Many people go into business because they are passionate about the products or services they can offer as part of that business. Often, franchisees have chosen to purchase a franchise because it is a lower-risk business option than a start-up. While most business owners have a trusted accountant to advise on the company finances, it pays to understand some key terms and what they mean for the success of your business.
Some of the most important and preventable causes of business failure are related to franchisees’ inability to understand and manage the business finances. Poor financial control including lack of records, poor debtor management, inadequate cashflow or high cash use are among the causes of failure. These could potentially be prevented if the franchisee had a clearer and more detailed understanding of some key financial terms.
Ten essential financial terms
Gross profit ratio
Gross profit divided by sales: measures the gross profit margin on each dollar of sales. Insufficient gross margin may not cover operating costs or produce an acceptable level of profit.
Current assets divided by current liabilities: measures the ability of the business to meet its short term liabilities as they fall due from its current assets and as such is a measure of liquidity. The higher the ratio, the more likely the business will be able to meet its current liabilities out of current assets.
Debtors divided by sales multiplied by days in the period: the number of days’ worth of sales represented in the trade debtors’ balance. This is also called the average collection period for receivables and is a measure of how efficient management is in controlling customer credit.
Return on investment
Net profit after tax divided by net assets: Measures the after-tax return on assets employed in the business and as such is a definitive measure of performance reflecting how much the business has earned on funds invested.
Debt to equity ratio
Total liabilities divided by net assets: measures the business’ total debt (short- and long-term) versus shareholders’ funds available and is useful in assessing the long term sustainability of the business.
Creditors divided by cost of goods sold (COGS) multiplied by days in the period: creditors are a useful source of finance. By delaying or extending the payment of creditors, the company is effectively using the creditor to fund working capital requirements.
Profit after tax minus the movement in net debt: shows the increase or decrease of free cash available in the business to be taken as drawings or dividends at the end of the period. If the owner wishes to increase their equity in the business and the working capital then this would be funded out of free cashflow, therefore reducing the amount available to be taken as drawings or dividends.
Inventory divided by COGS multiplied by 365: shows the average number of days that inventory is held before it is sold. Stock sitting on the shelf is unavailable cash until it is converted to a sale.
EBIT (earnings before interest and tax) divided by interest: measures the ability of the business to cover interest commitments during a temporary downturn.
Percentage of current year sales compared to prior years: Measures the ability of the business to achieve a satisfactory growth rate in sales. Sales growth must exceed any increases to the business operating cost structure otherwise profitability will be eroded.
- EBITDA: earnings before interest, taxes, depreciation and amortisation
- working capital position: ability to meet debts as they fall due
- asset turnover: refers to the amount of revenue produced per dollar of assets available to the business
- depreciation: the apportionment of the cost of a capital item over an agreed period
- dividend: a payment made per share to the company’s shareholders. It is based on the profits of the year, but not necessarily all of the profits
Business failures rarely happen overnight: the warning signs of insolvency can be identified and, if the underlying problems are addressed early, the business may remain viable. A business is considered viable when it is either returning a profit that is enough to give a financial return to the business owner while also meeting its commitment to creditors, or it has sufficient cash resources to sustain itself through a period where it is not returning a profit.
Franchisees who have a strong understanding of basic financial terms and what they mean for their business are more likely to be successful. However, this does not replace the need for an experienced, professional business adviser, who can support the company in reaching its full potential.
This article first appeared in Franchise Business Magazine.
For more information about this article, please contact your nearest RSM Office