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Five Crucial Questions
You Need to Ask to Insure Business Success
By Gary Goldstick
Vol. I, Issue 2
Approximately 90% of business failures occur because
of bad management; the rest fail because of bad luck, employee dishonesty,
natural disasters, departure or death of a key employee who cannot
be replaced. "Bad Management" encompasses strategic and operational
mistakes, miscues, and poor judgment.
During the course of interviewing a client whose business
is experiencing financial problems I try to discover why and how
the business stumbled into its current problems. The answers invariably
include the following:
"I didn't consider all the events and factors that
could go wrong," or "When I made the decision to invest in project
X, I didn't expect Y event to occur, which caused all the problems."
Both answers convey the same information: namely the
executive did not adequately assess the risks of the project and
was "surprised" when it failed.
Failure to thoroughly assess risks often causes bad
business decisions and increases the probability of business failure.
Simply stated, risk is the probability that an investment, project,
or business decision will not develop as planned and will have adverse
financial consequences for the investor. An example will illustrate
the point.
Let's assume you own a successful greeting card store
in downtown Portland. The store provides you with a pretax income
of $150,000/yr. You want to build on your experience by opening
a second store in Lake Oswego. You locate a suitable site. After
meeting with your contractor, your CPA and your marketing consultant
you determine that the front end investment for the second store
will be $500K; this estimate includes the funds required for tenant
improvements, inventory to stock the store, promotion in advance
of the store opening, working capital, and pre-opening expenses.
Your CPA prepares a cash flow projection showing that
break-even sales will be reached in six months; the losses that
will be accumulated until break-even is achieved are projected at
$200, 000. Therefore, your total projected investment is $700K.
The pretax earnings for the first five years project at $0, $175K,
$225K, $275K, and $300K respectively.
You like the deal. It "feels good." You need the additional
earning to send your child to Stanford. You decide to finance the
second store by borrowing $400K on the real estate of the downtown
store that you own free and clear. The additional $300K you need
will be provided by a second mortgage on the family home. The combined
$700K loan requires interest only payments for five years of $75K/yr.,
and debt service of $120K/yr. for the following 15 yrs.
That's the picture. Now for the questions:
1. What's my investment?
The investment is $700K assuming the accumulated loss
until the business breaks even is $200K or less. Note that all the
expenses other than the loss are somewhat under the entrepreneur's
control; however the projected loss is only a guess. It could be
less, or, as is more often the case, it can be considerably more.
Because the loss is unpredictable, the required investment is also
unpredictable. The investment that we just calculated is only an
estimate.
2. What's my return? How much will I make?
Using a discount rate of 7%, your CPA calculates that
the Present Value (PV) of the five years stream of earnings after
debt service is $477K.
3. What's my target return on my investment (ROI)/yr.?
Target ROI = PV__= $477K___ =13.6 %/yr.
I x 5 $700K x 5 4.
4. What's my Expected Return based on my quantified
risk?
You ask your marketing consultant to make a study
of the new store's prospects. The consultant will evaluate the current
competition for the new card shop. This assignment will include
estimating the sales and earnings of all stores that sell cards
within the new storeÙs geographic area, the likelihood of new entrants,
etc. Based on his research, the consultant concludes the following:
There is a 50% probability that the new store will
achieve its target projection.
There is a 30% probability that the new store will
achieve 1/2 its target projection.
There is a 20% probability that the store will never
achieve break-even.
The consultant further advises you that if the store
does not achieve break-even. You will have to liquidate and your
loss will be $650K plus the loss you're willing to sustain beyond
the projected $200K operating loss. You decide that you must limit
your loss to $700K, the amount you've borrowed.
Your Expected Return over five years is therefore,
Expected Return = PV x .50 + ý PV x .30 -$700K x .20
= 4.9 %/yr.
I x 5 yr.
The difference between the target return of 13.6 %
and the Expected Return of 4.9% is a measure of the risk of the
project; but it is not the only measure of risk. You need to address
the next question, a question, unfortunately, few ask.
5. If the store fails and the 20% probability becomes
a reality, can I afford my worst case loss of $700K. Since the 700K
lost investment was provided by mortgages of the successful downtown
store and the family home, the $120K/yr. debt service will have
to come out of the $150K/yr. earnings of the downtown store, leaving
only $30K/yr. to support your family.
You need to ask yourself whether you can cut your
standard of living by 80%^ if the second store fails. If the answer
is yes Ò which I doubt - you can afford the risk. If the answer
is no then you can't afford the risk; and you probably should start
promoting Portland State as his first college choice.
If you are willing to question your business projects
in the manner outlined above you will materially increase your probability
of success and substantially decrease the probability of making
risky financial decisions. Don't let your company become one of
the 90% of businesses that fail because you overlook these five
crucial questions.
Gary Goldstick, CMC is the principal of G. H. Goldstick
& Co., a management consulting firm located in Tualatin Or; he helps
emerging, under-performing, and financial troubled companies develop
and implement financial and business strategies to achieve stability
and profitability.
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