Red flags alert franchisees to financial trouble
Canadian Business Franchise
Published Mar/Apr 2005
Spotted any of these problems in your franchise?
- Several of your suppliers have changed their terms with you to COD.
- Your bank has reduced your overdraft.
- Your GST and retail sales tax remittances are behind schedule.
If situations like these are cropping up in your franchise, consider them “red flags” warning you of looming financial problems. But they may not be a reason to panic – at least not yet.
If you take corrective action before or as soon as you see any of these signs, you may be able to avert a major financial crisis – and maybe even strengthen the financial foundation of your business at the same time.
There are many possible contributors to financial pressures in a franchise; some – such as shifting economic, demographic or social influences -- could be entirely beyond your control. But often, financial challenges arise from within a business and can be resolved if dealt with in an appropriate and timely fashion. Following are some of the common causes of financial red flags – and how to deal with them.
Lack of financial planning
Every franchise owner needs to know the current financial situation of the business, where it’s going and how to plan for upcoming needs. This requires forecasting. If you don’t do this type of planning, then the first financial hurdle your business faces could be its last.
On the other hand, franchisees who develop financial forecasts create powerful planning tools that serve to strengthen the business.
- A profit and loss forecast identifies anticipated sales and expenses.
- A projected balance sheet points out the company’s anticipated financial position for a specific future period: the assets the business will own and the liabilities it will owe.
- A cash flow forecast estimates the amounts and timing of cash expected to flow into and out of the business each month in the coming year.
These forecasts can help you to:
- identify where your franchise stands now,
- determine where the business is going,
- anticipate slow cash periods,
- budget for the cash needs of the business,
- plan for capital improvements, and
- anticipate future financing needs.
Using these forecasts, you can develop the right financial strategies to meet the needs of your franchise under a wide range of positive and negative conditions.
Poor monitoring of the bottom line
Taking your eyes off the bottom line can easily lead to overlooking escalating financial problems. Some simple financial monitoring exercises will help you to track your progress and anticipate problems.
Review balance sheets and income and cash flow statements every month. These three financial statements will provide you with a comprehensive picture of where your business stands.
The balance sheet portrays your financial position at the end of the month; it summarizes assets, liabilities and net worth, showing what the business owns and owes at that point in time.
The income statement (also known as a profit and loss statement) provides an overview of your sales, gross profits, expenses and net profit – or losses – during the month. The cash flow statement tracks the daily inflow and outflow of cash each month; this enables you to identify periods of slow revenue and high expenses. By comparing these financial statements with the forecasts you have prepared, you can determine whether you are achieving your goals, note trends and establish profitability benchmarks.
Evaluate your performance by measuring key financial ratios. There are a number of ratios that can assist you in measuring the financial health of your franchise; it’s a good idea to look at these on a quarterly basis:
- sales for year to date,
- gross profit margins,
- cost of sales as a percentage of sales, and
- labour rates as a percentage of sales.
Once you’ve calculated these ratios, regularly track and compare them with your own business and with those of other franchises in your industry sector. These benchmarks will enable you to proactively monitor your performance against industry standards.
Over-spending
Many business owners spend on capital improvements without first determining whether they will directly benefit the business. Unless you effectively use fixed assets, they can quickly drain cash from your franchise.
Therefore, before spending on equipment, leasehold improvements, autos and other big-ticket items, ensure that your prospective purchase will make a direct contribution to your business. It’s also a good idea to review expenses every quarter, eliminating those that don’t demonstrate a return.
Under-capitalization
Running out of cash is the most common cause of business failure. This is why every business owner needs to anticipate future cash requirements – and to put into place contingency plans. Consider lining up prospective lenders, or regularly depositing money into an interest-bearing account that you can draw upon in an emergency; or negotiating an overdraft option with your financial institution.
Businesses with a high debt-to-equity ratio are particularly vulnerable to cash crises. Thus, you’d be wise to monitor the company’s debt-to-equity ratio, which, ideally, should be in the range of 1:1. If the ratio is approaching 3:1, you need to reduce your debt load.
Under-investing in the business
As a franchise grows, owners are often tempted to quickly increase their remuneration. But there must be a balance between remuneration and investment in the business.
If you draw increasing amounts of cash from the company for personal use, you must be careful not to starve the business of the funds required to maintain it health. Every dollar reinvested in a business is a dollar that can contribute to its success.
Every franchise owner needs to establish a system of procedures and controls that will alert you to financial problems – in sufficient time to avoid or to minimize damage.
If you feel that you simply don’t have the time or expertise to carry out these precautions, you might want to consider business process outsourcing (BPO) of your accounting. This is a trend that has gained momentum following the recent wave of corporate financial scandals. An accounting firm experienced with franchises can help you establish and manage an appropriate bookkeeping and accounting system – and monitor the bottom line.
Either way that you manage it, be sure to establish reliable financial systems and benchmarks and to keep a watchful eye on profitability. If you do so, it’s likely that you’ll never spot any red flags – just the signs of a flourishing franchise.
Rick Chittley-Young, CGA, is a principal of BDO Dunwoody LLP (www.bdo.ca). BDO is one of Canada’s leading accounting and advisory firms, which helps entrepreneurs, family businesses, franchisors and franchisees succeed. If you have questions about this article or would like to receive BDO’s “Tax Factor” newsletter, contact Rick in the Oakville office at (905) 844-3206 or rchittley@bdo.ca.
