Financial Advice

by Westpac

last updated 22/07/2019

Fit To Fight

by Westpac

last updated 22/07/2019

Dean Madsen of Westpac discusses the economic cycle and how franchises can prepare for change

After being in growth mode for seven years, some economists are suggesting that the New Zealand economy is entering a ‘mature’ phase – still growing, but more slowly. The strong growth has provided a tail wind for business, with some sectors performing better than others. Tourism and construction have been particular stand-outs, with record numbers of international tourists visiting our shores and a shortage of homes due to high levels of net migration and previous years of low investment in the construction sector.

Slower growth this year had been predicted for some time, and has now been matched by a slowdown in consumer spending and a drop in business confidence. So what are some of the factors that could impact on business, and why are franchise businesses better positioned to deal with these?

here are four possible factors to consider:

  • A slowdown in net migration
  • Any increase in interest rates
  • Any increase in inflation
  • A drop in business confidence leading to reduced investment

Should any of these factors eventuate, consumers would have fewer available dollars, resulting in a decline in discretionary spending. Such a reduction would have an impact on different areas in the economy, as consumers spend less on non-essential items or become less likely to purchase big ticket items. This change in spending habits would impact businesses differently: for instance, quick service restaurants might pick up additional sales from people who can’t afford to dine out at restaurants as often but who still don’t want to cook for themselves.

Where sales are reduced, this will most likely lead to lower profitability or cash flow, meaning that a business owner would have less cash (funds) available to utilise in any of three main areas:

  • Investment in business assets
  • Repayment of any debt
  • Owners’ drawings

A significant downturn in the economy could also lead to suppliers tightening up on credit terms, meaning you may have to pay for goods purchased earlier than previously required. This would also have an impact on the liquidity of your business and would further reduce cash available in your business.

good news for franchisees

So how can being part of a franchise mitigate these or other factors? Well, successful franchise systems have several attributes that could be of great benefit to franchisees during a downturn. These include:

  • A well-established franchise system with scale and strong supplier relationships may be more insulated from risk. It has the power to obtain better support for its franchisees from suppliers during a downturn than a smaller business with less bargaining power.
  • The experience and expertise of the franchisor will come to the fore. If a franchise has been through previous economic cycles and learned what to do in the tough times, they will be better placed to manage the franchise group’s strategy. This will be of particular benefit for newer franchisees.
  • The franchisor may be able to provide or negotiate further support during more difficult trading times. This could be in the form of better trading terms, deferred royalty payments or advertising support.
  • In addition, the franchisor may review how franchisees are operating their businesses, either as a group or on an individual basis, and look for further efficiencies to reduce costs or ensure that local marketing initiatives are as effective as they should be.

be prepared

Economic cycles are a normal part of life and every business needs to be prepared for both positives and negatives. However, it’s difficult to predict when downturns will occur, how long they will last and what impact they might have on specific industries. As a smaller nation we often get more impacted by external global shocks (although New Zealand’s economy performed better than most after the GFC). It’s important, then, to be prepared for business conditions to change over time. Ask yourself, do you have sufficient equity or ‘wriggle room’ to enable you to make the most of opportunities should economic conditions decline?

The way to do this (preferably with your accountant) is to develop a Maximum Risk Adversity (MRA) case to assess your ability to repay your loans if the business is impacted by various adverse factors. These could include:

  • Reduction in sales by a certain percentage;
  • Reduction in business gross margins;
  • Increase in expenditure;
  • Or a combination of the above.

The benefit of completing a MRA will be to give you an awareness of what the impact could be on your business and personal circumstances. That gives you an indication of what to look out for and puts you in a better position to react at an early stage. It’s worth noting that businesses that have a strong financial model in place during downturns in the economic cycle are often best placed to make the most of the upswings that follow.

During the last downturn, we saw customers use various different strategies to ensure they were well-placed to withstand the impact it could otherwise have had on their business performance:

  • Some customers sold down assets to reduce debt and improve their cash reserves;
  • Some changed their funding structure to put a more appropriate one in place for their own stage in the business life cycle;
  • Some looked to restructure their funding to ease the burden of high loan repayments on cash flow, or sought temporary assistance.

the good news for buyers

If you are looking to purchase a business at the moment, you should give careful consideration not only to the possible impacts of any downturn but also to how much you should pay for the business you are looking to purchase.

In recent years, low interest rates have boosted all types of asset class prices, including the value of businesses. Most business sales are based on a multiple of earnings; however, what happens to the business value when earnings decline or interest rates rise? Care needs to be taken to ensure you are not overpaying for a business from Day 1, and this is where trusted advisors such as a specialist franchise accountant and lawyer can be invaluable in helping you negotiate a realistic price.

Despite the negative perceptions of downturns, they can actually present opportunities for growth. They can make it easier to find premises, negotiate leases and find good employees. The value of property can also reduce, making it cheaper to purchase or develop new sites.

So how well placed are you to face the challenges of change in the economic cycle – whenever they occur? A little planning and foresight now will go a long way towards putting you in a better position. 

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 legal, accounting and other advice.

See this advertorial on page 20 of Franchise New Zealand magazine Year 27 Issue 3

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