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Why the Next Recession Won’t be Anything Like The Great Recession

It’s official – we’re experiencing the longest economic expansion in U.S. history. Since the Great Recession, the U.S. has experienced approximately 130 months of growth. Of course, with any bull run, one begins to ask themselves, “when does the music stop”? No one wants to be left without a chair, yet I constantly hear of wealthy, intelligent individuals preparing for the next catastrophe. While I certainly am not Pollyanna about the economy, I apparently hold a vastly different belief than the majority of people. In this post, I’ll explain why we absolutely will not see a major downturn and why the next recession will more closely mirror other minor recessions that we’ve had over the last 100 years.

The Great Recession

Markets cratered rapidly and panic was rampant

First, let’s define what the Great Recession actually was. At this point, it’s been labeled as the worst economic decline since the Great Depression that started in August of 1929 and ended around March 1933. Here are some important metrics that will help you understand just why the Great Recession was so painful for Americans:

  • Real Gross Domestic Product (GDP) fell $650B or 4.3% of total GDP of $15T
  • Household net worth fell $11.5T or 17.3% of $66.4T
  • Unemployment spiked at 10% with 8.6M or 6.2% of the work force losing their jobs
  • The financial system seized up with banks unable and refusing to lend because they were unsure of their own financial strength

One of the major stories of the Great Recession was that ~10M Americans lost their homes to foreclosure. At the risk of oversimplifying the issue, this is what really caused the Great Recession (yes, some of this was in the Big Short, but you really need to dig into the details of it):

  • Collateralized debt obligations (CDOs) that were once used to hedge risk on commercial debt were almost entirely replaced by mortgage backed securities which were tainted with toxic mortgage products.
  • CDOs were granted high rating status by ratings agencies which gave the appearance of security, even though they didn’t know what comprised the CDOs.
  • Based on these high ratings, pensions, governments, and other safe investment vehicles invested in CDOs in the hopes of achieving higher returns for the portfolio.
  • Because CDOs had mutated and become so complex and convoluted, investors had no idea what they actually owned and how much was toxic. This uncertainty caused the financial markets to seize up.
  • Once the economy began to falter in 2007 and 2008, these underlying mortgages proved to be disastrous because the homeowners could not handle the payments that the mortgages required. Because they could not refinance out of these mortgages due to home values declining and banks freezing up, home owners began to default.
  • This daisy chain of defaults, and institutions not knowing exactly what they were holding on to, resulted in the financial crises as banks refused to lend and assets worth billions of dollars became worthless or lost massive value.

Where Are We Today?

Opinions vary wildly

It’s a bit shocking to see where the U.S. economy is today compared to a decade ago. By several measures the economy is on sound footing:

  • As of November 30, 2019, the U.S. unemployment rate is at 3.5% compared to 10% during the Great Recession (more on this in a later post)
  • Household net worth stands at $113.5T as of the last report
  • Gross Domestic Product has grown at 2% to 3% even in the face of a struggling housing economy. Estimated GDP at the end of Q3 was $21.54T
  • The Dow Industrial Average sits at ~28,500
  • Home prices have largely recovered to surpass the highs set just prior to the crises. Every market will differ.
  • In 2019 alone, U.S. workers have experienced wage growth of ~4% which has been increasing over the last few years. Not as much as needed to allow the economy to go gangbusters, but steady.

By every indication we’re at the market high, poised to drop and possibly drop hard and fast. But why?

Are We Poised For a Recession?

I hear it nearly every day now from a number of different places.

  • “I’m stockpiling cash to get ready.”
  • “I don’t want to buy in this market and regret missing out on deals that will come when prices fall.”
  • “Is now a good time to buy? I can’t find any deals.”
  • “This cycle is the longest in history. It’s just bound to come unraveled.”

Really, the underlying theme here is that we’ve been recovering for too long. The stock market is too high. Prices for real estate are too high. Everything is too high. But, is that reason enough to cause a recession? And not just a recession, but a really bad recession? One that mirrors the Great Recession? Because no one I speak with thinks it’s going to be a minor pull back. Everyone is convinced that we’re about to have another major crises.

Every time I hear this, I ask why? What is going to cause not a minor recession, but a major recession?

What is a Recession?

The most basic definition is that a recession occurs once GDP retracts for two consecutive quarters. That means that the economy has to actually contract for a full six months before we call it a recession. That’s a major lagging indicator and can make it very difficult to tell when we’re actually starting down the path of recession and whether we’re in a full-blown recession. There are other helpful indicators, but for purposes of this article, let’s just stick with the most basic definition.

So, we’ve got six months of declining GDP. Keep in mind, that’s not slowing GDP, but actually reversing GDP. The economy is shrinking.

The United States is a bit unique compared to the rest of the world. Our economy is primarily driven by consumer demand and purchases by consumers. This includes purchases for t.v.s, cars, clothes, computers, iPhones, etc. When a recession occurs, consumers are purchasing less and thus businesses begin laying off workers or reducing payrolls. When companies reduce staff or the income of its remaining staff, this puts additional pressure on consumers being able to purchase goods to help fuel the economy. Thus, we have a vicious cycle of retraction. This is why you’ll see the federal government offer tax cuts and outright tax rebates/refunds to consumers to help spur the economy. The U.S. economy needs consumers.

Are We In For a Recession in 2020?

I’ll go ahead and deliver the punchline since you made it this far.

No, we’re not going to have a recession in 2020.

And no, we’re not going to have a major crises for the next downturn.

In the near term, there are simply too many positive variables working to prevent a recession in the United States. Employment is at an all time high, workers are making more each year, there’s positive innovation at work, banks and other creditors are still lending with little reservation, and the housing sector is even showing signs of new life. In addition to these factors, the Trump administration appears to have prevented a full blown trade war with China and those headwinds which were at play in 2019 hopefully will dissipate for 2020. There’s clear evidence that the trade war with China caused uncertainty for businesses which prevented them from deploying capital and taking business risks which would have further grown the economy.

Ok, great, the economy is on steady footing now, but what’s lurking in the shadows? Real estate is too high, so we’re clearly going to have a repeat of the Great Recession, right? Bank balance sheets are full with commercial and residential loans, so they’re over leveraged, right? Student loans outstanding are a ~$1.4T and when they default, that’s going to trigger a crises, right? The stock market is at an all-time high, so that’s going to trigger a recession, right?

  • Yes, real estate prices have largely recovered and even exceeded pre-crises levels, but why should that mean that they’re over inflated and bubbly? This is related more to inflation, higher costs of building, low interest rates, and a lack of inventory. I predict that we will actually see a gradual slowing and leveling of real estate prices in the next few years – without a crises. Home builder confidence is at an all time high and they’re building homes as quickly as they can. Trade deals with China, Canada, and Mexico help the housing market as labor and materials can be acquired more cheaply. Low interest rates have allowed borrowers to purchase more expensive homes, but, they’ve qualified for those loans under tight underwriting requirements. No more ridiculous appraisals which helped aid in the crises. The loans being written today and over the last decade are some of the safest loans that have been made in U.S. history. I know, because I run a mortgage company. It’s safe paper. As more housing inventory hits the market, we’ll see less pressure on the existing supply and prices will cool. As Millennials continue to hit their working stride and earn more, demand for houses will increase which will spur additional building. Also, we’re going to have Boomers moving out of their homes and selling to a Millennial generation that is desperate for housing inventory. More on that below.
  • Bank balance sheets concern me a bit and we’ll cover that more later. But, the loans being written have better loan to value ratios and are secured by better collateral than in the last two decades. The loans on bank balance sheets are good paper. There’s just a lot of that paper and liquidity is getting a bit tight.
  • Student loans don’t scare me one bit. For a few reasons. The first and primary reason is that no one, to my knowledge, is packaging these loans up, slicing and dicing them via Collateralized Debt Obligations (CDOs), and then creating additional massive leverage on them like what happened with mortgage backed securities. The investors holding on to these loans know what they got themselves into. They’re fully aware of the risks and no one is committing massive fraud to try to hide performance. Secondly, student loans stick with the borrower no matter what. There’s no defaulting on them. In essence, they will always have value because the borrower must always perform. So, even in a wave of “defaults”, someone could provide the liquidity to the market and that investor would be made whole at some point because the loans would perform.
  • The stock market is at an all-time high. I would say it is well poised for a pull-back. But this is going to be made worse primarily because of automatic computer trading and ETFs. These are new devices and instruments that have never been as popular or prevalent as they are in today’s society. We’ve already seen what happens when a “flash crash” occurs. It’s not good. But, a decline in the stock market does not trigger a recession. See the definition above. It may hurt overall household wealth, but there’s no indication to me that corporations are going to disappoint shareholders through missing earnings – at least not a major scale. The economy is doing well, consumers are doing well, and companies are doing well.

You may still be under the impression that the “next one” is going to be bad. As bad as the last one. I simply ask you this: why? What is going to trigger the financial system to seize up and collapse? What massive gamble is going to come unraveled? What financial product has the world invested heavily in without understanding the product? What assets are artificially inflated? The questions go on and on. At the end of the day, it all boils down to the fact that we as humans suffer from a bias that the most recent event is going to be the next event. It’s not a bad survival mechanism, but it’s terrible at helping us predict events.

What Am I Watching Out For?

I always want to be watching out for signs of instability. In 2018, the 10 year Treasury spiking and rising to 3.25% caused major problems in residential real estate. We don’t need that to happen again in the next few years. That will make it too expensive for borrowers to purchase homes at these higher prices without receiving larger wage increases.

I’m watching out for employment and wage growth. If wages don’t continue to grow, consumers cannot keep up with inflation. The stated inflation target and rate of ~2% is nonsense. The real inflation rate is much higher and I’m working on a post to cover that topic. It’s a major problem. Employment appears to remain strong, but the longer-term issue here is whether the jobs currently being worked are sustainable for the future. Society as a whole has a very long way to go when it comes to expansion in science and math. We’re only just scratching the surface of the opportunities in space. Opportunities in the human genome. Opportunities to reverse climate change. There are plenty of opportunities in the future. The question will be whether workers have the time, resources, and insight to make necessary changes before it becomes too late for them to pivot. We need more resources dedicated to educating the work force and preparing them for the future.

The stock market should continue to perform well through Q3 and possibly Q4 of 2020. Investors very likely have seen the best days of the stock market and should not expect to see the phenomenal returns of the last few years. This run up has been aided by the massive liquidity sloshing around in the markets after Quantitative Easing rounds. I will likely liquidate my investments around Q3 and will let the correction take place. A logical reason for a decline in the stock market is going to be corporations providing forward guidance that indicates a softness or earnings per share coming in weaker because the corporation has run out of opportunities to cut costs, expand market share, or increase revenue. A company only has so many levers it can pull.

There is a longer-term issue which has already been coined as the Silver Tsunami where the homes that Boomers own and may not be methodically selling will all the sudden start hitting the market in waves. That’s a big problem. For a variety of reasons. The first reason is that it’s never good for a glut of homes to hit the market at once. Secondly, a fair portion of these homes are in locations where Millennials aren’t located and don’t want to locate. That’s important because they’re the only generation capable of matching Boomers in terms of eligible purchasers by sheer headcount. And finally, these homes are going to be outdated and need work. If a potential homeowner is considering a 20 or 30 year home compared to a new home, they’re going to lean towards the new home. So this massive glut of homes could sit vacant in markets for a very long time. Given that the horizon of this event is 10+ years or greater, it’s difficult to assess the full impact this may have on the economy and local communities. Just know this is either an opportunity or a problem.

The final thing that concerns me is what is happening in the repo markets for large institutions. This story first broke in September where the short-term lending rate spiked as high as 10% for extremely short-term liquidity. This sparked a flurry of articles as the Federal Reserve immediately stepped in to provide liquidity and assurance to the market. Initially, this was written off as a cash crunch because companies needed to pay their taxes. At face value, that might make sense, but when you step back for a moment, you realize that would either be major financial mismanagement. Companies know when taxes are due. They know how much is going to be due ahead of time. If that was in fact the case, this would indicate that companies were suffering from not having enough liquidity. At the time, it was speculated that this was a short-term phenomenon, yet, the issue persists to today. There’s so much at play with what goes on in the repo markets, it would require a separate article from someone much smarter than me. Suffice it to say, it bears watching as these fractures could lead to a full blown break if the issue cannot be identified and mitigated.

What’s Your Prediction

Given this analysis, you should see that talks of another bad recession, this soon, are driven almost entirely be fear and short-term memory. What’s your take on what’s going to happen? I’d love to hear from you.

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My First Blog Post

Be yourself; Everyone else is already taken.

— Oscar Wilde.

While this is the first post of this blog, this is by no means my first attempt at writing. No sir, this is a never ending love hate relationship. I love the idea of writing. I don’t always love how my thoughts make it on to the “paper”.

In addition to starting numerous blogs and stopping numerous blogs, I wrote a novel related to the residential mortgage industry which is by “9 to 5”. You can find the link for that book here: https://tinyurl.com/srxfkos . I’m also working on a second book, but it’s not a novel. It’s a how to on developing commercial real estate. I’ll post the link to purchase that book once it’s finalized in late January.

The World According to Michael is going to be filled with business basics, how to succeed in running a business, observations about the U.S. and global economy, and personal development. A one-stop shop for anyone currently running a business or looking to get started in business.

What makes me qualified to offer advice? Well first, it’s the Internet. We’re all experts here. Secondly, I’m a Millennial. So of course I have the best advice to offer. In all seriousness, I’ve been running a business for the last 5 years. A business with over 300 employees and a lot of moving parts. A business that requires constant attention to stay on top of trends and to put out first. The residential mortgage business. Prior to joining the mortgage company I work for, I worked at PricewaterhouseCoopers (pwc) in Dallas as a tax CPA. I still carry my license, but I don’t practice.

Thanks for stopping by and I know you’ll find value from the content.

The Purpose of Business

What is This All For?

It seemed to be THE topic of the 2010’s regarding living a purpose driven life and fulfilling that mission through business. I’ve listened to more podcasts and read more articles surrounding this topic than I care to remember. Motivational speeches are filled with this rhetoric, “do what you love and you’ll find financial success.” Or, “create a business around what you’re passionate about.”

While this isn’t bad advice, and there is some helpful truth to these words, it creates a stigma that if you’re not passionate about something you can’t be successful. Or going further, you shouldn’t be in business unless you’re passionate about the problem you’re trying to solve. The truth of the matter is that being in business is a grind. It’s just simply a grind. There are fulfilling aspects of business that go beyond money or status, but at the end of the day, you must put in the work. Pursuing a passion through business at some point will become work. There’s ways to prevent burnout, but a passion, not fully supported, can result in burnout quickly.

The Problem with Passion

Passion is phenomenal. I’m not saying you shouldn’t use your passions as a guide to business. What I am saying is that you can have a business purpose that isn’t necessarily driven by a passion. The important distinction here is that you shouldn’t get in business just because you think it’s going to make you a good deal of money. I can speak first hand about this while I was in the construction business.

On the surface, construction companies have the capability to generate a lot of cash flow and higher margins on an expensive product. That’s tempting. But, there was absolutely zero interest/passion driving the reason I got into the construction business. It was “hey, I’ve got a level of familiarity with this and I think we can be successful.” This resulted in major headaches and financial losses. Had I been more passionate about the business, it might have been different, but ultimately we chose to get out after four years. In this case, a level of passion was important. It really wasn’t there. The business decision was financially driven and when we had to make a decision to continue to grit it or hit the eject button, it made more sense to stop. We needed a certain level of passion here.

The problem with passion is that you can quickly find yourself in a business that doesn’t make any money and carries such a niche level of interest that you’ve made a major financial mistake. Or, you may end up doing so many additional duties because it’s a start up that you quickly burn out. This is not uncommon, but it’s rarely talked about. Everyone focuses on Steve Jobs talking about how you must have passion for what you’re doing in order to be successful.

So How Does Passion Fit with Business

An emerging and more sustainable philosophy regarding your passions and how business fits, is that your business fuels your passions. If I’m interested in financial literacy, I don’t have to start an educational company in order to pursue that passion. I need to create a cash flow machine that allows me the time and financial means to then invest myself or money into a worthy cause.

This is important for two reasons. One, you have a driving force which is the passion that you want to serve. That causes you to wake up early, drive harder, and perform better than you otherwise would. The second reason is that you don’t experience direct burnout from your business which can cause you to abandon the passion or under serve the passion. When you’re dealing with product or personnel issues that are taking you away from the mission of your passion, you don’t find yourself at odds with your goal. You can separate the two in a way that serves both better.

Final Thoughts

There are times when a passion can fuel a wildly successful business. It is possible. But, it’s rare and those stories are over-glorified.

Realistically, you should start and manage your business knowing exactly what you’re trying to serve. Orient the business to allow you to pursue your passions wholeheartedly and you will find a higher level of satisfaction with less burnout.

Quick Update – New Year

End of the Decade

Good morning everyone! My goal has been to release a post a day, but I haven’t been able to do that. The good news is that the handful of posts that I’m working on should be highly informative and I think it will be well worth the wait.

I know you’re all waiting with bated breath.

No, I’m not going to post about goals, or how this is the end of a decade and the start of a new one. That’s someone else’s turf.

I will encourage and challenge you to change one little thing. Build on that one thing and continue to pursue that one thing until you’re satisfied with the change. I’ve always thought of achievement as a small adjustment to the rudder of my ship. Over time, that small adjustment has massive impact.

So, have a wonderful New Years Eve, don’t drink too much, and keep an eye out this week for a long post about the next recession.

The Fundamentals of Business – Pt 2

Intro

This post is specifically for those who have been in business for over a year. That may mean you’re still flying solo or you may have built up a team due to the nature or success of your business. No matter what the business looks like, I guarantee that you’ve started developing bad habits. It’s natural. Entrepreneurs tend to gravitate to those practices that they enjoy and are good at. So, the details that they don’t like tend to get swept under the rug until the wind of adverse conditions starts blowing and all the dust chokes them. I am absolutely NOT advocating that business owners spend large amounts of time doing tasks that are not the highest and best uses of their time. That’s why you create leverage and surround yourself with individuals that allow you to do more “on your business” rather than “in your business”. Yet, you absolutely must stay in tune with the basics of your financial foundation and the overall health of the business. Failing to review this information monthly, if not weekly, is setting you up for a major problem in the future.

Surveying the Land

Looking at the path ahead

Since it’s the end of the year, now is a perfect time to take stock of how you and your business performed this year. Did you hit the goals you set? If not, how badly did you miss? If you did reach them, why were you actually successful? In order to set yourself up for long-term success, you must know why you succeed or failed. It’s easy to dig into failures and determine the cause. It’s rare for someone to dig into why they succeed. This truly separates the long-term winners from those that limp along or succeed in spite of themselves. It’s not enough to realize that you sold more, made more, expanded, etc. That’s great. But if you’re not sure why you did, you’re missing opportunities to capitalize on that success, or, more importantly, to realize that it was a fluke. What if you were only successful because the market improved for all? As President JFK once said, “a rising tide lifts all boats”. Don’t get lazy and fail to analyze why you were successful. The reason may surprise you.

It’s also important to take this time to assess if the business is meeting your intended personal goals. More often than not, an individual starts a business for two reasons: 1) to make more money and realize financial freedom and 2) to control their schedule and not have to answer to someone else. Both of these are perfectly legitimate reasons to go into business. I will tell you that reason #1 can be harder to sustain. For that reason, it’s very important to have clear financial goals that allow you to gauge whether being in business is even worth it. This is especially important if you happen to be in a cash flow business which may appear to be profitable because you are flush with cash, yet you’re actually making little to no true profit when you properly account for where that cash must go. Construction related businesses are notorious for this. If you started the business for reason #2, you need to take a step back and determine if you actually were as free as you thought you would be. Running a business can be a cruel task master. It’s easy to go into business so that you can have more flexibility to spend time with family and pursue personal goals, yet you find yourself 100% consumed with the state of the business and whether it’s going to make it. Don’t sacrifice your family at the altar of “a better life”. It’s never worth it. You’ll look back on the missed games, missed dates, missed laughter and despise your company. Especially if it ultimately fails which is a fairly high probability.

The Rat’s Nest

This section will cover the most important balance sheet accounts. If you’ve made it a year or longer in business, it’s critical to stay dialed in to your numbers. This can be akin to unraveling a tightly knotted mess. Surviving simply because you can “kite money around” is a dangerous game and you’re ultimately going to have to pay the piper. That can get you into legal trouble if you’re not careful.

The Balance Sheet

The balance sheet of a business is one of the least appreciated tools for a business owner. It’s also dangerous to overlook. A balance sheet is a snapshot of a business at any point in time, typically the end of the month. Beyond cash and net income, a balance sheet also carries future cash inflows and outflows.

Accounts Receivable

Outside of Accounts Receivable (A/R), there are very few balance sheet accounts more critical to the life of a business. Most businesses run on the accrual method of accounting or don’t deal directly in cash point of sale systems. This means you’re floating your customers on YOUR credit and in order for you to stay in business, you must collect on these customers. Typical payment terms average 30 days, but you can incentive quicker payment with a slight discount for 15 or 20 day terms. You will need to assess what makes sense for your industry. It’s not always 15 or 30 days that really matter, but rather whether a business collects the payment at all. That may sound crazy, but as you attain more customers and move beyond the “every sale counts” phase of your company, you may discover that you have massive leakage from customers that don’t pay in full, pay very late, or don’t pay at all. This account needs to be audited monthly. There are no exceptions to this rule. If you fail to audit this account monthly, you may find that your sales have dried up, yet you’ve been banking on collecting your AR for cash, but there’s really nothing left to collect. Yikes. That’s a terrifying proposition. In performing your audit, retrieve all of your invoices or bills of sale and make sure that whoever you billed is included in your AR. If they’re in your AR, are they late? Can you trace that money into your cash account? If you show them as paid, yet the cash never hit your account, you’ve just been embezzled from. Congratulations. Unfortunately, a slight level of paranoia and distrust must be present at all times when dealing with accounting and cash. As a business grows, it’s very easy to conceal items at the surface level to hide fraud and stealing. Dig deeper and make sure that the sales cycle fully completes. In reviewing your AR, you may find there are customers that you need to cut, have a difficult conversation with, or even praise. Timely paying customers are a major asset to a business. Slow paying customers can be a detriment because you’re basing future expansion and spending on their payment. Don’t be afraid to cut a customer for poor payment. Or, just charge them more. Supply and demand will take care of itself.

Inventory

Similar to AR, this must be audited at least quarterly. For businesses that maintain inventory, this can be a massive area of waste or theft. Unfortunately, inventory can spoil or walk off. Having tight controls over your inventory can save you heaps of money each year. It can also tighten up your cash flow. A growing inventory balance can be dangerous. Your cash is tied up in your inventory. Turning that inventory may take a long time. Don’t allow your inventory to build to unacceptable levels. Additionally, don’t allow your inventory to not properly cycle through your accounting system. This means that a quantity of item A should not hang around for months on end if this is not typical. This may mean that you’ve already sold item A and you’ve overstated your balance sheet. If you can’t locate item A, it’s been stolen or discarded. Keep your inventory balance clean and tight and you’ll run a more profitable, cash flowing business.

Fixed Assets

If you own a building, computers, furniture, or vehicles, you have fixed assets. These are legitimate assets that can be sold. However, they are also declining in value each day that they are used. Some business owners fail to properly depreciate their fixed assets and thus think that their business is worth more than it is. They may say, “hey, we own this building and these 10 cars and these 5 computers, so my business is worth at least $200,000.” That’s faulty thinking. You have to think about what you could achieve upon the sale or liquidation of the business. You’re not going to get $200,000. As a business owner, never consider your fixed assets as something that you can liquidate and take off the table. You’ll be in for a big surprise.

Accounts Payable

Coupled with AR, Accounts Payable (AP) is the life blood of a company. You should conduct a weekly audit of your AP. No exceptions. This is the money that you owe to suppliers, landlords, utility companies, etc. Failing to pay these vendors timely can result in a bad reputation along with less favorable credit terms. As a business owner, the better you manage your credit, the better your cash flow and net income will be. Businesses that pay timely receive lower interest terms, longer payment periods, and can work with vendors if they get into a crunch. Allowing your AP to increase past your AR and cash means that you’re upside down. You’re on a quick path to going out of business. You owe others more than you’re bringing in. This may be typical for a start up, but if you’ve been in business a few years, this is a major warning sign. Your AP is also a perfect area for fraud. Separation of duties is critical. The person putting in the AP needs to be different than the person cutting the check. It would be very easy for vendor Jones Electric and Lighting to be entered as a valid vendor and receive a monthly check. Audit your vendors a few times a year by paying someone hourly to call and verify invoices, addresses, etc. This is the #1 way to catch fraud.

Summary

By performing monthly business reviews, you keep your balance sheet tight and clean. A major problem for companies is allowing their balance sheet to grow by not cleaning up old information or by allowing accounts to languish and get missed. You will massively outperform your peers if you will stay dialed in to the financial metrics of your business. On the next Fundamentals post, we’ll cover analyzing key business metrics and leveraging a business intelligence tool.

The Fundamentals of Business

I’m always shocked when I hear business owners discuss how little they know about what is happening inside their own business. For many owners, they started out as a soloprenuer and could more or less gauge the business based on how their bank account looked. While this may work fine for the first few months of a business’ life, it’s a dangerous and silly way to run a company that you base your livelihood on.

If you currently do this, just admit to yourself that this is foolish and then commit to doing better. For some owners, they’ve been removed from the minutiae for years and so the thought of re-engaging in the details of the business can seem absolutely daunting. Where do you start? What’s a meaningful metric? How do you get started? First, let’s tackle what you should do if you’re brand new or starting from scratch and then we’ll move on to how to untangle the rat’s nest of an older business (in the next post).

Fresh Start

For those of you just starting out or recently incorporated, start here and then move on to the cautionary tale in the next post. There will never be an easier time to run your business than when you first start out. Why? Because the number of variables that you’re trying to manage is at an all-time low. Sure, you’re likely panicked at the prospect of getting enough sales to actually justify being in business, but you’re always going to have that struggle. When you’re a one man show and you’re making the sales, taking the deposit to the bank, writing the checks, etc., it’s very easy to eye ball everything. You’ll remember all the checks and card swipes. You’ll remember the sale number and the amount. Give it a year or two and this will all become a blur. Plus, you’ll likely have made your first hire to handle some of this for you which means they need a system to follow.

A smart first step is to lay out what is easy for you to understand from a balance sheet and profit and loss (PL) perspective. What I mean is you should label accounts in a way that is meaningful to you and your business. You’re likely going to be using QuickBooks (QB) or a similar piece of software and they allow you to code things the way that you want them. This is really important because in the event you hand this off to an employee or a book keeper later, you need to be able to explain what you’ve done and then you need to audit what they’ve done. Be disciplined in your approach to handling sales and expenses. Treat them the same month in and month out. Provide as much detail as possible and avoid the temptation of lumping all income into one account and all expenses into another account. It makes reviewing your business for the purposes of improving later nearly impossible. And whatever you do, do NOT allow yourself to say “I don’t understand the numbers, I just take what my book keeper gives me.” That’s a recipe for fraud/embezzlement and you’re chances of being successful are significantly reduced. Have the intestinal fortitude to understand the numbers and make sure that your business is on track. Trust me, I know how awful it is to look at losses. Losses month in and month out. Losses that are scary and sickening. I know. But, you must analyze the numbers and understand why you’re hurting and what you can do to solve the problem. Almost without exception, increasing sales activity and sales will be your number one solution.

The next critical step (among many critical steps) is to truly understand the cash flow of your business. Again, this will never be easier than it is now. Start with your fixed expenses. The things you must pay every month no matter what. This will be rent, employee salaries, your salary (if you’re lucky), a bank note, etc. Starting with these amounts is easy because you must cover this. Next, move to your variable costs. These are going to be estimates based on past production and future estimates. Variable costs will include flyers that you send out, meetings that you attend and pay for, product that you must purchase in advance, etc. The more business you generate, the higher your variable costs. This is normal and good. But, make sure you don’t leave out a critical aspect of a variable cost or your projections are going to be sorely lacking and you’re going to wander why you aren’t nearly as profitable as you expected. Make sure you account for everything. Rosy booking keeping and projections does no one any good, so don’t fall into the temptation of inflating your projections. Finally, end with your sales and income. Track and reconcile EVERYTHING. This is most easily accomplished through your bank account and your accounts receivable. Sales will increase your bank account. If you logged a sale, but didn’t see the cash, then it must be sitting in your accounts receivable (AR) which you now need to collect. If a sale is not sitting in the bank or in an AR, you’ve got a problem. I refer to this as “leakage”. Too much leakage and you’re business has an expiration date.

Summary

Out of the gate, if you’ll just focus on those two items above, you’ll be shocked at how easy business can be. That’s not to say generating sales isn’t difficult, because it can be. But business is really not that difficult. If your income exceeds your expenses, then you’re winning. Tracking this carefully is crucial.

As a final point that will be explored later, track everything. Track your sales activities, track your expenses, track your website traffic, track it all. When you carefully examine your business’s performance and metrics, you begin to see patterns. You notice what you should start and stop. This method of business is called the Hawthorne Effect. You can read up on it here. Essentially, what gets monitored, improves. Become a disciple of the Hawthorne Effect. You’ll be amazed at the results.

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