WHAT DOES THIS FRANCHISE
in this article:
Lorraine Lord and Philip Morrison look behind the figures to evaluate the true cost of buying a franchise and suggest ways to set up your new business for maximum success
There are all sorts of reasons for buying a franchise and going into business for yourself, but there’s one aspect that you’ll want to be really certain of – will it make money?
After you've analysed your own financial situation to work out What Can You Afford, you will need to throughly analyse the finanical implications of purchasing each business that you are seriously considering. In this article, we look at some of the key financial aspects of buying a franchise and provide some practical advice about the ongoing management of a business. As before, we asked specialist franchise accountant Philip Morrison to draw upon his professional experience.
As managing partner of Franchise Accountants, Philip has both franchisors and franchisees within his client base and as such has seen the franchise sales process from both sides. ‘I’ve prepared financial proposals for franchisors to present to franchisees, and conducted due diligence reports for prospective franchisees,’ Philip says. ‘In the purchasing process, I’ve often observed potential pitfalls that franchisees need to watch out for. For example, in some situations there can be up to 10 per cent extra in hidden costs, and if not picked up they can have a great impact on the success of a new franchisee’s business. Some franchisees go ahead without the right advice and buy a franchise, only to discover later that they have to dig deep to cover these hidden costs.’
The implications of failing to get the right advice are two-fold:
1. It can cause franchisees financial distress from the very beginning as they may become over-geared, under-capitalised and strapped for cash.
2. It can erode trust in the franchise relationship at a very early stage.
Such implications are easy to avoid with the right costing, careful budgeting and financial planning. There are many hidden costs which are unique to each franchise but some of the most common pitfalls are listed below:
Although training costs are often factored into the initial franchise fee (or itemised separately), they can fail to include travel and accommodation costs directly related to training.
Equipment & vehicles
Essential equipment or vehicles may be required for the business but funded separately, eg. leased. Where an existing vehicle is used, ownership may need to be transferred to the business. It is important to note these items carefully, cost them accurately and work them into the total figures.
Site costs may vary
Franchisors’ outline figures are often quoted ‘depending on site’. Lease and bond costs are site-specific and often are not known up-front. However, they need to be tied down as early as possible in the decision-making process in order to avoid budget blow-outs.
Are figures out of date?
It is important to ascertain whether the costing in the franchise proposal has been updated to reflect current market costs (eg, fluctuations in currency or cost of equipment). If the figures have not been recently updated, they may be understated now.
Are figures adjusted for New Zealand?
Given that many franchise systems are based in Australia or beyond, franchisees need to take care that costs and turnover figures have been adjusted for the New Zealand market – and New Zealand currency. This is something to be particularly aware of when dealing with a newly-imported franchise. Figures in documentation may be in a different currency, such as Australian dollars, meaning that costs are understated.
Are figures GST inclusive?
During due diligence, it is important to note carefully whether figures quoted by the franchisor are inclusive or exclusive of GST. Both figures have a place: the GST-inclusive figures are useful for cashflow forecasting (see below). However, if the figures are quoted including GST, profitability will be overstated or inflated. If you do not allow for GST in your planning, you could be in for a nasty shock.
The table below shows a simple profit and loss account for the same business, using both GST-exclusive and GST-inclusive figures. This shows that operating profit before tax is 15% higher, using GST-inclusive figures, than using GST-exclusive figures ($34,500 versus $30,000). The accurate profit figure for the franchisee’s business is $30,000. The additional $4,500 is the net GST he passes to the IRD – it is not his money. It would be dangerous to look at the figure of $34,500 and base one’s decision upon this level of profits.
Profit and Loss account
$ Excluding GST $ Including GST @ 15%
Sales 100,000 115,000
Less: Cost of sales 30,000 34,500
Gross profit 70,000 80,500
Less: Expenses 40,000 46,000
Operating profit before tax 30,000 34,500
Anorexic costs are those which don’t include the full expense amount, and missing costs are those which are simply not stated. It is vital to identify these in advance because they will erode margins, profit levels and earnings potential. It is also vital to have a true understanding of costs so that new franchisees can arrange adequate funding for realistic set-up and ongoing costs. Examples of such costs are outlined below:
Payroll costs Important costs such as ACC, holiday pay and KiwiSaver may be omitted altogether.
Insurance expense Not every insurance will necessarily be included within the initial insurance costing. For example, we noted that Fastway Couriers required all franchisees to have some kinds of insurance and recommended others, with separate figures being given for both - a very clear approach.
Accounting costs Some franchisors show accounting costs which only cover the cheapest bookkeeper with limited skills. It is strongly recommended that an experienced franchise accountant be consulted in order to save on taxation, get a realistic and hassle-free set of accounts and leverage many years of experience.
One other cost that might not be obvious at the start is the cost that you will incur if you get into a dispute with your franchisor. Good franchisors will have an alternative dispute resolution process, such as mediation, built into the franchise agreement – it’s a lot faster than going to court to resolve a dispute, and a lot cheaper for both parties, too. Members of the Franchise Association of New Zealand (FANZ) are required to include this under the Franchising Code of Conduct.
Get an estimate on these upfront to avoid any surprises – for example, which costs are paid by the franchisor and which by the franchisee?
This is just a brief summary of some of the matters you need to be aware of when doing your sums. It cannot be relied upon without seeking advice from a franchise-experienced accountant who can advise you on the specifics relating to the franchise system you are interested in purchasing. No two systems are alike!
Having looked at some of the pitfalls that can trip up the new business buyer, it should be clear that, if you are to make a truly informed decision about whether to proceed with any particular franchise or not, you need to consult a franchise-experienced accountant. ‘But an accountant doesn’t stop at pointing out where costs might be under-estimated or omitted,’ Philip Morrison points out. ‘They also have a major role in helping you to set up and run your new business in the most efficient way possible, which will help you maximise the return you can make on your investment.’ Here are some of the other services you should look for.
One of the first decisions when establishing your new franchise is to choose the structure of the business entity which is going to operate the business. Should you form a limited company or trading trust, operate as a sole trader or set up as a partnership? There is no single answer to this: it will depend partly on the nature of the business but also on your own situation. Each franchisee’s lawyer and accountant should work together on this to help them make the most appropriate (and tax-efficient) choice for their individual circumstances.
It’s a good idea to look for an accountant who can see you through all the steps involved in setting up and running your new business. These will cover the pre-purchase analysis of financial information, registration with the IRD to meet your fiscal reporting requirements, setting up your financial systems and ongoing support. Good systems enable good record-keeping, which in turn allows you to access timely and relevant management accounting information on which to base decisions, adjust direction if necessary and keep the finances of your business healthy. ‘Don’t just call on your accountant when time comes for the year-end reporting required by the IRD,’ suggests Philip. ‘Your accountant can do a lot for you in this regard and should be a useful part of your management team.’
If you keep them well-informed as to your progress, your accountant can also help you with the financial side of future decision-making as the business grows. Do you need more working capital or new equipment? What can you afford and how can it be financed? What return does any investment need to make – for example, what level of sales must a new piece of equipment produce in order to pay for itself? What difference will that make to your break-even point, and how will it affect margins? In an established franchise system, the franchisor may have a lot of information on these issues from other outlets – but often, only your accountant can work out the figures for your individual business.
Another huge benefit of using a franchise-experienced accountant, both before you buy a franchise and once you are running it, is that they are likely to know benchmarks for different industry sectors and can advise whether your figures are in line with industry norms. If your cost of sales percentage is too high, or your overall profitability is too low, he can point this out and you can work with him and the franchisor to see what can be done to improve your performance.
Another vital area where new franchisees will need to work with their accountant right from the start is tax compliance. Like any business, a franchisee must comply with the requirements of the Inland Revenue Department (IRD). This may seem daunting at first, but a good accountant will assist with registration for the required types of tax and advise the franchisee on how to make the on-going payments.
It is extremely important to know when all these taxes are due: returns must be filed on time to avoid penalties – and penalties for late payment can be quite severe. It is also very important to keep on top of bookkeeping regularly and keep copies of the returns that are filed. The IRD is increasingly encouraging businesses to file online instead of sending in paper copies. You can also set up online payments to the IRD in advance to save you running the risk of missing the due dates and incurring penalties.
Reporting requirements include:
GST (Goods and Services Tax) Most franchisees will be GST-registered unless their businesses are very small (see our article To Register Or Not To Register at www.franchise.co.nz). This means that they will need to make their GST payments to the IRD two-monthly.
GST may be paid on either a payments basis or an invoice basis. The payments basis is generally preferred, as it means passing GST payments on to the IRD only when they are actually received from customers, not when the sales are invoiced. This can be very helpful for the cash flow of small businesses. If your business is registered to pay GST on an invoice basis, you are liable to pay the GST to the IRD at the time of invoice, before you receive the payment from the customer. Your accountant will make sure this is set up in the best way for you.
PAYE (Pay As You Earn) Regular reporting is also required for all payroll deductions, including complications such as holiday pay, KiwiSaver, student loan deductions and childcare deductions. If you employ staff this can get very complex so you need to make sure it is properly set up in the first place and that you understand how to manage it.
ACC (Accident Compensation Corporation) ACC premiums are paid to ACC, not the IRD, but are mentioned here because they are an additional payroll item required by law. As a franchisee, you may be liable for both employer and employee premiums, depending on whether you employ staff.
FBT (Fringe Benefit Tax) This is charged on vehicles and other ‘fringe benefits’, and is usually paid quarterly. You will need to keep good records of, for example, how often your company vehicle is used for private purposes in order to ensure you are taxed fairly in this area.
Company Tax This is the tax on the profit that your business makes. It is generally paid on current year’s income as ‘provisional tax’ three times a year. After the year-end, when your actual profit tax liability has been calculated, there may be a final payment of ‘terminal’ tax if your profit is more than expected, or a refund if it is lower than expected.
Tax also has an impact on one of the most important aspects of running a business – managing your cashflow. This simply means ensuring you have enough money to pay your bills as and when they become due. In a well-structured franchise, the system itself and arrangements with suppliers should be such that this happens in a fairly straightforward manner on a day-to-day basis – providing you are achieving a healthy level of sales and controlling your costs, of course. But Philip says that allowing for taxes is one area of cashflow management that can often cause problems for new franchisees.
‘Managing your tax obligations in the first year of trading is critical. Often in the first year of trading, tax payments are deferred to the following year. Allowing for this in your cashflow planning is vital, otherwise you end up with a “cash crunch”. The worst case scenario means having to fund two years worth of tax within a short time span.
‘Failure to allow for this is one of the biggest causes of business failure. That’s why accountants often recommend that, for every dollar a franchisee earns, they should set something aside for the tax bill. It’s not always easy when you are trying to manage your cash flow and keep borrowing to a minimum, but it’s by far the safest thing to do.’
And, as Philip points out, it’s not just the annual tax bill either. Earlier in this article we looked at the profit and loss account including and excluding GST (Table 1) and pointed out that the figures excluding GST are the ones that accurately show the profitability of the business. Whilst the franchisee does need to consider sales and costs including GST for the purposes of forecasting his cash flow requirements, he must remember that the GST he charges customers is never actually his money. He is only collecting GST on his sales on behalf of the IRD and passing it on (after deducting the GST he has paid on his own expenses). The franchisee does have the use of the money for a short time, but accountants often recommend keeping GST in a separate, interest-bearing account so that the money is not accidentally spent before it can be paid to the IRD. If the franchisee chooses not to do this it is important for him to remember, when working out his cashflow requirements for the coming period, that he will need to pass GST to the IRD on a particular date.
Once again, having your accountant set up good systems at the beginning – and ensuring that you stick with them – can make life a lot easier for the new franchisee. ‘Many franchises include some form of financial management systems within the franchise package, and you should make full use of these but ensure that they are properly set up to provide the information you need to manage your business and stay out of trouble,’ Philip advises.
Online technology has also become increasingly helpful and easy-to-use for small businesses. Internet banking is efficient, and is useful for making payments or looking at statements at any time of the day or night. It saves sending cheques, and saves banking them too if you can persuade your customers to pay by direct-crediting your account. That means you can see every day which clients have paid you, keeping you on top of credit control and managing cash flow.
In addition, there are a number of online accounting packages that will actually synchronise with your bank accounts, and a system called Banklink where your accountant can take the information for producing your accounts directly from your bank statements online. ‘These all help to simplify bookkeeping and avoid the proverbial situation where a business owner presents their accountant with a shoebox full of receipts at the end of the year,’ smiles Philip.
Once again, though, it comes down to setting everything up properly in the first place. As we’ve seen from the examples above, consulting a good, franchise-experienced accountant right from the start has a number of advantages. It enables you to cost accurately and budget properly, to structure your business tax-efficiently, to establish your business systems in a way that will help you manage your performance better and to stay out of financial trouble from unexpected tax bills.
Add those advantages to the brand, the systems, the training and support provided by a good franchise and you will give yourself the best possible chance of creating a business that will not only get off the ground – but will fly high!
This article first appeared in Franchise New Zealand magazine Volume 19 Issue 3 2010
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