Accidental Entrepreneur: Knowing Business Financial Facts for Building Companies
Welcome to my 31st weekly article as this week is called “Knowing Business Financial Facts for Building Companies”.
In this article. I will cover some key financial concepts that are important to understand for the success of a project and of a company.
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“முடிவும் இடையூறும் முற்றியாங்கு எய்தும்
படுபயனும் பார்த்துச் செயல்” — திருக்குறள் (676)
“An act is to be performed after considering the exertion
required, the obstacles to be encountered, and the great
profit to be gained (on its completion)” — Thirukkural (676)
There are three areas to be considered when building products or companies. They are the underlying technology, the market/customers and the third one is the financials. Most of the engineers and entrepreneurs spend so much time on the first two they don’t spend enough time to focus on the financials. When I talk to my friends or colleagues from outside the USA, they mention this as a negative thing that US corporations do . They focus too much on the financial bottom line for everything. My response has been that without a financial foundation, no project or company can survive long term. In this angle, I learned to work with the finance department and understood the following principles which I apply in all projects,
NPV: NPV stands for net present value, which is a method used to determine the current value of all future cash flows generated by a project, including the initial capital investment. For a layman this is revenue generated on top of the expenses of the product development in today’s money. This value provides a clear objective way of determining whether the money invested in a particular project makes financial sense.
Let me get into a bit more detail into how to calculate the NPV. First factor in calculating NPV is determining the expenses to make the product. This includes resources, which are engineering, marketing, manufacturing, and sustaining/support for the lifetime of the product. Then add the capital expenses spent on the project and any manufacturing related expenses. This provides expenses in today’s money. Then based on market research and competition, marketing comes up with the total revenue annually until the product reaches the end of life. Simple math would be deducting expenses from revenue and dividing by total expenses into the NPV. Since the revenue spans multiple years, the equation can be a bit complicated. Having a positive return is a must for any products as corporations are not here to perform charity.
Net Present Value Formula Steps
1). Determine the expenses to make the product (resources, engineering, marketing, manufacturing, lifetime support for the product)
2). Add capital expenses spent on the project + manufacturing related expenses
3). Based on Competitive & Market Research, Marketing comes up with revenue projections
Since most of the data which goes into calculating NPV is futuristic, it is mostly estimates. This is where experience and having analytical capabilities is pivotal. I remember early in my career, trying to be thorough, my teams tended to create very conservative projections which meant we came up with high expenses and low revenues. That didn’t work well and most of my projects didn’t get approved. Then I learned the way to present the best, worst and middle level projections with written assumptions. During the project approval process, we would review all three cases and make some judgment calls. During monthly executive program calls we would review and update the business cases along with all project related expenses. This led to adjusting project scopes and making higher level calls easier objectively by removing people’s emotions out of the decision-making process. I found the NPV process very useful when discussing the project with my team members as well as engaging with customers.
ROI and Opportunity cost: Next financial item is return on investment. Just like NPV, ROI is another factor which is important for a company when it makes investment decisions. Every corporation has a company level financial goal set by the board or executive team. Since the corporation is going to invest money, it is important to understand the return. ROI is calculated by subtracting the initial value of the investment from the final value of the investment and dividing by cost of investment. Again, the finance department has a complex way of calculating this since the values need to be estimated and projected.
Where these mattered to me most is when deciding whether a particular project is the right investment for the company.
One of the reasons is that in the short term the project may look attractive but longer term it could be a cash sink for the company since the company would need to support the product during its life cycle.
Second factor is that the limited resources available at the company could be used in more strategic or profitable projects. This is called the opportunity cost of selecting one project over another. It is important to remove emotions and consider these points objectively and make the right decisions for the company. Many people, mainly strong-minded engineers and architects, miss this basic point and get demoralized. Once I understood this concept, it was easier to work with the finance department and come to collective conclusions which were good for the company and the team.
Gross Margin: Gross margin is simply calculated by subtracting the cost of manufacturing and supporting a product from the price of the product divided by revenue.
Another simple equation. Gross margin positive means that the product is being sold for profit. Gross margin for hardware products versus software products are highly different. Hardware products involve the cost of the physical product and shipping + physical warranty associated with it. Normally SW products have a very high gross margin. To calculate the gross margins, the marketing department needs various customer studies and market analysis of existing products.
From my experiences, evolutionary products have clear market value and therefore defined gross margins. On the other hand, that revolutionary product with an early to market advantage would have higher margins and flexibility. It is important to understand these factors during the early stage of product development. The reason for the early stage provides the program team with an acceptable product cost. Again, many people tend to miss the market value and build products which are too expensive. By the time the teams understand the real value, the product would need to be redesigned. This is the difference between a winning team and stagnant teams. Winning team makes these right calls and continues to evaluate the potential market value and pivot early in the process.
As anyone can see, understanding the fundamentals of committing, building, and selling products from financial angles help determine whether a company is making the right investments, return would be reasonable and won’t miss out on the opportunity cost. For those starting their career, it is critical to learn these basic principles. I did these by volunteering with my managers to collect and create an excel spreadsheet. This gave me access to work with the finance department to integrate program spreadsheets with financial models.