David Weusten is a financial consultant and founder of Financial Service Providers Ltd. He was formerly a specialist franchise bank manager, and is author of the book What Do Banks Want? which is available by emailing <a href = 'mailto:dweusten@fspnz.com'

David Weusten

You may choose to buy a franchise for any one of a number of reasons. Some people want lifestyle, some want control of their lives, and some want to make money. This article is about the money side. Whether you are looking to buy a new franchise or an existing one, before long you will come up against figures and spreadsheets that show how profitable the business has been or is projected to be. While it is essential that you take the advice of an accountant, I hope to explain how to read the figures for yourself. The better you understand what they mean, the better you will be able to interpret what your accountant tells you – and the more chance you stand of making the right decision. The three major sources of information about any business are the Profit & Loss Report (P&L), the Balance Sheet and the Cash Flow Forecast. Let's look at each of these in turn. <h2><a name= 'Profit & Loss'>Profit & Loss</a></h2> The easiest place to start answering the 'What's in it for me?' question is the Profit & Loss projections. All franchisors will provide figures on which to base your purchase decision, but before you start to analyse them, find out what these projections are based on. If you are looking at buying an existing outlet, are they the historical results of the outlet concerned? If your franchise is a new one, are the projections based on actual results of a particular outlet (and if so, is the comparison a valid one), or an average over many outlets? Are they realistic? Some franchisors will not provide projections as such, but instead give examples of figures achieved by outlets. In this case, you not only need to know how these figures might relate to your own proposed business but you will also have to prepare (with the aid of your financial advisor) your own projections. When you are looking at the financial side of buying a franchise, you use the P&L statement to work out what the projected return on the capital you invest is going to be. It is important to work this out after you have included a reasonable hourly rate to yourself for the time you will be putting in. Remember, the return on your capital should be greater than the return you would get if you banked the money and stayed in bed all day. You're taking a higher risk than you would if you left your money in the bank, and you need to be rewarded for that. For example, let's say that the capital cost of the franchise you buy is $300,000. If the net profit you make is $25,000 (after interest costs, your labour costs and depreciation), then the return on your capital is 8.33% pa before tax. This is comparable to returns you could get from fixed interest investments without the risk or effort of being in business. While figures will vary according to how much you are actually paying yourself and, for example, any tax benefits you might gain from working from home, I believe you should generally look for a return on investment of more than 15% pa. A Profit and Loss (P&L) report is generally presented on an annual basis, and often looks something like this. Sales $450,000 Less: Cost of Sales $270,000 Gross Profit $180,000 Less: Other Administration Expenses $94,325 Less: Interest, Tax & Depreciation $31,200 Net Profit $63,125 If the franchise in this example were bought for $300,000, the profit of $63,125 would represent a return on capital of 21% after tax - an acceptable return for most people, I would think.<a href="/fimage/url/43/Profit_and_Loss_1003.png" target="_blank"><img src="/fimage/url/43/Profit_and_Loss_1003.png" alt=" " width="450" height="538" /></a> Click the above illustration for a larger version A blank Excel cash flow spreadsheet may be downloaded free of charge by <a href="/system/CFF%20template.xls" target="_blank">clicking here</a>. <h2><a name= 'What To Look For'>What To Look For</a></h2> Of course, the initial P&L report provided by the franchisor or the franchisee selling the business will be a general one and will not take account of your own particular financial position. You need to adjust the P&L to factor in your own expenses: eg. if you plan to borrow all of the purchase price, you need to make allowances for interest costs. Check that such items as franchise fees, marketing levies and any fixed monthly fees payable to the franchisor are incorporated in the P&L statement with which you are provided, particularly if you are buying an existing business. If figures are provided to you by an existing franchisee, check with the franchisor to ensure that they are accurate. Franchise projections for new outlets often include a range of three to five projected levels of turnover (sales) ranging from the pessimistic to the optimistic. As turnover increases, your fixed overheads decrease as a percentage of your costs – eg, if you are paying $500 per week in salaries, that figure remains unchanged whether your sales are $5,000 or $10,000. However, it is important to point out that franchise fees and levies are often based on a percentage of turnover. This means that although they remain constant as a percentage of turnover, they will go up in actual dollar terms as your turnover increases. This is both a plus and a minus for the franchisee: you have to pay more to the franchisor as you build the business, but your payments only increase at the same speed as your business. It also means that the franchisor has a vested interest in growing your business and should provide you with the support and guidance you need to do so. Most P&L projections usually show the next 12 months trading, but I recommend that you do the projections to the end of the next financial year: ie, if a business is starting on 1st October I would do projections for the first six months then complete a projection for a full year after that. I do this to show the business's expected taxation and first year (or part year) trading results and what the Balance Sheet (see below) is expected to look like. Doing this also enables the franchisee to look at the projections once any one-off start-up costs (eg bank loan fees, legal costs, initial franchise fees, consultant/broker fees, etc) are taken out of the equation. The example on page 33 (you might like to copy and enlarge it) shows a P&L Report for a fictitious franchise. For reasons of space, the period covers only the first six months from start-up in October until the end of the financial year. (NB. The initials EBITD stand for 'Earnings before interest, tax and depreciation') For the sake of this exercise I have made the following assumptions: <ul> <li>I will have a loan of $100,000 at 9.5% interest only over two years</li> <li>Franchise fee is 6% of turnover </li> <li>National marketing levy is 4% of turnover </li> <li>Local advertising allowance is 2% of turnover </li> <li>I have budgeted $5,000 for professional fees (eg, lawyer, accountant) </li> <li>Estimated sales are at the mid-level of the franchisor's projections </li> <li>Shop lease costs are set at $4000 per month </li> <li>Wages to myself will be $3000 per month </li> </ul> As you can see I have not filled in all sections, as some are not expected to be relevant to the business at this stage, nor is taxation included in this example as it is such a variable, especially if the structure is a partnership or a company. Headings may also change according to the particular business in question. There are two important calculations to make when interpreting these figures. The first is to work out the Gross Profit Margin, which is calculated by dividing the gross profit figure by the sales (turnover) figure. Gross Profit ($147,800) Sales ($254,000) The example shows that this business achieved a gross profit margin of 58.18%. The gross profit margin measures your efficiency in producing goods. Understanding this figure will help you compare your results with industry norms or with other franchisees in your particular franchise. If this is done monthly, it will monitor your progress in controlling costs and can highlight at an early stage any deterioration in your margins. In many systems, the franchisor does this as well - that is part of the reason they collect your results. The second important figure is the Net Profit Margin, which is calculated by dividing the net profit figure by the sales figure. Net Profit ($77,828) Sales ($254,000) Net profit margin measures the overall profitability of your business, and reflects your control of general business expenses. In this example, the net profit margin was only 30.64% for the full period covered. However, because this was only the first six month period that figure is unrealistically low – in fact, the first month shows a loss of $9842, whereas by March the business is showing a much more pleasing profit of $29,158 – a net profit margin of 44.86% (March net profit divided by March sales). This makes it obvious why a set of projected figures for the next twelve months is desirable to get a full picture of the business's financial performance. To reiterate, it is important to review both your gross profit and net profit margins on a monthly basis to ensure they are maintaining the profit you expect or need to retain profitability. Balance Sheet The second important financial statement is the Balance Sheet, which can be described as a snapshot of a company's finances at any particular moment. It reveals the worth of a company, and how that worth is made up: its assets (what the company owns and each asset's current book value) and its liabilities (how the assets were funded). In the case of an existing business, the balance sheet will show you what you are buying; with a new start-up, it shows how solvent you will be at the end of the period and provides a valuable base for year-on-year comparisons. The arrangement of the assets on a balance sheet is usually based on their liquidity - the ease with which the asset can be converted to cash. For example, current assets are either cash or something expected to be converted into cash within the next 12 months, which thus aids the business's liquidity. Non current assets or, as they are more commonly referred to, fixed assets, have a value to the business but are not intended to be converted into cash. Such assets include plant and machinery, vehicles, land and buildings, etc. Although such fixed assets usually make up the bulk of non current assets, they are not necessarily the only group in this section. Other examples include investments and intangibles such as initial franchise fees or goodwill. Liabilities are the opposite of assets, and cover what the business owes to various creditors. Current liabilities list the short-term debts of the business and are subtracted off the current assets to show the working capital available to the business. This is vital, because many businesses are crippled through having insufficient working capital. Term liabilities are the debts that are being repaid over a long term – for example, a bank loan. This figure is usually shown less the current period's repayments, because this period is shown in the current liabilities section. The remaining section on the liability part of the balance sheet is Proprietorship or the equity the owners have in the business – in this example, shown as a shareholder's loan (the money the franchisees have put in as opposed to the money they have borrowed) and retained earnings (profit made which has been left in the business). After all the liabilities are subtracted from the total assets, the figures should balance. If a negative figure is shown (ie, if you have more liabilities than assets), the business is classified as insolvent and the management/directors should take immediate action to correct this or to cease trading. So a balance sheet for the start and end periods of our previous example might look like the one on the left. To keep things simple, this closing balance sheet is based on all sales income being received at time of sale and all creditors paid by the end of the month. In reality this is unlikely, as the next section will show. Taxation has not been calculated. The value of Plant has reduced to $94,000 because of depreciation – ie, it is worth less than it was, and you show that as a non-cash cost to the business (you don't have to write out a cheque). As a result, the net profit figure is $6,000 lower than the Cash On Hand figure. <div class="pic_center" style="width: 350px"><img src="/images_articles/weu_bs_1003.gif" border="0" alt=" " />   </div> A blank Excel cash flow spreadsheet may be downloaded free of charge by <a href="/system/CFF%20template.xls" target="_blank">clicking here.</a> Cash Flow Forecasts & Liquidity Valuable as Profit & Loss reports and Balance Sheets are, they cannot show the full picture of how a business will operate. For that, you need one further report – a Cash Flow Forecast. As the name suggests, this is a projection of the flow of cash into and out of the business - cash banked, payments made and the resultant effect on your bank balance - over a period of time. It is usually calculated on a monthly basis and covers a twelve-month period. If all the money you put into your business is tied up in, say, stock or equipment or in debtors, your business may be profitable but still have no money to pay its creditors. Profits don't pay bills - cash does, so it is important to have additional money in the business which can bridge the timing gap between, for example, paying for the stock you buy and receiving the money from selling it. This is called working capital. Strangely enough, many growing businesses fail because they do not allow for sufficient working capital in their planning: although they are making a profit, they do not have enough cash to pay for their debts and they go broke. Banks will ask businesses for their cash flow forecasts to establish overdraft requirements and demonstrate their ability to service the loan they want from the bank. Many business owners give this task to their accountants to do, but this is not actually necessary. If you take the time to do it yourself you can: <ul> <li>Save money </li> <li>Understand the projections and have ownership of the figures </li> <li>Have better control of your business by knowing the importance of each figure </li> <li>Make easier comparisons between actuals and projections </li> <li>Identify adverse trends at an early stage and take early corrective action.</li> </ul> <h2><a name= 'When would I do a Cash Flow Forecast?'>When would I do a Cash Flow Forecast?</a></h2> Every business should do one annually as a matter of course and review it frequently, but other triggers would be: <ul> <li>Buying a franchise </li> <li>Requesting borrowing or increased lending from your financier </li> <li>Major sales growth</li> <li>Capital restructure/repayment </li> <li>Major asset purchase</li> </ul> <h2><a name= 'How do I do one?'>How do I do one?</a></h2> While some franchisors will produce a cash flow forecast automatically as part of their projections, others do not. In any case, if you understand the way in which the figures work, you will be in a better position both to understand and to personalise any projection provided to your own situation. Before starting, you will first have to complete your Profit & Loss monthly projections. You should also ask the franchisor for a list of any assumptions made in creating these projections with regard to, say, projected sales levels, equipment or materials costs, and the reasons why they apply to your particular outlet. It is important that you record these assumptions and the rationale behind them as an attachment to your forecast, as these will enhance the credibility of your figures when you go to the bank. You need to consider: <ul> <li>Any borrowing: monthly repayments and any likely movement in interest rates </li> <li>Seasonal trends, if applicable </li> <li>Past monthly Profit & Loss and Cash Flow actuals, if available </li> <li>Purchasing schedule and payment timing </li> <li>Debt collection. Factor in your terms of trade and get advice from the franchisor on how they are respected: eg, what percentage of money due comes in within 30 days? 60 days? 90 days? Never? </li> <li>Creditor payment terms you have arranged with your suppliers and franchisor </li> <li>Capital expenditure plans </li> <li>Historical information on your industry and its likely effect on your business</li> </ul> A standard Cash Flow Forecast format is available from most banks, as well as regional development corporations. <h2><a name= 'Cash - The Lifeblood Of Business'>Cash - The Lifeblood Of Business</a></h2> Completing a Cash Flow Forecast allows you to understand the dynamics of your business cash flow and ensure you have sufficient cash to meet your anticipated commitments when they are due. Liquidity (cash) is the lifeblood of your business and without it your business will stall and probably die, just as you would if your blood stopped flowing. The example on page 34 shows how a Cash Flow Forecast is set out and how it works. I have also designed it to show the effect of selling on terms that have not been well thought out. In this case, the business has to pay its suppliers before it has received payments for its sales. Let's say 25% of sales are paid for in cash, 70% of sales are received 30 days after the sale date, and the remaining 5% is received 60 days after the sale date (NB. This forecast makes no allowance for the possibility of bad debt – that is, never being paid at all!). Even though the trading results of the business in the Profit & Loss section show it making a profit, it has not got sufficient cash on hand to pay its way for the first five months. Its much-needed working capital is being used to support its customers. Good franchisors will be well aware of the dangers, and will have structured their terms of trade and deals with suppliers accordingly: however, this example serves as a salutary lesson to those new to business. The Cash Flow Forecast graphically shows the difference between the profitability of the business as represented by the Profit & Loss report and the real position at the bank. For the first five months the business will have a cash shortfall which peaks at almost $30,000 in month three. It will therefore need to fund the shortfall through investing additional cash in the business or arranging an overdraft facility at the bank. Both are better avoided. Accordingly, you should find out the terms your franchise has with its suppliers and, if you are expected to offer credit to your customers, find out the terms and ask for an a detailed explanation of their impact upon the business. Another factor which can have an impact upon your cashflow is the timing of GST payments. These have been omitted here for reasons of clarity, but need to be discussed with your accountant. <a href="/fimage/url/44/Cash_Flow_1003.png" target="_blank"><img src="/fimage/url/44/Cash_Flow_1003.png" alt=" " width="450" height="663" /></a>Click the above illustration for a larger version A blank Excel cash flow spreadsheet may be downloaded free of charge by <a href="/system/CFF%20template.xls" target="_blank">clicking here.</a> <h2><a name= 'Conclusion'>Conclusion</a></h2> Buying a business - even a franchise - can never be entirely without risk, but the better informed you are, the more you can confidently predict success. The three tools outlined here can help you to analyse any business opportunity and give you a realistic understanding of how your business might perform. Of course, you should not make any decision without taking professional advice, and using an accountant and banker experienced in franchising will always prove a wise investment. In addition, many franchisors will provide you and your accountant with considerable help in preparing the necessary reports, and many will have standard formats into which they can log a number of variables to show how the business might perform in differing circumstances. Do not be tempted to avoid doing your own homework, however. If you take the time and trouble to understand the figures, you will be better prepared to start and manage your new business on an ongoing basis. A blank Excel cash flow spreadsheet may be downloaded free of charge by <a href="/system/CFF%20template.xls" target="_blank">clicking here.</a>

Making Sense Of The Numbers

36 When you buy a business, you need to know if it will make money and when. <author>David Weusten</author> offers a guide to three vital financial reports

2009-07-23

36-making-sense-of-the-numbers