Financial Risks

Financial risks range from having adequate capital to deal with the business dynamics to proper accounting and reporting of financial performance. These risks can be easily controlled via proper funding to eliminate the capital issues and using well educated and trained staff to deal with the accounting and reporting requirements. The goal of financial accounting and reporting is reliance on the tenant of accounting which states: “Good information input maximizes the probability of good information output for the decision aspect of business operations”. In effect, it is difficult for the owner of a small business to make good decisions without the proper information. An owner can by accident make a good decision with poor information. It is highly unlikely but remotely possible.

Value Investing – Principle #1: Risk Reduction (Lesson 6)

Value Investing

With value investing, steps are taken to dramatically reduce potential financial losses. Risk associated with financial loss is addressed through three important practices. The first and best defense against losses are the type of stocks purchased. Only the best are considered with value investing. The first section below explains this in more detail and illustrates the different tiers of stock and why the lower tiers are ignored with value investing. The second best practice to reduce risk is a comprehensive understanding of the respective industry where value investors trade. The second section below goes into a comprehensive explaination of how knowledge of the industry is essential with reducing financial risk. The final best practice to defend against losses is a fundamental understanding of a company’s financial depth, the ability to withstand years of economic turmoil. The third section below introduces this mathematical algorithm for the reader. In addition, it introduces the first financial term of many that are used with value investing – book value. This term is used throughout value investing as a standard to compare other investments against and of course the ability of the particular investment to withstand long-term negative forces and quickly recover from any unusual events.

There are still many other practices and tools to reduce risk; they include understanding how operating cash flow must be positive, using business ratios to understand trends and finally, using key performance indicators to assess productivity.

Value Investing – Risk Aversion (Lesson 2)

Value Investing

Value investing does require some volatility with the market in order to have opportunities to buy low and sell high. A static market, even one with level growth will not work with value investing. Fortunately, the market isn’t stable and volatility does exist. This volatility is driven by multiple forces: politics, interest rates, consumer patterns, environmental conditions and more. Thus, opportunity exists for value investors. However, value investors seek opportunity with minimum risk.

Investing in any financial instrument comes with risk. The absolute worse case is full economic chaos created by a meltdown of governmental authority. If this were to happen, it would not matter what kind of financial instrument an investor holds, all of them are worthless as you can’t eat paper. Some would say physical possession of gold is the only pure investment because it would be tradeable in case of world disaster. This would be true if there exists a government to enforce some resemblance of order allowing trade between producers and consumers.

Ignoring total breakdown, financial instruments do have a hierachy of risk associated with their potential to become worthless. Understanding risk aversion starts with understanding the spectrum of financial instruments and their inherent risk factors. In addition, this is further refined by size, i.e. market capitalization of the respective issuer of the financial instrument. Finally, risk aversion is also a function of the dynamic range of the respective company backing the financial instrument. The following sections provide this holistic thinking related to risk aversion, specifically as it relates to stock investments.

Financial Leverage in Real Estate

Leverage Ratios

Financial leverage refers to using a third party’s money to increase profit for the borrower. With real estate, the profit or equity in the property is the weight being lifted by the use of a lever (borrowing money) on the fulcrum (the property).

Vertical Integration in Business

Vertical Integration

Vertical integration in business refers to the process of gaining control over more steps of the product production stream. Whenever a business obtains or can greatly influence any one of these steps along the process of producing and selling a product, it is referred to as vertical integration.  

Internal Rate of Return (IRR)

Internal Rate of Return (IRR)

Internal Rate of Return or IRR is the value rate earned on investment made by the company with its working capital. In the small business world, this form of financial investment evaluation has little to no value. Allow me to restate this: ‘IRR has limited to NO value in the small business world’.

How Much is a Fair Profit? Part III of V – Risk

A third factor in determining a fair profit percentage is risk. Risk is divided into two types. The first is insurable and the second is uninsurable risks. Insurable risks are mitigated and have very little to no effect on the profit formula due to transferring the risk to a third party known as the insurance underwriter. Uninsurable risks are non-transferable and therefore the profit must be adjusted to compensate for this type of risk.

The Basic Principles of a Partnership

A partnership is a form of a business entity that provides many more advantages than any other form of business entity. There are several basic principles of a partnership that once understood, the reader can use to his advantage in the small business world. Below are descriptions and an explanations of the basic principles of a partnership and the corresponding legal impact.