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If All Knowledge Were Destroyed Except for One Sentence, What Would It Say?

Richard Feynman famously asked: "If, in some cataclysm, all of scientific knowledge were to be destroyed, and only one sentence passed on to the next generations of creatures, what statement would contain the most information in the fewest words?"

“The same mathematics of networks that governs the interactions of molecules in a cell, neurons in a brain, and species in an ecosystem can be used to understand the complex interconnections between people, the emergence of group identity, and the paths along which information, norms, and behavior spread from person to person to person.” —James Fowler is a political scientist at the University of California, San Diego.

 

Basically, the universe, ourselves, our thoughts, and our interactions all follow the same, simple blueprint.  Like chaos theory and fractals, the seemingly complex only appears as such until you understand the few simple rules governing the system.

Massively Distilled Wisdom

Introduction to the Income Statement for Non-Finance Geeks

Concept

The concept of the income statement is actually pretty easy to understand and you're likely already familiar with it:

Sales - costs = income

It's just like your bank account. When you get paid from your job, that's like sales (or more formally, revenue). When you blow part of your income buying out your local Wal-Mart of all the purple hoodies and Bieber CDs, that's like costs (or more formally, expenses). Whatever is left over is your savings (or more formally, net income). 

If you save this income from one pay period to the next, or one quarter to the next, then your bank account balance starts growing. The formal name for this concept is Retained Earnings, but that's located on the Balance Sheet, and is a post for a different day. 

 

Structure

So let's start with the top of the income statement and work our way downwards.  Every income statement is set up the same, top-to-bottom, and attempts to loosely organize the timing of creating and selling a product or service.  As you move downwards you start taking away each of the costs associated with running the business until youre left with net income (or in some cases, a net loss).

 

Gross Profit

Gross Profit = Revenue - Cost of Goods Sold

Cost of Goods Sold (COGS) is a pretty apt description. It's how much it costs you to manufacture your product or deliver your service. 

Imagine starting a RedBull stand on your street corner (What? Lemonade is boring and I need more caffeine.). Every time you sell a can of RedBull, you have to first buy that can or manufacture it yourself. If you buy it, you're going to want to purchase it at as low of a price as possible (e.g., wholesale), so you can then apply a "mark up" and make a profit by selling it for a higher price. 

Advanced Note:  from economic theory, the optimal mark up is equal to:  1/(elasticity of demand).  The elasticity of demand is the sensitivity your customers have to your product's or service's price (i.e., how many cans of RedBull they buy if you increase or decrease the price).  Again, pricing theory is the topic for another post.

Thus, if you buy a can of RedBull for $1.50 and sell it for $2.00, then your gross profit looks like this:

$2.00 revenue - $1.50 COGS = $0.50 gross profit

 

 

Gross Profit Margin

Margins are a way to compare two different-sized businesses in the same industry (higher margins are better).

In the example from above, our gross profit margin (GPM) is as follows:

$0.50 gross profit / $2.00 revenue = 25% GPM

A 25% gross margin business isn't one you want to start. Why? Because before you even wake up in the morning you've only got 25% of your sales price to work with.

To put this into perspective, professional services businesses typically have super high GPMs because the only cost of producing an incremental sale is the people's time. On the other hand, commodity businesses typically have very low GPMs due to the very cost intensive nature of gathering raw materials from their natural locations.

 

Operating Income

Next up are all the expenses associated with running the business. These are called operating expenses and include things like:

   Compensation and benefits 

   Advertising and marketing 

   Office space and supplies

You may have seen this crazy looking mnemonic before:  EBITDA (pronounced ee-bit-dah).  It stands for Earnings Before Interest Taxes Depreciation & Amortization, and is just a fancy way of saying operating income. After you remove all the expenses shown above, you're left with EBITDA.

 

Depreciation & Amortization

These words can seem intimidating but they actually represent the same concept. Let's compare this to when you purchase a car.  You've may have heard the phrase, "cars depreciate but houses appreciate". 

Depreciation refers to the fact that some assets reduce in value over time (e.g., cars and computers).  Because they lose value, you need to account for this on the financial statements, by applying one of a few different methods. The most simple of these is called Straight-Line Depreciation. Basically, if the computer was purchased for $2,000 and won't be replaced for four years (referred to as the "useful life"), then you the the following:

$2,000 computer / 4 year useful life = $500 depreciation per year.

Attend of the four years, you're assuming the value of the computer will be $0. If it's not, then you need to account for its "salvage value". Assuming the salvage value is $400, you have: 

($2,000 computer - $400 salvage value) / 4 year useful life = $400 depreciation per year

Amortization is the exact same concept, only it refers to debt like interest or finance charges, while depreciation is used to refer to assets like equipment.

 

Interest & Taxes

Ah yes, the wonderful world of debt and taxes.  We probably don't need to get into taxation because it gets complex quickly.  All you need to know is that accounting rules aren't an exact science so there are plenty of ways to legally manipulate accounting income to pay fewer taxes, if that's the financial strategy the CFO is perusing.  

The other issue with taxes is that they're iterative (warning: you're about to go cross-eyed).  That means that you calculate the tax payment based on income, which is after you've excluded all expenses.  But, taxes are an expense too, so you have to keep calculating the tax expense, subtracting it from income, then calculating tax again.  It's a paradox that's handled simply by hard-coding this expense after the first calculation.

Interest is can be interesting too (pun intended)!  It's only an issue if the company has debt. If there are no loans, then there's no interest to pay (sort of like a house that's completely paid off).  If there is debt, then it's broken out into short-term (i.e., less than one  year) and long-term (i.e., greater than one year) debt. There's also what's called the "current portion of long-term debt", which just means the amount that's due in this fiscal year.  Clearly, there are different interest rates for each loan that needs to be serviced, but the Interest line item collects all of it into one dollar amount.

 

 

Net Income

Easy.  Add up all the revenue, subtract all the expenses, depreciation, amortization, interest, and taxes, and whatever is left is called net income.  In the public company world, there's also a term called EPS (Earnings Per Share), which represents net income divided by the Common Shares Outstanding.

 

Net Income Margin

Similar to gross profit margin or operating profit margin, net income margin is equal to net income divided by revenue.

Retail clothing manufacturers (e.g., Guess) will have high gross profit margins (e.g., 70%), but low net income margins because it costs a lot to market and sell an item of clothing.

On the flip side, scalable Internet technology companies (e.g., Living Social) will have high gross margins and high net income margins.  This is due to the fact that COGS of selling one more unit of software is $0 (it's already been developed, you just have to download it from the app store). Marketing costs, therefore, are typically the largest expense, outside of compensation and benefits, that a software company will have. This is why venture capitalists invest in technology companies, not in bars, restaurants, or retail stores.  They're just not easily scalable. 

 

Finance.

 

Marketing Research: Fascination With Celebrity = Monkey's Asses. Yup.

Monkey

I've been using this example a lot in client meetings lately because it tells a pretty compelling story about why we can't turn off TMZ and have 18 subscriptions to US Weekly.

From a 2005 ABC News article:

Dr. Michael Platt, a neurobiologist at Duke University Medical Center, led an experiment with 12 adult male rhesus macaque monkeys that he says may help explain the fascination with celebrities like socialite Paris Hilton.

Platt conducted the experiment by offering thirsty monkeys a choice: their favorite drink, in this case Juicy Juice cherry juice, or the opportunity to look at computer images of the dominant, "celebrity" monkey of their pack.

Despite their thirst, they chose to look at the pictures.

"What is celebrity for a monkey but their status?" said Platt.

Monkeys with status have food, power and sexual magnetism -- everything the others crave. The impulse to look at these "celebrity" monkeys was so strong, it superceded thirst.

But they were not willing to give up the juice to look at pictures of subordinate monkeys, Platt found. In fact, they had to be bribed with extra juice to watch the rhesus riffraff.

Interestingly, the "celebrity" monkeys, says Platt, were just as interested in their fellow celebrities.

The male monkeys were also willing to pay (with more juice) to see female monkeys' hind quarters. Monkey porn?

 

So what do you think, does obsessing over celebrities make us a monkey's ass?  No comment.

Behavioral Marketing

What Type of Business Do You Want to Start?

I have a few rules:

  1. No Debt -- If you're exploring a capital intensive business and need to raise debt to fund it, my question is why?  Why would you take the financial risk of the business not working out?  Examples include large inventory expenses for retail or manufacturing operations (unless you can pre-fund it using Kickstarter), and even franchise businesses.  If you need to raise capital, do it through equity, not debt.
  2. Cash Flow Positive -- If there's a mis-match between accounts receivable, accounts payable and cash on hand, you're dead in the water.  One operational tactic to make sure you never get in a cash flow negative situation is to collect cash before delivering any products or services (ideally 100%, but even 50% is better than 0%).
  3. Enormous Market -- If everything goes perfectly, and it won't, how large is the total market size?  $100,000?  Run screaming. $1 million?  That's better.  Every company or consumer on the planet?  Now we're talking.  See:  Facebook, not Foursquare.
  4. Built-in Marketing -- This is a tricky one to explain so I'll try to use an example.  One previous marketing strategy we used for Evolyte was to sell the hottest Christmas gift during the largest shopping week of the year and build in social incentive so purchasers would have to recruit other purchasers. The result was nearly $30,000 in reserved sales from 1 day of marketing. Can you build something like that into your business?
  5. Scalability -- Last, and maybe most importantly, if your business grows does it cost more or less to get the same amount of sales?  If less, then you've got efficient scaling.  That's why all the VC and Angel funding is poured into technology and internet companies, not restaurants or bars, because opening a new physical location costs exponentially more buying another server to handle more traffic.

My advice? Stick with the internet.

 

Strategery

Everyone's An Employee, Everyone's A Manager

From Jason Fried, founder of 37Signals, the guys behind Ruby on Rails and Basecamp project management software, on their organizational structure:

What we learned is that adding a dedicated manager and creating a hierarchy is not the only way to create structure. Instead, we decided to let the team be entirely self-managed. There's still a team leader, but that role rotates among the team every week. Each week, a new leader sketches out the agenda, writes up the notes about problems and performance, and steps up to handle any troubled customer interactions.

 

There's something to be said for perspective and it opens your eyes to things you never thought mattered.

Behavioral Science