UNDERSTANDING FINANCIAL management is critical to the success of any contractor. One of the best books I've read on management listed the 10 rules of business. To paraphrase:
"The first rule is don't run out of cash, the second is to not to run out of cash, the third is to always to have cash on hand and rules four through 10 are not that important."
Financial management's importance cannot be overstated. The Rule of 72 is a key concept. Maybe, it should be the 11th rule.
Which is more, $5 million or a penny doubled every day for a month? Surprisingly, the answer is the penny. This illustrates the power of the Rule of 72. This is a simple financial rule that dramatically shows the power of doubling. It demonstrates the power of time with interest to produce-a large financial outcome.
This solidly points to the importance of expense discipline and financial management for construction firms. Done with frugality, the reward is substantial wealth at a relatively early age. Done poorly and we work longer than we want to.
The reward is substantial wealth at a relatively early age.
The math of this rule is simple. It gives us a simple calculation to determine the doubling period for a given interest rate. For example, if a principal sum is earning a fixed rate of interest of 6%, that sum will double in value in approximately 12 years (72 ÷ 6 = 12). If the principal sum is earning interest at a rate of 12%, it will take only six years for the principal sum to double in value (72 ÷ 12 = 6). Divide other interest rates into 72 and observe the time required to double your initial principal.
Using the same logic for expenses provides us an insight about business costs. Let's review the example of a common tax write-off — the 6,000-lb. vehicle used in a company's business. There is a significant tax write-off for making a new vehicle purchase of this size.
It is called a "Section 179 Deduction." It emanates from the desire of Congress to assist farmers with capital investment. The construction industry has rightfully used this incentive to its advantage. In essence, the provision states, if a vehicle or other heavy machinery — 6,000 lb. or more — is purchased new, then the option exists to write off the total cost against the income of the business for that year. The business may write off a portion, if it chooses.
As a result, some contractors ( typically younger) have purchased expensive SUVs and trucks. They assume that saving taxes is one of the best financial strategies. Is this the wisest choice? From a financial perspective, could there be a better alternative?
Let's use the example of making $25,000 net profit before tax in 2005.
We will assume that that we will not make this Section 179 purchase, keep our old truck and pay the expected taxes. What will be the outcome?
For the sake of our discussion, our firm is a Subchapter S corporation. From our earnings last year, let us assume that we will pay the government about $5,000 in taxes, leaving us $20,000 to invest.
Our $20,000 is for our personal use (no double taxation in Subchapter S corporations). We make the decision to invest it in a reputable no-load mutual fund. Without hesitation, we can project a 10% return on this investment. Using the Rule of 72, we know in 22 years that this sum should grow to $160,000. It is exciting to think of the possibilities, such as repeating this net profit scenario and investing it likewise over a 10-year span.
To restate, if we are less concerned with paying taxes to the government and more concerned with our personal wealth, we can build our long-term financial strength. We are justified to deny ourselves the extravagance of a luxury SUV or new work truck. In another way, the Rule of 72 shows that few tax incentives are worthwhile.
Consider this during your next tax cycle. We believe that at the end of a contracting career, being financially independent is what most contractors desire. Understanding the Rule of 72 is a primary step to getting there.
Matt Stevens is a management consultant who has worked only with construction contractors since 1994. McGraw-Hill will publish his new book, "Managing a Construction Firm on Just 24 Hours a Day," in September. The Website for his firm, Stevens Construction Institute, is located at stevensci. com. He can be contacted at [email protected].