Understanding Basic Business Principles

January 3, 2013 | By | 4 Replies More

Business is very simple. To succeed, an entrepreneur simply needs to follow the universal laws of business. Whether the business is a one-person shop or a billion-dollar conglomerate, they are governed by the same business principles. This is the premise of Ram Charan’s primer on how companies work in his book “What the CEO Wants You to Know : How Your Company Really Works.”

What the CEO Wants You to Know : How Your Company Really Works” is a blueprint for entrepreneurs seeking to understand the basics of the business of money making. Anyone who plans to start a business or is trying to grow one should get a copy of the book.

Many people spend more than a hundred thousand dollars on an MBA without learning to pull the pieces of the business puzzle together. This book, using simple language and real-life illustrations, describes the various elements that comprise a business and the relationship of these variables.

The most important thing to remember is that business laws are universal. While it may appear that running a one-person business is simpler, it requires the same kind of decision-making a CEO of a billion-dollar company makes. In fact, according to Charan, the “best CEOs and the man or woman running the one person shop think the same way.”

A solo home-based entrepreneur and a CEO both think of every aspect of their businesses – product, sales, customers, profit margin, return on assets. They both know which of the items in their product line are profitable and which are not. Both understand the value of customers, and the importance of keeping their products moving off the shelf. Except of course a home-based entrepreneur may not use the fancy management terminology preferred by big corporations.

If a person understands that certain business principles are universal, then that person has what Charan calls “business acumen.” Business acumen is the ability to focus on the basics and make money for the company.

According to Charan, every business conforms to the three basic parts of moneymaking – cash generation, return on assets (combination of margin and velocity), and growth. Whether running an online or traditional business, a business owner must understand these parts individually and the relationship between them. These three basic parts, plus customers, form the nucleus of any business.

business growth

1. Cash

Cash generation is the difference between all the cash that flows in the business and the cash that flows out. Cash is the lifeblood of any business, or as Charan describes it, “the company’s oxygen supply.”

An astute entrepreneur must always ask the questions: Does the business generate enough cash? What are the sources of cash generation? How is the cash being used? Failing to ask these questions often spell the end of the business. Without cash, a business can be in trouble even if other aspects of moneymaking – profit margin and asset velocity – looks good.

If the business generates sufficient cash, the entrepreneur is in a better position to grow the business. An entrepreneur can make better investing decisions, not to mention be more in control, if it has its own cash rather than borrowing money from investors.

2. Return on assets (combination of margin and velocity)

An entrepreneur uses either his own money or someone else’s money to invest in the business. The things invested – be it products, store or web site – are the business assets.

An entrepreneur possessing acute business acumen will ask the questions: How much money will be made with these assets? What kind of money is being returned through their use? In short, a smart entrepreneur must always ask, “What is the return on assets?” An entrepreneur must follow the rule: the return on assets has to be greater than the cost of using their own money and other people’s.

Earning a good return on assets has two components – profit margin and velocity. Return on assets is simply nothing more than profit margin multiplied by velocity. In simple arithmetic, return on asset is

Return = Margin x Velocity

A grocery owner will earn more if she is able to clear her shelves and replace the goods everyday. Wal-Mart, for example, has a 360 inventory turns in toilet tissue. This implies that the entire inventory of toilet tissue is sold almost everyday. Wal-Mart, therefore, recoups its investment in toilet tissue everyday, plus some profit.

Even if profit margin is small, a business can thrive if it has a fast turnover of its inventory. A faster velocity leads to a higher return. The faster the inventory reaches the customer, the better it is for the business. According to Charan, the best companies have a return on assets greater than 10 percent after tax.

3. Growth

Growth is vital to every business. It energizes the business and creates new opportunities. However, growth for growth’s sake does not do any good. According to Charan, the growth of a business “must be accompanied by improved margin and velocity, and the cash generation must be able to keep pace.”

A smart entrepreneur does not only push for sales. Instead, he or she must know how and why the business is growing; and whether the growth can be sustained. Sales may be growing, but if the cash situation is getting worse the entrepreneur must take the prudent approach and step back. When growing a business, the businessperson must determine if the company is generating or consuming cash, and whether profit margin is improving or getting worse.

Another characteristic of a person possessing business acumen is his or her ability to find opportunities for profitable growth when others can’t. Charan gives the case of Wal-mart and Sears, and the difference in the two giant’s approaches to growth. In mid-70s, Sears considered the retail sector as a mature business with no room for growth. Hence, Sears diversified into new markets and opened its financial services division. On the other hand, Wal-mart continued to open new stores while maintaining a higher-than-average return on assets. Wal-mart’s bold move when others considered the industry flat paid off: in 2000, Wal-Mart had sales of $165 billion compared to Sears’ sales of about $40 billion.

4. Customers

A universal law of business is that no business can thrive without customers. Hence, a smart entrepreneur instinctively understands his or her customers. As Charan explains, entrepreneurs with business acumen have a close connection with their customers and possess strong conviction that the business cannot thrive without satisfying them.

Entrepreneurs must always know the pulse of their customers. A savvy entrepreneur knows that the best way to get to know the customer is to make the special effort to observe and talk directly to people who use their products and services. Find out what the customers need – directly from them. Direct contact provides insight that even expensive market research cannot.

In thinking about customers, Charan advises to keep it simple. A business owner must clearly know what the customer is buying. It may not be the physical product or service alone, but intangible qualities such as reliability, convenience or trustworthiness.

The secret of the great CEOs of our time, such as Jack Welch of General Electric, is their “intense focus on the fundamentals of business.” The best CEOs have a knack for bringing the most complex business down to the fundamentals — the same fundamentals that govern a small family shoe shop or an online store. Like these CEOs, entrepreneurs should never lose sight of the basics if they want to succeed.

Business is all about common sense. Alas, it is surprising to find how often this common sense of business is lacking. This book will help anyone understand in plain and simple language the basic building blocks of a business and use them to figure out how a company makes money and operates as a total business.

Recommended Books on Basic Business Principles:


Lyve Alexis Pleshette

Lyve Alexis Pleshette is a writer for PowerHomebiz.com. She writes on various topics pertaining home businesses, from startup to managing a home-based business. For a step-by-step guide to starting a business, order the downloadable ebook “Checklist for Starting a Small Business” from PowerHomebiz.com

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  1. Timothy Eller says:

    Fantastic Post about using basic principles in any business.Some folks are just looking for the quick way around.

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