CFO

1. Linear Regression = sum of the square of least deviations ... essentially, linear regression can be used to make a straight line forecast. In excel this the forecast function which uses x as the value you want to predict, known xs and known ys.
2. Break-even and break-even dollars. BE = FC / 1 - (VC/S) ... BE units = FC / (unit sales price - unit variable costs).
3. NPV and IRR calculations are necessary for project decisions.

A Global Financial Tailspin

If a penalty is not present for those who take a risk and fail, what disincentive do they have to not try the risky maneuver again? I am a hands-off, deregulation man myself but after reading some of these articles and gaining an understanding of what went on, I think that if any regulation is needed it is in the bond market.

The stock market is fairly translucent, the bond market is opaque. This is what allowed the bond institutions to package up all of the junky mortgages and get them reclassified at a better rating. This was not the cause of the subprime mortgage catastrophe, but it certainly made it worse.

I believe it shouldn't be allowed to get to the point of failure in the first place, at least not on such a massive level based on a massive bet that was founded on unethical financial practices.

The more I read about this the more I come to understand that what happened in the secondary markets, the rolling of the bad loans into tranches which were then rolled into CDOs to mask the bad loans which were then insured with credit default swaps, it was like "Dumb and Dumber Go to a Casino." The problem is, they were having fun making these high stakes, ludicrous bets with billions of dollars. I find it hard to believe that a few key individuals could have been responsible for throwing us into a global, financial tailspin but the more I read, the more I believe this to be the case.

I believe in capitalism and free markets but when a few key players have the power to destroy the free market and opportunity for others, a referee must step in.

The Engine for a Better Business Model

The following is an excerpt from Building a Small Business That Warren Buffett Would Love available at Amazon.com.

The Business Plan - Well Yeah There is an Outline But This is Not War and Peace

If you perform a web search on the term “business plan outline” or peruse your local book warehouse, you will inevitably come across a half a dozen, varying outlines. My motto is: find one that you are comfortable with and then get very comfortable with that outline, quite similar to Warren Buffet’s line, “put all of your eggs in one basket and then watch that basket closely,” except he has a billion dollars and I do not. If you are dusting off the old business plan or starting from scratch then you need to familiarize yourself with a good outline. And remember, this is not an Ayn Rand novel.

A Living, Breathing, Implementable Document

In a perfect world, your business plan would sprout arms and operate the cash register but the truth is it is probably dead in a drawer somewhere next to an old Kenny Roger’s CD you keep around for “me” time. Your mission now is to find that drawer, open drawer, grab feather duster and get to work. Your business plan in part contains your hopes and dreams for your business as well as how to operate the whole thing. It sure as heck deserves a better fate than Kenny.

As far as the living, breathing and implementing part, your business plan should be wired directly into the business. At a minimum, this should be done by reviewing and tracking the progress against the key elements of the plan in bi-weekly team meetings and quarterly strategic meetings.

Let’s examine specific sections and see how you are stacking up:

The Vision and Mission – sometimes viewed as the enlightening, blue sky statement that hangs on the manager’s wood paneling – it sounds idealistic and cute but the real world says otherwise. The real world says to hell with your idyllic view of how you think your business should run, I’m in charge. But isn’t the Mission why you went into business in the first place? The Vision and Mission at a minimum is the driving force of the business, the fountainhead the business is chasing after. The whole point of having one is to use it to drive through the daily onslaught of reality. It should be kept at the forefront and reviewed daily. If you haven’t developed an overall mission or vision stop now, do not pass go, do not collect $200. Get to work putting one together by asking who do we serve, why do we serve them and how do we serve them? What is our overall purpose for being in business? What should our business look like now and in the future? Write it down and read it at every meeting.

Business Description and Product or Service Description – this is the section that says “we will deliver quality service and products in a unique and outstanding environment. Our customers will be wowed by us until their head’s explode.” Great! Now the question is, how is this glorious statement tied into the business? What is the standard for checking up on customer satisfaction and product quality? Are the customers surveyed on a regular basis and is the information reviewed in team meetings? It should be.

Which brings us to our next area of planning and integration …

Management and Personnel

If you bring your “A” game to this section you will develop an organizational chart. If you bring your “A” game, a cup of coffee and a knack for delegating, then you will flesh out roles, responsibilities and accountability for each position listed in the org chart. In keeping with the previous product and service example, if you show up at a meeting and don’t know who is responsible for improving customer service, then chances are the business has some unhappy customers. If the organization chart indicates that Joe is responsible for customer satisfaction then the meeting script would go something like this … “Joe, we are receiving a fair amount of customer complaints. Any insight into this?” or “Joe, our customers are raving happy, how’d you do this?”

Ideally, Joe would wake up from his nap at this point and ask “are you talking to me?”

If everyone knows their roles and responsibilities and accountability, then in theory, big surprises should not occur.

Marketing

The marketing section should detail the varying channels that will be employed to market the business – web, print, radio, blimps, wacky, waving, inflatable-arm, flailing, tube-men, etcetera. This section should also include a measure on how to grade the effectiveness of each channel. How are you doing? If the newspaper ads are providing a rate of return of 150% but the radio spots are barely breaking even, then perhaps it is time to kick out the radio channel advertising and beef up the print ads … or invest in half a dozen more wacky, waving, inflatable-arm, flailing, tube-men.

Finally, Financials

No matter how you slice it, the purpose of a business is to make a profit. It is therefore imperative to examine for profit on a monthly basis by preparing and reconciling monthly budgets back to actuals. If this is not being done, then again, do not pass go, do not collect $200, go directly to your local book warehouse or search on “budgeting”. Budgeting is a very important tool for the health of your business. Additionally, as a part of the planning process, longer-term forecasts have been prepared. It is helpful to review and compare the forecasts to actuals. Opportunities for improvement may exist.

Get cozy with the balance sheet and cash flow statement as well. You don’t have to be an accountant but understand the differences between assets, liabilities and equity and how a cash flow statement differs from an income statement. Ideally, over time, the business is building assets and increasing equity over time, not metastasizing into a hopeless spiral of death. If you are continually throwing good money after bad into a black hole of debt, it is time for radical improvement or time to cut your losses.

Goals and Milestones – You Said You Were Going to Live up to Them, How’d you do?

Although by all appearances The Secret was a profitable attempt to repackage motivational material from the 80s and market it into an international bestselling book and DVD, the real secret is to set meaningful goals and milestones for your business and keep them in front of you at all times. Goals will serve as a motivational engine that will drive you forward even when you don’t want to go into work for the day and should describe where the business heading and prompt you to take the steps to get there.

In the existing business plan, review the goals that were created and check to see if they have been hit. If not, why not? Keep the business goals in front of you and the staff at all times and remember, be specific: It is much better to say “I want to weigh 171 by December, 25^th 2011 at 7pm” than “I want to lose weight.” In the second example you can take off a sock and then cheer “mission accomplished.” In the first example, you have to step on the scale on December 25^th and face facts.

Some Goals and Milestones to Think About

1) An exit strategy is not a planned fire escape route. It is the ultimate goal of the business. Are you going to work until you hit the ripe old age of 110, hand it off to the kids, or sell it for a nice sum of cash? Michael Gerber, author of eMyth Revisited, asserts that the goal of every business owner is to eventually sell the business. How much will you sell it for?

2) When will you reach financial independence? You didn’t start the business to have a hobby. At what point will your passive income be equal to or greater than your expenses?

3) How much revenue will the business generate in the next three and five years? How much net income?

4) Will you expand and open additional stores this year, create a new strategic alliance, or perhaps diversify the product offerings? Sometimes though it is best to remember that many business opportunities will come your way and it is best to not jump at all of them.

The Times They are A’Changin

Many business owners do not accommodate for change in their business plans. They remain rigid and hope that everything will roll out exactly as planned. If it doesn’t, they are typically at a loss and cannot adjust.

The point is, plan for change. The budget should have a miscellaneous category for unforeseen expenses and a best case, worst case and most likely revenue projection.

Implementation – It’s a Pretty Document … So What?

Again, as previously indicated, if you have a great plan chock full of financially literate terms such as “nominal rate of return” and “net present value” then good for you … you have a great vocabulary. If you actually use the plan in the business then regardless of vocabulary, you are focusing on the important part of writing a business plan. I can’t emphasis this enough: the plan needs to be integrated into the business on a strategic and tactical level via company meetings and day to day operations. The individuals responsible for facilitating the key functions of the business need roles and responsibilities spelled out and a standard that they are being held accountable to. The mission, vision and goals should be at the forefront of the business. The cash flow projection should be reconciled monthly.

Wrapping Up

In summary, the business plan is typically gathering dust in a drawer next to a fork stashed away for lunch. More than likely the initial development process was haphazard, painstaking and a relief to finish. In reality the plan, if done correctly and implemented, provides a great vision and map for your business to succeed as well as a consistent experience for both the customer and employees. It provides a standard of operation in your business and delivers a consistent value proposition to your customers. It creates the future by laying out goals and milestones, and builds rail-road tracks to take you there. It is a cliché to say it is a “living document” but the fact is the business plan can be a multi-cylindered engine that drives you to a better business model.

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Building a Small Business That Warren Buffett Would Love,available at Amazon.comorBarnesandNoble.com.

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One Million Jobs.

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Stocks Versus Real Estate Investing

 The proponents of leverage argue that real estate has numerous advantages over stock investing. A Warren Buffett business perspective investor would argue though that a consumer monopoly stock investment is far superior to a rental investment due to its strong economics and the potential reinvestment value.  

Here are the advantages to rental according to the property investment proponents.

Ten Advantages of Real Estate

Cash Flow

The chief thing regarding cash flow is that the property is self-maintaining as far as expenses go. It is a business model in itself – the income minus the outflow equals the cash flow. All expenses should first be covered in order for the investment to make sense and secondly the property should generate cash flow which adds icing to the cake of property appreciation. When comparing real estate investing to stock investing, it is important to not only compare the national average real estate appreciation rate of 6% to the historic average stock market return of 10%, you must also factor in the cash flow received.

In addition, the cash flow is passive. Although you might have to handle tenant issues, arrange for repairs or do them yourself, your physical presence is not required 100% of the time in order to generate the income. In the stock universe, relatively, cash flow must be generated via dividends unless you plan on dipping into capital gains or principle. Although it is not impossible to generate a healthy amount of cash flow through dividends, it is difficult to find yields that match ten to fifteen percent rates of return on money invested in rental property. Additionally, dividend stocks must be monitored for dividend cuts and omissions, just as rental property must be managed for vacancy and repairs and maintenance.

An individual is financially independent once their monthly passive cash flow is equal to or greater than their monthly expenses.

Control

In the stock universe the individual stock investor does not have much control over a business’s operations or management – unless of course you are Warren Buffet and own a controlling interest. Thus, it is really difficult to have an impact on the company’s financial results.  If you own shares of Coca Cola, you can buy up all of the Coke at your local super market in order to ratchet up sales but we both have to agree, this would be a fruitless effort.

In the real estate universe, if you own a rental property, you can increase rents, screen tenants, throw in some new landscaping, paint the walls, drive by the property in the evenings and check its appearance. If rents drop in the area by $25 you can drop your rent rates and keep vacancy rates low. If prices go up, you can raise rents. In real estate you have much more control over the investment, unless of course you use property management. In stocks, the control comes through the initial and follow-up analysis in order to make buy, sell and hold decisions.

There exists a hypocrisy in the land of rental property though. If you manage the property yourself in order to gain control then the property is no longer a passive investment. If on the other hand you hire property management, the property is now move of a passive investment but you have minimal control … just like a mutual fund.

Appreciation

Real estate on average appreciates 6% nationally. Although this has not been the case recently, when comparing apples to apples, let’s use the long-term returns for both stocks and property. Stocks appreciate on average at 10% over the long-term, real estate at 6%. The problem with the simple 10% versus 6% rate comparison, from a property investor’s point of view, is that it does not take leverage into account.

Leverage

If you put $20,000 down on a $100,000 property and it generates $3,000 a year in cash flow, what is your rate of return? It is $3,000/$20,000 or 15%.

If the property increases in value by 6%, how much have you gained?

Answer: $100,000 x 6% = $6,000

How much of a rate of return is this over your initial investment?

Answer: $6,000/$20,000 = 30%

When you add this to your $3,000 of cash flow, your true rate of return is $9,000/$20,000 or 45%.

If you took that money instead and invested it in a stock mutual fund, how much rate of return would you expect? 

Answer: 10% over the long haul.

Stocks 10%

Real Estate 45% … when you account for leverage which can swing both ways.

‘Nuff said.

Additionally, one of the pros of a rental real estate investment is that the tenant is essentially paying down the mortgage and buying the asset for you over time.

Depreciation

This is one of those lovely phantom tax deductions a property investor gets to claim at the end of the year that will turn rental money into 0% tax money. According to Rich Dad, your earned income is taxed at 50%, your portfolio income or dividend income is taxed at 15% and your passive or rental income can be taxed at 0%.

Here’s how:

You get to depreciate residential real estate property over 27.5 years and commercial over 39 years. If you cash flow at $20,000 a year out of your property but have depreciation of $25,000, you have a tax loss of $5,000 and no tax is paid on income. Sure, it is easy to argue that the property is actually depreciating and generating a real repair cost, but this expense is already factored in in the income statement.

The Depreciation Equation:

(Total Asset Value – Land Value) / Depreciable Years = Annual Depreciation

Refinance

If you increase the property value you can refinance it and withdraw the money tax free. Say you finance a $200,000 property and through a property improvement plan (reduction in vacancy rates due to more thorough tenant screening, an increase in rents based on a rent premium for ground floor apartments, etcetera) the property is now worth $250,000. You can now refinance the property at $250,000 pay off the initial $200,000 and withdraw the $50,000 tax free.

Asset Protection

Two things here: insurance and incorporation. If a stock drops 50% in value, what protection do you have? Perhaps a stop loss order or a put option? If a rental property investment burns down, what protection do you have?

Answer: insurance

The second form of protection is incorporation. By placing your property in the bucket of a legal entity, you shield your personal assets should from most legal attacks stemming from the property.

1031 Exchanges

A property investor can roll over property gains tax free by buying bigger properties using a 1031 Exchange. The capital gains do not go away – they carry forward but by using a 1031 exchange, you can continue to roll those gains into bigger and hopefully better properties tax free. If you finish and choose not to hold the last property or roll it, you will have tax consequences.

Hedge Against Inflation

Because real estate is a tangible asset, it will generally rise at the rate of inflation or higher. Historically inflation has averaged 4.1% a year. That means real estate, with its average, historical appreciation of 6% has beaten inflation by nearly 2% and this does not take into account cash flow.

A Physical Asset

You can walk up to a piece of property and touch it. You can inspect it, you can visit the tenants, you can see cracks forming in the walls. With a stock, in a lot of respects, it exists out in the ether. Sure if you own Coke you can drink a Coke and you can go visit Coke headquarters in Atlanta. But the investment truly lives throughout the intricate business model which you do not directly manage. A property on the other hand, can be managed directly by you.

In Conclusion

To sum up there are many advantages in real estate investing over stock investing and many analysts neglect to make a fair comparison between the two. Many merely compare the 6% appreciation in real estate to the 10% return in stocks. What they are leaving out chiefly are the benefits of passive cash flow, leverage and depreciation. Once these three factors alone are included in the mix, it is clear that real estate has some unique advantages over stocks. I do not wholeheartedly endorse real estate investing by itself. I believe one must have a diversified investment strategy across the three investment asset classes of stocks, real estate and business, not just merely a handful of mutual funds.