STUART WALSH, DIRECTOR OF FRANCHISE FINANCE, EXPLAINS HOW TO CALCULATE THE WORKING CAPITAL YOU WILL NEED IN THE EARLY DAYS OF RUNNING A FRANCHISE
So you’ve decided which franchise is right for you, you’ve done your homework and you know all the costs involved in getting set up, but how much working capital do you need?
Let’s start by understanding what we mean by working capital. Technically, it’s the excess of current assets over current liabilities, but that doesn’t help people who are not accountants.
When you prepare a cash flow forecast for your new business, you set out what cash you expect to get in and when you will get it and what costs you will have to pay and when you will pay them. As this is not an exact science — it’s more of an educated guess — you need to have extra cash available to allow for the fact you may not receive money from your sales when you expect. Your customers may pay you later, but you might still have expenses that must be paid to maintain your business.
This additional cash is the working capital in your business. In our experience, one of the most common reasons for the failure of a franchise business, which after all is a proven business model, is that the new franchisee simply underestimates the amount of working capital they will need. They just run out of cash, even though their business could be achieving its target for sales.
Interestingly, the people who are most at risk are those who have the resources to fund their franchise by themselves without the need for finance. Franchisees who need to raise finance will have their business plan reviewed by a lender, which will want to satisfy itself there is sufficient working capital.
Those who self fund usually assume they will have no problem getting finance if they run into problems. If you think about this for a minute, they will need to approach a bank with a story that says they failed to plan their cash flow properly and their business is in difficulty and in need of emergency funding — not an attractive proposition for any lender and unlikely to succeed in getting finance.
It’s easy to see why people can get this wrong, as you can’t predict exactly what will happen in your business, but there are plenty of things you can do to make the right decisions when it comes to working capital.
One of the many benefits of buying a franchise is that other people have already tried and tested the system and their experience provides you with information that will help you decide on the right amount of working capital.
To decide how much you need, start by testing your financial projections against the experience of existing franchisees. Speak to as many as is practically possible and ask them about the level of sales they are achieving and the costs in their business. Timing is critical, so be sure to ask how long it took them to reach their current level of sales. Then return to your business plan and amend your assumptions to reflect your knowledge.
Next you need to decide how much of a buffer you think you will need — the amount of cash remaining in your cash flow forecast at the end of each month. This will depend on the nature of your business. For example, if it’s cash based, such as a coffee shop, you know your sales will be received in the same month and you will most likely have credit terms with your suppliers, so you can more accurately predict your cash flow. If your business issues invoices, say to large business clients, it can be unpredictable how long they will take to pay you and you may need more working capital as a result.
The big challenge is to predict how quickly your sales will grow in the early days of the business. If your forecast is too ambitious and you don’t achieve your targets, you could run out of cash. If your forecast is too pessimistic, the business plan may not appear strong enough for a lender to approve your financing. Try and be as realistic as possible and talking to existing franchisees will help you benefit from their experience.
Don’t forget to include VAT in your cash flow projections if this applies to your business, as this can have a significant impact. The timing of VAT coming in and out of your business and when you submit VAT returns will change your cash flow considerably. It is a common mistake for new franchisees to forget the VAT implications, especially on the start-up costs.
Finally, look at the monthly cash outgoings of the business. Ask yourself: If my sales were delayed, what impact would that have on my cash flow? You need to build in sufficient extra funding to cover a reasonable shortfall.
Once you start to trade, you will need to monitor your performance against your forecast. If you have underestimated your working capital, you will be able to see why and where the difference has occurred. Should you need to raise finance, such as an overdraft to cover a short-term issue, you will be able to explain to your bank exactly why the situation has occurred.
Hopefully, you can see just how important it is to prepare detailed, monthly profit and loss and cash flow forecasts for your new business and by incorporating a projected balance sheet you can be sure all the numbers add up.
To run a successful business you don’t have to know how to do everything, but you do need to understand what you can do and where you don’t have the necessary skills. If finance is not your strong point, don’t ignore this attention to your working capital, as it could cost you your business.
There are plenty of places where you can seek help. Here at Franchise Finance, we prepare detailed projections and working capital requirements when we prepare business plans and we also run training courses for people who want to understand the finances of their business. You can also talk to your accountant, who can advise you on working capital.