How inventors can help your financialsAug 03, 2023
The best inventors and thinkers in the world became that because they were extremely good at asking questions.
Isaac Newton, who, after observing an apple fall from a tree, asked why it fell straight down, rather than at an angle or upwards. This question ultimately led to the formulation of the law of gravity.
Albert Einstein asked what the world would look like if he rode a beam of light. This question led to the theory of relativity.
Thomas Edison constantly tinkered and asked questions, which led to him being awarded over 1,000 patents and innovations in the phonograph and light bulb.
Richard Feynman famously asks childlike questions and developed a whole technique around it. This approach led to contributions to quantum mechanics and participation in the Manhattan Project.
Christopher Columbus asked if he could reach India by going west, which led to the discovery of the Americas.
The list goes on and on and on.
Asking questions is an essential part of the human experience, which makes it an essential part of business. But macho culture has turned its back on asking questions. It’s not cool.
You’re supposed to know already.
It’s on this premise that I’ve built my whole newsletter and Twitter feed. Business owners and leaders are afraid to acknowledge they struggle with financial statements and numbers in their businesses. Because of this, I view it as my job to fill that gap.
But, growing up, children aren’t afraid to ask.
Why is the sky blue?
Are we there yet?
Can I have that?
What are you doing?
Where do babies come from?
And the one we love the most… why? why? why? Us: “Because I said so.”
But here you are… reading an email newsletter about why the children were right to ask why.
The 5 Whys
So of course, one of the best problem-solving techniques comes from another inventory, Sakichi Toyoda, of Toyota Industries.
By asking “why” five times, you’re able to get to the root of your problem and start working on problem-solving. While there is nothing magic about doing it five times, but is generally found to be effective to get to the root causes.
Here is how it works:
- Uncover a problem, ask why it happened.
- Once you have that answer, ask why that situation occurred.
- Continue until you’ve gotten to what you think is the root cause.
Using this method is like peeling away layers of wallpaper on an old house. You get a new scene, new problem to assess. Through each peeling, you get closer to the original state.
Once you’ve found that original state, you can now decide how to address the situation.
if you don’t make it down to the “bottom layer” and start painting, the wallpaper will bubble. The end product is useless.
In the same way, businesses that get down to the base layer of their problems are more likely to grow and make progress, instead of stagnating or declining.
The water jug
Let’s use an example that anyone can understand.
Problem: The water jug in the refrigerator is empty.
- Why is the water jug empty? Because my wife really likes water and didn’t refill the jug when she emptied it.
- Why didn’t my wife refill the jug? Because our 20-month-old son was jumping on the couch.
- Why was my son jumping on the couch? Because he’s 20 months old and that’s what 20-month-olds do. And my wife has to get some things done during the day and can’t watch his every move.
- Why does she have to get things done? Because her husband leaves out papers, food, and forgets the chores.
- Why does her husband forget the chores? It’s just what guys do.
Solution: Get a housecleaner to visit once a week to help with the tasks; also consider doing your chores… because that’s what mature adults do. Also: maybe you should pay for the water line to the refrigerator. That would help, too.
(This may or may not be a real scenario. I won’t confirm or deny.)
You can see how there are multiple directions you could go and multiple potential solutions. The key is to do the mental gymnastics to be
- honest about the real root causes
- willing to backtrack and take another path
Tying it to the numbers
So, what does this look like when looking at financial statements?
I’ve posted in the past about 3 types of financial statement analysis:
Horizontal Analysis is comparing the current period to prior periods. So current month to previous month or previous year(s).
Vertical Analysis is comparing values up and down the statement. A good example is many businesses have a percentage of sales number on their Income Statement. This allows them to compare individual line items to what percentage of sales. For many lines, this should be consistent month to month and you can set targets.
KPIs are obviously well understood, but it’s just a set of metrics that are illustrative of your business’s financial outcomes.
Combining this analysis with the 5 Whys method is almost a magical experience.
Let’s walk through an example.
You’re a professional services business and your profit margins are 21% lower than YTD.
1: Why did the profit margin decrease?
- Overhead Expense increased from 18.6% of revenue to 22% of revenue.
- Cost of Revenue increased from 51% of revenue to 46% of revenue.
2: Why did Overhead Expense increase?
- Payroll expense increased from 10% of revenue to 12%.
- Travel in July was 30% of the total for the year.
3: Why was travel higher in July?
Many of the lawyers went to a conference.
4: Why did the lawyers go to a conference?
To improve their skills and network with outside council.
5: Why did they network with outside council?
To expand the services the law firm offers and build relationships that could lead help recruit new lawyers.
- Calculate the ROI of the conference.
- Track leads that are received.
- Look through firm for relationships cultivated.
- Set goals for contacts made by all lawyers.
- Cut conference in 2024 if it’s determined the ROI isn’t enough.
This is a rough example, but it shows you how you get from numbers to action.
You’ll also notice how KPIs were established to track the return and find justification for the expense.
Within the example Income Statement, you can also look at Billable Labor and Payroll Expenses. Digging into these, you could run the exact same root cause analysis using 5 Whys.
As you do this analysis, you’re looking for things out of the ordinary.
As you analyze your business, tying your numbers back to your decisions is one of the most important things you can do.
The reason I write about Frameworks & Finance is because I see them interlinked in a way that they can’t be unlinked.
When you can use frameworks, like the 5 Whys, to look at your numbers, you unlock the next level of financial insights.