I have a confession to make. For most of my life as an entrepreneur I never understood my financials. Even today, there are times when I feel frustrated looking at them. I think what bothers me most is the feeling I get that everyone else understands them but me. Bankers, CPAs, and “real” entrepreneurs understand their numbers. I have two engineering degrees, 11 patents, credit on 15 video games, I built a company that launched an industry… but half the time I look at my financials I feel like an idiot.
Let me give you an example. A while ago we began to buy back GameTruck franchise locations, starting in Portland, Oregon. Our plan was to combine the entire fleet into one company over time. For this to work, we needed to devise a way to remotely manage a franchise profitably. It is famously hard to figure out to what degree a local owner contributes to the success of a franchise location. Owners fill in all kinds of gaps, and do all sorts of work that is essential, but not captured in the Franchise operations manual. My goal was to figure out what that work was, and how to make sure someone had the job of making sure it all got done. Small business owners are the worlds best utility players. They are the glue that holds many a concept together. Pull them out, and it might take two or three employees to replace them.
But simply replacing them was not enough. We needed to replace them AND turn a profit.
So of course the financials would be my scoreboard. However, because we run an events business, predicting our business performance is much, much harder than you think it would be.
You see, we track two numbers, sales and revenue. Customers (usually parents) will book a birthday party in April that will be held in May. This means they pay the deposit in April and the balance in May. Simple, right?
That’s what I thought. I was wrong.
It turned out predicting our actual monthly revenue felt completely random. I saw more consistency in a slot machine than from my franchise location financials. Why was it so freaking hard to anticipate our April franchise revenue?
I mean, it’s only made up of two numbers, deposits taken and balances paid. Yet every month we would see some totally crazy random number when the Profit and Loss (P&L) statements showed up.
This was maddening. In a month where we “sold” 24,000 worth of past booked parties, I expected to see… 24,000 in revenue. Instead my P&L showed 17K. Seventeen freaking thousand dollars. What the hell? (Turns out timing of credit card payments mattered a lot.)
My controller assured me the number was correct. But how? How could that be correct? Few things frustrate me more than seeing a number I don’t understand. Why the hell could we not predict our cashflows?
It turns out my story is not unique. Most of my friends who also used cash-based accounting have similar frustrations. Of all the analytics, dashboards, and tools I use to run my company, my financials felt like the worst tool of the bunch, but the one I was expected to respect the most.
I hate feeling like an idiot.
But what could be more frustrating to an engineer like me than high latency (late) “accurate”, unpredictable information?
As an engineer, I am used to clean signal. I use mathematical models to project what will happen with a high degree of fidelity. When I designed the first game trailer, I could use Ohm’s law,
Which stands for Voltage = Current Times Resistance, to calculate exactly how much power I would need to run the video games and the air conditioners. I sized the generator requirements correctly because I had a solid model. That is the kind of clarity I expect from systems that produce numbers as their outputs.
In fact, every other system I use to manage my business delivers information in real time. I can see daily sales reports, web traffic, conversion rates, I even have to slow down sometimes to give the team a week to work through lead volume. But there is nothing like finance, which shows up two weeks after the end of the month with numbers I’ve never seen before or predicted. How am I supposed to make decisions with a system like that?
That’s not clarity. It’s confusion dressed up as something important. And it drives me nuts. What’s more, when I need it most, I often trust it the least.
During one of the most difficult periods in the history of the company, I felt reduced to managing our cash with a piece of paper and a pencil. The paper had two columns, one was daily cash in, the other was bills I had to pay in stack rank order. Why pencil and paper?
Because I couldn’t trust any of the “official” systems to tell me what was going on, and I needed daily updates. I couldn’t wait three weeks to find out we might miss payroll.
But what could I do about it? Accounting wasn’t going to change for me. So me and my financials sat in this uneasy sort of truce for a long time, until I met a guy named John Zdanowski. I met John through the Phoenix Strategy Group. He is a former sonar engineer who earned his MBA from Harvard. John spent most of his career working on complex underwater scanning systems which, like dolphins, use sound waves bouncing around underwater to “see” through the murky depths. As he put it, that job was to pull the “signal” (the image) out of the “noise” (all the scattered echoes). This resonated with me immediately, drawing me back to my days working as a product engineer at Motorola’s Radio Frequency Semiconductor Division. We made chips with a high “signal-to-noise ratio.” These semiconductors are crucial components of any cellular network.
“When I got into finance,” John explained, “I expected to find disciplined mathematical modeling of business. But what I found was 500 years of legislated cruft. It was almost all noise.”
I had never really thought about the origins of accounting before. I did my own research and discovered John was right. But it was much worse than I imagined. The origin of accounting goes back more than 600 years to Florence, Italy.
Giovanni de’ Medici had a problem. In the late 1300’s he had started a family bank. And as was the practice at the time, they only loaned money to their wealthy friends or the Pope. But they had a problem. There were these new people coming on the scene, merchant captains who were delivering returns over 1000%! Ever hear of Marco Polo? He’d already shown the world what the silk trade could pay out, and a new generation of captains was chasing the same fortune. The Medici were missing out, and Giovanni wasn’t having it. But how do you loan money to someone who is not in your trust network? How could he make sure the captains didn’t just steal the money and say the goods were lost at sea?
His answer to that problem has been passed down to us over the centuries. He created double-entry accounting, the system of marking debits and credits in a ledger. At first it was a secret, something the Medici kept to themselves, but with it they could track the flow of money. It was so successful their friends clamored to have it, and even the merchant captains themselves told other bankers and financiers about the system. Word spread for the next hundred years, until a Franciscan friar and mathematician named Luca Pacioli finally wrote it all down, publishing the Summa Arithmetica, the first book on formal accounting. This allowed them to train people to become accountants to meet the burgeoning need for people who knew how to apply the system.
As fascinating as this story is, it also points to the origin of my frustration with accounting in general. In engineering, all of my training was based upon modeling physical reality. Electricity moves through metal wires, electrons bumping around. Newton created calculus to model his physics. But accounting wasn’t based in any physical system - it was based in a deeply human system.
Medici didn’t create double-entry accounting to model some underlying physical reality. He created it to ensure that he wasn’t being cheated. It was a form of legislated trust. In short, he created it as a form of remote surveillance and compliance. And from that beginning, accounting has experienced less real innovation than any other “discipline” we teach in school. There have been revolutions in art, the sciences, engineering and math. But when accounting breaks - rather than reimagine the system, governments legislate new standards, adding another layer of sediment to the mix.
And of course the government got involved because they want to make sure the taxes are getting paid, Medici’s new system served their needs perfectly.
The only person this system didn’t serve perfectly? The small business owner!
No wonder my financials irritated me. They were not designed to help me, the business owner. They were originally designed to serve the bank! And six centuries of legislative cruft added more noise than signal.
I mean seriously, how is a small business supposed to make use of an 80 line report that shows up half a month after everything has happened? This is not a tool for managing a fast-moving company, it’s a tool for surveillance and compliance. It’s a tool to tell people outside your company what happened, not a tool to help you understand what is happening, nor what needs to happen.
And if you have the good fortune (or the bad luck) to found a company that is really different, like GameTruck? Good luck finding someone to model that for you. I know, I tried. I spent a mortgage worth of money on consultants, CFOs and financial gurus trying to model my franchise business all to no avail. What I learned is that most financial professionals could apply the model they learned. None of them could develop one. If it didn’t fit what they already knew, they gave up. Leaving me to fly blind by the seat of my pants.
Until I met David Metzler at the Phoenix Strategy Group. David showed me the model John had developed, what he called his Integrated Financial Model, the IFM. The IFM is what happens when a sonar engineer tries to pull the financial signal out of the accounting noise. And it’s brilliant.
For the first time in twenty years of doing business, I ended up with a system that made sense to me, the business owner. Instead of getting distracted by a hundred line chart of accounts, John zeroed in on what mattered most for all businesses. How much profit does each customer generate compared to the cost of acquiring (buying) that customer?
He called that the unit economics of your business. And you can calculate that for any business. How do you find that number? By tracking down four, just four, not 80, not 100, four numbers. Your advertising spend, your sales, your revenue, and your gross margins. That’s it. Let me give you an example to make it clear.
Let’s say you sell birthday parties, like me, for 200 for labor, gas, taxes, and fixed fees like royalties. Leaving you about 12.50 to buy a lead from a Google Ad campaign. And your sales close rate is 25%. That means it costs $50 to buy a customer. How often does this customer buy from you? To keep the math simple, let’s say it’s one time.
That makes your Lifetime Gross Profit (LTGP) from that customer 50. The Unit Economics of this business is therefore… 250/50 = 5.
That’s a GREAT number! The trick, however, is getting enough parties to cover all the fixed expenses. But… suddenly you can see the power of this model.
What if I could get a customer to buy more than one party? What if we could improve our close rate? What if we could improve our gross margins? What if we could reduce our fixed costs?
I was sitting around fretting over the lack of profitability in my business waiting until I could make one video game trailer profitable until I saw this model and then realized one trailer was in a sense already as profitable as it could be, but that was not enough cashflow to float the fixed costs. I desperately needed a second trailer to make the model work, and that’s what I did, I went out and brought another trailer into that market.
For the first time in 20 years I had a financial model that served me. I could finally see what I needed to focus on, the decisions I needed to make. I could understand the “physics” of my business and by tracking 8-10 numbers, not 80 to 100, I could make better decisions that would make my business consistently profitable.
Spending weeks every month accounting for all that happened? That’s not engineering, that’s surveillance and compliance work. Modeling your business profitability? That’s building a cash engine!
It took twenty years for me to find a financial modeling system that worked for my business, something that could help me make decisions, and because of its simplicity begin to forecast how my decisions would impact the cashflow of my company. But even more important than that. As a leader of my business, I finally had a way to connect each department and show them how they contributed to our financial success.
That is the exact opposite of confused frustration, and it feels a lot better than trying to track cash with a paper and pencil.
Clarity, alignment, impact, and results. That’s what I want as a business owner, and that’s what the IFM gave me. I now have a diagnostic and predictive model I can use to grow my company. And I have to say that feels a lot better than flying by the seat of my pants.