Analyzing Your Franchise P&L’s
Written By: Dennis L. Monroe, Esq.
Monroe Moxness Berg PA
Sometimes it is said that the eyes are the window to the soul, and I would say the same is true about a company’s profit and loss statement (“P&L”). Profit and loss statements are the window to a company’s success. This article encapsulates my 30 plus years of looking at P&Ls for the franchise community.
I like to see P&Ls divided into seven categories. The following is a list of these seven categories, along with my in-depth description.
The most important exercise when analyzing your sales is to make sure you understand each component of sales, by type and by product. Sales needs to include an in-depth review of customer counts, customer check averages, sales by day part, sales by day of the week and any other way you can slice and dice sales. I particularly like “sales by customer” or sometimes called check average, which can help determine where you need to be on your pricing threshold. Sales by customer data also helps you analyze customer trends, which is a key element in today’s volatile sales market.
Cost of Goods Sold There are two components in this category:
- Product costs
- Product costs, like sales, needs to be analyzed by various product groups so you can determine a true product mix and have an understanding of profitability by products sold. If you are dealing with things like food costs, I like to see a detailed understanding of food costs by food group, particularly items such as protein and non-protein. Additionally, in other types of businesses, such as auto service and repair businesses, the various types of product sales like tires, auto parts, services, and labor should also be detailed. Also, it is important you understand the number of units sold for each product classification. The cost of supplies is usually listed under product costs. These would be supplies that are used but may not be products sold. Additionally, both product costs and supplies are subject to inventory adjustments. Product costs are always determined by the amount of opening inventory plus purchases less the ending inventory. Also, inventory turn is a key matrix. Low inventory levels and food turns improve cash flow.
- Labor cost. This category is broken down into:
- Production labor, which is normally hourly, non-exempt labor used to produce the product sold;
- Management or exempt labor used to manage the business; and
- Everything involved in labor including health insurance, workers’ compensation, payroll taxes, and severance payments.
You can further break these categories down into various labor components such as front of the house, back of the house, senior management and contract labor.
Sales less cost of goods sold equals gross margin. This is the first real key matrix. Each industry in the franchising world has a different matrix as it relates to costs of goods sold, gross margins and income from operations. For instance, if you are in the restaurant or auto aftermarket industry and are working with a high cost to goods sold ratio and significant labor and high product cost, we normally see gross margins in the 30-40% range. It is very important to analyze your gross margins based on other businesses in your industry. In addition, many franchise businesses determine the bonus for the management team based on gross margins.
Sometimes labeled as controllable and uncontrollable expenses, this category includes a wide variety of expenses. Below are some of the major categories:
- Marketing expenses can include various programs, including free products, reservation systems, employee and community relations, direct and indirect advertising, social media and ad fund fees paid to the franchisor.
- General Administrative
- General administrative expenses is a broader category and are expenses involved at a store level, such as credit card fees, legal and accounting fees, licenses, permits, music, satellite television, franchise royalties and office expenses.
- Occupancy expenses include insurance, rent, CAM charges, utilities, telephone, percentage rent, real estate taxes and anything related to occupying the space.
- Repair and Maintenance
- This classification includes all necessary repairs and expenses which are not capitalized. Trash removal and cleaning are part of this category.
We subtract operating expenses from gross margin and arrive at operating income which is the holy grail of franchise unit economics. There has been much written on this subject but there are a few general observations that can be made. We like to see the unit level economics for store operating profit in the neighborhood of 15%. Once we start getting much lower than 15%, it may become difficult to pay for corporate overhead and debt service. Many units do not start out with that type of profitability; and sometimes in the franchise world, because of royalty payments, it is difficult to get to 15%. However, I still believe 15% is a threshold amount; and, I prefer to see store operating profit for each unit closer to 20%. This operating profit is the real source of cash for the business.
Other Income and Expenses
From operating income we then subtract the non-store or over store expenses, which we call other income and expenses. The first item in this group would be interest expense (netted with interest income), depreciation and amortization. Sometimes we include pre-opening expenses if it is a new facility which for GAAP purposes needs to be an expense. Corporate overhead, management fees or corporate allocation are the cost of services that are supplied by the overstore management. If it is a single unit and there are no other units to spread this expense to, then this would normally be G&A under operating expenses. The corporate overhead can be a very subjective allocation or it may be governed by a management agreement. The depreciation we are speaking of here is depreciation on a GAAP basis and should come close to the approximate useful life of the assets that are being depreciated. Therefore, in many ways, it is a real expense.
Net income is the deduction of all of the above to come up with the bottom line; that is, the economic effect of the business to the owners. I have omitted any taxes in arriving at net income because most entities involved in the franchise industry are flow-through entities, such as Sub Chapter S corporations or LLCs and pay minimal tax.
- The following are problem areas I have seen on franchise company P&Ls:
- Inadequate accounting for labor, making sure that all factors are included in the labor costs, such as vacation and sick pay.
- Rent expenses not complying with GAAP which says rent expense is the average rent payments over the life of the lease rather than the cash payments.
- Under accrual for percentage rent.
- Repair and maintenance costs are either too aggressive by expensing everything or under aggressive where there is too much capitalization.
- Improper accrual for rebates, loyalty clubs, and gift cards.
- Incorrect treatment of equipment leases.
- Excess management fees (sometimes also called corporate G&A). In most cases, we like to see the G&A at 5% of sales or less. If it is a closely held company and more of a lifestyle, sometimes the management fees may be as much as 8%; but in general this fee should be less than 5%.
One other P&L term which I would be remiss in not discussing is the famous EBITDA. In most cases this is equal to operating income less corporate overhead and adding back any depreciation amortization and interest and taxes. This really is the ultimate free cash flow.
In conclusion, there are no items on the P&L that should not be analyzed. Benchmarking with other franchisees or other like industry companies is key.
Dennis L. Monroe is a shareholder and Chairman of Monroe Moxness Berg PA, a law firm specializing in multi-unit franchise finance, mergers and acquisitions, and taxation. Monroe Moxness Berg PA is located at 8000 Norman Center Drive, Suite 1000, Minneapolis, MN 55437-1178; (952) 885-5999. For previously published articles, and other Monroe Moxness Berg PA information, please refer to our Web site at www.MMBLawFirm.com.