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How much can I really make in a franchise business investment? PART 3

Guest post by: Mary Tomzack

Article Overview: You're considering investing a bunch of time and, in many cases, a huge portion of your savings in a franchise business opportunity. Maybe you're even quitting your old job and career to pursue your dream of owning your own business. But first you want to know how much money you could expect to make from your franchise investment. In part 3 of FranchiseHelp's 3-part series on how to calculate a franchise's potential return on investment, we dive into how you can calculate the cash flow and returns potential of your target franchise opportunity.

How much can I really make in a franchise business investment? PART 3

In parts 2 and 3 of the 3-part review of how to determine how much money you can make in a franchise business, we discussed basic franchise accounting (part 1) and how to set up your franchise business plan model to estimate your potential revenues / sales (part 2). Now we go into the real details, where we work out how to calculate the potential cash flow and returns of a franchise business.





Part 3: Estimating Potential Cash Flow and Franchise Investment Returns

As we discussed in part 1 of this series (Basic Franchise Accounting), cash flow is simply the difference between the cash the business takes in and the cash the business spends.

A cash flow analysis can tell us when we might expect to encounter either a cash shortage or a cash surplus. Our purpose in putting together these cash flow numbers is to get a picture of whether working capital (our funds on hand to bridge the period between cash outflows for costs and expenses and cash inflows from customer payments) is sufficient to operate the business.

Let's say our model thus far (from parts 1 and 2 of the series) is set up as follows:

• The franchisor shows $2 million in royalty payments from franchisees for last year in its Item 21 financial statements;
• Our initial investment to buy a franchise will be $50,000 (including the franchise fee, start-up equipment, furniture and rent);
• To finance our investment we've gathered $70,000 ($30,000 from savings and $40,000 from a home equity loan;
• After subtracting our initial investment, we have $20,000 remaining to cover operating / working capital.

What we then need to determine is: will a $20,000 cushion be enough to get our business through the startup phase or will there be a cash shortfall, necessitating a scramble to raise additional funds?

Refine Sales Projections

We begin by looking at our projection of annual sales (which we had estimated above using information from the franchise disclosure document Item 19 and Item 21). Let's say projected annual revenue for our chosen franchise is $250,000. To produce a rough projection of potential monthly sales we can simply divide the annual revenue estimate by 12.

However, if by speaking with current franchisees we learn that there is a seasonal skew to revenue (i.e., sales aren't evenly balanced throughout the year), we'll need to work this information into our sales projections. For example, if we're investing in a tax preparation franchise, our period of highest revenue will likely be the first 1/3 of the calendar year (January through April). So, if we detect seasonality to the proposed business, we should build this into our projections by assuming that more than 1/12 of total year sales will fall into certain months (our "high-season" months) and less than 1/12 of total year sales will fall into other months (our "off-season" months).

Adjust for Credit vs. Cash-Based Businesses

After we've built a reasonable estimate of sales for each month of the year, we'll need to consider whether we are investing in a cash-based business or in a business that extends credit to its customers.

Most (but not all) consumer-facing franchises operate on a cash basis, meaning their customers pay immediately for any goods or services received. For example, when is the last time you gave the teenager behind the register at Domino's an IOU that says you'll be back in 30 days to pay for those 2 medium pizzas? Most (but not all) business-to-business franchises operate on a credit basis, meaning their customers are expected to pay at some point (15, 30, 45, 60 or even more days) after receiving their goods or services.

If our target business is in the practice of extending credit, then we'll need to reflect the typical credit terms in our projections. For example, if our credit terms are net invoice payable in 30 days, sales that occur in January should have receivables noted as being paid in February. If we want to be more conservative (given some customers' tendency to pay late), we might assume that payments on January sales will arrive in March. To develop the most accurate projection we'll want to speak with current franchisees to get a sense for how quickly their customers typically pay.

Project Cash Expenditures

Once we've adjusted our projections to reflect any timing considerations for credit, we need to make a list of expenditures (cash outlays) for a typical month. Such expenditures will include: cost of goods / supplies (these figures should come from the franchisor), rent, loan payments, payroll, advertising, telephone, utilities, insurance, royalties to the franchisor and other miscellaneous payments. One common practice in financial modeling is to split expenditures into two categories: fixed monthly payments (such as rent, which should be the same each month) and variable payments (such as royalties, which vary depending on the amount of sales generated in a month).

Calculate Available Cash

Now we simply add up the incoming cash and collections to determine our total cash available figure and add up all the monthly expenditures for our total cash paid out figure. We then subtract total cash paid out from total cash available to calculate our net cash available before distributions to owner and debt service. At this point, if we don't plan to pay ourselves a salary from the franchise over the projection period and if we have no debt payments to service we are done with our cash flow calculations.

Otherwise, from net cash available we subtract any salary we plan to pay to ourselves from the operations of the franchise (such salaries are known as distributions to owner). Finally, we subtract any debt service amounts (our loan amortization) to calculate our ending cash balance or net cash available after distributions to owner and debt service.

When we've finished with these calculations, it's time to analyze the results:

• If our ending cash balance / net cash available comes up negative several times over the projection period and we can't increase our working capital to plug these holes, we might need to rethink our choice of franchise investment!
• If our ending cash balance / net cash available stays out of negative territory throughout our projection period, assuming we've followed all of the steps outlined above diligently, we are in very good shape and should continue with our investigation of the investment opportunity.

Estimating Potential Profit and Loss

Lastly, we'll put together a projected profit and loss (P&L) statement for a two-year period.

The good news is that most of the numbers we need are already calculated if we have already built our annual sales and monthly cash flow projections. To construct our P&L statement, we take the following approach:

First, we take our anticipated first-year sales and subtract from that our anticipated cost of the goods sold / cost of sales. Cost of goods sold / cost of sales is equal to our beginning inventory plus any inventory purchases we make less our ending inventory. This gives us our gross profit / gross margin number.

Second, we add up all the expenditures for the year from our cash flow statement, which represents our total expenses. Here we have to be careful not to forget to include non-cash expenses such as depreciation and amortization. For a detailed explanation of these accounting concepts, FranchiseHelp has a guide to advanced franchise accounting, but those details will not be necessary when building up your basic franchise projection model.

Finally, we subtract our total expenses figure from our gross profit number to calculate our first year's profit (net income) or loss before taxes.

To produce our second year's P&L projections, we simply assume a reasonable increase in sales (speaking with current franchisees in the system for a realistic figure) from year 1 to year 2 and a corresponding increase in our cost of goods sold (which you can usually assume will remain a constant percentage of sales). Some second year expenditures will remain the same (rent, insurance, utilities, and possibly advertising) while others (such as payroll, royalties to the franchisor, and telephone) may increase (again, we can speak with current franchisees to help us form a judgment on these items). Subtracting expenses from gross profit will give us net income or loss before taxes for the second year. Unless circumstances are unusual, we should be projecting a larger income or profit figure in our second year.

Final Thoughts on Building Franchise Financial Projections

Why must we go through all these financial exercises?

Though time-consuming, these calculations can reveal whether the investment you're considering makes sound financial sense. In other words, the projections you produce will answer the question with which we began this discussion: "How much money will I make?"

If you're completely unfamiliar with reading financial statements or uncomfortable developing financial projections, that's ok: many prospective franchisees go through the financial modeling exercise with their accountant. In any case, don't skip this very important piece of your franchise due diligence analysis. If the numbers come out as less than ideal and you choose to go ahead anyway (perhaps because you have fallen in love with the franchise), you may find yourself working longer hours than you ever expected with very little in the way of salary or profit to show for it.

Following the steps above, comparing financial data from several relevant FDDs, and verifying your assumptions through conversations with current and former franchisees, you should be able to produce a very robust, cool-headed projection of how much money you can expect to make in any particular franchise opportunity.





Time to Take A Bow!

If you just got through the entire 3-part series, you should have a very robust franchise business model - likely one that is better than 99% of what other prospective franchisees may have. Of course, the quality of the model is only as good as the information that goes into it. Your next steps should be to:

1) Have your accountant review the model with you to make sure you haven't made any basic arithmetic errors or that you aren't forgetting to include any major expense items, for example;

2) Go speak with current franchisees in the system (you can find a list of these folks, along with their contact information, in the FDD itself, or you can just walk over to one of the stores to see if the owner is in). See if they agree with the assumptions and calculations on which you've based your projections. Existing franchisees are often extremely candid about their businesses (off the record) and are an invaluable source of advice before you yourself invest.

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