Westpac - Interesting Times

The first half of 2008 saw economic conditions deteriorate and the NZ economy officially enter recession. Drought, tighter credit conditions, a housing market in rapid retreat and the skyrocketing cost of living apparently crush business and consumer confidence. 

That said, some predict the worst of the downturn is already behind us. They expect that upcoming tax cuts, lower interest rates and a return to more normal weather patterns are factors that should see economic growth rebound in 2009. What do these economic uncertainties mean for someone wanting to purchase a franchise?

Strong forces circulating around the economy can cause distress for some and boom times for others. As a consequence, prospective purchasers must complete their due diligence with even more care than usual. In addition to researching the franchise, you need to consider the impact of changing economic conditions on the industry in which it operates.

There are a whole range of areas to consider when purchasing a franchise and you can access a list of over 200 questions at www.franchise.co.nz. For the purpose of this article, however, I'd like to focus on industry risk.

Industry Risk & Business Cyclicality

All franchises operate within the larger framework of their particular industry. These can be broadly divided into Product Industries and Service Industries.

Product Industries make distribute and sell tangible goods.  They can include manufacturers, wholesalers and retailers.  Examples include food, gift or party-ware franchises.

Service Industries make and deliver activities rather than products.  Examples include business coaches, lawnmowing and computer/IT franchises.

The tendency of sales and profits in any given industry to rise and fall with the periodic rises and falls in the economy is called Cyclicality.  These changes in the economy are often accompanied by and linked to changes in interest rates. Some industries are highly cyclical with an economic boom causing huge expansion and recession causing bankruptcy. Examples of these include the automotive, aircraft and real estate industries. Other industries experience less dramatic swings in performance as the economy rises and falls.

Counter-cyclical industries also experience cycles, but their timing is opposite to the economic cycle.  During times of economic expansion, these businesses may experience a downturn in demand for their products or services while a recession may encourage growth in the industry.  Examples of businesses that may thrive during economic downturn include appliance rental firms or cabin rental businesses.

Non-cyclical industries are relatively unaffected by economic cycles, with demand for their products or services remaining stable during both boom or recession.  Usually they are supplying a staple good or service; examples include food retailers and hairdressers.

How much impact will a boom or recession have on my proposed industry?

It is important to identify and evaluate the degree of magnitude any economic swings may have on the industry you are considering. How quickly will any economic changes affect you and how much of an impact will they have?

If the main reason for variability in the economic cycle is interest rates, then it stands to reason that those industries that are more sensitive to interest rate change have the greatest swings - both positive and negative. Home mortgage lending is highly cyclical - when interest rates rise, the volume of customers purchasing or refinancing homes drops within a very short period of time. Those involved in this industry may have to wait some time for increased business; however, they will be one of the first industries to benefit from a positive change in the economic cycle.

To determine the impact of these cycles on your preferred franchise, carry out the following:

• Study the patterns of industry performance in prior economic cycles. Look for patterns of cyclicality and discuss the likely effect any change in the economic climate may bring with the franchisor and long-standing franchisees.
• Understand how the industry is impacted by changes in interest rates, fuel costs or fluctuations in the currency. Are any changes likely to impact on sales and profitability before the franchisee has a chance to react? Those that are impacted quickly by change, and have the greatest variation in profitability, should be identified. These franchisees have the least time to prepare and they may have to weather prolonged periods of lower sales, reducing the ability of the business to operate effectively and repay debt.
• Is the industry vulnerable to shortages or increased costs of labour? This can have a marked effect on some industries; eg. the local textile and garment manufacturing industry.

Sources of Industry Data

You may find useful information in:

• Government statistics and research publications.
• Private and university research publications.
• Investments analysts' reports on an industry.
• Industry-specific trade journals or association research.
• Considerable information is also available on the internet, eg. the Department of Statistics website.
• Information is also held in public libraries or can be sourced direct from trade or industry associations.

Summary

The current economic slowdown creates both problems and opportunities. Doing proper due diligence, with the help of knowledgeable specialist advisors like franchise accountants, lawyer and bankers, becomes more important than ever. Looking at how the economic cycle influences the chosen industry will greatly assist informed decision-making.

This article is taken from Franchise New Zealand magazine Volume 17 Issue 3

Contact details for Westpac

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