuring one business against another or one product or offer against another, right? Leverage ratios indicate how your company uses debt. So how much debt? Or how much money has the business borrowed? And can they pay it back? So sometimes businesses use that as a way to grow really quickly. But a leverage ratio can give you a heads up, it's like, hey, this company has borrowed a lot of money and they're not bringing very much in and that may be highly likely that the lenders are not going to be paid back. It's good to know that in advance. And that's what leverage ratios help you figure out. Liquidity ratios indicate the ability of a business to pay its bills. So how much cash does the business have at this point in time? What does it owe in the case of bills or current liabilities? And can they pay their bills? If the business can't pay their bills, they're probably not going to be in business very long. So if you're in an investor in a company, it's probably worth looking at that before you funnel more money into the business, right? And efficiency ratios indicate how well a business is managing assets and liabilities. So how much inventory does the business have? How long does it take to collect a payable, so collect money from a client that when services have been rendered, right, some of the throughput things that we were talking about earlier, that's an efficiency ratio, how well is the business operating? And how is it changing over time? So tracking some of the stuff helps you figure out where are we right now? How can we improve and is what we're doing working to actually improve the business based on where we want it to go? Does that make sense? Okay. So the point of all of this stuff, right, lots of definitions about how finance works in a business context. The whole point of the bookkeeping, the accounting, the financial statements, and the financial ratios comes down to this, which is cost benefit analysis. So if the data you're examining doesn't lead you to make changes to improve your business, you are wasting your time. Right? We're not tracking these numbers just to track the numbers, we want to do something with it. And so a cost benefit analysis is the process\ of examining potential changes to your benefits, to try to estimate if I want to make this change, what's it going to cost to me in terms of money and energy, right? And what are we expecting to get from that, and if you expect to get more than you are spending, it's probably a good decision. If you expect to spend more than you expect to get, it's probably not a good decision, right? That's what finance is, right? We track all of these numbers, and we pay attention to how they're changing over time because it helps us do this. It helps us figure out what we should change, make changes, measurement, and see if it works. And if it works, keep doing it. If it doesn't work, stop doing it or do the opposite thing. Right? That's it. So if you want to make more money, here's how you do it. It's called the four methods to increase revenue. So believe it or not every single business in the world. If you want to improve the revenue or increase the revenue that that business brings in, there are four and only four ways to do that. And the best way of imagining this, I found is thinking about a restaurant. Let's say you're the manager or the owner of a restaurant and you want to bring in more money. How would you go about doing that?
Bring more customers.
Yeah, bring more customers in the door. First more customers equals more people buying food, what else?
Raise prices, more prices assuming the same number of people are buying the same number of things means more revenue coming into the business, right?
Yeah, upsell, would you like fries with that?
Exactly. Would you like fries with that, selling them more things brings more money into the business, right? And?
Come in twice a week for lunch instead of once.
Exactly. So the same amount of customers coming in twice a week instead of once a week means more money coming into the business, right? Those are the only four ways you can increase revenue for a company, bring in more customers, have those customers buy from you more often, have buy more per transaction and raise your prices. That's it. So increasing customer quantity, average transaction size, purchase frequency, or raising your prices, those are the only four things that you can do to bring more money into a company, right? So this is just like so many of the things that we've talked about during this course, this is a very useful checklist, right? You want to improve a business? Go down the list, how can we bring in more customers? How can we get them to purchase more? How can we get them to purchase more frequently? And can we raise our prices? That's it. So raising your prices is one of the only four ways you can increase your revenue. So the ability to raise prices is very, very valuable. And if you're only capturing a tiny percentage of the value that you are creating, you may have a lot of flexibility in terms of your ability to raise prices. Now, if like Nick, you're in the commodities business and everybody is selling exactly the same thing, and there are very few differentiating factors, your ability to raise your prices may be very, very limited. Because if the price goes up, they'll just buy it from somebody else, it's the exact same thing, right? So, pricing power is important because it allows you to overcome the effects of inflation, or increased raw material costs or increased electricity costs, or overhead costs, or any of the costs that may go up. If you have the ability to raise your prices, you also make your business a lot more resilient. Because you can take some of those hits and just pass it through the customers in the form of increased prices. Okay? Now, the higher the prices you command, or can command, the better you're able to remain sufficient, right? So pricing power is a really good thing because it allows you to make sure that that number is always higher than it needs to be. Right? So if you have a choice, if you're evaluating different opportunities, pricing power can become another criteria. Which of these ideas would have the best ability to potentially raise prices in the future based on what you know now? That's probably going to be the more valuable idea. Make sense? Okay. Now, two concepts that are extremely, extremely important when analyzing, particularly the marketing and the sales aspect of your business. These two concepts are lifetime value and allowable acquisition cost. So lifetime value is the total value of a customer's business over the lifetime of their relationship with your company. Or in other words, how much is a new customer worth to a business? Right? One of the ways of increasing your revenue is bringing a new customer in the door and lifetime value says how much in financial terms is a new customer worth to us? Right? So that's the idea of lifetime value coming up and you do this based on data. Some of it may be industry data, some of it may be data that you collect personally, but the person who buys from you, how much are they worth in present and future business for the company over the lifetime of that relationship? Once you know that number, you get to do something really cool, which is the next idea called allowable acquisition cost. And allowable acquisition costs, says okay, if I have a new customer coming into my bike shop, they are worth $12,000 to me, over the lifetime of the relationship, how much of that in my willing to spend in order to establish them as a new customer? The higher the lifetime value of that customer, the more you can feasibly spend in order to attract and retain them. Right? The rule of thumb, this varies a little bit by industry based on the amount of risk present in a transaction, but the rule of thumb is you should be willing to spend up to one third of your customer's lifetime value in acquisition cost. Overhead. Overhead is the minimum ongoing resources required for your business to continue operations. So you can think of overhead as all of the things that you have to pay for, just to keep the business going, right? So your rent and your facilities and your electric bill and phone, before you make a single sale, there's a bunch of things that you have to cover every single month, just to keep the lights on. All of those things are considered overhead. And the lower your overhead, the easier it is to remain sufficient, right? If you're not spending a whole lot of money, you don't need a whole lot of money coming in every month just to keep the lights on. So the lower your overhead, the greater your flexibility, right, because you don't have as much of a thing to catch up on every single month just to make sure you you're still in business. Now, overhead is really, really, really important if you are building a business that is either financed with loans, or with outside venture capital, because when you're building a business, particularly with something like venture capital, investors may give you a couple million dollars to build this business. And your overhead is the rate at which you are spending this fixed pool of money and you can actually do a very basic calculation, which is the amount of money we have in our bank account divided by how much we're spending each month equals the number of months this business has remaining to live on life support until it must support itself, right? It's called your burn rate, right? So the amount of money that you've acquired from investors divided by your burn rate equals the number of months you can keep going without revenue coming in the door, right? It's a time limit. Okay, so tracking your overhead and minimizing your overhead in a lot of ways is a way that you can extend the amount of time you have to build the business before you have to be bringing in enough money to cover your overhead and some extra. Right? Does that make sense? Okay, now overhead is a way of thinking about costs and well defining two very specific important types of costs here. So fixed costs are costs that do not fluctuate with the amount that you're selling, or the volume that you're producing, okay? So all of your overhead costs are usually fixed, you're going to pay them anyway. Gonna pay your rent, gonna pay your electricity, you're gonna pay the salary of your employees like, all that stuff gets paid, regardless of how much business you do. Variable costs are directly dependent on the amount of volume You do in any given month, right? So if for example, you run a T-shirt business, for example, and you're making screen printed T-shirts, and you're selling them on the internet or something like that, the amount of cotton fabric that you go through in a given month is directly related to the number of T-shirts that you manufacturer ends up, right, that is a variable cost. It fluctuates with the volume. And so, going back, remember, we were talking about accumulation and amplification, and how businesses grow and fluctuations to volume. There's an important little thing here about costs. So reductions in fixed costs accumulate over time, right? So if you save $1,000 a month, every month you save $1, and that as an as an as and you're saving 12,000 a year. Right? Reductions in variable costs are amplified by the total volume that the business is doing. So going back to the espresso making, or the Starbucks making shots of espresso, if Starbucks figures out a way to save 10 cents per shot of espresso, that is multiplied by the entire number of shots of espresso that Starbucks makes for the rest of time. Right, that number can really add up. Incremental degradation is, remember yesterday we were talking about incremental argumentation, the improving of whatever it is that you're offering, and going through the iteration cycle to make better and better, better and better, better. incremental degradation is the opposite of that. And it is included in finance, when we're talking about the finance and accounting stuff, because you know, accountants and finance folks kind of have a reputation of being the penny pinchers of the business world. It's like we need to reduce costs to improve our profitability, reduce costs, reduce costs, reduce cost. And the important point here is saving money doesn't help you if it lowers the quality of your offer in a meaningful way. So you know, saving money is a good thing. And cost saving measures accumulate over time, and they end up having a huge impact. But if that impacts the quality of your offering and less people purchase from you, it can be very counterproductive, very quickly. So cutting costs can only save you so much money, right? Creating more value is something that you can always do more of. So, idea right now, breakeven, which we've already touched on a little bit earlier, but let's define it now. Breakeven is the point where your business's total revenue exceeds or equals or exceeds its total expenses since opening for trade. So you can imagine, when you hang out your shingle as officially being in business, you start spending money, and you keep spending money As long as that business exists, right? So the point at which the total amount of revenue that you have brought in during the life of the business equals the total amount of money you have spent to get to the point of bringing in that money. That is your break even point, right? And it's a little bit deceptive because you just think of breakeven revenue equals expenses. Great. And it's it's easy to track that on a monthly basis, right? So let's say you're spending $100,000 a month, you bring in $100,000 a month. So yeah, we broke even. No. Because you may have had a year of spending $100,000 a month and you have $1.2 million of expenses that you still need to recoup by bringing in more money, right? So it's total revenue, life of the business, total expenses, life of the business. That's the break even point. So your break even point changes constantly. So if you're starting a business, it's important to keep track of how much you're spending and how much you're making. And really track how much is it going to take to reach the break even point because the break even point is the magical point in the life of any business when you finally start making money. That's a good thing, you need to reach that at some point where the business is going to close, right? Because you've been spending more than you've been making. So the more revenue you bring in, and the less you spend, the easier it is to reach breakeven. If you don't spend a whole lot of money before you start bringing in money, that's a really good thing. You don't have a payback period. If you're investing really heavily in the hopes that your revenue will suddenly catch up, you need to pay attention to this very closely. Make sense? Okay. Amortization is also something we talked about a little bit earlier, but let's define it formally now. Amortization is the process of spreading the cost of a resource investment over its estimated useful life. Okay, so remember, we were talking about the waste management company amortizing their garbage trucks over a 10 year period versus a five year period? Amortization is just taking this really expensive unit that you have to pay for usually all at once, the garbage truck, and matching the cost of that or attributing a percentage of the cost of that over a very long time period. And amortization can really help you if you have to make huge resource investments in the expectation that that resource investment is going to pay out or give you a capability of paying out over the longer term. Now, purchasing power, purchasing power is the idea or it's the sum total of all liquid assets a business has at its disposal. So purchasing power, quick definition is the amount of cash that you have in your bank account in a given time. Plus the amount of money that people are willing to lend to you, plus the amount of investment that people are willing to invest in you if you need it. So I think there's there's an old program by Jim Rohn, who's a business teacher, business coach, that has been around for a long time. And it's like it used to be in business that when your cash account reached zero, that was game over for a business, right? No more money. You're done. These days, you can whistle right on by zero, right? You can take out lots of loans, you can take on lots of venture capital and take on investments. So purchasing power is just all of those things examined at once, right? What is the total amount of your ability to pay your bills, whatever the source of that cash comes from? Right? Just like in old school video games where it's like some condition is met, you get this like big flashing Game Over sign. Running out of purchasing power is the game over condition for a business, right? The moment you can't pay your salaries, the moment you can't keep your lights on. That's the game over condition. Now, speaking of that, the cash flow cycle is a related way of figuring out, cash moves through a business in predictable ways. And if you understand how cash moves through a business, there are some things you can do to make it way less likely that you will run out of purchasing power and clothes and so, two really important sub-ideas here. Receivables are promises from other companies that they're going to pay you money at some point in the future. Payables are commitments that you've made to pay other businesses or somebody else at some point in the future, right? So it's not going back to the cash flow statement. It's not that you've actually cut a check to somebody. It's that you've committed to cut a check at some point in the future. It's not that somebody has actually paid you something that you can deposit in your bank account. They've just given you an IOU that says they will pay you in the future, right? So this adds another layer on top of our very basic checking account, right, you have your cash going in out but you also have promises of people to pay you and promises that you've made to pay them. Now, if you want to maximize the amount of purchasing power you have at your disposal at any given point, here's how you do it, you maximize the amount of cash you have in your bank account, right? If someone has promised to pay you, you make sure they pay you as quickly as, actually pay you as quickly as humanly possible, right? And if you have promised to pay somebody else, you wait as long as humanly possible to actually cut that check, right? And if you do those things, your purchasing power expands, right, because you're holding on to the cash that you have, you're getting paid really quickly. And you're not paying until the absolute last moment that you have. So a lot of big companies that have complex accounting, finance procurement departments, play the cash flow management game, because the nice thing you can do with what's called the float, so the money you've committed to pay, but you're not paying yet until the very last minute, you can invest that and make a return on it. So a lot of insurance companies, lots of large companies manage that cash as a way of generating a little bit of an extra return. Large companies do this all the time. In my opinion, it's better not to play the game because it adds another layer of complexity on top of all of these other things that are way more important for us to pay attention to which is creating more value and happy customers in a way that's financially sustainable. Opportunity costs, opportunity cost is the value that you are giving up for making a choice. So whenever you invest time or money or resources in something, you are simultaneously choosing not to invest that time, energy, resources, money in something else, and your next best alternative to what you would otherwise invest the time, energy, money. That is your opportunity cost. Time value of money is a financial concept that makes its way into a lot of financial analysis books. And the best way of understanding time value of money, we're not going to go into the formulas, we're not going to do equations and all of that stuff. The best way to understand it is a dollar today is worth more than a dollar tomorrow, how much more it's worth depends on the opportunity cost of that dollar. What would you do with the dollar if you didn't do this thing that you're doing now, right? There are lots of ways to financially put an accurate dollar value on that based on the situation you're currently in. But that's the basic idea, the more profitable options you have to invest, the longer the period of time you're looking at, the more that dollar is worth today. Okay, it's a way of evaluating one financial decision versus another in examining the options and choosing the best one. Right? Does that make sense? If you're really interested in the formula, look on Wikipedia, it's pretty straightforward. It's built into a lot of calculators now. You can, it's pretty straightforward to use it based on your own data. That's the general idea. A dollar today is worth more than a dollar tomorrow, how much more it depends on what else you could do with it, right? Now, compounding, it's a really fun idea. Compounding is the accumulation of gains over time. So what's interesting is the classic example of how compounding works in finance, is let's say you invest a dollar in something that gives you a 10% return. How much do you have after the end of the period? A dollar and 10 cents, right? Now let's say you take the result of that and you invested in the same thing that gives you a 10% return. What do you get?
Well, you get $1.21 on top or yeah, $1.21, right? So, why is it, or actually it's $1.22? Yeah, okay. Not gonna do the math, right? But you get more because in the second period you are investing, you're not investing a dollar anymore, right? You're investing a dollar and 10 cents, and that gets you that extra little penny on the end. $1.21, right? Do that over and over and over. Every time you invest, you have a larger sum of money to invest. And at the early stages, it feels really small. Do that for 50 years. And all of a sudden, that tiny difference at the beginning compounds into hundreds of thousands of dollars per period where the cycle keeps continuing. Right? There's there's an old story about a peasant that ended up doing a favor for a king. And the king asked the peasant what they wanted as a reward. And the peasant said I would like one grain of rice the first day. And then the next day, I would like double the amount of grains as the previous thing. Right? So one, double it, double it, double it, 30 days, calculate that up. And it was all of the grains of rice that the entire kingdom had at its at its disposal by the end of 30 days, right, doubling and doubling and doubling and doubling adds to very, very large numbers extremely quickly. Right? So if you can double your business every single year or more, your business can grow really, really big, really, really fast. Which is why, so we've been talking a little bit about venture capital, right? How does it work? And why do folks do it the way that they do it? A lot of it is investing in things that make a company grow really, really fast. Because if you can double yourself for five to 10 years, you can go from nothing to absolutely huge in a very short period of time, right? That's compounding, right? Investing and accumulating gains over and over and over again over a long period of time. If you can find something that compounds, you are golden. Because every dollar you invest produces that return over and over and over again. Make sense? Leverage. Leverage is fun too. Leverage is the practice of using borrowed money to magnify potential gains. And the best way of thinking about this is let's say, okay, let's say that you are interested in investing in residential real estate, for example, and you are interested in purchasing a house and you have a choice. You can put a, let's say the house is $200,000. You could put $40,000 down. So 20% on a single house, or you can put 5% down, $10,000 a piece on four houses that are all $200,000. Right? So that's the choice, one property versus four properties, right? If the house doubles in value from $200,000 to $400,000, in situation one, you've made how much? Huh? Double your money, right? If you purchased four houses, and that happens all the house doubles in price. How much have you made?
Yeah. Right. That's leverage, right, the same amount of initial investment capital, by borrowing more money, right, investing less of your own but borrowing more from other people, you have magnified your gains, right? That's why leverage works, okay? Now, the hierarchy of funding is a general principle that I found in businesses that take on outside forms of funding, whatever that happens to be, whether that's a loan, or whether that is investment capital of some kind. And the general principle is that if you are in a position where you need funding, you need to hire employees, you need to buy equipment, whatever. If you do that out of your own personal funds, that's great because you get to keep full control over the business. The more funds you need to make the business work, the more you need to borrow or the more you need in terms of investment. You can get that money if it's a sound business idea but there's a trade off, there's a cost. And that trade off or the cost is the amount of control, you have to give up over the business in exchange for that money, right? And in general, there's a pattern, the more outside funding you need from whatever the source, the more control over the operations of the business you need to give up in order to make those investors or lenders feel comfortable about loaning you that that amount of money. Now, my personal preference here and this, this is an idea called bootstrapping. When I build a business, the way I generally tend to like to go about it, is what's called bootstrapping the art of building an operating business without funding. No big loans, no investment capital, just the cash you have in the bank account and whatever revenue that you can raise by yourself. The nice part about running a business is raising venture capital raising investment is a full time job in and of itself. It's tremendously draining takes a lot of time, right? Going out and getting loans requires a ton of work, and you're giving up control over the business as a result of doing that. If you fund the business yourself, you can run it however you want. And that is really, really free in a lot of ways. So in general, the best thing that you can do as a person who wants to start a business at some point or is in the process of starting a business, bootstrap the business as far as you possibly can go by yourself. And if there's something that you really want to do and you think is really important, then look into loans and venture capital, if you need to, but you would be really, really surprised at how far you can get by just investing in the business, putting your own time and your money into it. Right?
Then have your customers help with your innovation investment.
Exactly, exactly. Okay, few more ideas here. Return on investment. So return on investment is the value created from an investment of time or resources. It's how much you received from what you invested in, versus how much you invested in it. Right? Like so many things we were talking about financial ratios, this is a really important one. And a lot of times, sometimes it's expressed as a ratio. Sometimes it's expressed by percentage, but it talks about the same thing. Now, tracking return on investment can help you make decisions between competing alternatives, right? If you have data about I get a 10 X return from this, versus a .5 return from this. I'm going to do more of this and less of this, right? It's a very useful comparison tool. It's also useful at comparing offers and entire businesses against each other, sometimes in extremely different industries, right? This particular market or industry is doing really well producing a huge return without a whole lot of investment. This is very capital intensive, very expensive, not a huge return, right? So you can start making decisions about what markets or industries to operate in, based on return on investment. Sunk costs. Sunk costs are investments of time, energy and resources that cannot be recovered once they're made.
I love the quote that you have.
Oh, yeah, so there's a quote by W. C. Fields who is a really old school time comedian, says if at first you don't succeed, try, try again, then quit, there's no point being a damn fool about it. That's a perfect definition of sunk costs, there are going to be times you invest in a new product or a new offer or something you think is going to work really, really well and you try and try and try and try and try and you've spent a whole bunch of time and money and it's just not working. Okay, remember our conversations of loss aversion? We hate to lose, we hate to feel like we've wasted our time, it makes us feel stupid. We hate it. And so we try not to have that situation. Sunk cost is where our natural tendency to loss aversion can really come back to bite us. Because the more time and energy and money you've invested in something, the less you want to stop. Okay? But if it's not gonna work, the very best thing that you can do is stop. Stop wasting all of the time and energy and money and start doing something else. Internal Controls. Internal Controls are a set of specific standard operating procedures of business uses to collect the data that keeps the business running smoothly, and helps you spot trouble. So these are all of the things that help you, the numbers that help you figure out is the business running well, is something going wrong or is something breaking or is there something we need to pay attention to and just like financial ratios have a bunch of different types, or categories of ratios that are useful, there are a bunch of different types of internal controls that are useful. So the five types or the four types are budgeting, supervision, compliance, and theft and fraud prevention. So budgeting is estimating future costs, making a prediction about what you're going to spend in the future and taking steps to ensure that those estimates aren't exceeded without some good reason. So for example, you may say, we expect to spend approximately 10% of our revenue for marketing and sales support reasons. And you can track that right? What is that number, what is that in dollar terms? If one month, you look at the numbers, and marketing and sales support is 40% of your revenue, there better be a darn good reason for that or something is really wrong. Right? So it's just the basic, what do we expect to spend? What do we actually spend? And is there a discrepancy there that we need to look at? Right? That's budgeting. Supervision is important in businesses that rely on employees or outside firms for important parts of its business process. So if you hire employees, contractors, you have a complex process that you're trying to manage, so like a factory production line, you may measure something like an error rate, right? The number of products that come off that line that aren't acceptable for sale, within a certain threshold, a certain amount of errors, okay, use budget for it. If that spikes, you have a supervision error, you know something needs to change in that process, because something's gone wrong, right? Compliance is necessary when a business operates in an industry affected by government regulations. So there are some things particularly if you're applying publicly traded company, there are some things you absolutely have to track in terms of your cash, in terms of how you do your financial statements, you need to make sure that you are operating within certain parameters. A good example of this is health and safety. Right, the number of injuries you have in your particular facility, that's an internal control, you track it to make sure it is within a certain acceptable threshold. If it's not, you need to change something. Right? And fraud prevention, important to protect against the risk of financial loss by some unscrupulous party. Three closing thoughts to be exact is I've noticed a pattern and this is kind of anticipating some of the system's stuff that that remains to be discussed in the rest of the personal MBA. But I've noticed a pattern in the types of businesses that can continue to grow and grow and grow and grow over a long period of time. And the way that you might expect that to work like business starts and grows, and it keeps growing in a very linear fashion until it's really, really, really, really huge is not actually accurate. Business is not that clean. There's lots of ups and downs that happen along the way. And so a more accurate picture about businesses that grow and continue to do well over time, is there's a cycle that happens and I call this the sustainable growth cycle. So systems tend to have a natural size. And in order to grow, they have to go through a process and that process looks like this. The first part of the cycle is expansion. That's the growth, looking at new opportunities. Investigating what's out there in the world, and really aggressively expending resources into getting bigger, okay? That's the part that kind of feels accurate, right? At a certain size, the growth starts actually straining the company. Because as you grow, or if you're focused on growing, you may not be focused on the systems or the processes or the things that makes sure the quality isn't as at an acceptable state, right? And if you continue to push on the growing, things start breaking. Right? So the second part of the sustainable growth cycle is maintenance, making sure you are adequately executing upon all of the opportunities you have in front of you, and fixing some of the things that are starting to break at this new threshold, right? Then after a certain point, you get to the third phase, which is called consolidation. And that's where you've done a lot of the analysis and you start to see that there are some things that we're doing that is kind of dumb, and we should stop doing that now. So consolidation is getting rid of things that aren't working, getting rid of the waste getting rid of the efficiency, right? So there's, it's almost like you could use a gardening analogy here. At the beginning, you let the plants grow, right, lots of fertilizer, lots of water, they reach a certain size, and you want to maintain them, keep the bugs off of them, all of those things. Then after a while, some of the plants do really well and some of them don't. So you prune the stuff that's not working to give more space for the things that are, right? And the cycle and companies that do really well over an extended period of time, you see the cycle repeat over and over and over again, expansions, maintenance, consolidation, and the consolidation creates room for further expansion to take place, right? Does that make sense? Just a more accurate picture of how businesses become really successful. The trick is to not have the expectation that you are going to be expanding to the farthest reaches of the universe without going through a maintenance or consolidation cycle, right? So when you get there, don't fight it, go through the cycle, the business is going to be better for it. Okay, thanks. Now the middle path is an idea that is extremely old. The first literary reference that I know of this idea comes from Aristotle, of all people thousands and thousands of years ago. And he put it this way, the master in any art avoids what is too much, and what is too little. They search for the mean or the average and choose it. So a lot of the things that we've been talking about over the past two days, it's possible to do too much of it, right, go to one extreme and that's not functional, to do too little of it and that extreme is not functional either. There's some happy middle ground that you have to find. And the middle path balancing between too much and not enough, that's what makes business and art as much as it is a science, right? There's an incredible amount of judgment that has to take place between what is too much and what is not enough in finding that good, happy medium. And the thing is, nobody can tell you what this is. You have to find it. It's an experiment. So you just pay attention to what you're doing. you embrace the uncertainty that is inherent in running a business and you're just trying to find that happy medium between too little and too much, okay? Last idea is the experimental mindset. The experimental mindset basically says, treat everything you do in business as an experiment, because the fact is, you don't know whether or not it's going to work. So instead of getting really all caught up in, it has to work, it has to work, I need to predict if this is going to work before I do anything, say, I don't know if it's gonna work, but I'm gonna try it. And I'm going to try it in some small way that doesn't put the entire company at risk that doesn't bet the farm, I'm just going to do lots of small experiments. And if it works, great, I'm gonna keep doing it. And if it doesn't work, I'll stop doing it and start doing something else. And the more experiments you do, the more you learn. The more you learn, the more you improve, the more you improve, the better the business becomes and everybody's happy. You're serving more customers, you're making more money, and you're having more fun. So there's a really wonderful quote now and I'll end the official part of the course with this. There's a wonderful quote by Julia Child, the the famous TV chef, and she was on a show, doing a demonstration about flipping potato pancakes. And like world renowned chef, she's flipping these pancakes and she just flops one like really bad on the floor, and she just laughs and she says the only way you learn how to flip things is just to flip them. And that's exactly how you learn business, right? You have an idea of what you're trying to do and you do lots of small experiments and see how it goes. And keep doing the things that work and stop doing the things that don't.
Josh Kaufman is the author of the #1 international bestseller The Personal MBA: Master the Art of Business as well as the upcoming book The First 20 Hours: Mastering the Toughest Part of Learning Anything. Josh specializes in teaching professionals