Be Thankful for What We Have

Several days ago, my wife was sworn in as an U.S. citizen in a ceremony in Chicago. Having dealt with the government bureaucracy throughout, we did not have high hopes for the occasion, but were pleasantly surprised by the ceremony that took place. Along with the 140 other new citizens and several hundred friends and families, we sang the national anthem and recited the pledge of allegiance. We watched a video about immigrants and also a music video with the song, “Proud to be an American”. The new citizens recited the oath to their new country.

For me, the highpoint of the ceremony was when the new citizens came forward to receive their certificate of naturalization. Of course, this is the digital age, so there were several new citizens taking selfie-videos of themselves receiving the certificate.

The person that impressed me the most was a gentleman in his 60’s, who really looked the part of an immigrant; neatly dressed but somewhat grizzled, with the rough hands of one who had done manual labor for many years. When he received his certificate, he held it aloft in both hands as high as he could reach to show it to friends and family across the room, and then began jumping up and down in a dance of sheer joy, a wide smile on his face. This was an important moment in this man’s life!

Of course, bureaucracy was on display that day as well. It took longer to check in the 141 prospective citizens than the actual ceremony. The Bulldog noted several quick changes in process that could have cut the time in less than half, but I kept my peace that day.

Afterwards, my wife told me about a comment that one of the bureaucrats made during the checking in lineup. Seeing the long line waiting to check in, she asked how many were there. When she was told that it was 141, she said, “Wow, why so many? Are they giving something away for free? I want some!” My wife had the right thought, but she did not verbalize at the time. I will now, “Ma’am, you’ve already got it, and you don’t even know!”

What the bureaucrat had was the liberty and blessings of being an American citizen. Unfortunately, at least at that moment, she seemed to have forgotten that fact. Many do, including myself from time to time. The freedom to live as I would like, to be an entrepreneur and build a business that supports my family and my community. The freedom to express myself and my ideas. We often take these things for granted, and often it is immigrants who remind about these freedoms.

To quote Churchill, “”Democracy is the worst form of government, except for all those other forms that have been tried from time to time.” (From a House of Commons speech on Nov. 11, 1947).

 

Unintended Consequences

Business agility demands that a business be ready to react quickly to their environment in order to take advantage of change. However, there are times when a fast change results in unintended consequences. Many are the stories of plans gone awry, even when well researched and grounded in fact. All the more reason not to make snap decisions that can take your business in the wrong direction. Here are some questions that can help you discern the difference.

Are we equipped to handle the change? There are many companies that are the victim of their own success. Something that seems like a good idea turns out to be a great idea, to the point that the company is unable to keep up with demand. Before making a change or introducing a new product or service you need to ask several questions. The first is about volume, do you have the infrastructure to keep up demand? The second is about resources, do you have the people to keep up with the demand.

What would we do if demand was 2 times what you predict? 10 times? 100 times? Using hypothetical numbers allows you to analyze what effect different scenarios might have on your business. You may discover that up to a certain point, you can handle the new business or increased volume that a change may foster, but nothing beyond that point. If that is the case, you may want to introduce the change or new product to a smaller segment of your clients or the market.

Is the change based on fact or a hunch? It is true that there are those that can study a market and get a “gut-level” sense of what is going on. Generally speaking, I would not believe that of myself, and you should be skeptical as well. Is your hunch based on research and data, or is it based on anecdotal evidence but not supported by more extensive research? Getting to market with a new product or service includes doing a certain amount of research to back up the hunch.

Do you have a Plan B? If the new product or service does become successful beyond what you can handle, do you have a Plan B in place? Plan B can include outsourcing on a temporary basis, or using temporary staff to fill in. Be ready for success beyond what you predict.

These simple questions can help your business avoid unintended consequences on the road to success.

Tragedy in Connecticut

As a person who grew up in Connecticut, I have been as shocked as others from the horrific event in Newtown, Connecticut. I offer my sincere condolences to the families of the victims and the people of Newtown.

DuPont Analysis: Capital, Debt and Equity

Capital equals debt plus equity. We hear this phrase, but do we really understand what it means? The best explanation that I ever head was also the simplest. Capital represents all of the assets of the company. Debt and equity represent who owns those assets.

As an example, if a company has $1,000 in capital assets, and $400 in debt, then equity is equal to $600. The bank, or whoever holds the company’s debt, owns 40% of the capital, and the owner(s) of the company own 60%. The proportion of debt and equity to capital is also known as the company’s capital structure.

We should also note that, although we express these relationships in dollars, we may not be talking about cash in the bank, but about other types of assets that could include buildings or other real estate, equipment, inventory as well as other intangible assets, such as good will (which is another topic completely!).

You will recall from last week that return on equity (ROE) was the ratio at the top of the DuPont pyramid (for an image of the pyramid click here), so let’s start there. ROE represents the earnings that a company makes on each dollar of invested equity. In other words, it is a sign of how each dollar of equity is contributing to the bottom line. The calculation for return on equity is:

Net Income
Equity

So, if a company had net income of $12,000 and equity of $100,000, then ROE would be 12% (ratios are usually expressed as a percentage). In other words, for every dollar of equity, the company returned $.12. One way that the ratio can be useful is to compare it to previous years. For example, if the previous years’ ROE was 8%, you could infer progress.

On the other hand, if the previous year was 16%, you could infer the opposite. Another way to use ROE would be to compare it to your industry’s average. If the industry’s average was 20%, for example, your company could be at a competitive disadvantage.

As we work down the DuPont pyramid, we see that ROE can be broken down into two constituent parts, Return on Capital (ROC) and Leverage. ROC is similar to ROE, in that it expresses the return on each dollar of capital in the company. Its’ formula is:

Net Income
Capital

If the same company as above had $150,000 in capital, then the ROC would be 8% or a return of $.08 on each dollar of capital. As in the previous example, you could compare the ROC to previous years, or to company expectations for this year, or you could compare it to the industry ROC. All would be useful in understanding how your company is performing.

At this point you might exclaim, “Wait a minute, how can ROC be less than ROE!” The answer to the question reveals the power of leverage, as well as the usefulness of the DuPont Analysis. To explain the power of leverage, let’s look at the capital structure of the company, that is, the ratio of Capital, Debt and Equity.

Let’s start out by assuming in a first example, that the company actually had no debt. If that was the case, then there would be no difference between the account of capital (debt + equity) and the amount of equity. Therefore ROE would be $12,000/150,000 = 8% and ROC would also be $12,000/$150,000 = 8%.

In reality, we said that the company had $150,000 of capital. If equity is $100,000 then based on the formula capital equals debt plus equity, then the company has $50,000 in debt. Let’s now look at the formula for Leverage:

Capital
Equity

Based on the formula, our example company has leverage of 150,000/100.000 = 150%., or simply expressed, 1.5 When we apply the principles of the DuPont Analysis, this becomes clear.

Ratios at each level of the DuPont Analysis are equal to the ratio above. So, another formula for ROE is:

ROC x Leverage = ROE

In this case 8% (ROC) x 1.5 (Leverage) = 12%. By using debt to increase the amount of invested equity, the company was able to get a better return. If the company had no debt, they actually would not have had as good a net profit.

We can see then that by deconstructing the top ratio, ROE in to ROC and Leverage, we have a better understanding of the company’s financial structure and why they have made the returns that they have. Next week, we will continue to delve deeper into the DuPont pyramid.

DuPont Analysis: The Numbers Don’t Lie

Over the years that I have been working with small businesses and entrepreneurs, I have discovered that there is no better way to judge the health of your company than through financial analysis. As the title of this blog states, the numbers don’t lie. A good financial analysis can lead you directly to the source of any problems within your business. Yet, many small business owners and entrepreneurs don’t spend a lot of time on financial analysis, or only do so superficially.

In my experience, one of the best ways to analyze you business’ financials is based on a method developed early in the 20th century, the DuPont Method of ratio analysis. The method was created by F Donaldson Brown, an employee of the DuPont Company, as a way to manage General Motors . The DuPont Method was considered the standard until the 70’s, although I still find it a very useful tool.

The DuPont Method introduces a pyramid of ratios with Return on Equity at the apex (click here to download a file). At each level of the pyramid, the method deconstructs ratios into their constituent parts. For example, Return on Equity is composed of Return on Capital multiplied by Leverage. Return on Capital and Leverage are then decomposed into their constituent parts and so on.

The key highlight on financial ratio analysis is to see how financial operations drive value. Some finance people refer to this model as the value drivers model; others, as the financial levers model. The former see value drivers as the explanation of how an entity makes money and increases its value, hence the term “value driver.” The latter view financial ratio analysis as the method for identifying the triggers of financial results, hence the term “financial levers.”

There are three different types of ratios within a DuPont analysis: profitability ratios, activity ratios and solvency ratios. Profitability ratios analyze whether or not you are making money, and why. The question why is the most important part of that inquiry. Many are the occasions when an entrepreneur or small business owner will say to me, “According to my Profit and Loss statement, I am making money. Why is my bank account empty?” Profitability ratios will help to answer that question.

Activity ratios will help you understand how efficiently your business is operating. For example, if your business turns over its capital 3 times a year, but your competition does so 5 times a year, you could be at a competitive disadvantage. In other words you will find it harder to compete because the competition used its capital more efficiently.

Finally, solvency ratios will tell you whether or not you have the financial wherewithal to stay in business. There are many businesses that are the victim of their own success. A business that has a great product or service that others want to buy may expand so rapidly that they don’t have the capital resources (money) to keep up with the expansion. Solvency ratios will help you understand where you are in terms of capital resources and how fast you can grow.

So, tune in for the next three weeks as we take on the DuPont Method.

i Project Management Accounting, Callahan, Stetz & Brooks, John Wiley and Sons, Hoboken New Jersey, 2007
ii Ibid.

Know Your Competitive Advantage

Competitive advantage is what all businesses are seeking: it allows your business to charge higher prices for your products and services or to get more customers. Everyone is seeking competitive advantage in their market.

Gaining and maintaining competitive advantage requires that your business be focused on the proper things; that is simple, but not always easy. There are really only two areas of business focus in order to establish competitive advantage: first, you must be competitive in your industry and secondly your business must differentiate itself from the competition. Sounds like a contradiction to me! Let’s take a closer look at each.

In order to be competitive in your industry your business must do “industry basics” well. For example, if you are Starbucks, you can have the nicest storefront possible, with great music and a cool ambiance. But, if your coffee is not at the right temperature, or tastes bad, you will not be able to compete in your market. For a coffee shop, temperature and taste are basics and the company must focus on them in the right way.

In what might seem to be contradictory, it is also true that you should not exceed your industry basics in the name of competition. That practice can be costly and self-defeating. Take the example of a distribution company that competes in a market where 5 day delivery of goods is the standard and customers do not expect more. If a company were to spend time and money on next day delivery, they would be wasting money creating differentiation that their customers don’t want. Doing so puts the focus in the wrong place and could actually hurt the business.

In many cases, businesses do not always focus on the right places to understand industry basics. For example, a business’ financial results, in comparison with the industry median for that result is often a good place to see where your business stands in your industry.

A software development company might look at their software production cost (Cost of Sales); they may not be competing on price, but if their production costs are significantly higher than others in the market, they will have a hard time competing. Proper focus here will keep them competitive in their industry.

Differentiation, on the other hand, is not about industry basics. It is about how your business can do something differently to distinguish itself in the industry. Of course, what you do differently must also be something that your market wants!

Let’s look at distribution again. Supposing that the company that tried to differentiate with quick delivery took some time to talk to their customers that are retail operations. Perhaps they might discover that their customers spend time breaking down the goods they receive from the distribution company into smaller lots for reshipping. The distribution company might be able to save their customers time and effort by packaging their goods in such a way that the customers would have minimal repackaging to do.

At times, it might be possible to turn an industry standard on it’s’ head in order to gain competitive advantage. Prior to Starbucks, most of the coffee industry was centered on fast food coffee chains such as donut shops. Fast was the operating word. Starbucks created a product that included not just upgraded coffee, but an entire experience.

The company wanted people to stay longer, not leave quickly. Starbucks achieved tremendous success with that strategy; only recently have they made moves that have harmed them (but that’s the topic of another Blog).

The name of the game in competitive advantage is to stay focused on the right things for your industry!

Small Business and the Unemployed

For several years I have been presenting seminars at Career Place in Barrington, Illinois, working with numerous unemployed. Many of these people had developed a one-page handout that contained highlights of their qualifications and experience. Often, a list of targeted companies was also on the one-pager.

The problem is that most of the companies targeted on these handouts were Fortune 500 and other large companies. Unfortunately, many of the large companies have not been doing a lot of hiring lately. I counseled these people to look at small businesses, because when you consider companies with $500 million annually in revenue and less, there are several thousand in the greater Chicagoland area. I am sure that this is true in many other metropolitan areas as well.

For the unemployed there are two questions to ask: why seek out small business and how to do so?

Why the unemployed should seek out small business.

Most entrepreneurs that start businesses have great experience…in something other than business. The entrepreneur focuses on doing whatever is necessary to get the business going. In particular they are focused on their customers, how to find them and how to get the customers to buy.

During startup, entrepreneurs are usually less interested in business practices than in their fundamental expertise. And for them, this is the correct attitude to start with. However, if the entrepreneur’s idea gets traction and the business starts to grow, there are a host of business pitfalls that need to be avoided. In the past, I have written articles on the importance of tracking cash flow, in particular incoming cash as a basic and often ignored process. In other cases, entrepreneurs have never done a “break even” analysis that would show them whether or not they are profitable.

Many unemployed have the skills necessary to help these small businesses grow and thrive. On the other hand, often small business owners don’t even know what they need. There have been times when I was discussing different aspects of business with entrepreneurs only to have them discover that I had information and skills they needed; they just didn’t know that they needed them!

In other cases, small businesses are seeking the proper people to help them, but the positions they are trying to fill don’t show up on Monster or in ads. This brings us to the second question.

How to find and reach out to small businesses.

Since many small businesses do not know what help they actually need, or have limited resources to find people, it is up to the unemployed (or employed looking for a change) to find the small business and reach out to them.

There are many resources on the Internet and in libraries that can aid the research. A good example is the Business Affiliations Database from Lexis Nexis, available in many libraries. You are able to search for companies by many different variables. First, to find the kind of company that you would like to work for determine the SIC or NAIC codes (industry classifications) using an online database, easily found in a search for NAIC or SIC. Once you find the classification of the company’s industry, you can use that as part of you search. In addition, you can search by company revenues and geographic area.
Now you have a list of companies to approach, but what to do next? Corporate Affiliations will list, for most companies, the owners and officers.

My suggestion is to write a letter to a person at the company explaining that you are interested in possibly working in their industry and are conducting research. Who should you choose to write to? That will take a bit of creativity, but here is an example: supposing that you are an experienced marketing person, and you notice that the company does not have a marketing director listed. Your best bet is to contact the person that would most likely have a marketing director reporting to them, perhaps the CEO or COO. Then write your letter.

Several days after your letter has been sent, follow up with a phone call requesting a short meeting (15 to 20 minutes) where you could ask questions and conduct your research. If you find a gate-keeper, try to enlist their help; explain the research that you are doing and ask for their help in setting up an appointment. Be sure never to say you are looking for a job.

Once you have an appointment scheduled, be prepared not only to ask good questions, based on industry research that you will do before the appointment, but also be ready to talk about what you do and how it is applied. Often, you will be surprised at the interest the person you are meeting will have in what you do. Even more so, you will frequently be directed to other people to contact, both within the company as well as at other companies.

Small businesses need a variety of experienced business professionals in order to thrive. Use the information in this article to take the initiative and find a niche for yourself in small business.