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Monte Carlo Simulations

May 23, 2017

Monte Carlo simulations are used to determine the probability of outcomes under a range of circumstances. It is used in myriad ways including in financial planning and with life insurance.

A typical use is when making investment or financial decisions, we are usually told that there will be a given result, and it needs a “far-out” circumstance for it not to occur. Well, these are “educated guesses” at best or marketing talk that is just conjecture without any substantial backup. The Monte Carlo simulation is a computer analysis that runs every alternative and provides percentages of probability of the outcomes.

When an investment manager gives you a convoluted asset allocation configuration with a dozen or more investment categories you might be told that the projected portfolio return would be a certain percent. Well, the Monte Carlo program can run thousands of possibilities for each item resulting in the probabilities of attaining almost any return from zero to almost 100%. Somewhere in that model would be the projected result the investment manager told you. Using that projection and looking at surrounding amounts of the selected range you can then judge the probability of attaining the result you are being told. A practical use would be to suggest the sufficiency of assets and cash flow needed when a future retirement is contemplated under favorable and poor market environments.

Another use is with a whole life insurance policy that requires 20 or more annual payments until it is “fully paid.” The Monte Carlo simulation can tell you how likely that projection is. Alternatively you can also enter lower and/or higher payments to see the change in the probability. When I deal with clients in their late 40s to late 50s and they are presented with these policies and I am asked to review the projection, I use a Monte Carlo simulation as a guide. I usually end up telling them that the likelihood of attaining their goal is not as great as they are being told and I suggest a higher premium amount that would increase the likelihood of their goal – they then tell me to mind my own business!

Other uses are with variable rent or loan payments, option and warrant valuations, discounted cash flow models, value at risk analyses, evaluating complex capital structures, quantile modeling, derivatives, financial reporting, executive compensation, and contingent payment and earnout projections. It is also used extensively for scientific, environmental and meteorological purposes.

Monte Carlo simulations are not new; I have been using them for over 30 years. They are helpful, and a tool, and are something to be considered in the appropriate circumstance. Hopefully this blog gives you an understanding of what they are and takes some of the mystery and guess work out of what they are.

Charities that let people steal from them

May 18, 2017

Hardly a week goes by that I do not read about a theft, fraud, misappropriation, defalcation or egregious wasteful spending at some charitable organization. Some are perpetuated over many years – perhaps as many as seven years.

Lack of controls, oversight, disinterest, or lackadaisical care creates an atmosphere where an already weak person can spot an opportunity or perhaps an uncaught or unguarded careless mistake gives birth to a pattern of ongoing criminal action by someone that never had an unlawful thought.

Who is to blame? Management, the Board of Directors, large donors and any other stakeholder involved with the organization. Thieves spot areas where there is a lack of accountability or managers without an understanding of the financial information that is provided or should be provided on a regular basis.

Establishing and implementing controls is not that difficult. Wasteful spending and stealing appears on financial statements in categories of expenses that are out of sync with what they should be or larger than usual. It just needs the recipients to look at what they get and question illogical, unexpected or unexplained amounts that stick out as not being typical. Balance sheet changes should also be reviewed regularly with reasons for differences clearly understood. Part of a sound system is quick and reasonably accurate financial statements and supporting documentation that are reviewed by those in charge or involved stakeholders including substantial supporters.

There are generic controls that can be implemented, if not already in place. Further, almost every organization has its peculiarities requiring special attention and controls should be adapted for this. Establishing many of these controls is not costly and can usually be done quickly.

However, in my opinion, a major impediment to effective controls is neglect by those trusted with the administration and oversight of the organization. Doing it right only takes a few minutes a month. For some suggestions see my blog posted May 11, 2017. Start today to get it right. Do not place yourself in the position of having to explain why there was a theft or extreme waste under your watch.

“I Hate Ballet”

May 16, 2017

Actually I love ballet. I thought I hated it until I went to one. The same with opera, concerts, Shakespearian plays, and even poetry readings [Naw I still hate poetry readings – never been to one!].

Try new things. You really cannot know you hate something until you’ve tried it – and you might be wrong – you might like it! And think about the added enrichment to your life!

Every owner is absentee owner

May 11, 2017

I contend that almost every owner is an absentee owner, regardless the amount of time they spend working in their business. I claim they are absentees since, while present, they are not managing but rather working in their business on what needs to be done…that moment or that day. They are not really running their business – they might as well be in another part of the country. Given that this is so there are a few things they could get and if they spend focused time of just two or three minutes a day and a half hour once a month they can gain control over their business and have data they can use to their fullest extent. On the other hand, if they were really an absentee owner, what type of information would they want to receive daily and monthly? Here is a listing and reasons.

Daily reports (about 3 minutes)

  • Daily cash report – this is a single sheet with the daily cash receipts, disbursements and cash account balance – time to view: 1 minute
  • 4 or 5 key performance indicators – This is essential information about the business for the previous day. Examples are number of units produced and sold, total production hours or total personnel head count, hotel rooms occupied and average room rate, pounds of steel received and shipped, patient visits and medical or dental procedures performed, restaurant covers, order backlog, chargeable hours, hospital bed count and average stay, new real estate listings and closings, or orders received and shipped or hit ratios from websites – time to view: 2 minutes

Weekly reports (about 2 minutes)

  • Summary of aged accounts receivable schedule compared to previous month’s and the beginning of the year amounts – time to view: 1 minute
  • Summary of aged accounts payable schedule compared to previous month and beginning of the year – time to view: 1 minute

Monthly reports (about a half hour)

  • Profit and loss statement for current year by each month of the current year, and compared to the yearend amount for the previous year – time: 2 minutes
  • If a product is sold, review monthly percentage of purchases to sales [this should be done when reviewing the profit and loss statement) – time: 1 minute
  • Look at percentage of all labor and benefits costs to sales – a separate schedule should be prepared for this – time 1 minute
  • Balance sheet for current year with a column for each month and the previous year’s ending amounts – time: 2 minutes
  • Aged accounts receivable schedule – time: 5 minutes (with bookkeeper present or skype or on phone). Without bookkeeper – 10 minutes
  • Aged accounts payable schedule – time 3 minutes
  • Inventory valuation from perpetual records compared to previous month and to the prior year’s ending balance – time 2 minutes
  • Schedule of bank loan covenant compliance – time: 1 minute
  • Sales from 10 largest customers compared to previous year’s sales: 1 minute
  • Purchases from 10 largest suppliers: 1 minute
  • Average invoice amount by month for the previous 12 months: 1 minute
  • Review general ledger transactions for month and year to date: 5 minutes

Ongoing as necessary

  • Approve contracts and single purchase commitments over a predetermined dollar amount, e.g. $20,000, $100,000 or $250,000 depending on size of company
  • Have on-line access to accounting system

At least once a year to be performed by independent accounting firm

  • Internal control review
  • Review one bank reconciliation for each bank account chosen randomly
  • Review tax withholding payments made by payroll service for a randomly selected month
  • Sales tax returns and payments’ review
  • State and local tax compliance review
  • Form 8300 cash reports review
  • Review one of each report provided to the “absentee owner”

This listing looks involved, and it is, but with the information presented properly and promptly the time spent for the owner should not be onerous. Also, this is a way to control your business. The amount of time suggested is negligible based on the total time you already spend and this will enable you to have better control over what is likely an important asset for you. Try it – it works!

A postscript is that if your business does not have ability to provide the information shown above, that is a clear indication of a business out of control with serious deficiencies.

How to structure a deal to buy a ball team (or any business)

May 9, 2017

Recently a group including Derek Jeter and Jeb Bush “won” the rights to make an offer for the Florida Marlins baseball team. Depending upon how the deal is structured will determine how much Derek and Jeb would own. The announcement presents a good opportunity to explain how many business acquisitions work.

When Steve Ballmer bought the L.A. Clippers for $2 billion he simply wrote a check and became the 100% owner. However, most deals are not done that way. They have intricate funding and various levels of ownership. My blog on April 3, 2012 told about the purchase of the L.A. Dodgers so you can reread that for some background information.

For clarity, I used a nice round number of $1 billion, but it is likely the team will sell for a greater amount. Let’s suppose the team will sell for $1 billion and that a group of people will get together to acquire it. A minority investor putting up $10 million would own 1 percent of the team [$10 million / $1 billion]. If financing was obtained for half of the price, then only $500 million of investors’ money, called equity, would be needed. Now that same $10 million would own 2 percent. If $800 million could be borrowed, then the equity would be $200 million and $10 million would buy 5 percent of the team. Simple math: The more that is borrowed, the less the investment; however, the greater the borrowing, the greater the risk since downturns do occur and there is a higher chance for the equity to get wiped out.

There are reasons for some people getting equity without investing their proportionate share and this is variously called sweat equity, managing equity, equity for guaranteeing debt or equity for a marquee person to be involved. Options to acquire stock at insider prices are sometimes issued to people running the business where they could benefit from their positive performance.

There is a variation to the above and it is what Warren Buffett usually does. He invests a small portion for the common equity and a much larger amount for preferred equity or stock. The preferred stock pays a higher than usual dividend and can be redeemed at a fixed point in time or converted to common stock. He did this with Coca-Cola, Bank of America, General Electric, Goldman Sachs, Heinz and too many others to mention. With the preferred he is guaranteed a dividend (which is federally taxed to Berkshire Hathaway at only 10.5%), gives up a little of the upside but can reap the benefits of substantial growth in the value of the common stock.

Consider this column as Business Acquisitions 101. Now you can follow the intrigue with Derek and Jeb, or any other acquisition, a little easier.

It is always about the customer

May 4, 2017

Last week United Airlines placed a full-page ad in many newspapers with a bullet point: “We will develop new tools and training for employees to solve issues for our customers in the moment.” An admirable statement and while it is late for them, hopefully it will be followed through on.

It is always about the customer. Businesses make their money from customers. Sales revenues provide our salaries and hopefully the long term financial security that needs to kick in after our working days are over. Everything a business does should be focused on providing great customer experiences – great service, great products and services, great delivery, great and clear pricing, a user-friendly company to deal with, and quick apologies when necessary (that are hopefully few and far between). This could be defined as a customer centric culture.

The responsibility for the implementation, dissemination and breeding of this culture rests with those at the very top of the company. It involves leading by example, the right type of and frequency of training, and procedures that make it easy for customers to place orders, make returns and present complaints. It involves conferring employees with empowerment and responsibility to make decisions and offer solutions to customers at their discretion if a problem arises. It involves team members continuously thinking how they can help customers. It involves solving problems while satisfying the customer. It needs team members to really feel they are team members.

A measure of positive customer experiences is evident with the frequency of orders and payment, additional services or products purchased, requests for assistance when expansion is contemplated, or referrals that result in new customers and in today’s world of social media a dearth of negative comments.

I have always been focused on customer service and because of this I look at experiences I have as a customer that are either better than average or simply bad. I notice the exceptions, and think about how they occurred and each time it brings me to the leadership management provides. A simple lesson for us (me and my readers) is to not let our organizations become prone to poor experiences and to be champions of great customer experiences.

This column refers to businesses but can also be applicable for not-for-profits that deal directly with the public.

Whatever business you are in and products or services you provide it is should always be about the customer.

College Graduation Speech

May 2, 2017

Most colleges graduation speakers give inspiring speeches, or try to. What type of speech would you give if asked? Will it be like most of the others? If asked, here is mine for this year.

Speeches are supposed to be long – long enough to justify the effort of appearing with the anticipation of great words of inspiration from a speaker that hopes you will find dynamic and exciting. Chances are it is doubtful you can walk away with more than one or two action items. I decided to give you a short checklist of what you could do to succeed and hope that you adopt much of what I am saying…to make your life better. What you think of me is not relevant – it is about you; and my planting seeds that will help you grow.

  1. When you present a speech – short is better than long
  2. When you prepare memos for your boss or a client – short is better than long. If what you wrote is long, prepare an executive summary – that is a fancy way of providing a cliff notes version that will offer your recommendation clearly and succinctly on one page
  3. Be involved in what you work on – understand the overall project and the part you are working on
  4. Take ownership – that means follow through with the rest of the people picking up on the project after you
  5. Look at your output – does it make sense – is it relevant – is it meaningful – does it add to the reader’s knowledge? Does it contain usable information? It not, it ain’t any good!
  6. Never, ever, start something if you do not fully understand the instructions. Most people dispensing assignments do not take ownership but rather just go through the motions of passing the work off. If you do the job ineffectively you will get a reputation of being sloppy inaccurate and nonresponsive. If you make the person assigning the work repeat their instructions numerous times until you get it, they will think you are a pain in the butt, but when the work is delivered the way they needed it, a reputation of producing good, thorough and on time work will overshadow their earlier unfavorable thoughts of you. On the other hand, a reputation of producing unacceptable error laden work never goes away
  7. Always meet the deadline. If it becomes clear you will not meet a deadline, let your boss know as soon as it becomes evident, not ten minutes after it was due
  8. If you must ask questions, try to save bunch them together but don’t let that hold up your work on other parts of the project
  9. Do not chase your tail for more than a half hour or some other reasonably short period. If you find yourself not making progress – put it aside and work on another part of the project
  10. Ask for help if you need it – the sooner the better
  11. When you come across something new, make that your opportunity to learn about it. Many opportunities do not repeat themselves
  12. Get involved – join and participate in industry and professional associations and read their journals. Keep current with business news

This is a checklist you should look at daily until it becomes second nature. Your success depends on it. I wish you much success with the rest of your life which is starting right now! Do not waste this opportunity.