Master the numbers from the outset to ensure your franchise has the best prospects of success.
Author: Gillian Morris, UK Head of Franchising, HSBC
Taking up a franchise is an exciting prospect. Ahead lies the prospect of building your own business, with the added assurance of a supportive network.
While you’re embarking on what should be a tried and tested business format, that doesn’t mean you should take the financial health of your prospective business for granted.
The franchisor will give you valuable plans and projections – but don’t assume they’re accurate. Satisfy yourself that you understand the figures, so you can assess the franchise objectively.
Of course, you can always get help from your local accountant, but you need to have a basic personal understanding of the figures too. With a firm grasp from the start, you’ll be well equipped to make the best decision.
Here we explore the sets of figures you’re likely to come across in franchise presentations and prospectuses – and as you build and grow your franchise.
Cash-flow forecast
The old adage has it right: cash is king. It’s essential to have ready working capital on hand to manage the everyday demands of your business.
That means the cash-flow forecast is the most important document. It measures the anticipated flow of payments received, against the products or services you supply.
These predictions are critical because sometimes you may have to allow customers credit and wait for payment, which carries the risk of not being able to pay your own creditors.
In a volatile economy, it’s especially important to be wary of assumptions about cash-flows. 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’s 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, for example, you may have invoiced sales for which you haven’t received the cash, or used energy for which you haven’t yet been billed.
It’s also worth bearing in mind that the accounts show the overall result of trading for a set period: they don’t necessarily reflect the current performance. This is a good reason for having quarterly, or even monthly, management accounts in addition to annual accounts.
Once you’re in business, avoid any unwelcome surprises. Planning ahead, with a clear understanding of cash-flows, while monitoring payment collection and reconciling the books in real time, will give a true understanding of your company’s cash position.
Profit and loss forecast
The profit and loss forecast matches the income and expenditure of a 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 allows 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 should advise you how the figures have been reached – 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?
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. You should factor these costs back in when assessing whether you want to go ahead and buy the franchise.
By law, if your business is a limited company, you’ll need to produce a profit and loss account each financial year. Self-employed sole traders and partnerships don’t need to do this, but they must complete a self-assessment tax return, which provides 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.
Break-even
Break-even represents how much sales volume your business needs before it starts to make 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: that is, can you expect to sell X number of units in an hour, day, week or month?
To calculate your break-even point, split your figures to determine gross and net profit. Gross profit is the difference between the income from the sale of the goods and the actual cost of buying in the goods. Net profit is arrived at after deducting all other costs from the gross profit, including rates, heating and administration.
Balance sheet forecast
A projected balance sheet is a statement of the assets and liabilities of the business. It shows what the business will own (fixed and current assets), against what it will owe (long-term and current liabilities), at a particular point in time. The liabilities are deducted from the assets; the figure that’s left is balanced by the owner’s capital in the business.
Fixed assets include property, equipment and vehicles, while current assets include cash, debtors and stock. Current liabilities 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 over a period of more than 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.
Terms sometimes used by bankers in relation to balance sheets include:
- Liquidity – A business is liquid when its current assets exceed its current liabilities.
- Capital position – This is the stake, or owner’s capital. It’s a good indicator of a business’s financial strength, but only when viewed in relation to the size of the operation. A business with capital of £1m is very strong if its annual turnover is £500,000, but much weaker if its turnover is £100m.
- Gearing – 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% is usually considered ‘highly geared’. A heavy reliance on borrowed money makes a business more vulnerable to increases in interest rates.
Accounting conventions can affect the way a balance sheet looks, so be sure you know how the figures are arrived at. For instance:
- Freehold properties are often included at the price at which they were bought many years earlier; the value today is likely to be much higher. This difference is referred to as a hidden reserve, because it only becomes apparent through a formal revaluation exercise.
- If an existing business has been purchased, an asset may appear in the balance sheet under goodwill. This recognises 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.
- Stock can be overvalued or undervalued. It is often valued on a conservative basis at cost, whereas its resale value might be a more realistic representation. Equally, the valuation might include a proportion of old stock that is in reality unsaleable, so this stock would be overvalued.
Weigh the evidence
Use the franchisor’s projections as a starting-point to evaluate the franchise and make your decision on whether you want to go ahead. How long will it take you to get payback 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 important.
You don’t want to lose your hard-earned savings, so take time at the outset to understand the costs and potential returns, and to build your own business plan.
About the Author
Gillian Morris has over 25 years’ experience in the financial services sector and was appointed as UK Head of Franchising, HSBC UK in January 2022.
Morris joined HSBC in 2017, as part of HSBC’s Commercial team in Northern Ireland and in January 2019 became Head of Corporate Banking & Agriculture, Northern Ireland for HSBC UK.
Prior to joining HSBC, she worked for Lloyds Banking Group, based in London, having joined as a graduate trainee. Her career to date has encompassed relationship banking, structured asset finance as well as strategy development and business performance.
She holds a Law degree from Queen’s University, Belfast and a BSc(Hons) in Banking and Finance from UMIST and is an Associate of the Chartered Institute of Bankers (ACIB).
franchiseunit@hsbc.com
Franchise loans | HSBC Franchising | HSBC
Gillian Morris has over 25 years’ experience in the financial services sector and was appointed as UK Head of Franchising, HSBC UK in January 2022.Posted: 21st November, 2022