Disclaimer: This blog post provides general information and should not be considered financial or legal advice. Always consult with qualified professionals before making any investment decisions.
Investing in a franchise can be an exciting opportunity. It can also be an intimidating one when your finances are at risk. To help feel more confident in knowing you’re investing in the right franchise, one critical area to examine is the franchise’s financial health.
Tips on Examining a Franchise's Financial Health - According to the Franchise Business Law Group, 86% of franchisors now include FPRs in their FDDs. - The FDD will include the franchisor's audited financial statements in the exhibits. These statements typically include a balance sheet, income statement, and cash flow statement. Each document contains indicators of the economic health of a franchise. - Analyzing financial ratios (liquidity, profitability, leverage) also enables an understanding of the franchisor's financial health. - Beyond the franchisor's overall financial health, also pay attention to unit economics, f/k/a average unit volume (AUV), which is the relative performance of individual franchise locations. |
What to Look for in the Franchise Financial Statements
Numerous surface-level indicators suggest a franchise's financial health, such as initial investment figures and royalty percentages, which forecast what you can predictably earn when you invest. By digging deeper and doing a more thorough financial due diligence process, you can have more confidence in investing in a healthy and sustainable system. Here are a few key areas to consider when assessing a franchise’s financial health and making a more informed decision.
Where to Find Franchise Financial Info: The Franchise Disclosure Document (FDD)
The Franchise Disclosure Document (FDD) is a legal document that franchisors are required to provide prospective franchisees. It contains crucial information about the franchise, including its financial performance and other key details.
Item 19 of the FDD is particularly important, as it may contain Financial Performance Representations (FPRs). FPRs are representations that, if included, can provide valuable insights into potential earnings, sales figures, and other key financial metrics.
According to the Franchise Business Law Group, 86% of franchisors now include FPRs in their FDDs. However, it's essential to understand that FPRs are optional for franchisors. If a franchisor does not include an Item 19, they cannot provide any financial performance information outside of the FDD.
It should be noted that Federal Trade Commission (FTC) guidelines specify franchisors are forbidden from telling prospective franchisees how much they can make by providing earnings estimates or indicatong profit potential in any way.
How to Analyze the Franchisor's Financial Statements
The FDD will include the franchisor's audited financial statements, typically consisting of a balance sheet, income statement, and cash flow statement. On each document are indicators of economic health.
The balance sheet provides a financial snapshot of the franchisor at a specific point in time. It lays out what the company owns (assets), what it owes (liabilities), and the owner's stake (equity). A healthy franchisor should generate significant revenue from ongoing royalties and fees from existing franchisees, rather than being overly reliant on initial franchise sales. This indicates a sustainable, service-oriented business model. Also, look for a strong base of liquid assets (like cash) that can easily be converted to cover short-term obligations. Conversely, keep an eye out for excessive liabilities (debt). A franchisor weighed down by excessive debt may struggle to invest in system improvements, marketing, or support for its franchisees, especially during economic downturns.
The Income Statement, also known as the Profit & Loss (P&L) statement, tells a story over a period, usually a year, detailing the franchisor's revenue, expenses, and ultimately, its net income (profit). It's your window into the franchisor's profitability. Compare income statements over several years to gain a more comprehensive understanding of the financial situation. Are both revenue and profits showing consistent growth? A pattern of increasing profitability suggests a well-managed and expanding system.
Finally, the Cash Flow Statement reveals the actual movement of cash in and out of the business. It's broken down into cash from operating, investing, and financing activities. For potential franchisees, positive cash flow from operating activities is a robust signal. It means the franchisor is generating enough cash from its core business operations to sustain itself and grow, without relying heavily on borrowing or selling assets.
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Key Financial Ratios to Consider
Analyzing financial ratios enables a more nuanced understanding of the franchisor's financial health, moving beyond raw numbers to reveal underlying trends and strengths.
Liquidity Ratios, such as the current ratio and quick ratio, are essential for gauging the company's immediate financial stability, revealing its capacity to meet short-term obligations without stress.
Beyond short-term, Profitability Ratios like gross profit margin and net profit margin are critical for understanding how effectively the franchisor generates income from its sales and assets. These ratios indicate the efficiency of the business model and its ability to turn revenue into profit.
Furthermore, Leverage Ratios, including the debt-to-equity ratio, shed light on how the company's assets are financed, indicating the reliance on debt versus equity. A balanced approach to leverage is generally preferred, as excessive debt can signal higher risk.
Understanding Unit Economics
Beyond the franchisor's overall financial health, it's critical to understand unit economics, which focuses on the economic performance of individual franchise locations.
This insight provides a realistic picture of what your potential business could generate, as both franchisors and franchisees use unit-level economics to identify, measure, track, and manage the performance of their companies at the individual unit level.
Key metrics in the analysis of unit economics include the unit profit and loss (P&L), which details revenue and expenses for a single location; the break-even point, indicating the sales volume required to cover all costs; and the payback period, showing how long it typically takes for a franchisee to recoup their initial investment.
Often, in Item 19 of the FDD you will find the average unit volume (AUV). The AUV refers to the average annual sales that a brand is recording across all operating locations. It depends on several factors, such as year-over-year growth, franchise fees and overhead.
The AUV provides a general understanding of how profitable a franchise investment may be, and more easily allows prospective franchisees to compare one brand in an industry to another.
Spotting Signs of a Healthy vs. Struggling Franchise System
A healthy franchise system is typically characterized by profitable franchisees, demonstrating that the business model works successfully at the unit level. You'll also often find strong franchisor support and training, which empowers franchisees to succeed. Furthermore, a truly healthy system exhibits sustainable growth, expanding steadily without overstretching its resources or support capabilities. These indicators collectively paint a picture of a well-managed and robust franchise opportunity.
Conversely, a struggling franchise system often presents several red flags that warrant caution. One significant indicator is high franchisee turnover, suggesting that existing owners are not finding success or satisfaction. You may also notice declining customer satisfaction within the system, which can affect unit-level profitability and brand reputation.
If existing franchisees are not reaching their financial goals, it signals a fundamental issue with the business model or the support provided, making it a risky investment for prospective owners.
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Kimberly Crossland is a copywriter, content strategist, and creator. Her goal is to inspire meaningful change through a strategic and thoughtful approach to life and business. In her free time, you can find her homeschooling her kids or on the road looking for a new adventure together with her boys.