Westpac - Know Where You Stand

As a banker, I am frequently asked, ‘What is the maximum level we can borrow for this franchise?' and, ‘What percentage will you lend us against this franchise?' The real questions that prospective franchisees should be asking is, ‘What is the appropriate level of debt that I can afford?' and, ‘How does it affect the risk associated with purchasing this business?'

The amount of cash that a franchisee is able to invest represents their level of equity in the franchise they are purchasing. The more cash you are able to put into the purchase, the more equity you will have in the business and the less debt you will require.

This is important because the less debt you have, the lower the level of loan repayments you will have to make to repay the debt. Loan repayments represent a fixed cost to the business. The benefit of having lower loan repayments (and therefore lower fixed costs) is that it reduces the level of sales a business needs to make to cover these fixed costs. This is called their break-even sales level. Other fixed costs that a business may have to pay include rent, franchisee's drawings and power, insurance and accountant's fees, to name a few.

To illustrate the benefits of having lower fixed costs, we have calculated the break-even sales level for two franchises that have the same gross margin but different levels of fixed costs.

This shows that Franchisee A's sales can drop by $50,000 more than Franchisee B before they would make no profit. At a time when a lot of businesses are experiencing a decline in turnover, having a lower break-even sales level may be the difference between paying the bills or having to close shop.

We can therefore conclude that Franchisee A would represent a lower risk than Franchisee B.

As a franchisee, it is important to understand the break-even sales level compared to the current sales level of the business you are buying or already operating. The difference between break-even sales and existing sales represents the room you have for a downturn in sales. The less room you have, the higher the risk. This is important for your investment decision and also to any lender providing funding for your business.

If you are establishing a new outlet, obviously you will not have any current sales performance to compare. However, if you are buying into a good franchise system, you should be able to get a good feel for what the break-even sales level would be for your new outlet. A franchise system with good benchmarking information will be able to provide you with gross margins, sales levels and fixed costs being achieved by other stores within the system. Using this information, as well as other fixed costs you can also include those that would be specific to your own situation, ie:

-          amount of drawings you need to take to repay personal debt and provide for your expected level of living costs.

-          amount of rent relating to the proposed store location.

-          debt servicing costs for the loan required to buy the business.

Once you have calculated your break-even sales level, you can also compare this to the performance of other stores in the franchise system that have similar demographics to your store's location.

If you consider your store to be located in a secondary (or weaker) location than other stores, you (and your banker) would consider the purchase a higher risk if you had to achieve break-even sales above the system's average sales level. Conversely, you would consider the purchase a lower risk if your break-even sales level was below the system average.

In these difficult economic times, smart business owners are looking at ways to reduce their fixed costs to ensure the ongoing profitability of their businesses. There are a number of strategies a business owner can use. These include:

-          Selling excess or non-performing assets to reduce debt.

-          Renegotiating rents.

-          Reducing staff levels.

-          Cutting out unnecessary costs.

-          Renegotiating loan terms to lower outgoings.

Break-even analysis can also be used in a variety of other ways to help business owners make decisions. For instance, if your franchisor wanted you to re-invest in your business by doing a re-image that would involve taking on extra debt, you could calculate the level of additional sales required to cover the increased funding cost, eg:

Re-image costs            $100,000

Loan required               $100,000

Repayments                  $30,000pa

Based on the example we used before, we can easily calculate the required level of sales to cover these additional fixed costs.

Additional Fixed Costs of $30,000 divided by Gross Margin @ 50% = $60,000 additional sales required. Can your franchisor show that your investment will produce this return? If so, you'd be crazy not to do it.

So, whether you are purchasing a new franchise or taking on more debt to invest into an existing one, break-even analysis is a useful tool. It enables franchisees to calculate the level of risk associated with their investment decision and to make an informed decision about whether to proceed. It also helps you set monthly, weekly or even daily targets for yourself and your staff - and that is a benefit in any business.

About the Author

Dean Madsen is a Senior franchise business manager for Westpac and based in Auckland. He or the Franchise Team can be contacted on Email: franchising@westpac.co.nz or phone on 0800 177 007. The views and opinions expressed in this article belong to the author and do not necessarily reflect those of Westpac. The information contained in this article is intended as a guide only and is not intended as an exhaustive list of matters to be considered. Persons entering into franchise agreements should seek their own professional advice.

This article is taken from Franchise New Zealand magazine Volume 17 Issue 4

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