THE BEGINNERS' GUIDE TO UNDERSTANDING THE NUMBERS
in this article:
Philip Morrison of Franchise Accountants explains what financial reports can tell you about the business you’re buying
Making Sense Of The Numbers
People buy a business for many reasons: wanting to work for themselves rather than someone else; provide employment for the family; live in an area they choose; enjoy a different lifestyle; comply with residency requirements or any one of a hundred different reasons. Ultimately, though, everyone wants to make enough money to support the family, pay the bills at home, put something away for retirement and have an asset they can build up and sell when the time comes or pass on to a family member.
But one of the biggest problems facing anyone buying a business is getting their head around the numbers. That’s true for many people who have business experience, so it’s an even bigger hurdle for newcomers. No matter what your background, though, it’s worth taking the time to read the financial reports and understand what they actually mean before you make your mind up about any opportunity. In fact, it’s essential to making an informed decision.
And it doesn’t end there. The financial reports generated by your accountant and accounting software can help you evaluate how your business is doing, what it needs to grow and how you can make it perform even better. Learn to understand the numbers and you can build a better business.
In this article, we’ll talk about three key financial reports and what they can tell you about the business you are hoping to buy – or already own. These are:
- Profit & Loss report
- Balance Sheet
- Cashflow Report.
It’s important to point out that this article won’t replace the need for you to get professional advice from a franchise-experienced accountant, but should help you to understand that advice when you get it.
From a financial point of view, the first thing any business buyer wants to know is: ‘How much money is the business making, or could it make?’ The answer can be found in the first of our three reports – the Profit & Loss.
This report shows the sales revenue of the business, less the costs of providing the products or services the business sells, and less the overheads of operating the business. It then calculates the profit (or loss) of the business – the bottom line.
The Profit & Loss report for a typical franchised business might look like this:
Of course, if the business is an existing franchise with a trading history, the figures shown will be actual sales achieved and costs incurred, so you can see how the current owner has been operating the business and compare them to indicative figures from the franchisor. For example, is the current franchisee spending a higher or lower percentage of revenue on rent or staff compared to others in the group? Any significant differences may point to areas for improvement.
On the other hand, if the franchise is a new opportunity, the figures will be forecasts which may or may not be achieved. In general, franchisors are pretty good at forecasting costs based on their experience of other outlets. Where you will want to reassure yourself is in the sales area. What are the predicted figures based on and what are other franchised outlets in similar locations or territories achieving?
Test each income and expense line for reasonableness. Compare each of the income and expense lines against what you would expect from this type of business – we call this type of analysis ‘benchmarking’. This will highlight any anomalies that will require further investigation.
While any good franchisor will have such statistics available, because they are commercially sensitive the franchisor may not be prepared to make them available until you have joined the franchise. You should therefore ensure that your accountant has relevant experience across a wide cross-section of franchises. Some indicative questions you might consider are:
- Is there seasonality?
- What are the trends?
- Is this a cash business or does it offer credit terms? If the latter, what is the level of bad debts (people not paying)? And how long are customers taking to pay?
- What is the sales cycle? What is the average time between quoting a job and closing the sale?
- And, for a new franchise, how long will it take to reach the necessary sales levels to reach break-even (where the business is paying for itself) and to start to make a return on the money you are putting into it?
The first figure calculated is called Gross Profit, which is the difference between what you sell a product or service for and the direct costs for delivering that product or service: eg, if you buy a product from your supplier for $4 and sell it to customers for $10, then your Gross Profit is $6. This represents a 60% margin. Sounds good, yes?
But Gross Profit isn’t the ‘bottom line’– out of this figure, you still have to pay all the other things that you need to run your business: rent, rates, electricity, insurance, salaries and all sorts of other costs that you’ll be incurring whether you sell anything or not!
You also need to factor in the ongoing franchise fees. In some franchises, these may be calculated as a percentage of sales or as a mark-up on product, in which case they are directly related to the sales figure; in other franchises, there may be a flat weekly or monthly fee. You’ll want to be sure that the fee is realistic and allows for a fair return given the projected level of sales. And you also need to factor in the financing costs (how much are you planning to borrow to buy the business and what will the repayments be?), and a living wage for yourself and any family members.
After including all these items, you’ll end up with a much lower figure called Net Profit. This is the famous ‘bottom line’ that shows the real profit (or loss) for the business and will help you to decide where your future lies.
But I’m afraid that’s not the end of it. You also need to consider the fact that some of the assets essential to the business, such as a van or a shop fit-out, will wear out over time and need replacing. Remember you’ll need to pay tax, too.
1. New franchise business earning projections are just that – projections. They are not a representation or guarantee of profitability; they are indicative only, and need to be analysed carefully in your due diligence process.
2. Do your sums – is the return on your investment adequate? Does the profit the business can earn provide an appropriate return, given the risk involved? For example, if you will invest $100,000 for an annual profit of $20,000, this would be a 20 percent return. Government bonds pay under 4 percent so this might seem a pretty good deal, but they involve a lot less risk (and work!). Again, consult your accountant.
3. Finally, it’s important to realise that the profit the business generates is not money you will be able to take out of the business. Profit does not equal cash! (see more about liquidity below).
As we said at the beginning, people buy a business for more than financial reasons. If you’re choosing a franchise for its lifestyle options – eg, because it allows you to work part-time alongside an existing job, or it enables you to work flexible hours or start and finish early – you may not require as much income as you would want from a full-time franchise business. However, you still won’t want to pay more for a business than it is worth, and this is where you’ll need to look at both the Profit & Loss and the Balance Sheet.
The Profit & Loss shows the performance of the business, while the Balance Sheet shows a snap-shot of the financial condition of the business at a particular moment in time. It is made up of three broad elements and formatted as follows-
Assets – What the business owns
less Liabilities – What the business owes
equals Capital/Equity – The net worth of the business.
An example of a balance sheet is below:
Assets are split out according to their order of liquidity – in other words, the amount of time it would take to convert them into cash. They go from Current Assets (such as cash in the bank, which is immediately available), Accounts Receivable (the balance owed by debtors – customers on credit terms who haven’t yet paid), and Stock (including raw materials, work in process and finished goods ready for sale) to long-term assets called Fixed Assets. These long-term assets are typically what generate the cash in the business: eg. Plant & Equipment, Land & Buildings, Motor Vehicles.
Liabilities are the opposite of assets. They are split out on a similar basis according to when they fall due for payment. Current liabilities are usually those requiring payment within 12 months such as accounts payable (balances owed to your suppliers for purchases of product & services). The ‘cash lock-up’ or liquidity of a business is measured by the difference between the current assets compared to current liabilities. Term Liabilities are those which can be paid off over a longer time such as a bank loan to finance the business, or hire purchase which financed some plant.
Capital/Equity is the funds that the franchisee introduces into the business. For example, the franchise business cost $500,000 to buy which is funded by a bank loan of $200,000 and funds introduced of $300,000. The accumulated profits the business generates are referred to as ‘retained earnings’, and added here.
So a Balance Sheet tells you a lot about the solvency of a business and the cash locked up in it or, put another way, the working capital requirements of a business (see below).
Whether you can afford to buy the business or not doesn’t depend so much on how much money you have as how much you need to borrow – and whether the business can afford to service the loan repayments on that borrowing. That often comes down to the cash generation ability of the business.
It has been said cashflow is more important than profitability in operating a business. After all, you can own a profitable business and still fail if your cashflow is not managed properly. hence the saying, ‘cashflow is king.’ This where the last of the three reports comes in – the Cashflow Projection.
This is a report that you as a franchisee, your accountant and your banker will require in your assessment of any business opportunity. So what does it do that the Profit & Loss and Balance Sheets don’t do? It adds a whole new dimension to the numbers in the Profit & Loss and that dimension is Time.
There is a timing difference between when you make the sales on your Profit & Loss report and when the cash is actually paid into your bank account. There’s a time difference between when you pay your suppliers for products and when you sell them to customers. There’s also a difference between when you collect GST and pay it (and your other taxes) to the IRD. Accordingly, you need to calculate how much cash will flow into and out of your business and, most importantly, when.
To fund you through the period between cash going out (eg, buying stock) and cash coming in (customers buying the items and paying their bills), you’ll need additional funds. This is called working capital and you’ll need to factor this in when you buy the business over and above the purchase price. After all, there’s no point in spending every dollar you have on buying the business if you can’t afford to run it (see our article on working capital here). That’s why the Cashflow Projection is so important – it tells you how much you’ll need to have available as working capital as your business grows. Here’s an example:
There is a lot to consider when buying any business and a franchise is no different. Although franchises have the advantage of benchmarking so that targets and performance criteria can be shared across the group, it’s still important for any incoming franchisee to understand the numbers that make their business work. Knowing how to read the three key reports is a vital part of understanding the viability, sustainability and affordability of your business.
The good news is that you are not alone. If you’re shopping for a franchise, make sure you consult a franchise-experienced accountant and get the help you need. That way, you’ll know that you’ll get all the information required to make a sound financial decision and set you up for success in your new business.
This article first appeared in Franchise New Zealand magazine Volume 23 Issue 04
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