Thursday, July 28, 2011

What is a financial model?

I recently posted an article about the importance of having a proper financial model. A friend gave me a valuable feedback, saying that the posting must be easier. Following his guideline, I will try to explain the definition and benefits of a financial model, so that 10th graders can understand. (A 10th grader who wants to know about financial modeling… is worth a LinkedIn connection for sure!)

A financial model is a forecasting tool. You put variables into the model, then it gives you back a forecast. It is called a financial model because the model gives back financial forecast. When you plan a business, you have basic assumptions about your operation. These assumptions are the input into the financial model. The model will return the expected result of your business in financial terms.

Let’s suppose that you have a business of selling Kryptonite rings to people who want some form of protection from Superman attack. You know what price to charge to your customers. You also have some approximation about the number of rings you can sell in a given time period. You know the costs of running the business. You put these variables into the model. The model will return the expected result of your business – in financial figures.

Why do you want to have a financial model for your business? There are two very important benefits. First, it will tell you if the business idea is worth the try. If the model says that you will go bankrupt in 6 months, you have to think it over. Either you should find a remedy that will save your business from going down, or you need to scrap the business idea altogether. In most cases, you will be able to find out a way to make your business worth the try, for example, by reducing unnecessary costs or securing more loans.

The second benefit is being able to get better prepared for surprises. Your business won’t fold out as you expected it to, because life isn’t designed that way. Things change. The business environment can change dramatically after a certain amount of time. There are simply too many things that are outside of your control. As a wise businessman, you have tons of “what if” questions. A good financial model will answer these questions.

Let’s suppose that the suppliers of Kryptonite sell the ore at higher prices. You know that your business will be affected in an adverse way, but how much? Your financial model will answer this question. You change the inputs, and you have different results. You can test how much adverse change in variables your business can stand. This is called a stress testing. You are much better prepared if you have plans for several possible scenarios. A good financial model will help you do this.

My advice is this: Go get a good financial model. With a small up-front investment of time and money, it will save you from many surprises in the future.

Wednesday, July 27, 2011

Little Things We Can Do – 1. Stop Using Garburators

Water pollution is much worse than solid waste in that it cannot be geographically contained. In other words, you get a whole lake of water with mild contamination instead of a small stack of soil with high contamination.

To decompose a cup of coffee (120ml), 1,800 liter of water is required. Complex technicality set aside, this means your cup of coffee includes 1.8 grams of substances to be decomposed by the microorganisms in water. If you use kitchen towels to absorb the remnant of coffee, you contaminate a couple of paper sheets. But if you throw it into the sewer, you contaminate as much as 1.8 tons of water. A simple story indeed.

Then why do garburators (garbage disposal) matter here? Garburators let you dump solid wastes into the water! A spoonful of spaghetti can be disposed of in solid form and occupy a tiny part of a landfill, if you dump it in the garbage can. But if you flush it down your kitchen sink using the garburator, it will contaminate some tons of water in no time.

When I first arrived in Canada, I was surprised by people’s indifference to this problem. A part of the reason would be Canada’s plenty water resources. I met a very well-educated lady in her 30s who held positive views about environmental protection. While talking on the topic of environment, I found out that she had never thought of garburators as a polluting device. It took me quite a while to make her see the point. Perhaps this is only natural, because most of us do not question the way we live our lives.

There are disputes about this matter, sewage versus landfill for food waste. The best solution for food waste is composting. But if you have to choose between sewage and landfill, I would suggest landfill. My primary reasoning is the scarcity of water resources. Even worse, the vast majority of water resources – be it seawater or fresh water – is common goods, which means nobody is given the ultimate responsibility to protect them. That is why we have several “trash islands” floating around in the high seas.

Stop using garburators. There are alternatives. You begin making changes.

Saturday, July 23, 2011

Entrepreneur, you need a good financial model

What does it take to make a successful startup? Idea, of course. Entrepreneurial spirit, whatever it is, also counts big time. Cash, for sure. I would like to add: You need a good financial model, as well.

A financial model serves two very important functions in a business at its initial stages:
1.      It proves the financial feasibility of the business model.
2.      It attracts investors.

The first function is the raison d’ĂȘtre of a financial model, especially at the beginning stage of the entrepreneurship. You know the business idea, and perhaps also ran some back-of-an-envelope calculation several times already, with good results. But hey, you are neither fast nor comprehensive enough to skip a computer calc session.

I have an episode. A friend of mine was planning a new start-up. The business idea sounded so good that I wanted to pour what money I had into the business if I could. Still, I wanted to test the financial feasibility of the business model, and volunteered to run a model for him. VoilĂ . The business could yield a whopping 150% ROI in 4-year time span if everything turns out as desired. But the financials stood on very precarious conditions. For example, if the SG&A goes up by only 20% (which is very probable in many occasions) the business was projected to wreck in the second year due to cash crunch. Another very important finding through the pro-forma analysis was, the investors in the second year could easily give up the idea of putting their money into the business, because they need to be under severe penalty in equity distribution compared to the first-year investors, who naturally require higher portion of equity to get compensated for proportionally greater risks. I recommended him, first, to reduce operating costs in the first year as much as possible, and two, to try to get all the necessary investment in the first year, so that he should not face the dilemma of attracting investors with dog pooh. As can be seen in this case, you never know for sure, until you run some real cold hard calculation.

The second function of a financial model is attracting investors. Think about it. A few simple line charts and pie graphs make a dull business plan look much snappier. Looking cool, believe it or not, is better than not looking cool in any aspect of life, including the 20-minute session you will be presenting to readily distracted would-be investors. But more importantly, shrewd investors seek solid information. The simple fact that you ran scenario analysis to prove the financial feasibility of your business idea, is a proof that you are not another guy next door with a run-of-the-mill idea from nowhere. Of course, they will also try to check whether your calculation is sound. This is also what you want them to do, unless you are trying to run a well-tuned scam.

One very noteworthy side benefit of building a financial model is getting to know your business better. Building a financial model requires a lot of discussion between the consultant and the entrepreneur. This naturally leads to reflections and deep thinking about your business, which will enhance and deepen your understanding of your own business and the business environment, which can lead to valuable insights on how to run your business.

The conclusion: go get a financial model. The small investment of time and money up-front will save you tons of troubles in the road ahead.

P.S. I can help you! Click the logo below and visit my site. I am providing free financial modeling service to start-ups and SMEs.

Friday, July 22, 2011

Renting vs. Homeownership - Real Estate Overheat in Canada

The question as to whether to rent or to own a home is a dilemma for many people in modern economy. In Korea, it has long been regarded as a norm that you should buy a house once you can get the loan sufficient to back up your seed money. After buying the house, you rent it, of course. You rent another house for your own use. That is happening here in Canada these days, according to the most recent Canadian Business magazine.

I was forced into this question actually a few years ago. I was to stay in Korea for about a year, and wanted to live right next to my workplace so that I can walk to my office. Even in Seoul, a city well known for top-of-the-world housing price (yes, I admit that Tokyo and Moscow are even worse) the vicinity of my workplace (the Central Government Complex of Korea) was notorious for its price level. Everything (even a piece of bread) was at least 20% more expensive there, so I had to run a cold hard calculation regarding my largest chunk of expenditure – housing.

It was a small studio in an officetel building. Buyout price was $170,000. Monthly rent was $925. The opportunity cost of the buyout is about $850 per month at 6% interest rate APR. Did I have an investment option of 6%? Not really, but it was something like 5.5%, which is close enough. Then the difference is $75. Considering tax and utilities, the difference gets smaller. Another big factor to consider is the time horizon. Because of the peculiarity of time (yes, the financial crisis) it was uncertain if the price would go up. Usually, going up was taken for granted, but time has changed. Then there is the administrative cost, the biggest chunk of which is the commission paid to the broker. All considered, it did not make sense to buy. So I rented. It was a very straightforward calculation.

Something similar appears in the Canadian Business magazine, for the situation today in Canada. Buyout price is $850,000. With $400,000 down, the monthly mortgage payment is given as $3,000. (The article appears to assume 7%, 30-year mortgage.) The opportunity cost for the downpayment is $2,000 per month at 6%. The monthly rent for the same house is $3,500. To rent wins by a landslide.

I travelled Europe long time ago as a back-packer and was impressed by the culture of lifelong renting. Back to Europe more than 10 years later, I found Norway getting caught in a real estate buying spree. Construction was going on in every corner of the city of Oslo, including one construction site blocking the path from my apartment to the nearest supermarket. A Norwegian friend told me of his own story of buying a house and then seeing its price jump threefold in about 5 years.

Everyone heard of the episode of the tulip bubble in the Netherlands back in the 17th century. People buy with the hope of someone else buying from them at even higher price in the future. This can’t last forever. I see this kind of dangerous race in the housing market in Canada these days.

Monday, July 18, 2011

The Tipping Point - Marketing Implications

I saw The Tipping Point in the number 2 spot in a list of marketing books most recommended by marketing professionals. Malcolm Galdwell says he never intended the book to be a marketing book. Not a book of some purpose, to be precise. However, it is regarded as a marketing book, even a great one. Come to think about it, the book starts with the now-famous anecdote of Hush-Puppies epidemic in New York City. It is so natural that people tend to think of the book in the context of marketing strategies. Anyone would be happy to receive a trophy for "the best design of the year" for doing nothing.

So, I will briefly talk about the three factors Malcolm elaborates in his book, which make products/ideas go over the tipping point. Then I will talk about the implications this factors have in terms of marketing strategies. (Believe me. I already did comprehensive consulting services to two companies, including marketing strategy development.)

Malcolm says three factors are crucial in making a product/idea tip:
1.       The Law of the Few
2.      The Stickiness Factor
3.      The Power of Context

The law of the few states that it requires some special people to make something tip. Connectors are the people with hyper people skills. They attract people. Mavens are information specialists. They have passion for certain product categories, and are eager to share their knowledge with other people. Salespeople use their persuasive power to nudge people into buying decisions.

The stickiness factor is a certain feature of a product that requires endless interaction from the consumers. Malcolm gives an example of the famous children’s show, Blue’s Clues, as having this stickiness factor in abundance.

Malcolm also emphasized the power of the context where the product/idea is positioned. Violent crimes could spread when the New York subway was infested with graffiti and free riders, but no longer when the context changed.

Then what are the implications these three factors have on marketing strategies?

First of all, the law of the few is actually about the Pareto Principle, or the 80/20 rule. Of course, we all want to focus on those 20 percents, if we can. What Malcolm did was identifying the people in the 20% category – they are connectors, mavens, and salespeople. Connectors can be easily spotted in social network service websites, such as Facebook and Twitter. If you reach one twitterian with 1,500 followers, you are actually reaching way over 1,500 people, considering all the weak ties connecting those people. Mavens are naturally drawn to having their own blogs. You can easily connect with them via their blogs.

Then what about the stickiness factor? Malcolm says the stickiness factor is certain memorable contents of the product/idea, which leaves a long-term impact on the consumer. But I believe the stickiness factor can be found in other parts of the product/idea, even outside the product/idea. For example, Apple’s design, I believe, is a surefire stickiness factor. A more comprehensive approach will be more effective in identifying and strengthening the stickiness factor.

Finally, the context. When you think of context in terms of marketing, I suggest you do it in two dimensions – statically and dynamically. Social, economic, political, and technological context is very important in relation with the positioning of a certain product. You cannot sell Nazi outfits in Germany however fashionable they are. But the dynamics of the context – we call this a trend – is even more important. So, when you plan to position your product in the market, be sure to throw it in the position where the future trend will find itself.

Thursday, July 14, 2011

An Oxymoron of Sustainable Development: The Case of Natural Gas

Sustainable development is an oxymoron when you think about the actual usage of the phrase. Moreover, the focus is on development, as the grammatical composition of the phrase suggests. Also in practical terms, the term is used to point out the necessity of environmental thinking for the sake of long-term profitability. Even then, sustainability thinks in terms of net present value, where future value is belittled because of its uncertainty and distance. But you know – for the future generations, it is neither uncertain nor distant. We are already living at the expense of future generations with regard to fiscal policies, and do not feel much qualm about living at the expense of future generations’ rights to natural resources and, more importantly, the planet itself.
I lived in Switzerland from 2004 to 2007, and was continually entertained by the Swiss government’s dancing to and fro regarding policies to meet the Kyoto Protocol target in emission reduction. The neighboring country, Germany, was stepping bold into the future, while Switzerland was weighing between many alternatives with just about the same minuscule audacity. A few cents of emission tax was heavily attacked by the business world, and was soon abolished at the initial stage of discussion. This went on and on, moving from tax on fuel to tax on heating oil. However, this was nothing compared to what I had to encounter when I moved to Norway in 2007.

Today, the David Suzuki Foundation released a new report about the impact of natural gas production on climate change. ( According to the report, rapid expansion of natural gas production capacity can have a net negative impact on the fight against climate change. Also, unconventional natural gas such as shale gas can lead to direct environmental damages, as shown in the case of the U.S. shale gas development. Natural gas is seemingly an easy way to get ahead with both of sustainability and development. But the report says it is all about development, when you actually take a deeper look at it.
Recommendations are the usual ones: more governance, more direct actions such as carbon capture and storage (CCS), and publicity. I have seen this set of recommendations since several years ago in so many different countries and in so many different settings, that they begin sounding like some political propaganda.
My conclusion is simple, as always: Enough said. Walk the talk.