Projections: fact or fiction

Everyone going into business will sooner or later need to get to grips with the figures. With franchising you should be looking at a tried and tested business format, so you should be provided with projections showing how the business could perform. By Lorna Smith, former senior franchise manager at HSBC Bank.

As a franchisee, you should have a basic understanding of any financial information you are shown, or you need to produce. Of course, you can always get help from your local accountant, but you should understand the figures so you can assess the franchise. What are the sets of figures most commonly seen in franchise presentations and prospectuses?

Cash-flow forecast

In many ways, the cash-flow forecast is the most important document. It measures the anticipated flow of payments received, against the products or services you supply. It is vital to try to predict what will happen because sometimes you may have to allow customers credit and therefore wait for payment, but by doing so you risk not being able to pay your own creditors.

Many otherwise successful businesses have gone bankrupt simply because they don’t have enough money to pay suppliers who are not prepared to wait. It is not uncommon for businesses to show healthy profit levels and yet be strapped for cash, and for others which have healthy cash levels to show losses.

One of the main reasons for this is that the accounts reflect the position at the end of the relevant accounting period as if all income had been received and all expenditure made. In reality, this is not often the case.

For example, sales made within the last month or so may well have been invoiced out, but the cash may not be received until after the end of the accounting period. Conversely, electricity may have been consumed during the period, but the invoice for its supply may not have been received.

Cash-flow is an area which is often overlooked, but it needs to be given a top priority because if not properly managed, it will cause problems for your business. It is worth bearing in mind that the accounts show the overall result of trading for a set period and do not necessarily reflect the current performance. This is a good reason for having quarterly, or even monthly, management accounts in addition to annual accounts.

You might expect a healthy turnover and have planned accordingly, but if your customers have problems paying your income can soon dry up. Even a well performing business can get into trouble if income does not coincide with expenditure. Forecasting is not an exact science, but the figures are valuable as long as they are based on thorough research and an understanding of the marketplace. Banks usually like to see cash-flow predictions for at least 12 months and more often for two or three years ahead. This forward planning enables the bank to identify how much working capital is required by the business. The main items the forecast should identify are projected sales, direct costs and overheads.

Ensure your estimates are as realistic as you can make them, and be careful not to make the figures too optimistic – err on the side of caution. Overheads in particular can be costlier in reality than were estimated and actual sales lower than were expected.

Don’t be tempted to measure the success of your business purely in terms of bottom-line profitability. Although profits are important, it is cash-flow which enables a borrower to repay a loan on time. So cash management is vital to all businesses. The purpose of a cash-flow forecast is to predict the cash position on a regular basis, usually monthly.

Reasonable assumptions must be used in the projections – it is no good assuming that debtor payments will be received within 30 days of being invoiced if experience shows that they normally take 45 days. It is best to err on the cautious side and assume payments will be received later than you might normally expect and that payments out will need to be made slightly earlier.

A cash-flow forecast is normally drawn up showing all the expected receipts, category by category in a given period, followed by all the payments out. A net inflow and outflow for the period is established and then added or subtracted from the opening cash balance to produce an anticipated end of month position.

Profit and loss forecast

The profit and loss forecast matches the income and expenditure of your business to the period in which goods or services were provided. Business plans often include monthly profit or loss forecasts for the first year of operation, followed by monthly or quarterly projections for two or three years. This profit forecast will enable you and potential investors to assess whether the business is viable in the long term.

Often, a franchisor will provide projections for two or three years trading to give you an idea of how the business could progress. The franchisor will often advise you how the figures have been arrived at and, if not, you should ask. You may be given a range of figures, representing different levels of franchisee performance, or perhaps showing different sizes of outlet. The figures should be based on actual franchisee performance, or in the case of a new franchise on the operation of the pilot units.

You should do some investigation yourself, and not just take the figures as read. Check the business rent and rates in your area if the franchise is premises based. If you need to employ staff, what are typical wage rates, and how easy is it to recruit them?

By law, if your business is a limited company, you must produce a profit and loss account each financial year. Self-employed sole traders and partnerships do not need to do this, but they will need to complete a self-assessment tax return, which will provide similar information. However, it is a good idea to produce formal accounts, particularly if you need to borrow money, as the bank will usually ask for the figures.

Often the projected profit and loss figures provided by the franchisor do not include any deductions for depreciation, borrowing costs or drawings/salaries, as these may vary according to each franchisee’s situation. You should factor these costs back in when you are assessing whether you want to go ahead and buy the franchise.

The salaries or drawings of sole traders and partners are treated differently in accounts from the salaries of directors of limited companies. The salaries of directors are deducted in the accounts and net profits are shown after these payments. However, the drawings of sole traders/partners are shown in the balance sheet under the heading capital accounts so net profit is shown before these payments. The same also applies to tax. Income tax due by limited companies under PAYE (being a company liability) is usually shown in the accounts. Tax owed on drawings is not usually shown as it is the personal liability of an individual, not the business.

Break-even

Break-even represents how much sales volume your business needs to start making a profit. The break-even point is important when looking at profit and loss projections. You should think about how realistic the projected break-even sales volumes might be. Is it reasonable to expect that you can sell a given number of units in an hour/day/week/month?

Gross profit is the difference between the income from the sale of the goods set against the actual cost of buying-in the goods. These costs are often known as direct or variable costs as they are associated directly with the cost of the goods and vary more or less in proportion with sales.

Net profit is arrived at after deducting all other costs from the gross profit. These costs include rates, heating, and administration, etc. and are known as indirect or fixed costs. This is because they do not vary directly with sales and do not generally change; businesses do not receive a reduction on their rates just because they are experiencing lean times. Splitting the figures like this allows you to calculate the break-even point.

Balance sheet forecast

A projected balance sheet is a statement of the assets and liabilities of the business. It presents the anticipated financial position of your business at a particular moment in time. It does this by showing what the business will own in terms of fixed and current assets, against what the business will owe in terms of long-term and current liabilities.

Balance sheets are usually presented showing all the assets, and then deducting the liabilities to parties outside the business and leaving a figure, which is balanced by the owner’s capital in the business.

Fixed assets include property, equipment, and vehicles, etc. Current assets include cash, debtors and stock, while current liabilities will include trade creditors and other short-term creditors, such as rent and rates and bank overdrafts. Long-term liabilities will usually be in the form of loans or other borrowing taken over a period in excess of 12 months. In limited companies, the owner’s capital is usually the issued share capital and the accumulated profit and loss account balance. For partnerships and sole traders the owner’s capital will be the capital accounts after drawings.

When discussing balance sheets bankers will often use the term liquidity. A business is liquid when its current assets exceed its current liabilities. In theory, current assets such as debtors and stock can be quickly turned into cash to settle urgent and outstanding current liabilities. Obviously, there is more to the assessment of liquidity than this simple definition as stock cannot always be sold quickly.

Another phrase often mentioned in association with balance sheets is the capital position. This is the stake or owner’s capital which is a good indicator of a business’s financial strength. The strength of the capital position, however, needs to be viewed in relation to the size of the business operation. For instance, a business with capital of £1m is very strong if its turnover is £500,000 per annum, but much weaker if its turnover is £100m per annum.

Gearing is another term often used in relation to the balance sheet. This refers to the ratio of the borrowings of a business in relation to its capital (normally shareholder funds and any retained profits), expressed as a percentage. A business with a gearing greater than 100 per cent is usually considered to be highly geared as its borrowing exceeds its capital. A heavy reliance on borrowed money makes a business more vulnerable to increases in interest rates, and higher payments are likely to drain cash flow.

Accounting conventions can affect the way a balance sheet looks. This is not to say that balance sheets are not a true and fair view, but the basis on which the figures are arrived at should be closely examined and the appropriate conclusions drawn. Freehold properties are often included in balance sheets at the price at which they were bought many years or even decades ago. It is likely that the property will have a current market value in excess of its historical value. This difference is referred to as a hidden reserve because it only becomes apparent if a formal revaluation exercise is undertaken and the increased value is reflected in the balance sheet valuation. If this is done, the balancing item will be shown in the owner’s capital.

Alternatively, if an existing business has been purchased, it may have an asset in the new owner’s balance sheet under goodwill. This is the value placed on the business over and above its tangible value in recognition of the existing level of business and numbers of customers. Goodwill is intangible and will certainly disappear if the business runs into difficulties. So it is often discounted when professionals are looking at the capital of a business. In any case it should be written off (amortised) over a period of years.

Stock can be overvalued or undervalued depending on the circumstances. It is often valued on a conservative basis at cost, whereas its real value might more realistically be represented by its resale value so leading to a hidden reserve. On the other hand, the valuation might include a proportion of old stock that is in reality unsaleable so this stock would be overvalued.

Any projections provided by the franchisor will only be a basis for you to build your own business plan and projections, but they will at least give you a starting point. You should use them to evaluate the franchise and make your decision on whether you want to go ahead. How long will it take you to get pay-back on your initial outlay? How much will you need to borrow to get the business up and running?

Money is not always the only factor in choosing a franchise. Quality of life and the satisfaction of being your own boss, with support from the franchisor and the franchise network, are also very important.

You don’t want to lose your hard-earned savings, so time taken at the outset to understand the costs and potential returns, as well as assessing the other important aspects of the franchise, will be time well spent.