Five Crucial Questions You Need to Ask to Insure Business Success
By Gary Goldstick
Vol. I, Issue 2

Approximately 90% of business failures occur because of bad management; the rest fail because of bad luck, employee dishonesty, natural disasters, departure or death of a key employee who cannot be replaced. "Bad Management" encompasses strategic and operational mistakes, miscues, and poor judgment.

During the course of interviewing a client whose business is experiencing financial problems I try to discover why and how the business stumbled into its current problems. The answers invariably include the following:

"I didn't consider all the events and factors that could go wrong," or "When I made the decision to invest in project X, I didn't expect Y event to occur, which caused all the problems."

Both answers convey the same information: namely the executive did not adequately assess the risks of the project and was "surprised" when it failed.

Failure to thoroughly assess risks often causes bad business decisions and increases the probability of business failure. Simply stated, risk is the probability that an investment, project, or business decision will not develop as planned and will have adverse financial consequences for the investor. An example will illustrate the point.

Let's assume you own a successful greeting card store in downtown Portland. The store provides you with a pretax income of $150,000/yr. You want to build on your experience by opening a second store in Lake Oswego. You locate a suitable site. After meeting with your contractor, your CPA and your marketing consultant you determine that the front end investment for the second store will be $500K; this estimate includes the funds required for tenant improvements, inventory to stock the store, promotion in advance of the store opening, working capital, and pre-opening expenses.

Your CPA prepares a cash flow projection showing that break-even sales will be reached in six months; the losses that will be accumulated until break-even is achieved are projected at $200, 000. Therefore, your total projected investment is $700K. The pretax earnings for the first five years project at $0, $175K, $225K, $275K, and $300K respectively.

You like the deal. It "feels good." You need the additional earning to send your child to Stanford. You decide to finance the second store by borrowing $400K on the real estate of the downtown store that you own free and clear. The additional $300K you need will be provided by a second mortgage on the family home. The combined $700K loan requires interest only payments for five years of $75K/yr., and debt service of $120K/yr. for the following 15 yrs.

That's the picture. Now for the questions:

1. What's my investment?

The investment is $700K assuming the accumulated loss until the business breaks even is $200K or less. Note that all the expenses other than the loss are somewhat under the entrepreneur's control; however the projected loss is only a guess. It could be less, or, as is more often the case, it can be considerably more. Because the loss is unpredictable, the required investment is also unpredictable. The investment that we just calculated is only an estimate.

2. What's my return? How much will I make?

Using a discount rate of 7%, your CPA calculates that the Present Value (PV) of the five years stream of earnings after debt service is $477K.

3. What's my target return on my investment (ROI)/yr.?

Target ROI = PV__= $477K___ =13.6 %/yr.
I x 5 $700K x 5 4.

4. What's my Expected Return based on my quantified risk?

You ask your marketing consultant to make a study of the new store's prospects. The consultant will evaluate the current competition for the new card shop. This assignment will include estimating the sales and earnings of all stores that sell cards within the new store┘s geographic area, the likelihood of new entrants, etc. Based on his research, the consultant concludes the following:

There is a 50% probability that the new store will achieve its target projection.

There is a 30% probability that the new store will achieve 1/2 its target projection.

There is a 20% probability that the store will never achieve break-even.

The consultant further advises you that if the store does not achieve break-even. You will have to liquidate and your loss will be $650K plus the loss you're willing to sustain beyond the projected $200K operating loss. You decide that you must limit your loss to $700K, the amount you've borrowed.

Your Expected Return over five years is therefore,

Expected Return = PV x .50 + ř PV x .30 -$700K x .20 = 4.9 %/yr.

I x 5 yr.

The difference between the target return of 13.6 % and the Expected Return of 4.9% is a measure of the risk of the project; but it is not the only measure of risk. You need to address the next question, a question, unfortunately, few ask.

5. If the store fails and the 20% probability becomes a reality, can I afford my worst case loss of $700K. Since the 700K lost investment was provided by mortgages of the successful downtown store and the family home, the $120K/yr. debt service will have to come out of the $150K/yr. earnings of the downtown store, leaving only $30K/yr. to support your family.

You need to ask yourself whether you can cut your standard of living by 80%^ if the second store fails. If the answer is yes Ď which I doubt - you can afford the risk. If the answer is no then you can't afford the risk; and you probably should start promoting Portland State as his first college choice.

If you are willing to question your business projects in the manner outlined above you will materially increase your probability of success and substantially decrease the probability of making risky financial decisions. Don't let your company become one of the 90% of businesses that fail because you overlook these five crucial questions.

Gary Goldstick, CMC is the principal of G. H. Goldstick & Co., a management consulting firm located in Tualatin Or; he helps emerging, under-performing, and financial troubled companies develop and implement financial and business strategies to achieve stability and profitability.

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Other newsletters by
Gary Goldstick:
Revilalizing the Under-Performing Company

Ten Dos and Don'ts to Keep Your Banker Happy

So Your Client is Killing Her Business? Tell Her!

>The Business Health Index is a self-testing instrument that will provide a business owner a general diagnosis of the company's health. Take the test

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