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Thursday, May 30, 2013

User Friendly Financial Statement Analysis

Assets burn cash.  Loans, credit lines, credit card balance transfers and shareholder investments produce cash.  Managing the sources and uses of cash is crucial to surviving in any business.  Most restaurants fail due to inadequate capital infusion during the start-up phase.  Some people never get the door open for business due to lack of cash.

Cash is king for many restaurants.  Many managers and owners do not understand how to read a balance sheet.  Assets other than cash require cash.  If your receivables, inventories and prepaid expenses increase your assets go up but your cash goes down.

Many restaurants have a difficult time paying suppliers on a timely basis. The impact is significant. Suppliers will add late payment fees, offer tighter credit terms, charge higher prices and in the worst case scenario require cash payment on or before delivery. 

For those readers who do not love accounting and financial statement analysis, there are a few key ratios and formulas which can bring a big benefit with a small effort.

Working Capital Considerations
Ability to pay suppliers is often difficult due to the nature of cash flow in the restaurant industry. Sales turn into cash on the spot or a few days later as credit card charges are wired to bank accounts. Employees are paid with a 7 to 10 day lag (sometimes longer) and suppliers are paid in 30 days.

Using employee and supplier financing works OK until the sales tax payment is due. Cash is plentiful until these statutory payments come due (often with big late payment penalties).  If your company has a rough time making the sales tax payment, a beginner's level grasp of financial statement analysis can help.

Where do you go to help monitor this important issue?  Balance Sheet

The current ratio is calculated by dividing the current assets total by the current liabilities total. Unfortunately, inventory bloat makes the current ratio useless in our industry.

Avoid over stocking your shelves to improve cash flow and reduce spoilage. Substitute the Quick Ratio for the current ratio.

Quick Ratio = (Current Assets - Inventories)/Current Liabilities

A quick ratio below 1.0 is very dangerous. A good ratio is 1.25 or higher.

Capital Expenditures and Financing Options
Capital expenditures are made in the operation to produce a positive future value.  Increases in liabilities, including longer times to pay suppliers and employees, increase cash flow.  Liabilities are a risky way to finance your business.  Managing financial risk will help you grow your business at a sustainable rate.

Compare your equity accounts (common stock, paid in capital, retained earnings) with your total net fixed assets (property, plant and equipment net of depreciation).  A company with a low financial leverage will have more shareholder's equity than net fixed assets.  If a company employs financial leverage, they will have a long term debt figure which reflects loans required to invest in the company.  There are two ratios which you can use to monitor your long term financial health.

Debt to Equity Ratio = Total Liabilities/Shareholder's Equity

Try to stay below 1.0 if possible.  A major manufacturing company (auto plant) may have a ratio of 2.0.  Restaurants should be much lower.  There are publicly held restaurant companies with a debt-to-equity ratio above 10.0.  These companies want to maximize return on equity by using financial leverage to acquire assets.  They may be buying restaurant companies or opening lots of new restaurants. 

Fixed Assets Ratio = Net Fixed Assets/Long Term Debt

Picking an ideal fixed assets ratio depends on your appetite for debt financing and your business health.  One company may have a ratio of 1.0 where the long term debt equals their net fixed assets.  In theory, the ability to repay the debt is high.  I recommend removing net leasehold improvements from your net fixed assets.  If you lose a leased premise, the value of these improvements may be very low.  Equipment may be worth far less than the book value due to a vibrant after market for restaurant equipment.

By performing simple division using a handful of numbers on your balance sheet, you can determine your ability to pay suppliers on a timely basis and keep your long term debt in line with the money raised from shareholders while prudently investing in fixed assets needed to run your restaurant business.

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