Let’s be Realistic

Differing expectations and perceptions from all the parties concerned can lead to misunderstandings and unnecessary acrimony 'down the track' should there not be some objective basis for answering these questions.

One simple tool we have found helpful, and we commend to both franchisors and franchisees for consideration, is what is technically called breakeven analysis but I prefer to regard it as the 'let's be realistic' tool.

The 'let's be realistic' tool helps reduce three of the critical questions (the bottom line, the risk, the capital investment) in considering a business into a simple yet objective test able to be understood by all parties.

It is a simple six step process taking about 10 minutes. In this process I have assumed a retail franchise business but it could be modified to incorporate a service or manufacturing business.

Step 1: Determine your profit target

What profit would you like to achieve each year in this franchise (include your own salary)?

Rather than just 'pulling a figure out of the air' (or assuming what other franchisees have achieved will be the norm) why not break your profit target down into its financial components to determine if it is reasonable. This is especially important in franchises where the establishment of a credible profit history in a particular franchise location will be important in future negotiations with the franchisor. There are two key components in determining an adequate profit target in a business.

i. Return on Investment (ROI)

What is your investment in the franchise? This is the total assets of the business, which is normally the capital cost investment in the franchise. How have you have financed this investment? Is it with debt and/or equity?

Let us say your investment is $650,000

What return should you expect on this investment? Another way of expressing this is to ask what level of risk is appropriate to have me invest in this franchise?

Break the rate into the three components used by financiers;

a) The risk free component (usually regarded as the Australian Government bond rate which is currently at approximately 6.5%). This is about as risk free as you can get.

b) Add to this the business risk rate which will vary depending upon the franchise. Be realistic on this as you are the one running the franchise with all the attendant risks and stresses. To ask this question will perhaps force you to do some more due diligence or investigatory work. For the sake of this exercise I shall assume this is double the risk free rate (which is quite realistic for many established franchise businesses). Say 13%

c) Then add some more for the exit risk, or the risk involved in getting your investment back. How easy will it be to exit this franchise? This again forces questions to be asked about the term of the franchise agreement and the options available. This again is a variable you will need to assess yourself but let's say it is not a high risk and you estimate it to be 5%.

Total these three to give you an appropriate rate of return.

Thus the return on investment (ROI) in this example is 24.5% on your investment of $650,000 which is $159,250. Let us say $160,000.

ii. Return on Effort (Salary)

What salary is appropriate for your time and effort in the business? This is often a very subjective decision depending upon your motivation and drive, but you need to target at a minimum a living salary to provide encouragement for 'pressing on' in the business as well as providing for your practical needs.

For this exercise I shall assume a salary (ROE) of $100,000.

Thus the profit target is the total of these two components of return on investment (ROI) and salary (ROE). In this exercise they total $260,000.

Step 2: Determine your overheads

This means all the franchise expenses apart from purchases, and your own salary.

I appreciate this is a broad brush approach but these should be relatively easy to estimate from the disclosure document from the franchisor. Having an understanding of all the operational costs involved is a side benefit of this exercise, especially in franchise where there can be misunderstanding on the ongoing franchise fees and charges.

For this exercise I shall assume the total overheads are $650,000

Step 3: Calculate your target gross profit

This is a simple addition of the above two target figures for profit and overheads.

For my example this is $260,000 (profit) and $650,000 (overheads) totalling $910,000

Target Profit + Overheads Target = Gross Profit

Step 4: Determine your target gross profit %

This is the % of sales remaining after your cost of goods sold (GOGS) has been deducted.

The franchisor should be able to give very accurate guidance on the GP% expected in the franchise.

For my example the target gross profit % is 38%

Step 5: Calculate your target sales

This is your Target Gross Profit (Step 3) divided by your Target Gross Profit % (Step 4).

In other words what sales revenue do you need to achieve your profit target for the year?

In my example it is $910,000 divided by 38% which equates to a total sales target for the year of $2,394,737 say $2,400,000.

Step 6: How to utilise this information

Is this target sales realistic? The best ways to determine this is to relate to very normal operational factors in the franchise. The most common is reviewing the days and hours open. This will help you to arrive at a daily or hourly sales amount to achieve the target sales. Then divide this by the average transaction size to determine the number of customers required each hour or day. This provides a very common sense and operational way of assessing what achieving this target means. If you do not think this is achievable now is the time to raise these concerns with the franchisor.

This is a reasonably quick, objective yet powerful tool to assess the feasibility of a franchise business. It can be used by both the franchisor and franchisee, and can avoid many of the misunderstandings that can so easily develop in the assessment stage of a franchise.

By Brett Stevenson, Lawler Partners Chartered Accountants