With franchise businesses, the fates of franchisors and franchisees are tied. Done right, this offers both parties an advantage: the franchisor benefits from the energy of the franchisee & the franchisee benefits from the brand & support of the franchisor & the network of many other franchisees.
If a potential franchisee is going to benefit from a franchise, they need to build their business on a firm foundation. A good franchisor will be willing & able to demonstrate how capable and part of this will be demonstrating their financial position. With this in mind, before buying into a franchise, prospective franchisees should take time to understand the franchisor’s financial position.
A franchisor’s financials reveal more than just profit or loss – they offer a glimpse into the business’s stability, growth potential, and ability to support its franchisees. The franchise disclosure document (FDD) plays a critical role in this evaluation, especially sections like Item 21, which include audited financial statements. Here are some key things for a potential franchisee to look at:
What are the things you need to know on the franchisor’s income statement?
The income statement (also called the profit and loss statement) is a key part of the franchisor’s financials. It tells you how much revenue the franchisor generates, what expenses they incur, and what their net income is over a specific period.
Key things to look at include:
- Revenue Sources: Is the franchisor mainly making money from selling franchises, or from ongoing royalties? A business model heavily reliant on franchise fees might indicate unsustainable growth.
- Profit Margins: High revenues are meaningless without solid profit margins. Look for signs the business is efficiently run.
- Growth Trends: Compare income statements over a few years to see if the franchisor’s revenue and profits are consistently growing – or shrinking.
What financial statements are required for a franchise disclosure document?
The FDD is a legal document that franchisors must provide to prospective franchisees. It includes 23 key sections, or “items,” that outline everything from fees to legal history.
Item 21 specifically includes the franchisor’s financial statements. These usually consist of:
- Balance Sheet (assets, liabilities, and equity)
- Income Statement
- Cash Flow Statement
All statements must be audited by an independent CPA in most cases, ensuring that the numbers are verified. Newer or smaller franchisors may be allowed to submit unaudited statements under specific exemptions, but that’s something to be cautious about.
For more perspective, here’s what you would expect from these elements:
Balance Sheet (Assets, Liabilities, and Equity)
The balance sheet provides a snapshot of the franchisor’s financial position at a specific point in time. It shows what the franchisor owns (assets), owes (liabilities), and the value left over for owners/shareholders (equity).
- Assets: These include cash, accounts receivable, property, equipment, and intellectual property. High levels of assets – especially liquid ones like cash – can indicate financial strength
- Liabilities: These are debts or obligations, such as loans, accounts payable, or lease obligations. Excessive liabilities might signal that the franchisor is over-leveraged and could be more likely to suffer in a more difficult economic environment
- Equity: This is the residual value after subtracting liabilities from assets. Positive equity shows that the franchisor has built value in the business, while negative equity could be a red flag
Why it matters: A healthy balance sheet suggests the franchisor has the resources to support its franchisees and invest in system growth.
Income Statement
Also known as the profit and loss (P&L) statement, this report shows the franchisor’s financial performance over a given period – usually a fiscal year.
- Revenue: Look at how much income the franchisor earns, particularly from royalties (ongoing franchise fees), product sales, and franchise fees
- Expenses: Includes costs of providing support, marketing, legal, training, and general operations
- Net Income: The bottom line – this is profit or loss after all expenses. A consistent profit over time usually indicates operational health
Why it matters: The income statement reveals how well the franchisor runs its business, how sustainable the model is, and whether it depends more on selling new franchises or supporting existing ones.
Cash Flow Statement
This report tracks the actual movement of cash in and out of the business. It’s broken into three key areas:
- Operating Activities: Cash generated (or used) in the core business operations. Positive cash flow here is a good sign.
- Investing Activities: Cash spent on or earned from buying/selling assets like equipment or property.
- Financing Activities: Cash from issuing shares, taking loans, or repaying debt.
Why it matters: A business can appear profitable on its income statement but still struggle to pay bills if cash flow is weak. The cash flow statement tells you if the franchisor can cover its day-to-day obligations and reinvest in the system.
What is the significance of Item 21 in the franchise disclosure document?
Item 21 is where you’ll find the franchisor’s full financial picture. This item provides three years of financial statements, allowing you to assess:
- Financial stability: Can the franchisor meet its obligations and support a growing franchise network?
- Trends: Are earnings consistent or volatile? Is the company carrying increasing levels of debt?
- Cash reserves: A healthy level of cash can indicate the franchisor is capable of supporting franchisees with training, marketing, or system upgrades.
If the franchisor is not financially sound, it can affect everything from support to brand reputation – so don’t skip over this section.
How to understand the franchisor’s financial performance
To truly grasp the franchisor’s financial health, you should:
- Compare year-over-year data to spot trends in income, expenses, and cash flow.
- Analyze debt levels – excessive liabilities may be a red flag
- Look at franchise revenue vs. system revenue to see if the business depends more on growing its network or on helping existing franchisees succeed.
- Consult an accountant with franchise experience. These documents can be complex, and a professional can help you interpret the risks and strengths.
Whilst financial statements are important to get a picture of the business over time, don’t rely solely on the numbers – speak with existing franchisees to confirm whether the financial support promised by the franchisor aligns with reality. Financial statements will tell you about the history of the business but it’s just as important that you’re joining a franchise with a future. Some of this will be evident by speaking to people involved with the franchise & the enthusiasm & attitude of those that work in the business & other franchisees.
If you are interested in becoming a franchisee, Belvoir Franchise Group offers potential franchisees support & transparency. We have helped hundreds of franchisees start & grow successful businesses. We do this by being open from the outset & determining whether it is in both your & our interest to build a business together. If you are interested in having a conversation about becoming a franchisee, please get in touch.
