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Creating a healthy balance between debt and equity for your franchise

Shaun Coard
10.29.21
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Managing risks is essential to being a business owner. Being a successful franchise owner means knowing when to speed up and grow your business using debt or when to slow down and grow organically. As a senior VP of franchise banking with 25 years of experience working with franchise owners, my advice is this: your financial ratios should be one of your guiding lights

Financial ratios help business owners gain meaningful information about their company and are used by investors, banking partners and franchisors to track a business’ performance. They also help business owners compare their franchise performance with industry average to determine if management is making efficient use of their assets. Insight gained from your financial ratios can help shape the direction of your business plan and understand your current debt and equity position to set realistic long-term business goals.

Financial ratios that impact franchise businesses

Financial ratios are grouped into different categories such as liquidity, leverage, profitability, efficiency, and market value. Each financial ratio provides different insight into the performance of your business, and since some ratios are more relevant in certain industries, knowing which ratios are relevant to you as a franchise owner will go a long way to set up your business or success. For the sake of this article, we’ll focus on leverage ratios, liquidity ratios and coverage ratios.

Leverage Ratios

Leverage ratios measures the indebtedness of your company and are commonly viewed in two categories: financial leverage or operating leverage. Operating leverage refers to the percentage your company’s revenues covering i fixed or non-controllable cost. Financial leverage refers to the amount of debt your company has used or will use to finance its assets and business operations.

Leverage ratios are important to franchisees as these ratios provide an indication of the long-term solvency of a business. An appropriate amount of leverage is vital to maximize growth opportunities. It is important for franchise owners to understand that leverage can be a double-edge sword. Too little leverage hinders your company’s ability to grow. Too much leverage can lead to bankruptcy. Your franchise banker will help you understand why actively managing your Debt-to-Equity and Debt-to-EBITDA (earnings before interest, taxes, depreciation, and amortization) ratios is important.

Debt-to-equity ratio. There are several types of leverage ratios, but the debt-to-equity ratio is one that franchisees should pay attention to. This ratio measures how much debt the franchise business is carrying compared to the amount invested by the owner. A lower ratio indicates a greater ability to repay debts and take on additional loans to support business expansion and growth. This ratio is an important number to watch because an increasing debt-to-equity ratio year over year may indicate that your business is overburdened with debt, which puts your business at higher risk during an economic downturn or major business disruptions.

Businesses should aim to have debt lower than 80 percent of equity. You may find it difficult to get a business loan or increase your credit exposure if your debt-to-equity ratio is too high.

Debt-to-EBITDA Ratio

Another important ratio is the Debt to EBITDA ratio, which measures the cash generated by your business that is available to pay debt before covering interest, taxes, depreciation and amortization expenses. Calculate this ratio using the debt found on your balance sheet divided by EBITDA from your income statement. Franchise owners should aim for a low debt-to-EBITDA ratio.

There are multiple ways you can create a healthy balance between debt and equity generated organically through your business operations: lower your debt-to-equity ratio and increase your fixed charge coverage ratio:

  • Paying down your loans on time, making principal reductions, and not taking on additional debt when you are trying to decrease leverage.
  • Keeping your operations lean and efficient by maintaining your fixed cost to revenue below 50%.
  • Avoid having higher inventory levels beyond what is needed to fill orders.
  • Restructuring debt. Consider refinancing current business loans with high-interest rates, especially when current market rates are low, which can help to lower your overall debt-to-EBITDA ratio.

Liquidity Ratios

Another important financial ratio for franchise owners is the liquidity ratios that indicate your company’s ability to pay short-term obligations. The three liquidity ratios commonly used by your franchise banker – current ratio, quick ratio, and cash ratio and are calculated as follows.

  • Current Ratio = Current assets divided by current liabilities
  • Quick Ratio = Cash + Accounts receivables + Marketable securities divided by current Liabilities
  • Cash ratio = Cash + Marketable securities divided by current liabilities

To calculate each ratio, place current liabilities in the denominator. Current ratio is the simplest to calculate. Quick ratio is a stricter test of liquidity. Cash ratio is the most stringent test of liquidity. Maintaining a healthy amount of liquidity is essential. Liquidity has an inverse relationship with leverage. Too little liquidity can lead to bankruptcy. Too much liquidity warrants the question if management is properly using cash to maximize growth opportunities.

Coverage Ratios

While good cash flow management is important for any business, it is critical for franchise owners. These ratios measure a business’s ability to repay current liability payments and financial obligations. Franchise owners should pay close attention to cash flow coverage ratio also known as debt service coverage ratio.

Debt Service Coverage Ratio (DSCR). This is the most common financial ratio used by banking partners to determine ability to repay debt. The simplest way to define DSCR – a company needs $1.25 of net income for every $1 of debt.

One of the key financial metrics used to calculate DSCR is Earnings Before Interest, Taxes, Depreciation and Amortization also referred to as EBITDA. This metric is used to evaluate a franchisee’s operating performance and can be used as a proxy for your operation’s cash flow coverage ratio. It is useful when comparing your business to other franchise operations in your industry.

Cash flow coverage ratio. This ratio measures the ability of a business to pay off current expenses or debt with cash flow from your business. Simply put, it shows the available amount of money you generate from your company’s operation to meet your current financial obligations in a given period. Investors and banking partners are especially interested in this ratio as it shows them whether your resources are optimally utilized to generate cash flow.

Without sufficient cash flow, you may miss opportunities for important technology and equipment upgrades that can help your business stay efficient and competitive. To improve this ratio, work on improving your operational efficiency by:

Integrating your payroll and benefits system. Many integrated systems help predict business needs and keep your records updated, which can help you plan your cash flow more effectively.

  • Investing in a system that manages both your receivables and payables, and identify potential gaps between the two, is another good tool to have. Reducing the gap between when you need to pay your suppliers and when you are receiving payments from your customers can greatly improve your cash flow. Such systems typically provide customized cash flow reports and can help you better keep track of your cash flow.
  • Identifying your business patterns. Franchises, especially those in the retail and restaurant industries, could have seasonal peaks and slumps. Analyzing your company’s patterns can help you know when to invest and take on debt, and when to economize and reduce your debt.

Conclusion

Regular analysis of your business’ financial ratios can help you recognize and adapt to trends affecting your operation, make informed decisions to improve your business finances, and track your progress towards your business goals. As these ratios provide one of the key measures of your business’s success from a cash flow, debt, and equity perspective, having favorable ratios will affect your ability to obtain financing.

Franchise owners face unique challenges. Often, they need a banking partner who know their challenges and has the expertise to anticipate problems and recommend solutions unique to their business. To better meet your financial and business goals, work with a banking partner who best understands your needs as a franchisee.