Researching Franchises by Numbers

How to understand and use a franchise’s financial statements to make a well informed investment decision.

Researching Franchises by Numbers

Many individuals, when they first consider making an investment into a franchise, assume that every franchisor must meet stringent financial requirements before they can market their franchise opportunity. To the contrary: With the exception of those franchisors who are members of the Franchise Association of South Africa (FASA) and adhere to its best practice code of ethics, no government entity regulates franchising in South Africa, therefore opportunities on offer to prospective investors go unchecked. This means that financially weak companies may still be able to offer franchises.

In other words, you need help. For the unsophisticated investor or the person who does not engage the services of a chartered accountant as part of their franchise opportunity review team, the lack of any fiscal quality control over the offering of franchises could cause significant problems.

When you invest in a franchise, naturally you hope the franchisor will remain in business for as long as you are a franchisee and quite a bit longer. The franchisor promises to provide you with services that help you get the business up and running, as well as those you need throughout the life of your franchise.

These promises were part of the written bargain contained in the franchise agreement. Often the franchisor will exceed its written obligations; in fact, many franchisors do. Some of the most satisfied franchisees are those of systems where the franchisor under-promises and over-delivers. These franchisees often cite the additional services as the reason they recommend the franchise to others.

Unless the franchisor is financially sound, continually growing the number of domestic locations in the system each year, improving profits at the franchisor level and increasing unit sales and profitability of the franchisees, it may not be able to meet either its written obligations or provide some of those other services franchisees have come to depend on.

Indeed, unless the franchisor is profitable and growing, they might not be there for the long haul, and the entire system – including your investment – will suffer. Keep in mind that the system is really only healthy when the franchisor is financially strong. Therefore, you must look closely at the franchisor’s financial statements and get an understanding of whether the franchisor can provide the services you’ll require.

Before making an investment it is advisable to request the following financial information on the company, including:

  • A balance sheet for the past two years
  • A statement of earnings for the past three years
  • A statement of cash flows for the past three years
  • A statement of stockholders’ equity

The financial statements should be audited by an accounting firm and contain extensive notes that provide explanations about the franchisor and its financial condition. When you examine the financial statements and notes in conjunction with the disclosure document and other information you obtained during your due diligence, you’ll start to get a clear picture of the strength of the franchisor and your risk in becoming a franchisee in that system.

The first thing you should look for in the financial statements is the opinion letter from the auditors. Does the letter indicate any ongoing concern or other issues? Look at the balance sheet – what is the franchisor’s net worth? Can it meet its obligations? Are its liquid assets sufficient to meet not only its current obligations but, more important, those obligations it’s making to you?

Look at the franchisor’s statement of earnings. Even if the company is profitable and has improved earnings over the three years shown, look closely at where it’s getting its income. If the majority of its earnings are coming from franchise sales, verify that the locations generating those franchise fees are actually opening as scheduled.

Look at the income from royalty and other continuing fees. Are they increasing each year? If the locations that generated the franchise fees are not opening, and the royalty income is not increasing, you have a clear indication that something may be amiss or that the company’s long-term viability is questionable. Is a significant portion of the revenue coming from the sale of franchises locally or overseas?

Frequently, franchisors don’t break out the details of where their revenue comes from and may simply list the information as “Franchise Fees.” Ask the franchisor for a breakdown of that figure. It’s important that you see a progression of increasing revenue from royalties and other continuing sources of income.

Some franchisors can readily provide the breakdown to you. If they can’t or won’t, you or your accountant should estimate that information by multiplying the franchise fee by the number of new locations in the system, adjusted for any changes in the deferred income from the balance sheet. When that product is subtracted from the Franchise Fees line on the income statement, you’re generally left with a rough estimate of the continuing royalty income.

The notes to the financial statements will generally provide you with additional information about various line items in the financial statements. Knowing what to look for is key to identifying whether the franchisor will be there for the long haul.

Do you need an accountant to work in conjunction with you and your lawyer in examining the franchise opportunity? The short answer is yes. Most important, you need an accountant who understands how to examine a franchise system’s financial statement.

Some may not understand the nuances of a franchisor’s financial statements, as much of the value in the assets of a franchisor don’t appear on their balance sheet. Why? Because the bricks-and-mortar assets are on the franchisee’s balance sheets. The franchisor’s asset is the future royalty and other income streams that will occur as the franchisees prosper and send their payments to the franchisor.

Even mature franchisors occasionally get into financial difficulties; some have even failed. If you take your time and do a thorough review of a franchisor’s financial and other information, you can limit your risk considerably.

Franchise Zone
About the Author
Franchise Zone is published by Entrepreneur Media SA. It offers advice and franchising opportunities in South Africa.

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