Think Like an Investor
If you invest $100 into something what is an acceptable rate of return? Do we want that $100 to return $100, $50, $15 over a period of time n? As a corollary what risk are we willing to handle? For that $100 are we willing to lose all $100, $50, $15? All investments have a potential for loss. It is the nature of the beast.
However, every task a human does must be thought of as an exercise in investing. We are making a decision based on current information with the hope of an expected future outcome. I do laundry today and I have clean clothes to last me till Tuesday. I wait till Friday and an unexpected out of town trip and now I have to scramble to do laundry.
Investing can and should be be methodical. What is the future outcome, what are the risks? What are the risks of doing nothing? What are you willing to invest to get to that future outcome? How can you derisk the outcome?
Capabilities Based Investing
The Allied Forces put a stake in the ground during D-Day. A single point to control from which they were able to reach the rest of Europe from the Western Front. Similarly, a company should enter businesses from which it can expand its capabilities or improves its ability to deliver.
Most of the time there is interest in building conglomerates but a conglomerate has the problem of not shared capabilities. How does GE’s light business match the aircraft business. What are the capability that are shared?
If on the other hand growth is based on expanding existing capabilities certain things can be attained.
- The existing business can increase its flywheel based on this new capability.
- A new capability based business can be independently run to self-optimize resulting in new business opportunities.
- Expand into unrelated industries based on capabilities.
Capability based growth is different from industry based growth in that it at its core follows with comparative advantage. What are we the absolute best at and how can we use that to address multiple different industries versus an industry based company that limits itself to a single industry which may limit its growth.
Essentially the crux of this is that growth should happen from strength to strength.
Leave the Table
A business is an entity that exploits an opportunity. It has a natural lifecycle and with the application of creative destruction a company’s lifespan is getting shorter and shorter. Think years to months. While a company may lay the groundwork to exist a long while a new entity can arise and displace the old one rapidly.
So all companies must behave like temporary organizations that exist to exploit a market opportunity as fast as possible and once the value has been captured closed or sold. It is a natural cycle.
The way this functions in practice is:
- Sell first then build what we are selling. Do this rapidly with no-code tools then move to code if needed.
- Every entity should be as independent as possible from the other companies having their own team. Interaction should be minimal.
- Selling a property should be as simple as transferring a GitHub repo, the domain and DNS.
- Not everything we build will work out we need to accept it and move on. Fail cheap and fast.
The beauty of this approach is that as our vision is far reaching we can naturally attack a problem constantly as new solutions arrive and clear out the old to get to our goal faster.
Financial literacy is one of the most important part of how we function. We cannot work unless we understand it well and have a common base line of knowledge.
- Do you have a lot of debt?
- Can you pay off your debt immediately if you need to?
- Is your debt working for you?
- How are your Financial Ratios?
- Free Cash Flow? (Cash from Operating Activities – Cash Invested in Capital Equipment)
- Days Sales Outstanding – How long does it take your customers to pay their bills?
- Quick Ratio – Ensure that we are not running out of cash and are growing at a steady rate. (Current Assets /
- Gross Profit Margin – How can we reduce the cost of delivering our services?
- Net Profit Margin – How can we increase the revenue while reducing the cost of getting additional revenue?
- Debt to Equity – We want to use financing to grow our business but we shouldn’t be over leveraged?
- Cash Conversion Cycle. How long do we have to convert outflow to inflow to have working capital?
How do I read an Income Statement?
- Income (is Revenue)
- The amount coming from sales
- Cost of Service / Cost of Goods
- What it costs to deliver the Sale
- Gross Profit
- Income – Cost of Service
- Should be positive otherwise business is not going to survive
- This is the cost income coming from delivering the goods
- The overhead of running a company including salaries, etc. that are not tied to delivering the goods.
- This is also where depreciation goes for stuff bought
- Taxes as well are here.
- Net Operating Income (Net Operating Profit)
- Gross Profit – Expenses
- This is what it costs to run the company
- Net Other Income
- This is money made from interest and other things unrelated to what the company produces
- Net Income (Net Profit)
- Total amount of profit / loss of running the company
How do I read the Balance Sheet?
The balance sheet is the cumulative growth of the company and so is an important document.
Assets = liabilities + owner’s equity
- Reduction in Inventory should increase Cash
- Accounts Receivable
- Think of this as a loan to the customer.
- Long Term Assets
- Buildings to have been bought a while ago and the value could have increased, but we can’t realize the change until we sell it.
- Long Terms
- Account Payable
- To vendors, etc. Think of money you owe as a loan the vendors gave you.
- Retained Earnings.
- Money that isn’t withdrawn and reinvested into the company.
- Retained Earnings.
Question to ask:
- Is your cash increasing or is it increasing because of an increase in liabilities?
- Are your liabilities increasing to increase you cash?
How do I read the Cash Flow?
The cash coming in and going out. Divided into three sections
- Operating Activities
- Cash from delivering our products and services.
- We want to increase the amount of cash coming here to be higher.
- The more money we get from operating activities the better.
- Increase cash flow by getting money faster from the customer, and delaying paying the supplier
- Investing Activities
- We need to invest money in the future so this is where we would do it.
- i.e Computers, machines, etc.
- There should be some investment here otherwise you are not investing in the growth of your company
- We need to invest money in the future so this is where we would do it.
- Financing Activities
- Money from loans, etc.
- How we get money from loans, our payments for loans, etc.
- Are you paying a lot of this? If this is how you are increasing your cashflow that isn’t necessarily good.
Free Cash Flow = Operating Activities – Investing Activities
Financial Ratios FAQ
What are the Profitability Ratios?
Gross Profit Margin (Income Statement)
Shows the basic profitiability of your product or service before overhead or expenes are added in.
gross_margin = gross_profit / revenue
- Is there a negative trend in gross_margin?
Operating Profit Margin (Income Statement)
operating_profit[EBIT] = gross_profit - operating_expenses operating_margin = operating_profit / revenue
- Watch the operating_margin to see if costs are increasing faster than sales?
Net Profit Margin (Income Statement)
After all the other expenses have been paid for including taxes, interest, etc.
net_margin = net_profit / revenue
Return on Assets (Income Statement, Balance Sheet)
- How effective are we using out assets to generate a profit.
- Don’t want it to be too high because that means the company isn’t investing in new facilities and equipment.
return_on_assets = net_profit / total_assets
Return on Equity
- What percent of profit you make for every dollar of equity invested in the company.
- “From an outside investor’s perspective, ROE is a key ratio. Depending on interest rates, an investor can probably earn 3 percent or 4 percnt on a treasury bond, which is eessentially a risk-free investment. So if someone is going to put money into your company – or if you’re going to invest in sombody ele’s business – he or you willl want a substantially higer return on equity.”
return on equity = net profit / shareholder equity
What are the Leverage Ratios?
debt-to-equity ratio = total liabilities / shareholder equity
If > 1 then there is more debt used to finance the growth. If less then there is less debt.
Bankers love this number because it shows how much debt the company has taken on versus the equity.
interest_coverage = operating profit / annual interest charges
How much interest is paid every year compared to how much profit is being made.
- If it gets too close to 1 it is a bad sign.
- If it is a high ratio then the company can take on additional debt.
What are the Liquidity Ratios?
current_ratio = current_assets / current_liabilities
- Don’t want to be anywhere near 1 since that means you will barely be able to cover the liabilities that will come due with the cash yo’ll hae coming in.
- Don’t want it to be < 1 since you will run out of cash in the future.
- A number too high means that the company is sitting on its cash.
quick_ratio = (current_assets - inventory) / current_liabilities
The quick ratio shows how easy it would be for a company to pay off its short-term debt without waiting to sell off inventory or conver it into product.
What are the Efficiency Ratios?
- Lets you know how well your balance sheet is doing.
Inventory Days and Inventory Turnover
- How fast can you move investory and convert it to cash.
days_in_inventory = average_inventory / COGS / day
- Give the number of days inventory stayed in the system
- day is usually 360
How many times inventory turns over every year.
inventory_turns = 360 / days_in_inventory
- How frequently you sell out your stock and had to replenish it.
- The higher the number of turns the tigher your management of inventory and the better your cash position.
- This is useful for retail
Days Sales Outstanding
Average Collection Period. How long it takes for customers to pay their bills.
days sales outstanding = ending accounts receivable / annual revenue * day
- day is 360
- ending accouts receivable = from balance sheet
- great number for entrepreneurs
- bring this down as it gives how long it takes for customers to pay their bills.
a high DSO is bad as it may mean the customers are in trouble.
Days Payable Outstanding
The inverse of Days Sales Outstanding. How long it takes for us to pay our bills.
days_payable_outstanding = ending Account payable / COGS / day
- higher the DSO the less happy vendors are.
Total Asset Turnover
total_asset_turnover = reveneue / total assets
- A company with lower turnover isn’t using as effectively as a higher one
- How efficient you are at generating profit from the income.
What is Return on Investment?
Return of Inveatment is based on current value of money
- The hurdle rate is what the opportunity cost of of getting a return else where at the present value.
- What is the free cash flow generated by the equipment. This is the estimate per year.
- What is the duration of the life of the equipment.
Net Present Value (NPV)
- Over a period of time
- Cash Flow Rate
- How much it will cost and how to estimate
A project starts
Year 0: It costs -10,0000 Year 1: It brings in cash of 2500 Year 2: It brings in cash of 4000 Year 3: It brings in cash of 5000 Year 4: It brings in cash of 3000 Year 5: It brings in cash of 1000
Discount Rate = What you could have earned elsewhere. Ex 6%
So you would do:
NPV = -10,000 + 2500/1.06 + 4000/1.06^2 + 5000/1.06^3 + 3000/1.06^4 + 1000/1.06&5 = -10,000 + 13,239 = $3,239
- If NPV > 0 then accept
- The 6% (discount rate is an opportunity cost)
- The money is not free and could have been deployed elsewhere
- If NPV is greater 0 than it is larger return than 6% we would have gotten elsewhere
- If comparing different projects the project with the highest NPV has the highest return
Cash Conversion Cycle
How long it takes to replenish cash.
day inventory oustanding + day sale outstanding - day payable outstandi