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A WORTHWHILE INVESTMENT?

by Peter Felstead and Maurits van den Berg,
last updated 01/01/2005

Peter Felstead and Maurits van den Berg look at ways to take the gamble out of buying a franchise

Winning at Monopoly or losing at Russian roulette? Buying a business could make you feel like either, but you want to reduce the risks as much as possible. With your hard earned savings at stake - let alone the funds you have borrowed - it costs too much to lose.

Buying a franchise is similar to purchasing any other business in that it requires a lot of careful research before making the final decision. There are some obvious differences - for example, with a franchise the business you are buying may not exist yet in the particular location. However, with an established franchise this should be offset by the experience of the franchisor and the actual figures he should be able to provide for other similar locations.

A lot of information should be made available to you by the franchisor. It is always worth taking professional advice in analysing it, but first it will pay you to examine it in detail yourself. A common sense and systematic method for making an initial evaluation of a franchise is suggested below.

A basic evaluation of hard core financials can be carried out with minimum fuss - don't worry, ownership of a Hewlett Packard financial calculator is not necessary.

Step 1 - requesting financial statements

The first thing to do is to get the information. You should ask the franchisor to supply the core financial statements relevant to the franchise business. These are: Profit statement, statement of assets and liabilities, and the cash flow statement.

You should ask for both the actual financial statements for a live trading franchise operation and also the projected/estimated figures for your own proposed franchise.

The projections for your own franchise should cover the first, second and third years of operation and the figures for the live operation should also cover all three years if possible. Ask the franchisor why he considers that operation's market similar to your own (and make a note to visit it and talk to the franchisee there).

Step 2- evaluating a profit statement

Having got the information, you now need to make sense of it. A business's yearly profit is calculated by totalling the year's sales of goods and services and subtracting all expenses relevant to those sales.

Gross Sales 100,000

Less: Cost of Goods Sold 40,000

Gross Profit 60,000

Less: Other Trading Expenses 30,000

Net Profit 30,000

When evaluating the profit statement, consider the following points:

Using the projected profit statements for your own business, identify how profitable the business will be in the first, second and third year's trading. Profit statements supplied by franchisors frequently make no allowance for tax or the cost of funds you borrow to accquire the business, as these vary according to individual circumstances.

Ensure that the cost of any private borrowings used to set up the franchise are taken into account. For example, if you borrowed $60,000 at 10% to purchase the business, the $30,000 net would be reduced by the $6,000 interest cost. Net profit reported before tax would now be $24,000.

You should also consider the after tax position. At a 33% tax rate, your after tax profit would be $16,080.

Other issues are relevant too. When will the business reach a level of profitability sufficient to cover your contribution of time and capital? Can this level of business be maintained? It is worth knowing that most franchised businesses will return a reasonable profit in the first year of operation.

Compare

Compare the projected profit statements for your franchise purchase to the actual profit statements of an existing franchise site. Do the projected sales and expense figures for your business correspond to those of the existing franchise? Are the expected levels of sales achievable and realistic? If not, ask the franchisor why.

Can you think of any other expenses which should be included in the projected profit statements? For example, is the budgeted salary expense sufficient to cover your labour requirements? Do the expenses include an adequate allowance for depreciation on assets used in the business?

Think about the special features of your territory. Are any of these factors going to influence your sales or expenses? For example, delivery-based franchises based on the central city will have different levels of sales and expenses from those based in rural or residential areas.

Return

Does the expected profitability of the operation provide sufficient reward for the capital you will have invested and the considerable effort you will have put in?

The required rate of return for your business will be determined by taking the base rate you would receive if you invested the same sum with a bank, then adding a margin for the level of risk associated with being in business. This risk factor needs to be determined with specific reference to the industry you will be operating in, and the other alternatives available to you. For example:

Current after-tax investment base rate 6%

Margin for business risk in general 13%

Margin for specific risks of retailing 6%

After-tax Return Required on Investment 25%

If the business cost $60,000, your required after-tax rate of return (after allowing for a reasonable wage or salary for efforts) would be $60,000 x 25% = $15,000. In the example above, the business is projected to return $16,000 in year one and already meets the required rate of return. It should be noted, however, that often a business will only exceed the required rate after trading for a year or two.

The after interest and after tax business profits should also be sufficient to reward the significant commitment of your time and commitment.

Step 3 - balance sheet

Obtain a list of assets that you will acquire when purchasing the franchise. This list will contain two types of assets: physical assets (eg, trading stock, shop fittings, motor vehicles, plant & equipment) and non-physical (the right to use the franchise system, name, etc.).

Check with independent suppliers that the price you will pay for physical assets is reasonable. For example, if the physical assets include a Z500 wood chipper costing $2,000, verify this price with an independent supplier.

The balance of the purchase price relates to the right to use the franchise business system and business name. Assessing the value for money you will receive for this cost is central to your decision whether or not to buy.

Step 4 - cash flow

Can you afford to purchase the business? In addition to funding the purchase price, you may have to inject cash into the trading operations during the establishment phase. The statement of cash flows (a statement of when cash flows in from sales and out from business expenses and asset purchases) will help identify your total cash requirements when purchasing and operating the business. This is an important issue when seeking bank funding.

The statement of cash flows will also highlight seasonal fluctuations in sales and expenses which may be encountered during the year. In addition, ensure that the cash flow statement represents the tax payments that your business will be required to make. This is a significant cash flow issue often not taken into account by investors.

Continuing the evaluation

Would you buy a family home just because the numbers stack up? Certainly not!

Well, the same applies to buying a business. Good franchises work because, in addition to purchasing the physical assets required, you acquire a proven recipe 'franchise system that works for other people and can work for you. The upfront franchise fee and the ongoing royalty payments are the price you pay to obtain the right to use the franchise system. The key question is, 'what do you get in return for these payments?'

The most important factor

It is well established that, above all else, the success of your franchise will depend on one thing - you! Ask if you can work in an existing franchise site before you buy. This will get you in touch with the practicalities of being a franchise owner, and of that particular franchise (understandably, owing to confidentiality some franchisors are unwilling to permit this until you enter the actual traning period).

If you are hard working and motivated even in adversity, have plenty of initiative, have the support of your family, are driven by customer service and are able to follow a proven system, then you can expect excellent results from the right franchise system.

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