Strategies

Meet Erin, who was just 21 years old at her college graduation, among the youngest of her classmates. Her hard work in college paid dividends. She made the honor roll, graduating near the top of her class. After graduation, she took a full-time job at a company where she had interned the prior two summers. Yet as confident as Erin was in her job skills, she had no knowledge or experience when it came to money. For now, she trusted that her natural caution about money would serve her well enough. But her considerable educational debt worried her, as debt worried many of her classmates. She knew that she needed to give her finances thought and learn more about money.

Managing money well depends on the strategies you follow. You may not realize that you’re following strategies, some for better, others for worse. Procrastination, for instance, is a common strategy people follow with their money. When they see a money problem, they’ll deliberately put it off, hoping it will go away, when deep down, they know it won’t. Ignorance is another common strategy people follow with their money. They assume that the less they know, the better, when they should instead find out. So, adopt the following sound strategies. Otherwise, you’ll follow silent strategies that aren’t sound.

Earnings

Make your earnings not just a given but a strategy. Earnings are generally the first ingredient for financial success. How much money you or your other household members earn matters. You can generally earn more or less, depending on what you decide. But how much you earn isn’t the only important factor. To win at managing your money, you also need to earn consistently, with no gaps or only short-term gaps. You can strategize over earnings. Earnings aren’t a given. They can fluctuate, and you have some control over them. Your earnings strategy matters to your financial success. 

Wisdom

Make money wisdom another money strategy. Making a lot of money doesn’t guarantee financial success. The more you earn, the more you spend. People with high income can have lousy finances. Conversely, people with modest or low income can have outstanding finances. Over the long haul, sound financial practices can do very well for just about anyone. High income is not necessary. Wisdom in finances is the bigger key to long-term success. Make the right money decisions based on the right principles, and you’ll soon see the difference.

Knowledge

Make money knowledge another strategy. Know money. Financial knowledge is powerful. With knowledge, you should feel more connected, engaged, and in control. Knowing money helps you recognize what you and your family are trying to achieve with your finances. Share your knowledge with your family. Commit to common money goals, while knowing how to achieve them.

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Part I: Personal Financial Management

Meet Pat, who was 28 years old at his college graduation after having spent a few years in the trades before starting night school. A “people person,” Pat loved his college co-curricular programs, although classroom studies not so much. Pat’s prior savings, part-time work throughout college, and night-school program enabled him to graduate with only modest educational debt. He had little concern for paying off that debt from the sales-rep job he took after graduation. He knew the job wasn’t a career. He’d figure that out later.

Personal

Sound finances begin with you. Yes, you are part of a family, the finances of which affect you. A rich mom, dad, or uncle can make a difference to you. If you are employed, your employer’s finances also affect you, in job security, advancement, compensation, benefits, and bonuses. The economy of your community and state, and of the nation and world, also affect you. Economic recessions and downturns in the stock market can impact you. But those outside influences aside, your knowledge, decisions, and actions matter most to your financial situation.

Accounts

Your checking and savings accounts are good starting points for your personal financial management. You probably have an account into which you place your income and out of which you pay your expenses. We used to call it a checking account, but we don’t write paper checks much anymore. Call it your household account. You may also have an account you don’t use daily, in which you keep savings you’ve accumulated, and out of which you might pay an unusual expense, like buying a car or making a down payment on a home. Call it your savings account. Open a savings account if you don’t have one. To manage your money well, you need both a household account and a savings account.

Reconciliation

Keep it simple. Reconcile your accounts monthly. To reconcile an account means to check your record against the bank’s record. If you keep a written check register for your household account, compare your register to the bank statement you get at the end of each month. If instead you rely on an electronic register for your household account, check the electronic register at least monthly. You need to ensure that you and the bank have the same understanding as to your deposits and withdrawals. You or the bank may have made mistakes. The bank, a retailer, or a scammer may have added a charge to your account. If you don’t catch the mistake or unauthorized charge timely, you may lose the ability to contest and correct it. Monthly reconciliation also ensures that you regularly think about money management.

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A. Principles & Practices

When Pat started at his sales job after graduation, he knew immediately that his personal finances would work. Money meant little to nothing to him other than the ability it afforded him to do the work that he loved. His first paycheck provided that ability. He could see that his earnings would soon pay off his modest educational debt. For the moment, Pat thought nothing else about money. Yet anytime he thought about marriage and a family, which was increasingly often, he began to think that money might have more to it than just sustaining his ability to work. By contrast, Erin had a different view of money. She feared her large and stubborn educational debt, although the more she thought of it, she realized that she had always been insecure about money.

Literacy

Managing money meaningfully involves knowing the principles that guide the practices. Learning the principles helps you know the purpose and value of the practice. Your practices may vary with changes in your circumstances. The principles will remain the same. Be idealistic in principle, while shrewd in practice. Commit to financial literacy. Learn about budgets, financial statements, investing, risk management, and taxes. Your personal financial success depends on sound money management. A basic knowledge of money management principles and practices, or financial literacy, is the ground for your success.

Family

To help yourself with money management, help your family with financial literacy. You won’t succeed if your spouse, children, or other household members are constantly pulling the opposite way. They’ll wear you down, and you’ll give in. Instead, let them see why you are making the decisions you are. Indeed, consult with them. Listen to how your decisions affect them. But also explain how your decisions are serving and protecting them. And explain the principles on which you are acting. Let them see the care you are taking, wisdom you hold, and discipline you practice. Teach sound money principles and practices to those who are most important to you, just as you serve them with other forms of love and care. 

Consumption

Manage your consumption. Appetites expand to our ability to fulfill them. The move you have, the more you want. Control that urge. The hungry seek food, while the satisfied seek better food. The homeless seek shelter, while the sheltered seek larger homes, second homes, and luxury homes. Even the highest income earners become debt-ridden and insolvent when failing to manage their consumption. Financial instability comes from consumption exceeding income, whether income is high or low. A sure way to increase financial stability is to reduce consumption. The study The Millionaire Mind reports that most millionaires had never spent more than $41,000 for an automobile, $4,500 for an engagement ring, or $38 for a haircut (including tip).  Most of their recreation was inexpensive or free, like watching their children play sports or entertaining friends at home. You need not forever deny yourself purchased pleasure. But you can often delay consumption.   

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B. Cash Flow & Balance Sheet

Expenditures by her co-workers surprised Erin, who was always cautious with her money. She winced when she saw a young co-worker driving a new car looking more like the luxury cars senior employees drove than her own high-mileage car or the modest vehicles of the other younger employees. One of her own small class of new employees had just flown to New York City to shop on Fifth Avenue for the weekend. Erin wondered whether she was missing something. She also did not want to stand out. She realized that she was eating lunch out at more-expensive restaurants than she should, mostly to feel accepted by her co-workers. Those expensive lunches troubled her, especially when she saw how much tighter her finances were at the end of the month.

Statements

Create and use a personal financial statement. It’s your best financial tool. A financial statement shows your financial condition. Wouldn’t you want to know? Businesses routinely use financial statements. Yet financially responsible individuals need a picture of their finances, too. A statement gives you that picture. Personal finances can take twists and turns and show trends that might not be apparent without a financial statement. Don’t you want to know if your savings and investments are trending up or down? If your debt is growing or shrinking? If your emergency fund has dwindled? If you’ll have enough money left at the end of the month to pay the mortgage or rent?

Complexity

You especially need a personal financial statement because your personal money management can be surprisingly complex. There’s more to it than meets the eye. On the debt side, personal finances typically involve not just revolving credit-card balances but also short-term debt like vehicle loans and long-term debt in the form of home mortgages and student loans. Managing your debt portfolio can be harder than it looks. On the asset side, you may have not just substantial personal property including motor vehicles, recreational items, and household goods but also real property in the form of a home, cottage, land, or rental property, and brokerage and retirement accounts. That’s a lot to manage. Get a good picture of it with a personal financial statement.

Monitoring

Personal finances are not only complex. They are also significant.  Your money management influences your ability to meet both basic needs and critical financial obligations. With money, timing is everything. Addressing obligations and seizing opportunities early or late can make big differences in the short run and long term. Five or ten years can pass swiftly, never regained, with your money headed in one direction or the other. Because you need to manage your money consistently and timely, you should be recording and tracking your personal finances. Write it down. Write it down. And write it down again. Update and evaluate your personal financial statement at least quarterly. 

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C. Loans & Debt

Erin had just to keep a written budget. She had always just relied on being stingy with money. Gradually, though, she realized how wrong stinginess can both look and be. Erin needed more confidence in where she spent and where she saved, to be able to say both yes and no to spending, with sound reason.  While her first try at a budget was pretty far off, she found after another month or two that her budget actually worked. She was learning that she could say yes in some places she had been saying no but should say no in a few places she had been saying yes. Soon, she was wondering how she had gotten along without a budget.

Credit

Credit can nonetheless be an effective component of your long-term financial plan, particularly in education and housing—not all education and housing, but in certain instances and when properly managed. Higher education can increase earnings over a lifetime. Home-mortgage debt can help you avoid rent and acquire and enjoy a residence, while owning an appreciating asset. Using a loan to acquire transportation is much more problematic because of the swift and substantial decrease in the value of the vehicle asset. Approach with caution any debt other than that which you use to purchase an appreciating asset. Poor, impulsive, short-term decisions can affect your financial future. 

Education

If you owe student loans, prioritize repayment. With federal subsidies, your student-loan interest rate may be lower than vehicle or mortgage interest rates. You may also be able to defer loan repayment for graduate or professional school, unemployment, disability, or other financial hardship. Student-loan programs may also offer loan forgiveness for public-interest work, after a period of years. Student loans, though, may not qualify for discharge in bankruptcy. Treat student loan repayment as a priority because of their limited relief and strong enforcement.

Repayment

Student loans can offer more variety in repayment options than other loans. The best option remains prompt prepayment of extra principal until you quickly retire the full obligation. Devote cash gifts, inheritances, bonuses, second-job earnings, and cash from sale of personal property to paying off student loans early. Student-loan programs may also offer graduated repayment plans in which your payments gradually rise over time, presuming that your income will also be rising. Graduated repayment plans are more expensive because the smaller initial payments go more to interest while paying down less principal. Choose graduated repayment only if you must do so. Student-loan programs also offer income-sensitive repayment tying payments to the level of your income. These programs have the same problem as graduated-repayment plans in that they tend to increase the loan’s total cost because of the delay in repaying principal. Extended repayment plans are an even more expensive option in that they extend the life of the loan beyond 10 years to 12, 15, or even as long as 30 years. Every extension increases the total cost of the loan.  Avoid these latter programs at all costs, whenever possible. 

Ratios

The ratio of your debt to your income is another helpful guide to ensure that debt does not destroy your money management. The ratio of your total debt payments to total take-home pay should not exceed 40%. For example, if your annual take-home pay after taxes is $52,930, then your total annual debt payments should not exceed $18,783 (40% of $52,930). Importantly, total debt includes mortgage payments or rent. If you do not have an obligation for mortgage payments or rent because you own your home or are living rent-free, then your debt-to-income ratio should not exceed 20% of take-home pay. These guidelines are not licenses to incur additional debt needlessly. Debt works only when used to purchase appreciating assets like a home and not discretionary, short-term consumables like vacations or entertainment.

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D. Risk & Insurance

Pat and Erin had married about two years after graduating from college. They had at first discussed buying a home while they were still engaged so that they could move into it immediately after the wedding. Yet their balance sheets showed them that they would barely be able to get together a 10% down payment. They would then have no savings. They would also have the financial burden of the mortgage payments, real-estate taxes, and homeowner’s insurance, plus the home’s upkeep, not to mention the improvements they would want to make. Their budgets showed them that they just would not make it financially. So they rented for their first year together, stress free and happily, while they saved for a bigger down payment. When they did buy a year later, they bought within a price range that enabled them to put 20% down. Four years after college, they were married, in a home with one child, had a second child on the way, and felt reasonably secure financially. Best of all, after just four short years of marriage, they had full confidence in one another and (unlike some of their married friends) no arguments over money.

Risk

Life brings events affecting your financial future. You do not control many of those events. Yet you are not passively subject to events. You are instead a participant in them. You can influence events, even if not control them. You can also prepare for unpredictable events in ways that mitigate their impact on your finances. You may not be able to control many things that will happen to you or your family, affecting your finances. You can nonetheless control the financial risks associated with those uncontrollable events. Financial historian and economist Peter Bernstein in Against the Gods:  The Remarkable Story of Risk credits our mastery of risk as establishing modern finance. It’s that fundamental. Your failure to address risk is irresponsible. To ignore risk is to relinquish your destiny to circumstances, diminishing your character. 

Individuals

You may think of risk management as something that companies, not individuals, do. Think again. Individuals face financial risks just as companies do. To reduce the risk of tort liability, we drive with care, limit our vehicle’s use to safe drivers, and buy vehicle insurance. To reduce the risk of property loss, we install smoke alarms, lock doors, and buy homeowner’s insurance. You can likewise reduce risk and mitigate loss in your financial plan to support your spouse, educate your children, and retire with reasonable income. You can act now to achieve long-term financial goals even in the face of catastrophic loss like severe accident or illness resulting in long-term or permanent disability.

Management

Managing risk begins with recognizing it. While some risks, like motor-vehicle accidents, are obvious, other risks, like lost services of a homemaker, are not apparent. Financial statements are risk-recognition tools. They help you see financial threats like declining earnings, excess expense, and skewed debt ratios. The AMA Handbook of Financial Risk Management defines risk management as predicting and controlling risk to create economic value. Managing risk means avoiding, reducing, or transferring it. You can avoid the risk of falling off your roof by not climbing onto it. You can avoid the risk of thieves stealing your diamonds by not owning diamonds. When you cannot avoid or reduce risk to safe margins, then transfer the risk through contract. Hire someone else to climb onto your roof to clean out the gutters. If you insist on doing it yourself, then carry health, disability, and life insurance. Insurance transfers risk to the company that issues it. If the potential loss is small, then you may choose to simply accept the risk, in effect financing the risk yourself if you should realize it. Maybe you own only a small diamond.

Insurance

Insurance is a prime way to manage financial risks. Insurance fills the gap between the goals you want to accomplish and the risks that could prevent you from achieving them. People tend to think of insurance in negative terms as insuring against negative things like accident, injury, loss, disability, and death. They then gamble by forgoing insurance, hoping in their invincibility or simply wishing to ignore bad thoughts. In positive terms, though, you insure goals more so than risks. The first step with insurance is to identify the good things you wish to achieve, and then insure against the bad things that could stop you. Insurance transfers the risk to the insurer, guaranteeing your plans with respect to the insured risk. When you choose not to insure insurable risks, you retain the risk of loss. Insurance shifts and manages risk. While some companies and advisors offer insurance as an investment, mixing risk management with investment generally makes for poorer results in both. Price and buy insurance, not an insurance investment. Invest separately.

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E. Investment

The combination of Erin’s 30th birthday and the unexpected death of a physician friend encouraged Pat and Erin to sit down one evening to look more carefully at the financial risks that their family faced. Their physician friend had died without any life insurance. The physician’s wife had to sell the home, take a medical receptionist’s job, and move with their children into a cheap apartment. Pat and Erin realized that their own family faced similar risks. They needed financial security against the death or disabling injury of either one of them that would protect their home, provide for their children’s future education, and enable future investment and retirement savings. They had a brief laugh that it took Erin turning 30 for them to realize their mortality, but the unexpected demise of their physician friend and the financial struggles of his surviving wife and children gave them real urgency. Pat called an insurance agent the next morning.

Time

Once you have earnings coming in, expenses under control, emergency funds in place, and risk management addressed, it’s time for investment. You have your foundation. Now, build on it. Begin treating excess income as your future, not your present. Take advantage of employer retirement contributions. Treat substantial gifts and inheritances as investments, not as windfalls to promptly spend to improve your lifestyle. You can think about investing before you have your financial foundation in place. But once the foundation is there, build your future.

Principles

Successful investing depends on following the right principles.  As Opportunity may present itself through an employer retirement contribution, substantial gift, or inheritance. But you usually make your own opportunity by laying a sound financial foundation. The first principle of investing, then, is to consistently put yourself in a position to do so. Investing doesn’t just happen. You make it happen by executing a thoughtful investment plan built on your solid financial foundation. Then, invest early and often, as soon and often as you are able. The race goes to the tortoise, not the hare. And take the long view when investing. While the term for your individual investments like certificates of deposit may be six months to one year, treat every investment as part of your long-range goals. Take the long view of investing. Here are other principles that the book Warren Buffett Invests Like a Girl—And Why You Should, Too recommends: 

• avoid overconfidence in investing; 

• instead, exercise suspicion and even pessimism;

• especially identify and manage investment risks;

• constantly investigate, research, learn, and adjust;

• avoid responding to peer pressure and herd behavior;

• learn from your mistakes rather than repeat them;

• don’t chase large short-term gains;

• instead seek consistent gains over the long term;

• make fewer and wiser transactions rather than more;

• question the experts both to test opinions and learn;  and

• always act with integrity while expecting advisors to do the same.

Risk

Know the difference between investment risk and planning risk. Investments carry different degrees of risk, from high to low and everything in between. Diversification and allocation, discussed below, can help manage investment risks. Yet the larger risk is that our plans will not reach our investment goals. Investments go up and down.  That market risk, though, is not the biggest risk you face. Your bigger risk is not to plan effectively, implement plans consistently, and assess and adjust those plans periodically to achieve your investment goals. The market is not your biggest challenge. You are your biggest challenge. Control that bigger planning risk. You are doing so by reading this book.

Capital

Do not treat investing as a necessary evil. Instead, celebrate that you are acquiring and directing capital to its higher and better uses. Earnest retirement saving and investment by individuals has subtly transformed and democratized the control and direction of capital. We are slaves to the whims of others until we own the means of our own production. Starting your business is one way of doing so, but saving and investment is another way. Individual investors now own about one third of total U.S. capital, largely through retirement accounts. That figure is on its way to one half or higher. Do a good thing for yourself, your family, and others. Work diligently, spend cautiously, give generously, save much, and invest wisely.

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F. Retirement

Erin had begun to accumulate funds in her 401(k) retirement plan both from her payroll deductions and her employer’s year-end contribution. One evening, she and Pat sat down to look at how they had invested those funds. The statement that had come in the mail that day showed 80% of her funds held in stocks and the other 20% in bonds. Erin was pretty sure that she had chosen a better balance, more like 70% stocks and 30% bonds, when she first opened the account at age 27. She and Pat checked their earlier statements, which confirmed that Erin’s stocks had made significant gains while her bond funds had fallen, throwing her portfolio out of balance. Time to rebalance and reap the reward of some of those gains, Erin and Pat decided. The financial-services company’s website showed evening hours. Following the age-in-bonds rule, Erin immediately called the toll-free number to redirect 35% of her total portfolio into bonds and 65% into stocks. The whole process took them about a half an hour, and they still had time for their evening walk.

Projection

You need to plan for a financially secure retirement. To plan for retirement, you need to know what retirement looks like to you. For most of us, retirement means ending substantial income-producing work. Retirement may be either voluntary or involuntary. Retirement often coincides with physiological changes associated with advanced aging. Retirement also implies enjoying life, we hope in good health and with enjoyable activities and good relationships. Yet retirement also implies the need for financial support to replace earnings. When planning for retirement, consider variations on the traditional plan of amassing a fortune off which to live in retirement. Recognize and pursue your core commitments. The book What Color Is Your Parachute? For Retirement offers these alternatives to traditional retirement:

• refocus your current career toward something more engaging;

• go part time to do only that part of your job you most enjoy;

• work only periodically on special projects;

• retire from your regular job to work for a current client;

• retire from your regular job to consult for similar employers;

• change careers to do something you would like more;

• start and run a new business;  or

• cut your living expenses drastically to retire early.

Planning

Younger generations today are less prepared for retirement than older generations. A report Retirement Security Across Generations:  Are Americans Prepared for Their Golden Years? from the Pew Charitable Trusts’ Economic Mobility Project indicates that Generation X members, born after 1965 and 1980, will have replaced only half of their income by retirement at age 65. In contrast, Baby Boomers born between 1956 and 1965 replaced 59% of their income. But two thirds of Millennials, born between 1981 and 1996, have nothing saved for retirement. We are increasingly unprepared for retirement. Increases in the age at which one receives full Social Security benefits, decline in Social Security’s full funding, increased life expectancy, and decreases in defined-benefit pensions add to the problem. More and more, we must plan on our own for retirement, largely through our own contributions to 401(k) and IRA plans.

Working

Working longer, or continuing to work part time, can be an option for those without sufficient retirement funds. According to the U.S. Bureau of Labor Statistics, a larger percentage of Americans over age 55 are working than ever before, with that percentage expected to increase. The Employee Benefit Research Institute reports that over 40% of employees plan to work past age 66. But check your employer and field. You may face a mandatory retirement age.  Altman Weil’s Compensation Plans reports that half of all law firms, for instance, require lawyers to retire by a specific age. Airline pilots, commercial truck drivers, law enforcement officers, and workers in other fields face similar regulatory requirements or employer restrictions. And working can get harder, especially with natural declines in strength, stamina, energy, and vitality.

Funding

Traditionally, retirement funding has involved the three-legged stool of (1) Social Security, (2) an employer pension, and (3) personal savings.  Today, the traditional three-legged stool, even supported by fourth and fifth legs of post-retirement work and home value, is wobbly. Social Security retirement benefits are only a floor for retirement funding. Check your anticipated benefits. The Social Security Administration website offers a retirement-benefits calculator, estimator, and planner. The SSA also indicates to expect funding at just 75% of the 2033 benefit level, due to withdrawals and underfunding of reserves. Congress has already incrementally reduced benefits by increasing the full retirement age and will likely continue to do so.

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Part II: Business Money Management

Pat had taken the proverbial plunge into his own sales-rep business, leaving his employer one year ago. Yet his transition never really felt like going solo. He had leased space in an office suite that had several other tenants. He knew most of the tenants before he ever thought of leaving his employer and joining their office suite. He also respected them, and they respected him. Within a short while of starting solo, Pat felt as if he had simply joined another company. He shared no finances, files, or confidential information with the others in the office suite. Yet he and they certainly shared back-and-forth referrals. Pat also had several willing mentors among them, just as they had the general benefit of Pat’s own knowledge and expertise. Solo practice was working for Pat, and he knew it.

Relevance

If you own a business, company, or firm you need to know the financial management of your enterprise. Your business won’t survive long without your exercising that knowledge. Business finances carry far greater risk than household finances. Bureau of Labor Statistics show 20% of new businesses failing in the first two years, 45% in the first five years, and 65% in the first 10 years. Inadequate revenue, poor planning, and inadequate capital are the top reasons why new businesses fail. If you don’t own a business but are an employee, consider reading this part anyway. You’ll learn your employer’s financial concerns and your own place within them. You may perform better, well enough to take an ownership interest or start your own business.

Theory

Think first of the reasons why individuals form business companies or firms with others. In theory, each individual could operate alone, buying from suppliers and selling to clients and customers based on the most efficient exchanges. Yet identifying the goods and services, determining their value, adopting the systems to produce them, and discerning the lowest cost require sellers to incur substantial costs. It’s hard and expensive to do it all alone. When individuals form companies or firms with others, they share and reduce those costs. Individuals share with their business partners and associates what goods or services to offer, in what form, produced by what systems, having what value, to which clients or customers, at what price, and by what delivery system. That’s the economic theory of a company or firm.

Solos

The economic advantage of companies or firms does not mean that solo practitioners remain at a cost disadvantage. Solo practitioners have ways to obtain the needed market and systems information. They can join business, trade, or professional associations, attend practice-management institutes, seek mentor relationships, and do networking and research. Solo practitioners can also operate through mutual referral arrangements as if they were members of informal companies or firms. Each solo practitioner knows the market and systems information within their practice niche and can use their mutual referral network to connect clients and customers with other solo practitioners for goods and services they do not supply. The financial principles in this part apply equally to large firms, small firms, and solo practices. 

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A. Industry Overview 

Erin had finally left the company that she had joined years earlier, in a transition that was both easier and harder than Pat’s transition into solo practice. Rather than going solo, though, Erin had joined with two other partners and an associate who also left her former company, the four of them forming a new partnership. The transition had been easy in that they had managed to keep their core clients. They did not lack for work, which had been her greatest fear. Yet a different challenge had snuck up on and almost overtaken them. None of them had been involved in the financial management of their former company. The complexity of their new finances had surprised them. The others had turned to Erin to take on that management. Her personal financial discipline had won her the respect of her partners. Yet she still had a steep learning curve to become her new company’s financial manager. She would have declined except that the financial work gave her an opportunity to work from home with more-flexible hours, which had been her primary goal in the new venture.

Sectors

Businesses, companies, or firms depend on knowing the size, scope, and vagaries of their trade, profession, industry, sector, or field. Learn about your field, whether you are in a retail sector, a professional-services sector, healthcare, manufacturing, construction, or another field. How large is your field? What percentage does your field represent of gross domestic product? Is your field larger inside or outside the U.S.? How does your sector perform in economic cycles relative to other sectors? Research until you can articulate your sector’s value to yourself, your family and friends, your business partners, your employees, and your customers or clients. If you don’t believe in it, no one else will.

Compensation

Know the compensation structure within your sector for every significant role on which your business, company, or firm will depend. Know how businesses in your sector compensate owners, managers, administrative employees, producer employees, laborers, and suppliers. Make sure you know how to engage and retain others in your business or to support your business, to secure work, manage work, complete work, and deliver goods and services. If owners secure the work in your sector, and employees perform and deliver it, then know the compensation arrangements for each, whether percentages, employee salaries, hourly wages, or vendor contracts. 

Owners

Businesses, companies, or firms generally compensate owners not to do the work but to finance the work, contributing the capital and accepting the financial risk of obligations. Businesses may also pay owners to secure or originate the work, supervise the work, produce some of the work at key stages, and deliver the work to the client or customer. When a business has multiple owners, compensation is generally by each owner’s economic value to the business. Economic value may depend on capital contributed, revenue generated through secured work, and profit from work the owner supervises, minus the owner’s share of business overhead. Even though an owner’s primary value may not be in the work the owner completes, when others could do so at a lower labor cost, for an owner to secure work may require the owner to demonstrate expertise in that work. 

Criteria

Performance and compensation criteria can change for participants in a business over time. The traditional firm evaluates the work of a new associate based on training ease, learning ability, work commitment, and adjustment to the firm’s culture and personnel. Performance and compensation criteria then move to skill at assigned work, management of work, effectiveness with clients or customers, and community contacts. As associates near management and partnership, compensation criteria change again to business skill, client development, and leadership and development of new personnel within the firm. Firms tend to abandon lockstep compensation schemes as associates move closer to partnership, rewarding individual performance rather than seniority rank. 

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B. Legal & Capital Structure

Compensation was the first major financial decision that Erin’s new company faced. Erin expected the two older partners to propose a formula, maybe a mix of billable hours and fees generated through client development. She was surprised when the partners instead suggested relatively modest salaries based on a wide range of criteria, with year-end bonuses based on the firm’s overall performance and additional individual criteria. Compensation suddenly looked a lot more subtle and variable than Erin had expected. For just a moment, Erin wondered whether the older partners might be manipulating things to their own advantage, but she quickly put the thought out of mind. Their proposal had been more than fair to Erin and the other younger partner. Erin realized then that companies in their financial management depend in large part on respect and trust among owners. Formulas can help, but each worker’s value and contribution is unique.

Structure

The legal structure you give your business matters. Businesses may organize as sole proprietorships, partnerships, limited liability companies (LLCs), subchapter S corporations, or C corporations. Our focus here on finance does not warrant full treatment of the various forms of business organization. Yet consider how a business’s legal structure can have financial implications. One significant financial consideration in choosing a corporate form is to limit the personal liability of owners. That liability may be on a long-term office lease, mortgage loan, or bank line of credit.  That liability may also be related to products liability, premises liability, negligence liability, or malpractice due to the actions of one or more participants. Another financial consideration for businesses in choosing a legal structure is to avoid double taxation at both the corporate and personal levels. Consider each legal structure with these two concerns, liability and taxation, in mind.

Solos

Some business owners choose a proprietorship without any corporate form. Doing so avoids double taxation at the personal and corporate level. Sole proprietorships also reduce accounting expense and administrative complexity. Sole proprietors do not offer liability protection. Whatever liability the business accrues, its sole proprietor also accrues. Sole proprietors would be personally liable when signing leases, financing equipment purchases, and opening bank lines of credit. Any interruption of the practice, whether because of family or medical leave, or economic recession, could leave the sole proprietor with personal liability for all business debts. 

Partnerships

Businesses have the option of organizing as partnerships. A partnership avoids double taxation. Partner earnings flow through the partnership to partners who pay the only income tax on those earnings. In that respect, partnerships accomplish a significant financial objective. However, partnerships do not protect partners from liabilities. Each partner remains liable for the partnership’s obligations, meaning that each partner is likely to be an individual defendant in any proceeding brought by a landlord, bank, or other partnership creditor. Each partner also remains liable for obligations incurred by the partnership through other partners. One partner’s malpractice becomes the liability of all other partners. While the flexibility and informality of partnerships can make them attractive, their pass-through liability has made them an increasingly disfavored legal structure.

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C. Annual Financial Planning

The first thing Pat did for his sole proprietorship was to form a single-member limited-liability company. He had bank accounts to open and service contracts to sign. Pat wanted to do both through a business entity rather than in his own name. He reviewed a few template LLC operating agreements and adopted one of them with few changes. The suppliers with which he then dealt accepted his LLC entity without requiring his personal guarantee. Yet Pat recognized that his LLC’s bigger value beyond limiting his liabilities was in helping him treat his business as something formal and serious. The moment that he handed out his first card with his LLC’s name on it, he felt on his way toward building something of lasting value.

Stages

Responsible businesses conduct annual financial planning. The book Results-Oriented Financial Management indicates that the type of annual financial planning depends on the business’s stage in its overall life. New businesses focus on preparing an initial financial plan. An initial plan creates a first budget, determines financial reporting, plans cash flow, acquires financing, determines owner compensation, and minimizes taxes. At the growth stage, established businesses focus on improving the planning process, ensuring appropriate financial management, meeting increased capital needs, clarifying ownership structures and interests, adopting retirement plans, acquiring marketing services, and adjusting compensation policies to reward innovation. Ensure that your planning covers these basics.

Crises

Businesses can also encounter a crisis stage. Be aware of, and plan to avoid, financial crises. A financial crisis can arise from loss of a single major client or customer on which the business over relies. Overly democratic management can slow financial decisions and adjustments. Compensation expectations can substantially exceed financial resources. Business owners and managers can lack knowledge and transparency around financial information. Overly rigid compensation systems can subject a business to manipulation and may not compensate for necessary inputs. Over reliance on billing may inhibit business development. Undercapitalization can prevent growth and affect cash flow. Poorly defined ownership structure, relationships, rights, and interests can lead to leadership conflicts. And inadequate financial controls and budget review can lead to financial losses. Watch for these hazards, and plan to avoid them.

Balance Sheet

Businesses, like individuals, benefit from a balance sheet and budget or cash-flow statement. The balance sheet shows the business’s assets against obligations. The net of those figures reflect partner equity. The balance sheet in effect shows the value that the owners have built up in the business. Poorly managed businesses can have negative owner equity. Owners use the balance sheet to ensure that the business protects their capital contributions and their ownership interest in the business increases in value. Businesses use balance sheets to ensure that they have the capital, resources, and liquidity for continued operations. Businesses also use the balance sheet to recruit or retain owners and to secure and extend financing. Consider the following balance sheet for a small business having two partners, two associates, and two part-time staff. See if you can discern whether the business is protecting capital contributions, has necessary capital and liquidity, and is growing.

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D. Targets & Analyses

Erin had worked closely for two years with her business’s accountant to develop a decent balance sheet and budget. The accountant from time to time mentioned the “P and Ls” that they should soon be producing and tracking each month. For a time, Erin did not know what the accountant meant, other than that the accountant was referring to profit-and-loss statements. Nor did Erin feel that they needed profit-and-loss statements, whatever those were. The budget seemed to work. Yet the accountant persisted, finally printing out a couple of profit-and-loss statements from prior months to highlight their differences and question Erin over trends. The accountant’s insight surprised and pleased Erin when it confirmed a trend that Erin had intuited from her vague sense of billings, revenue, earnings, and cash flow. From then on, Erin insisted on reviewing monthly profit-and-loss statements. Most often, the P&Ls needed only a glance. Occasionally, Erin caught things that even her older partners had missed. She began making decisions based on the P&Ls rather than on hunches and intuition.

Processes

Employing analyses and establishing targets are good for your business. We tend to look at absolute results. Did the business produce substantial revenue this year? Did the business profit from that revenue, and if so, then by how much? Yet absolute results only tell part of the financial story. The manager who tracks only absolute financial results hardly keeps a finger on the business’s real financial pulse. Instead, analyze the data. Compare the data to industry benchmarks. Establish targets, measure progress toward targets, and adjust to improve progress. Analyze, benchmark, target, measure, and adjust. This section shows some analyses businesses make and targets they use to improve financial outcomes. 

Risk

You can manage risk by analyzing financial statements. Use financial statements to identify and reduce risks, to increase the business’s value. Do not underestimate the number and seriousness of financial risks. But recognize that every risk also carries opportunity. Your business has as much to gain from managing risk as it has to lose from not managing risk. As you read the following risks to your business’s financial future, consider both their negative consequences and positive opportunities:

• investment risk of failing to gain a reasonable return on accumulated capital;

• liquidity risk of not holding capital in a form convertible to cash when needed;

• cash-flow risk of falling short of cash needed to pay critical suppliers despite strong earnings;

• debt risk of losing the ability to timely pay interest and repay principal out of earnings;

• security risk of losing control to creditors of pledged or mortgaged assets critical to operations;

• credit risk of granting customers or clients and others credit that you cannot convert into needed cash;

• valuation risk of paying more for assets than they are worth as markets change, causing substantial losses;  

• enterprise risk of pursuing the wrong opportunities or failing to pursue opportunities that later prove critical to sustaining the business;  and

• technology risk of investing in the wrong technology or failing to invest in the right technology and thus losing customers or clients to businesses with better technology.

Causes

Financial analysis involves distinguishing cause from effect. Financial statements show symptoms or effects of problems, not causes of problems. Consider high accounts receivable and tight cash flow. Those two data points are symptoms, not causes. High receivables and tight cash flow could be due to late-paying clients. But they could instead be due to late billing, which is a big difference. They could alternatively be due to inadequate documentation on billing, poor estimating and budgeting for clients, or poor-quality work, unsatisfied clients, or insolvent clients. To discern the difference, statements should include for each client the totals owed, billed, paid, and unpaid and due. You should also have reports on the amount in fees that you estimated up front, client payment history, the fee agreement, and estimate of coming billings from work in process and upcoming work. This detail helps you analyze the causes of your firm’s financial performance, before blaming late-paying clients.

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