Don’t Risk it: Simple Strategies can Keep Franchisors Financially Safe & Sound
Author: Rick Chittley-Young, Marina Ponton
Date: June 2010
Publication: FranchiseVoice
Being risk averse is a common characteristic of those who are drawn to the franchise concept of business expansion. After all, by comparison with other options to expand a business, franchising tends to be lower risk because franchisee capital drives the growth of the system.
But franchising a business concept is definitely not risk-free. While we often hear about the rise of franchise stars, there are also many spectacular falls about which we hear less often. Well-known names like Mrs. Fields Cookies, Denny's, Bennigan’s, Days Inn, 7-Eleven and Curves attest to the fact that even large franchise systems can fail. While the specific reasons vary, undercapitalization and poor financial management are often key culprits when it comes to business downfalls.
In the same way that we protect and preserve our own physical health by establishing good habits and following a regular maintenance regime, the financial health of a franchise system must be actively protected and preserved. This requires four steps.
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Develop appropriate financial projections and measures
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Ensure adequate capitalization
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Carefully monitor cash flow
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Regularly review franchisee sales and profitability
1. Develop appropriate financial projections and measures
In order to effectively manage risks, they must first be identified and measured. Then strategies must be developed and implemented to limit them, and results need to be continuously monitored. All of this originates in the business plan.
Comprehensive financial projections and measurements represent the foundation of a company’s financial risk management system. This system must demonstrate to partners, investors, potential franchisees and others involved in the success of the company that management has thoroughly considered the financial requirements, carefully estimated the profit expectations of the franchise model, and planned for contingencies. As well, once the franchise system is up and operating, this risk management system must be able to measure the financial performance of both the franchise company and its franchisees. This requires including the following projections – for both franchisor and franchisee – in the business plan.
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Pro forma financial statements (including balance sheet, income statement and cash flow statement) should be prepared for the short term (monthly statements for 12 months) and long term (three to five years; quarterly for the first year). These should be based on realistic assumptions to account for the typical delays and challenges experienced by every business start up
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A breakeven analysis that demonstrates what the company must sell in order to cover costs
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Relevant financial ratios that serve as benchmarks for management to monitor the financial performance of the overall franchise and that of individual franchisees. These ratios will be used to identify both performance strengths as well as emerging problems that could threaten the health of individual franchisees or of the entire franchise system. We’ll address the specific ratios that should be included later in this article
While preparing these financial projections and measures it is important to address areas of vulnerability. Owners and investors need to know which ones represent the highest risk and why, how these might impact the bottom line and what actions management intends to take should they occur. This approach helps to anticipate and address potentially serious risks, and enhances the likelihood of the overall success of the plan.
2. Ensure adequate capitalization
While capitalizing the expansion of their business through franchisees is widely appealing to prospective and current business owners, many franchisors “fail to launch” because they do not adequately capitalize their franchise systems. Too many prospective operators underestimate the capital needed and the time required to set up and establish the system before it begins generating profits. While franchise income can stem from a variety of sources - franchise fees, monthly royalties, franchise license renewal fees, marketing fees, mark-ups from the sale of goods and services to franchisees – it often takes months after a franchise sale for income to flow in on a regular basis.
Thus before selling even one franchise, adequate capitalization is essential to reduce the risk of franchise failure. The business plan should therefore include a comprehensive section on financing requirements with detailed estimates of all anticipated start-up costs until the projected breakeven point. These costs may include the following.
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Legal fees, including the development of the disclosure documents (which include the franchise agreement and audited financial statements), trademark protection, license agreements, etc.
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Accounting fees to prepare the appropriate financial projections and statements and a historical audit if an existing company will be the franchisor
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The development of an operations manual for quality control of the franchise system
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Marketing costs including plans, website, print materials, trade shows, etc.
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Land and/or building and equipment
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Staff
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Working capital reserves to cover operating losses until the business is capable of generating sufficient revenue
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Monthly overhead for six to 12 months
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Personal living expenses for six to 12 months
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Financing costs.
The latter is an important consideration. Along with a complete accounting of financing needs, the sources of these funds should also be identified in the business plan as well as the relevant financing terms.
Financing for most new franchise companies comes from the owners, supplemented by friends and family members, along with some bank financing. Investors or lenders expect owners to personally assume some of the risk with a solid self-financed capital base of 30% to 50% of the total debt. To secure the funds, lenders may require a second-charge mortgage on residential property or personal guarantees up to the maximum amount of the loan. This points out the importance of reducing the risk of undercapitalization. No one wants to lose their home or other valuable personal assets because they ran out of cash and the bank called the loan before the franchise became profitable. Thus the business plan should detail the amount of funding required, how the funds will be used and when investors and lenders can expect a return on their investment.
3. Carefully monitor cash flow
Even established franchisors run the risk of running out of cash if they accelerate growth too quickly or fail to adequately manage cash flow. Thus vigilant cash flow monitoring, which includes the following strategies, is an essential part of a financial risk reduction system.
- Know the company’s current cash position at all times by reviewing daily cash reports: opening balances, sources of cash, uses of cash, available cash and upcoming cash flow requirements.
- To measure business progress against goals, review monthly income statements, cash flow statements and balance sheets on a timely basis and compare these with projections.
- Assess financial ratios every month that measure the liquidity and profitability of the franchise system. At a minimum, these should include: net profitability, average number of days for payables and receivables, debt to equity and current assets to current liabilities.
- Review gross profit margins each month and look for profit “leaks,” especially in the areas of labour and fixed assets. To determine whether costing or pricing may require adjustments, also review gross margins by product line.
And, of course, the key to capital conservation is cautious expansion. Overly-aggressive growth can quickly deplete capital. Krispy Kreme Doughnuts learned this the hard way. Once dubbed “America’s hottest brand” by Fortune magazine, when the company went public in 2000 it over-expanded and took on massive debt. Many franchises subsequently went bankrupt, the company nearly failed and it has been trying to rebuild since then.
4. Regularly review franchisee sales and profitability
Finally, the health of any franchise is a reflection of the health of its franchisees. Since sales and profitability are key indicators of financial health, monitoring franchisee financial performance in these areas is critical. Regular monitoring of these indicators also has the added advantage of reducing other risks such as fraud and theft. Frequent checks serve as both deterrents and as early warning signals that can alert a franchisor to problems.
Effective monitoring starts with timely financial reports. Thus it’s important for the franchisor to ensure that franchisees deliver reports on a timely basis, as described within the franchise agreement. When a franchisee’s accounting records become consistently late, this could be a signal of serious financial problems that require attention.
It’s also important to ensure the franchise accounting system generates prompt franchisee results for sales, expenses, daily cash position, accounts payable and receivable and inventory. This can provide a timely alert to any significant changes in profitability or liquidity for individual franchisees and enable the franchisor to respond before contractual obligations fall offside.
Comparisons of defined metrics on a weekly basis also serve to identify any problematic trends. While specific indicators vary among industries and franchise companies, the following metrics represent a helpful base to build upon.
- total sales revenues by location
- same store sales during a specified week with the same week in the previous year
- number of sales by location and region
- average transaction size (or average sale per customer or average order value) by individual location as well as by region
- gross sales/income
- gross margin; where margin is declining, analyze individual components related to labour, materials, overhead, pricing or other significant areas
- expenses
- net profit
- cash flow.
Comparing and contrasting the results among franchisees and among time periods will reveal performance gaps. Studying the what, when, where and why enables a franchisor to devise appropriate responses. If the reasons for specific problems continue to be elusive, “spot checks,” where the franchisor reviews daily sales and performs reconciliations onsite, can often reveal underlying issues.
When it comes right down to it, there are really just four strategies – appropriate financial projections and measures, adequate capitalization, vigilant monitoring of cash flow and regular reviews of franchisee sales and profitability – that will enable new and growing franchises to stay safe, sound and financially healthy.
Rick Chittley-Young is a principal and Marina Ponton is a manager in the Burlington office of BDO Canada LLP, which helps entrepreneurs, family businesses, franchisors and franchisees succeed. You can reach Rick at 905- 844-3206 or rchittley@bdo.ca and Marina at 905-633-4928 or mponton@bdo.ca.
