Yours, Mine & Ours: Financial Success of a Franchise is a Shared Responsibility
Rick Chittley-Young, Partner
BDO Dunwoody
Many people choose a franchise based on what they enjoy doing: running a restaurant, operating a landscaping service, managing a store.
Typically, most won’t choose to buy a franchise because they enjoy bookkeeping. Or preparing financial reports. Or managing cash flow. When it comes to the financial health of a franchise, however, along with managing the day-to-day business, you also need to manage the financial health of your franchise.
While many potential business owners choose franchising over a personally-owned enterprise in order to reduce the risk of failure, it’s important to remember that the franchisor is not solely responsible for the success of each franchise – it is a shared responsibility. Every franchisee needs to assume personal responsibility for certain tasks that are part of the effective financial management of a franchise.
Depending upon the franchise system you choose, some franchisors assume a greater share of financial, accounting and reporting obligations. In other cases, the franchisee has more responsibilities. Thus when you are investigating franchise opportunities, you should also investigate your obligations in these areas because they may vary widely from one franchise system to another. You need to be comfortable with the financial and accounting responsibilities you are required to undertake.
Before you sign a contract to purchase a franchise, here’s what you should consider regarding your responsibilities for your personal and business financial success.
Have a basic understanding of business accounting
Proper accounting systems, records and analyses are vital to the success of any franchise. These help you to secure the financing you need to get up and running, monitor the health of your franchise, and assist in minimizing both the business and personal taxes you have to pay.
While software can perform many bookkeeping and accounting tasks and you can consult with an accountant to help you understand and act on the financial information generated, you also need a basic understanding of finance and accounting. At a minimum, you should be able to read and assess balance sheet, income and cash flow statements.
Investigate the financial health of the franchisor
To ensure the success of your franchise, you need to be sure that the franchisor’s business is financially healthy. There are a number of ways you can do this.
You can start by requesting disclosure documents from the franchisor. If you live in Ontario or Alberta, or the franchise company you are investigating operates in these provinces, provincial legislation requires that the franchisor must provide prospective franchisees with a copy of its disclosure documents prior to signing a franchise agreement.
These documents include proposed franchise agreements and financial statements: balance sheets, statements of earnings, cash flow statements and a statement of stockholders’ equity. The financial statements must be audited by a chartered accounting firm and will therefore include accountants’ notes. These notes can provide insights into the statements, including any special issues or concerns.
Ask an accountant experienced with franchises to help you review these statements to determine whether the franchisor has a history of profitable operations and whether the company currently appears to be financially stable. Since a franchisor’s assets comprise future royalties and fees from new and growing franchisees, you need to know whether income from these sources is increasing every year. Are new franchise locations opening as scheduled?
These documents represent the starting point for identifying the strengths and weaknesses of a franchise operation, but should not be the only information you rely on to make a decision. While you want to be part of a growing franchise system, you also need reassurance that the franchisor is reinvesting in areas that will support the long-term success of its franchisees, such as improvements to the franchise system and franchisee support as well as research and development.
Perhaps the most helpful information in the disclosure documents will be a list of franchisees, and their contact information. Your best bet is to call several of them and ask them about their experiences with the franchisor related to these issues.
Determine what the franchise can earn
Obviously, you need to know how much you can earn from your franchise. The answer, however, is rarely obvious.
Disclosure documents typically provide information related to the range of sales in various franchises, however the location you may be considering might not perform as well as others in a franchise system. You need to dig deeper to determine your potential revenue, profits and income.
Some disclosure documents may include “earnings claims” for various locations within the franchise system. In other case, you may have to rely on the income and expense or cash flow projections and calculate a range of actual or potential sales, costs, income or profit from a franchise.
The disclosure documents should also indicate the market conditions upon which claims for earnings are based, as well as any factors that may significantly impact results, such as location, product mix, or seasonal fluctuations. You can also ask an accountant who has franchise clients how to interpret earnings and whether they are feasible for your proposed franchise.
Also, ask several franchisees whether they are earning what was projected by the franchisor, and, if not, what factors have impacted their results. You can inquire about projections and actual sales, expenses, cash flow and profits. After speaking with a few franchisees, you should have a clear picture regarding actual operating results.
Determine whether you have the financial capability to invest in the franchise
Your personal financial health is crucial to the success of your franchise venture since there are significant financial obligations to investing in any franchise. While many companies advertise initial franchise investments at very attractive price tags, there are often additional start up and operating expenses involved. Don’t rely on the franchisor to decide whether you have the financial backing to buy and operate a franchise; you need to determine the total financial investment required before you make a commitment.
Start up costs may include, for example, not only a franchise fee to purchase the rights to the franchisor's trademarks, business methods, and distribution, but also many others. An initial cash investment, legal and accounting fees, insurance, training, licenses, promotional fees, leasehold improvements, inventory, equipment, furnishings, fixtures, signs, landscaping, and moving expenses might also be required.
Ongoing expenses may be equally numerous: ongoing royalties, advertising fees (local as well as contributions to regional or national programs), equipment maintenance, employee training, insurance, rent, inventory, and possibly others.
The principal financial problem new franchisees experience is undercapitalization. Thus it’s important to keep in mind that there will be a period of time before your franchise begins to generate a profit. You need to ensure that you have sufficient assets available to cover your own personal expenses as well as start up and ongoing expenses. To be on the safe side, you should estimate what you will need to operate the franchise for one year and your personal living expenses for up to two years.
To help you ensure that your estimates are practical, ask an experienced accountant to help you with your evaluation. Then ask other franchisees how their experiences compare with your estimates.
Know your accounting responsibilities and those of the franchisor
Each franchise system has certain requirements related to ongoing accounting and financial management obligations. These obligations vary depending upon the franchise system you choose and are spelled out in the franchise agreement.
Some franchisors, especially those that are large and well established, assume substantial responsibility for managing and monitoring the financial health of franchisees. They may require franchisees to submit weekly sales reports and monthly bank statements. Some may pay GST, PST and payroll source deductions on behalf of their franchisees. Others may prepare monthly financial statements. Some will provide comparisons of budgeted to actual results to help franchisees achieve target profits.
Many franchisees appreciate having these responsibilities assumed by the franchisor. There will, however, be a fee charged for performing these tasks. To determine which tasks will be yours, which will be the franchisor’s and what fees the franchisor charges for these accounting tasks, review the provisions related to books, records and reporting in the proposed franchise agreement in the disclosure documents.
Actively monitor the financial health of your franchise
Still, the financial success of your franchise ultimately rests on your shoulders. You need to be willing to actively engage in monitoring the financial strength of the franchise by regularly reviewing its financial situation and by managing cash flow effectively.
Review the balance sheet, income statement and cash flow statement every month. These will enable you to assess net worth, net profits or losses and cash flow. And, on a quarterly basis, calculate the following financial ratios to evaluate key performance measures:
- sales year to date
- gross profit margin
- cost of sales as a percentage of sales
- labour rate as a percentage of sales.
By comparing these ratios to those of franchise or industry averages, which are often provided by franchisors, you can evaluate the progress of your enterprise.
When you conduct these tasks on a regular basis, you’ll know exactly how your franchise is faring. If you need advice or assistance, consult with an accountant experienced with franchises. This professional can help you to interpret financial results, benchmark your progress within your own franchise system and with others in similar businesses – and provide you with guidance regarding how to strengthen results.
The bottom line? When deciding in which franchise to invest, select a franchise company that is financially healthy, that will provide the accounting support you need – and be prepared to share responsibility for the financial success of your new venture.
Rick Chittley-Young 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.
