Class 16: Financial Optimization - Maximizing Your Money Machine

Welcome back to Thinkk's course on enjoying your company. You've built a thriving business, but now it's time to fine-tune your money machine. Let's dive into the world of financial optimization – where every dollar counts and smart strategies can transform your bottom line.

The Growth Paradox: More Revenue, More Expenses

As your company grows, so do your revenues. Exciting, right? But here's the kicker – your expenses grow right along with it. More sales mean higher costs of goods sold. A bigger team means more software licenses and insurance costs. It's like trying to fill a bucket with a hole in the bottom – unless you plug that hole, you're just wasting water.

The Scaling Stage: Refining Your Financials

When you transition from the growth stage to the scaling stage, refining your financials becomes critical. It's not just about making money – it's about keeping it. As the old saying goes, "It's not what you make, it's what you keep." At Thinkk, we've seen companies of all sizes – from startups making 10k a month to established firms doing 50k a day with $120 million in assets under management – all falling into the trap of unnecessary expenses.

The Pareto Principle: Focus Where It Matters

Now, I'm not saying we need to scrutinize every paperclip purchase. Instead, we use a principle called Pareto, named after the famous mathematician and statistician. The idea is simple: focus on the expenses that have the biggest impact. We start with the largest expenses and work our way down. One change to a large expense can be more valuable than a hundred changes to smaller ones. This is where we get leverage and impact.

Typically, the biggest expenses are either salaries or financing costs. Let's look at how we can tackle financing costs with a real-world example.

The Harbor Ship Success Story

I once worked with a company called Harbor Ship. Their biggest expense? Financing costs. Now, some consultants might have shrugged and moved on. Not us. We dug in and found some game-changing opportunities.

First, we renegotiated the spread on their loans. We managed to reduce it from 3.5% to 3%. Doesn't sound like much, right? But when you're dealing with $80 million in loans, that half-percent translates to over six figures in additional free cash flow per year. That's not chump change, folks.

But we didn't stop there. We looked at the other side of the coin – revenue. Since companies with assets typically allocate each asset into an individual company, managed by a holding company, one of the easiest ways to increase your net profit per asset (and decrease your operating expenses per asset) is to increase the number of assets you have. This spreads your fixed costs like rent and salaries over a greater number of assets.

We also tackled their insurance costs. By leveraging their good incident history and size, we renegotiated their rates. When the insurance company initially balked, we got competitive bids. Suddenly, they were willing to match our new offers. The result? Another significant boost to free cash flow.

The Creative Approach to Cost-Cutting

The lesson here is clear: there are often great ways to decrease your expenses, but you need to get creative. Don't just slash budgets indiscriminately. Remember, you could cut a thousand small expenses and have the same impact as a 5% change on your biggest expense. Think big, think smart.

Advanced Financial Management Strategies

Now, let's talk about some advanced strategies for managing your finances:

1. Dynamic Pricing: Implement pricing strategies that adjust based on demand, competition, and other factors. It's like having a price tag that knows when to go up or down. 

2. Product Mix Optimization: Analyze the profitability of each product or service. Focus on your money-makers and consider phasing out the duds. However, you’ll need to dive deeper here. Your product mix may include loss-leaders, like Costco’s famous one-dollar hot dog, which incentivises customers to purchase other goods. It’s important to understand which products in your mix simply lose money, and which contribute to the overall profitability of the firm. 

3. Value-Based Pricing: Instead of just marking up your costs, price based on the value you provide to customers. If you're solving a $100,000 problem, don't be afraid to charge accordingly. As a general rule of thumb, you should keep about 10% of the value you create. So if you solve a $10,000,000 problem, charge $1,000,000.

4. Lean Operations: Adopt lean management principles. Cut the fat, not the muscle. Elon Musk is famous for running his companies like large startups. This lean approach allows them to keep their overhead low and allocate resources to the essential areas that ensure the well-being of the firm.

5. Supplier Negotiations: Regularly review and renegotiate contracts with suppliers. Remember, if you don't ask, you don't get. Use bids from competing suppliers as negotiating leverage to get your current suppliers to match their rates, or at the very least come close.

6. Technology Investment: Invest in tech that automates and streamlines processes. It might cost more upfront, but the long-term savings can be enormous. One piece of software can do the work of a thousand people, and it never complains or gets tired. 

Investment Strategies for Growth

But financial optimization isn't just about cutting costs – it's also about smart investments. Here are some strategies to consider:

1. R&D Investment: Allocate a portion of profits to research and development. Innovation is the lifeblood of growth. In 2022, Meta spent nearly a third of its revenue on R&D. While this led investors to turn bearish about the company’s future, the strategy ultimately proved successful when Meta quintupled its value over the next three years, became a leader in AI, and pioneered the first consumer-adopted VR and AR glasses. While 30% of revenue may be excessive on a year-over-year basis, consider spending at least 10% of revenue on R&D. It’s tax deductible and will set you up for the future.

2. Market Expansion: Use profits to enter new markets. This could mean new geographic areas or new customer segments. We covered how to expand into new markets in our last session, so listen to Class 15 for more details on how to do this right.

3. Diversification: Expand your product or service offerings. Don't put all your eggs in one basket. The financial well-being of your company comes down to both the quantity and quality of your cash flows. Diversified cash flows, coming from multiple uncorrelated industries with multiple departments responsible for their creation, assure investors of the company’s financial stability and increase the firm’s valuation.

4. Strategic Partnerships: Form partnerships or joint ventures to share resources and reduce risk. The benefits of partnerships go beyond risk-reward sharing. We covered partnerships in Class 10, so give it another listen if you need a refresher. The essence here is to target firms with complementary offerings, an audience that will benefit from this newfound relationship, and a brand appeal that allows for the transfer of goodwill. Microsoft and OpenAI’s partnership in 2023 is an example of a brilliant partnership.

5. Debt vs. Equity Financing: Understand when to use debt (like when interest rates are low) and when to use equity (when you need significant funds but are willing to dilute ownership). If interest rates are really low, consider fixed-rate debt versus floating-rate debt. Sometimes, companies take on debt to signal their financial health to investors, and the tax-deductible nature of interest payments makes it attractive for some firms. Whatever you do, optimize for a debt-to-equity ratio, debt service coverage ratio, current ratio, and debt-to-asset ratio that keeps the company’s health in good shape.

Financial Health Checks and Audits

Finally, regular check-ups are crucial. Here's what to focus on:

1. Regular Audits: Conduct both internal and external audits. They're like a physical for your business – they catch problems before they become critical.

2. Key Financial Ratios: Monitor liquidity ratios, profitability ratios, and efficiency ratios. These are your business's vital signs.

3. Cash Flow Management: Create detailed cash flow forecasts. Remember, profit is an opinion, but cash is a fact. Poor cash flow management will destroy your company’s value, regardless of how much cash you’re bringing in.

The Final Word

Financial optimization is an ongoing process. It's not about making drastic cuts or taking unnecessary risks. It's about being smart, creative, and proactive with your finances.

Remember, at Thinkk, we believe that the best businesses aren't just good at making money – they're excellent at managing it. By focusing on big-impact changes, making smart investments, and regularly checking your financial health, you can turn your business into a lean, mean, money-making machine.

In our next class, we'll be diving into sustaining growth and innovation in mature businesses. Until then, take a hard look at your financials. Where are your biggest expenses? What creative solutions could you apply? Your next big financial breakthrough could be hiding in plain sight.

Now go forth and optimize. Your bottom line will thank you.