Finance: Bring in Enough Money to Keep Going
Up to this point we have gone through the first four parts of the five parts of every business created something valuable we've attracted attention made people interested we have convinced people to purchase this thing and we've actually given it to them hey you now have a happy customer who is satisfied that they've done business business with you and you have more money in your bank account a zoo result we'll do this like the whole point right happy customer more money right and hopefully done in a way that allows you to since you now have more money in your bank account you can now go out and find even more customers and make them happy and have even more money in your bank account and just keep doing this over and over and over as long as you want that's what makes business awesome? You get rewarded for helping other people get what they want now right now we're going to cover the fifth part of every business which is finance in finances the part of business that people start to ge...
t really intimidated by our kind of freak out a little bit because uh there are numbers involved right it's 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, we're going to find the fifth part of every business the finance process is answering to 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? Is this 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 and 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. So finances just the process of looking at everything that we're doing in the first four parts of hurting business and answering those two very important questions we're 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 this is about his basic basic as it gets uh, profit profit is bringing in more money than you spend that's it so I have ah, fun little quote by scott adams the the who created the dilbert cartoon like remind people that profit is the difference between revenue and expense because that makes you look smart. It's pretty basic right? How much money to 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 you're wrong, materials suddenly become a way more expensive that's not of super 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 prophet 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 unexpected things changing in the market ok so what's interesting is that profit has also have has often been talked 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 proper 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 used 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 um 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 could make it any point and I made me legitimately giving a profit to do that I could make more money if I work more but that's not the only criteria that I used to judge the success of the business so it is a criteria it's an important one it's not the only one that makes sense. Great example. Thanks. Yeah, continuing with the discussion of profit aa lot of time, you could talk about profit. Excuse me. In terms of the number of dollars, each transaction brings you extra above and beyond what you've spent. You could also talk about it as a percentage. And this is it called profit margin. So it's, the percentage off the transaction that you get to keep after you take all of your expenses and the equations really simple, it is percent. 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. So what's interesting is you can never have more than one hundred percent profit, right? One hundred percent profit is, is you find something on the street that is abandoned that you decide to take and then you sell it for something, right? Cost you nothing. You get money. All of that is profit, right? Profit margin is different from what's called markup, which is the difference between the price of that you saw something at and what it cost you to provide, right, so resale business that businesses that were talking about earlier, they used what's called a mark up they will buy something let's say one hundred dollars and sell it at two hundred dollars or three hundred dollars and that's a two, three hundred percent mark up above and beyond what they cost it's important to not conflict too right just because you mark something up three times from what it cost you does not mean you have a three hundred percent profit margin yeah it would be awesome yes it would be awesome but the profit margin takes into account all of the costs of running the business that allowed you to make that that sail right um you can actually look into the industry different industries have different average profit margins usually dependent upon how many employees they have how large their technical or equipment needs are and what their states needs are if your business has a lot of expenses that it needs to cover to keep going your profit margin is going to be much much lower for example james in technology profit margin is much smaller than, say services yeah sometimes in the single percent right uh where with services if if you're not spending a lot of money to stay in business and most of what you're investing is your time and expertise your profit margins khun be much, much higher right? That makes sense you calculate like if you're a mom so on a sole proprietor would you because you're not necessarily as the business owner paying yourself as an employee when your sole proprietor would you calculate not pay attention to how much you're paying yourself you're just taking the profits tio live your own life off of where would do calculate to find out your profit margin of your business would you pay yourself and then figure it out or depends on what you're trying to do? So for example if you think at some point in the future you would either like to hire somebody else to run the business on your behalf or you would like to sell the business to somebody else it would be valuable for you to calculate a profit margin after accounting for the salary it would take for someone to do what you do if you're planning on running the business by yourself forever and it's not for sale the profit margin percentage really doesn't matter because whatever you bring in terms of profit is your salary and you can focus on maximizing that number instead of playing with the percentages so for example I don't calculate a profit margin for myself I have no need to because my expenses air generally really low whatever comes in uh after some basic business expenses his prophet and the number is the number okay so that's profit margin now the other thing to notice about profit margin and bigger businesses is that profit margin is a way of comparing one offer against another right, if you have one hundred different products and one of them has an eighty percent profit margin and the other has a two percent profit margin, they could be very, very different things is that it gives you a with evaluating which one is giving you more results based on the time and effort and expense it takes to put it makes sense. Now, dell, you capture is the process of retaining some percentage of the value provided in every transaction to remember when we were talking about using the value comparison method as a way of establishing a price value. Capture is a way of analysing 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 if you bring in a million dollars of revenue to a client based on something something you did like, say, is a consultant or as adviser, your client has an extra million dollars in the bank account and you charge one hundred thousand dollars for your advising service you're capturing ten percent of that value doesn't 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 nine hundred ninety nine thousand nine hundred ninety nine dollars to create that value it's not worth it, for the companies even talk to you, right? If you capture too much, it becomes a much less attractive if you if you kept your last bless you, uh, if you kept your 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. So there are two major approaches or philosophies about value capture, and you've probably seen elements of or people talking about both, maybe not in these terms, but it's kind of out there. Classical wisdom in the business world, particularly at places in academia or business schools, is maximization. Your job is a business owner is to create a lot of value but capture as much of that value as you possibly can to improve your profitability as much as they can, right. So if you can raise prices, raising if you can. If there's mohr things that you could do to serve a customer, do it. If there's some way that you can capture even a penny more of the transaction that will improve your profitability and that's a good decision, the opposite philosophy is minimization, right, your job. Is to maintain sufficiency, make it worth it for you to keep going, but create is much value for your customers, as you possibly can, and then capture enough to allow you to keep going. But there's, no need to maximize you could actually minimize that, seek to provide a lot of value and only get a little bit of it. Hey, now, most businesses operate in some sort of happy medium between the two, right? If it's, a cup public company that has a legal responsibility to maximize shareholder value, they will probably fall in the maximization camp, right? They almost have to. If you are running a business by yourself, you can choose whatever you like. The on ly caveat that I'll say is that if you take the maximization, the value captured maximization philosophy too far, you're doing what the adviser charging nine hundred ninety nine thousand nine hundred ninety nine dollars is doing, which is destroying the reason that people are doing business with the first place. So, in general, if I had to pick between the two, minimization is the most long term effective strategy, because you are making sure that it is worthwhile for your clients, your customers to do business with you, ok? So in both approaches create as much value as you can for people that's the basic criteria john and then make sure you're capturing enough of the value that you're creating to make it worth it keeps getting some big company examples of minimization uh yes can you think of some I was thinking costco also is that cost was a great example so so example retail establishments like sam's club and costco uh have it as a corporate policy that their profit margin on any product that they sell in the store will be no more than fifteen percent that's it they will never charge charge high price that results in them getting more than fifteen percent in value capture and the reason they do that is there in the business of providing really good deals for their members and one of the most profitable things that sam's club and costco cell it's not the products it's the memberships because the profit margin on the membership is one hundred percent right and if they provide if they continue to provide super great deals to their members those members keep renewing and so they've adopted minimization as a strategy to make sure it makes sense to be a costco member or sam right it's a great example hold from its fall under former social degradation paycheck the whole paycheck yeah it's a great business and focused on a very specific type of customer they're classic resale business and sometimes so an interesting strategy around this in retail is some retailers will choose some items that they will intentionally minimize the value that they're capturing sometimes to the point of losing money on every individual sales it's a strategy called a loss leader and the idea is there are some items like when I was working at pg tide laundry detergent is a big thing lots of people by lots of people go into a store specifically looking for so a retailers like target we'll say we're going to take we're going toe by these this tide from procter and gamble and we're going to sell it below our cost is going to be awesome deal exactly were that's why exactly making them and it gets you in the store because when you're in the store you're going to buy a whole bunch of other stuff because you're running nothing you say money guess so that's called a loss leader it's a way of attracting attention and getting people into a store by explicitly minimizing the value that they're capturing for one drink we have complementary products when I sold wine barrels that they sold him for pretty much what I sold them to but they would sell the soil the plants everything that complemented that product exactly same same counts exactly does that make sense now sufficiency is the point where businesses bring in enough profit that the people running it find it worthwhile to keep going for the foreseeable future so sufficiency is the point where you could call a business salad and sustainable right and sufficiency is not necessarily what what will call break even 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 a next best alternative that it 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 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 with the sufficiency numbers for you. So for example, when I quit my job png and I started my own business I had us a sufficiency number and the the idea is sometimes called if you're working for yourself if your bills are paid monthly right have to pay the rent, buy food, keep the lights on all of those things are monthly expenses so you can calculate sufficiency as I must leave number called target monthly revenue how much money do you need to have coming into your personal bank account every month to make it worth it? When I started my own business, my sufficiency number what would make it worth it for me to keep doing my own business versus going back to work at a big company was lower than like my salary from the big corporate job because there were aspects of working for myself that I valued higher. Even if I was going to be less money in making less money, I would have more freedom and flexibility to do it work on what I wanted to work on that was valuable to me, so that number was lower use him to decide what that is for you, and here is the best definition of what makes a business successful that I can think of if your business is bringing in at or above the amount of money at your sufficiency point you're successful that's it? How much money do you need to have coming in every month to make it worthwhile for you to keep doing what you do? If you are bringing an above that number, congratulations, you are running a successful business doesn't matter if you're bringing in ten thousand dollars or ten billion dollars, the scale of the business does not matter what matters is are you bringing in enough for you to keep going when you reach that point? Congratulations, you are a successful business person, an ideal we talked about yesterday let's define it completely here is valuation and evaluation 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 another individual came up to you and said, I would like to buy your company flat out. All right, you 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 public companies have something called a market capitalization, writes the worth of the entire company. When you look at the value of the entire company is stuck, valuation is something that applies to every business. Every business has some worth attached to it evaluation is just an estimate of what that might be at a point at a moment in time, and the higher the businesses revenues, the stronger the company's profit margins, the higher it's bank cash balance and the more promising future final evaluation. 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 businesses valuation, the more the easier it is to do lots of different things. You can borrow money from banks or or or other forms of lending. Way easier if you have a high valuation than a low one right? If you're public, your share prices higher because the business is worth more if you are interested in attracting outside investors, you get more an investment and you have to give up less ownership of the company if the valuations high right? So having high valuation is a super good thing now it's also important so if you are planning to have a public company or a company that is going to be be acquired, your businesses evaluation 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, decrease it if you run a private company by yourself and you have no intention of ever selling it ever, your evaluation 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 now now we get into the fund things so when people think of giants 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 balances and lots of really geeky accounting terms and there are a bunch of different types of financial reports they're a bunch of different ways that you can analyze the company's finances but there are three big ones and so we're going to uh talk about those now so uh the cash flow statement the income statement and the balance sheet and there are entire like five hundred 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 so there are a bunch of books that can help you dig more into this if 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 um 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 this can check our checking account online at this point. So imagine logging into your bank online and seeing the what it tells you. Right and it's, just a list. Here are all of the things that money has gone out for here. All of the places or time's 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 just looked at the cash flow statement that's it it's a ledger how much money's going in? How much goes going out? How much do you have left over? 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 sources operations so selling off lovers 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 from the sale or appreciation of that that's cash from investing in financing is cash that you would get from alone that you take out right? Get the borrow a hundred thousand dollars you have one hundred thousand dollars of cash flowing in your account also okay? So cash from operations investing in financing now the nice thing about the cash flows statement and is that cash doesn't lie right? It is in your bank account where it is not and barring barring something like out like outright fraud it's either in the account or not there's not a whole lot of opportunity to massage or for nagel the numbers right? So a lot of investors like we brought up warren buffett earlier uh we'll talk about the other two financial statements there's some room for interpretation in how you track certain things. There is no room for interpretation in in the cash flow statement that cash is there a word it is not. And by the way, if you run out of cash you are in a bad bad situation, right? So really savvy investors when they are interested in purchasing a business, that cash flow statement is the first thing they look at because there are things that you can learn there the can't learn in any other way make sense so checkbook leisure is a really good mental analogy for what a cash flow statement is now cash is important it's not the whole picture because cash is not profit so it is is very possible to have a nice big fat sum of money in your checking account at any given point in time and be losing money with every sale or to have your business be entirely profitable. So for example then in the insurance industry can you talk about how this works? Um sure, yeah, I guess you know, with our cost of goods sold, you know what what we're selling is insured to promise to pay something in the future but you know, what's unique is with insurance you don't really know how much that's gonna cost on dso you try to mitigate the cost by selecting risks that are, you know better risks than you know the next that'll turn you know, the next extra scout there, but at the end of the day you still don't know until maybe six months later with my business with crop or you know, depending on the other types of insurance, it may be years and years later to you know the true cost and here's the scale the company can be sitting on effectively a metaphorical bank account in the hundreds of millions of dollars and if a certain risk comes to pass they can be in wildly unprofitable, lose all of their money and be out of business overnight right here's another example let's take a retailer who buys stock on credit right so they worked with all of their their suppliers they get a bunch of things in the store and they don't have to pay for that stock for three months right? So they get a bunch of stock they're not paying anything and they start selling the stock and their bank account starts going up right looks like they're making a ton of money right because they're they're selling all of this stuff they haven't paid for yet so for three solid months which could be happening is the cash account is going up and up and up and up and up in the business doesn't realize that it has been unprofitable from day one and they're about to go out of business because when when the invoice rules in from their supplier they haven't been making more money they've been spending right so cash is great cash is not profitability and if you run your business on credit where 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 iss 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 that makes sense. Now in order to do this and to do this well, you have to account for things on on a slightly different basis. So if you're running your own company, you don't have an 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 come 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 your cash accounting it's not income until it, the cash is in your bank account, right? When you have inventory or things that require inaccurate income statement you use what's called a cruel accounting, which is you recognize revenue immediately when a sales made so products purchased services rendered whatever you recognize that income immediately and the expenses with that sail our associate id in the exact same time period even if you pay for them before pre pay or even if they're postpaid they're all matched and with the 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 riveting matching the expenses okay, a cia hiccup that happens with a lot of new creative new photographer specifically is they'll still do say a wedding package and they have an album in that wedding package and you know you're my client you book me in december and you're getting married in september of the next year and you might pay me in full in may who knows right? And so you pay me four thousand dollars and then or whatever it is and then the photographer and looks out and goes, oh yeah you know and lives often and spend all that money and then three months after the wedding's done, the client comes back and says, I want to start my album when the charter for goes oh no, I spent all that money my bank account's empty and that I've seen people go out of business because they weren't smart and stashed that away yes so it's the income statement is a way of being super careful about not getting into that situation er so what's what's interesting is the income statement is absolutely necessary for businesses that have a like between revenue and expense you have to match it to get an accurate picture of what your profitability actually is. The tricky part comes in it's the judgment and the assumptions that go into matching revenue and expense introduces lots of potential bias. Ok, so remember uh back during the most recent financial crisis with all of these big companies that are restating earnings and talking accounting fraud and all of this stuff this is where it happens right? You change a couple of assumptions and how revenue and expenses are matched and the number that looks like your profitability khun fluctuate wildly. We'll talk in a moment about a concept called amortization which is spreading the cost of something over a long period of time a change in a little assumption so for example, there was company waste management garbage garbage collection company was uh amortizing the cost of their vehicles is spreading out the cost matching the cost of the vehicle to revenue over a five year period of time. Right expensive truck has a five year life span there were they were counting for a little bit of that truck every month for five years right accounting assumption that's what accountants do somebody figured out in their accounting finance departments like hey, if we advertise this truck over the course of ten years the little cost every month for each of our trucks gets cut in half, right? When it gets cut in half revenue minus expenses equals more profit every month it looks like we're wait was were way more profitable now and all we have to change is an assumption, right? So that's what they did, they did that across all of their what probably tens of thousands of trucks all over the u s and then reality set in, and they found out that those garbage trucks don't last ten years poopsie yeah, so they were overstating their profitability for a very long period of time based on the assumption that was not true and reality came back to bite them in a very serious way. Okay, so that's, where you have to be really, really careful when you're constructing an income statement or you're looking one, you have to understand the assumptions that are going into the match, right? Particularly important if you are a potential investor in a company, so read the footnotes, they're important that's where the assumptions are and those are gonna be assumption. So I guess it's not going to be able to the only thing that you know about it is it's going to be wrong? Yes, you just don't know whether it's going to be you want to be as close as possible to what's right? Because that impacts in business and and for your own sanity it's better to be conservative on those numbers than to be aggressive on it and it's I wish this was not the case but it is true many particularly publicly are publicly traded companies have multiple sets of books they have the set of books that management uses to make decisions about where to deploy capital and they have the set of books that they show the public traded markets to make everything look as good as they possibly can um not the best practice in my opinion but happens and that's that's weapons management wants to run it conservatively uh the investors or the folks who are interested in managing investors want the business to look as good as it possibly can well, they're sets of requirements as well. So even in the case of berkshire hathaway I suspect that that the numbers that warren buffett uses in order to make the decisions that he needs to run the business or probably different from the required accounting standards that he publishes in in the annual report just because of laws and requirements right? So if you're running a relatively simple business like you're like a photography business or the business that I run your income statement is is actually very simple so in a given month tally up all of your sources of income that's your revenue tally up all of your sources of expense that's your expense revenue minus expense eagles profitability calculate some percentages put it in a nice spreadsheet which actually one of the bonuses to this course uh if if you formally enroll I show you my financial statement format you can use the same one that I do it's just a very basic spreadsheet telling up expenses tell you up uh revenue rent revenue minus expenses puts it in a nice easy toe track layout ok doesn't need to be complicated 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 network of a company as at a various at a certain date at a certain time here all of the assets to the things that the business owns that are valuable here all the businesses liabilities so the things that it goes to other people that have not been paid yet and assets minus liabilities equals what the business is worth when all of those liabilities air discharged too soon there pay back but so what makes the balance sheet balance is a interesting kind of a rearrangement of that question so assets minus liabilities sequels what's left over which is sometimes called owners equity you can using very basic algebra rearrange that equation to be assets equals liabilities plus owners equity so your assets and what it's worth after all the liabilities or discharge are always going to be equal right? There have to be basic math what that gives you if you're analyzing a company if you're analyzing your own company is a very useful check because if assets it does not equals equal liability plus owners 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 ok? So it's a very basic check step uh to find an air 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 and 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 is flowing and where the money is flowing out and if it's where they're not cool 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 one o one class and and we just happen to do it in fifteen minutes instead of six weeks two weeks into my college accounting class yeah just covered it good yes and if you understand this it's really not complicated is there a question it is the question I think a lot of people end up asking quite often and that being from was from climbing damn dan is there a difference between bookkeepers and accountants? Yes. So bookkeepers will help you track all of this information and put it into the proper format if there are decisions like on an income statement for an example that require the judgment of matching revenue and expenses and figuring out what those assumptions are and what they should be based on the available information that's a job for an accountant and there are there are accountants that focus on helping the management of a business make better decisions about how to spend money um and there are accountants that help the business optimized for tax purposes how to organize things in a way that make the business tax efficient so you could say bookkeeping is a little bit more mechanical in the data collection and making sure everything's their accounting is mohr judgment driven how you shoot you, how you should organize toe to improve things. One of the things that you could dio when you have these really nice financial statements is the statements are on ly is good as you were ability to look at the numbers and you use that information to make better decisions that improve the business right we're not just making spreadsheets to make spreadsheets were 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 the ratio that's a 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 once I've 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 is a very quick way of measuring one business against another or one product or offer against another. 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 used that as a way to grow really quickly, but a leverage ratio can give you a heads up it's like, hey this company's borrowed a lot of money and they're not bringing very much in and it may be highly likely that the 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 oh 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 and efficiency ratios indicate how well a business is managing ass schism liabilities so how much inventory does the business half how long does it take to collect a payable that so collected money from a a client that when services have been rendered right some of the through put things that we were talking about earlier that's an efficiency ratio? How well is the business operating and how is that 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 actually improve the business based on where we wanted 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 book keeping 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 process of examining potential changes to your benefits, to try to estimate if I want to make this change what's it's going to cost to me in terms of money and energy, right? And what are we expecting to get from that? If 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 finances 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 it works, keep doing it, it doesn't work, stop doing it or do the opposite thing right that's at any questions so far and this is like we just went through like managerial accounting the two a one now in ten minutes we'll think is a really good question curious of the studio audience has sense will come to you in just a second one coming online from sonora is can you please ask josh with salt which software? I guess accounting software he recommends ah young startup use I recommend that a young startup using very basic spreadsheet so a lot of a lot of folks would recommend like quickbooks or some big fancy accounting package you don't need it if you're operating on a cash basis and you don't have an inventory and you're not doing the cruel accounting uses spreadsheet and and actually download the one that I uploaded teo the course page on creative life you can see how the whole thing is set up uh what's nice is a cz a young startup is the more closely you track the numbers, the more you'll understand them and the more attention you pay to this, the better position you are to understand if your business is working and how to change it right? So particularly as you're getting started, being very, very close to the numbers is a really good thing, okay, now if you are running a more complicated business like a store that carries inventory, for example, you'll want to talk to a certified accountant who knows who has run these type of businesses in the past and they can help get set up from the beginning. So if your accounting is complicated, that is not one of the things you want to die like you should talk to an accountant, you should talk to a financial adviser and have them help you set up exactly what needs to be set up, but you're just getting started do it yourself. All it takes is a spreadsheet, okay? Bradley nelson from st alvin's and england asked, how do you increase the valuation of your company if you are the business? You know what? We're gonna talk? You didn't pull the john gringo, you could slide for that. I do the very next thing we're going to talk about. So you have been talking about ways of tracking data, right and it but if we're trying to make decisions that improve the business, we would like to make more money and spend less and all of those really good things, right? So if you want to make more money here's, I 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 reverend or increase the revenue that that business brings in, there are four and on ly four ways to do that and the best wave of imagining this I've found is is is thinking about a restaurant let's say you're 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 in the door first more customers equals more people but buying food what else face prices raise prices mohr prices assuming the same number of people are buying the same number of things means more revenue coming into the business right? Would you like fries with that exactly? Would you like fries with that? Selling them mohr things brings more money into the business right and come in twice a week for lunch instead of one's 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 air the on ly four ways you can increase revenue for a company, bring in more customers have those customers buy from you more often have them by have buy more per transaction and raise your prices that's it so increasing customer quantity average transaction size purchased frequents we purchased frequency or raising your prices those are the on ly four things that you can do to bring more money into a company 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 the business? Go down the list. How come we bring in more customers? How can we get them to purchase more? How could we get thunder purchase more frequently? And can we raise our persons? That's it and you can find thousands of ways to do that for any particular business. But this is the checklist that you use and if you do these things in combination with spending most of your time focusing on your ideal customers, which, by the way, come to your business frequently they purchase a lot. They spend a lot of money. All of these criteria is a good definition of an ideal customer too. You can think about this in terms of how do you make mohr of your customers more like your ideal best customers that are doing these things that make sense. What they have really interesting is more I study businesses, particularly with your book, how you break down everything systematically it's interesting you could start analyzing businesses you work with that are successful like starbucks, I noticed started saying, would you like a p street with that? Yeah, kind of with fries and I was like increasing average transaction size. Yeah, they also started doing something like those that was really smart if you come in in the morning and a lot of locations they will give you coupon say you should come back this afternoon would be two dollars yeah off off your your favorite drink they're trying to get you to come twice a day instead of once of the increasing purchase frequency it works, it works right. This is it's so simple when we talk about it in these terms, right? If you go into work and you find a way to affect one of these things, you are going to bring in the business a lot more money. And this is a good reason to go to your boss, for example, and say I did this that include pre approved our resume and you should pay me ten times more than you're currently paying me right? You could do that if you if your own a business it would be awesome to do that right? Try like ten x their salary overnight if you run your own business and you want to bring in more revenue, this is this is what you do and so you don't have to make it up from scratch used this as a checklist and you will come up with hundreds of ideas that you contest okay, but this the on ly four ways that you can do it right now pricing power very basic definition is the eye is your ability to raise your prices over time so raising their prices is one of the on ly four ways you can increase your revenue so the ability to raise prices is very, very valuable and if your only capturing the 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 only 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 there despite from something somebody else was 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. Ok, 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, 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 makes sense now two concepts that are extremely extremely important when analyzing particularly the marketing in the sales uh aspect of your business these two concepts are lifetime value and allowable acquisition cost so lifetime cost 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 in new customers in the door and lifetime value says how much in financial terms is a new customer worth to us right? This changes based based on the business you're running so if you are a grocery store you may be worth several tens of thousands of dollars to that business over the lifetime of the relationship then for in the insurance industry the lifetime value of a new customer can be astronomical can you give us a idea of what that looks like? Yeah I guess you know I work a lot with you know the insurance that my company writes is primarily for businesses on dh there certainly is it certainly is a value component to that but people seem to be a little bit more price conscious I would drink mohr on like life insurance side where you've got a very strong relationship with someone your business had to be a little more sticky that that value would be even higher absolutely so the more a customer pays the longer they tend to stay with your company when they sign up and the less that it takes to service a customer once that they once they're already paying you the higher the lifetime value the company we have a question that I question it makes me think about this journalist I profiled loud different entrepreneurs and companies in a few years ago profiled a journal entrepreneur in the northeast who sells bikes yeah, he was able to calculate that the customer lifetime value for that personal walks in it's like twelve thousand five hundred dollars yes that bike may cost anywhere from three hundred to one thousand dollars what he takes consideration they're kids that will be buying bikes for fixing their bikes and all those types of things and because he was able to calculate hey, they're worth almost thirteen thousand dollars over the course the career I can offer things like free service yes bring your bike back whenever you want if you don't like it I'll give you a brand new one kind of thing it was fascinating yeah and and that's there's a really powerful shift that happens when you fully realize like for this bike shop a new customer you've never seen before walking in the door is potentially worth twelve thousand dollars to you and you were going to treat that twelve thousand dollars customer away different from somebody who's just going to buy our random hundred dollars like 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 in 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 ok, if I have a new customer coming into my buckshot, they're worth twelve thousand dollars to me over the lifetime of the relationship how much of that am I willing to spend in order to establish them is a new customer the higher the lifetime value of that customer, the more you can feasibly spend in order to attract and retain them the rule of thumb this varies a little bit by industry based on the amount of risk president a transaction but the rule of thumb is you should be willing to spend up to one third ofyour looked up the customers lifetime value in acquisition cost right so you can do things like offering free service you could do things like all sorts of things that help bring new customers in the door that may feel really expensive right? You ever heard the statistic the average bank to acquire a new customer in a checking account just a basic personal checking account the bank spends between one and two hundred dollars per individual attracting people feels really expensive right until you realize that the lifetime of the relationship with that company each customer is worth thousands tens of thousands sometimes hundreds of thousands of dollars to the bank right there trading a little bit of money in exchange for establishing a relationship that is very, very profitable overtime right? So the higher the lifetime value of your customers the higher the allowable acquisition cost the more things you do to increase revenues of the four things that we talked about earlier increases the lifetime value of all evil customers right? So more of those things you do the higher the lifetime value them or you that you can spend bringing folks in the door. This is also one of the reasons why being a premium provider of what you do is a really strong position to be in because the more your folks pay in the higher they stay with you the higher their lifetime value and the mortar things you can feasibly due to bring in new customers in the door while still staying sufficient, right high prices and high profitability helps you do more things to grow the business does that make sense? Seems like common sense, right? But thinking about your business or analyzing your business in this way helps you make much better decisions about what to invest in and what skip it kind of got to get past the loss aversion yourself of going all one third of the life customers lifetime value I don't, I'd rather keep that, but then again, you have to look at if I don't spend that up to one third than that customer might never show up. And you know what? Fat zero anyway and that's that's not to say that he'd spend the entire third, but in general, the math works out such that if you spend a third, uh, you are ahead in general, so rule of thumb experiment and analyze your own data to see where that where that that nice point works for you. That's what a subscription model works so well, exactly how does that work? Okay? Because we won't tell you why the subscriptions yes, subscriptions worked really well, because you like, I think your example in the book, it was about sports illustrated spending so much on on the swimsuit issue because the lifetime value of that customer it's probably gonna buy a two or three or five years of subscription so if they charge and say twelve bucks a year for subscription that cost him ten bucks to acquire the customer they look still gain whatever the forty bucks more over the five years of owning that customer sounds really exact smart to analyze this I've never done it a mail in business but now I am yeah at one point on a rumor the exact numbers but sports illustrated was giving away a premium like a a phone that was shaped like a ball or something like that and that it costs the company like twenty dollars and to subscribe to sports illustrated for a year cost twenty dollars so it's like you're giving away something that's the entire first year of this subscription and it doesn't make sense until you look at lifetime value and allowable acquisition cost have there's a company that I I buy from who has increased their price by thirty percent over the past just over a year and I recognize that that my lifetime value to them as the customer is many, many, many, many times what I would think would be the break even point or that or what should be the what I would expect to be the this is the sufficiency level for for that vendor and any of that made that choice so I just kind of shake my head when I look at the I spend up to third for a third for acquisition and look at the turnover in that business or the attrition in that business and this kind of kind of shake my head and I recognize with my my next best alternative is and I have have some and it's just it's like this really tough situation if you worked with a vendor for a long time, absolutely any question from the internet? Yeah, we haven't coming in from colorado, and this question is with one third lifetime value spending that to acquire a new customer, what about costs of retaining the customer? Is is that part of the same amount? This is the cost of retaining a customer as well. So, so think about allowable acquisition and retention cost if you wantto build it all into the same thing. So yeah, all of the things that you can do to bring more customers in the door and make them we're really, really happy to stick around, particularly if you're running a subscription business. Attrition is one of the biggest things that that's that's, where folks stopped purchasing from you. Anything that you can do to keep that customer subscribing over a long period of time would fit into this idea. And you're right, it really makes a big difference, I think, as oppose a litany of someone just as a transactions that whether of your corporate clients and they could be paying who knows how much money over the course of next year's for workshops, you treat them a lot differently. We gonna deal, I may be working with them for eighteen years or something exactly, exactly and a lot of the things that you can do just to make life nicer for everybody that don't cost a lot just a little bit of time and attention and expense can a really major dividends over the lifetime of that relationship. All right, a question from the collections department from new orleans? I don't think so. Josh owes the money how do you calculate how long a customer will be with you? Because they won't always stay with you the years others d'oh, yes, so there's a couple ways you can do that. The best way to do it is look at data from the customers that you're serving now and your best customers. How long do they typically stay with you? So if you can make these projections based on your own data awesome when you're a new business, you may not have the opportunity to do that right? So there are in lots of industries, trade associations or groups that that aggregate data and share it with each other, and a lot of times they will share information about lifetime value in allowable acquisition because they want this industry to improve, right? Those sources of information are absolutely worth getting because it provides you data that you would not be able to get in any other way. Goal it's kind of why the prescription model or pharmaceutical models? Such a racket link you into that constantly have to come back and get your prescription, whatever it is indefinitely. Sorry, I'm a little biased. That's. All right. I want a business model like that space. Yeah, you could be very assured that a financial analysis on a pharmaceutical company has a expected lifetime value of a customer, as in that base, based on that perceived me that they make financial decisions based upon that. Okay, a couple more deficient definitions here. Overhead overhead is the minimum ongoing resource is required for your business to continue operations. So you can think of overhead as as all of the things that you have to pay for just to keep the business going right. So your, uh, your rent and your facilities in 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 are considered overhead and the lower your overhead, the easier it is to remain sufficient, right? 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 flexibility, right? Because you don't have as much of a thing to catch up on every single month just to make sure you see 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, maybe 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's month equals the number of months this business has remaining to live on life support until that must support itself, right? It's called your burn, right, 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 and 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 to cover your overhead in some extra right does that make sense okay now overhead it is a way of thinking about costs and will define a two very specific important types of costs here so fixed costs our 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 gotta pay your rent going to pay your electricity you're going to base 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 manufacture ends up right that is a variable cost it fluctuates with the volume and so going that remember we were talking about accumulation an amplification and how businesses grow in fluctuations to volume there's an important little thing here about costs, so reductions in fixed costs accumulate overtime, right? So if you save a thousand dollars a month every month, you save one thousand dollars and that adds and as in ads and you're saving twelve thousand twelve thousand dollars 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 are the starbucks making shots of espresso. If starbucks figures out a way to save ten 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 could reel we add up, right? So one of my favorite examples of this is is in the in the beverage industry, specifically aluminum cans or packaging in general, so in the olden days they were made of stainless steel, there were really big, really heavy lots of material there, and over time, structural engineers and packaging engineers have figured out a way to make cans from less expensive materials do it in a way that preserves the integrity of the can um, by minimizing the amount of material that it takes to have it structurally sound and to reach the end user without breaking and spring soda all over the place, which is kind of important, right? Every single minute improvement that the industry has made to the amount of material on the cost of material that it takes to make one can is amplified over the tens of billions of cans that the entire industry manufacturers and uses every single year for the rest of time. It's a saving of hundreds and hundreds of billions of dollars by making very small changes that are amplified over the entire system. That makes sense. So the more you understand your costs and the more you understand which costs accumulate in which costs are amplified over the entire system, the better you're able to make decisions that save you a ton of money or make you a ton of money over a long time. When you bring a burn rate and fixed in variable expenses, it makes me think of the dot com era. Wouldn't you think of it? Did you just laugh and know that this company's going to be out of business and nine months this was gonna be out in sixteen months? You know it it's interesting when looking at venture capital backed companies in silicon valley and in general a lot of times it's it's helpful understand that sometimes the game is not building a long term, sustainable business. The game is building a business that can have a high proceed valuation that is sold to somebody else. And then investors play hot potato with the business and try to sell it to somebody else until someone has left holding the bag and loses all their money right that's how a venture capital work that works in a very, very real sense now there are many, many, many exceptions to the rule and lots of people who are using venture capital to build a sustainable business that requires a lot of up front investment that's a good thing, right? But there are some businesses that that is not what they're doing or the game with their plane, so I think what's important is as a business person as an entrepreneur being very, very clear about why you are building your business, what you want to get out of it and making your financial decisions in a way that leads to that thing that you want incremental degradation is remember what? Yesterday we were talking about incremental augmentation, the improving of whatever it is that you're offering and going through the federation cycle to make it better and better better, better, better incremental degradation is the opposite of that and it is included in finance when we're talking about the financing and accounting stuff because you know, accountants and finance folks kind of have a reputation of being the penny pinchers of the business world like we did reduce costs to improve our profitability, reduce costs, reduced cost reduced 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 in the end 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 onley save you so much money right? Creating more value is something that you can always do more off right? So you don't need to focus on the penny pinching so much as creating mohr and more and more value over time because that's going to get you where you want to go just a cz much right it's like you know we've we've brought up my friend we meet a couple times in the personal finance courses that he teaches like you can only cut your expenses so much but there is no limit to the amount of money that you can earn if you're smart about it because it's so if you are going to focus on something, focus on delivering more value to earn more money, right? So control your costs but remember your customers are buying from you for a reason and so don't eliminate some of the really nice not so expensive things that give customers a reason to purchase from you and somebody else