Understanding Item 21 of the Franchise Disclosure Document: Financial Statements
Although motivations for starting a business vary, very few people (or none!) get into it just for fun. The goal is usually to make money, create a job for yourself, build something you can pass on to your children, or as a long-term investment.
For this reason, it’s important to pay close attention to the franchise agreements, particularly the numbers. Numbers rarely lie; the financial records of a franchise can offer valuable insights into whether or not you’ll succeed as a franchisee.
Of course, geographic location and business experience will impact your success. But if a franchise system does not have a proven history of profitability, then you may want to save your initial investment for one that does.
Item 21 of the Franchise Disclosure Document (FDD) provides detailed financial information about the franchise overall and is designed to help you determine whether the franchise offering is lucrative.
What’s Included in Item 21?
You guessed it: FDD Item 21 discloses the franchisor’s financial statements.
You’ll typically find three main types of financial statements for the last two to three fiscal years:
1. Balance Sheet
The balance sheet is a snapshot of what the franchisor owns and owes at a specific time. It shows the company’s financial position, listing assets, liabilities, and shareholders’ equity.
2. Income Statement
The profit and loss statement—also called the income statement—shows the franchise system’s revenues and expenses over the last three years. This information helps prospective franchisees assess the financial viability and stability of the franchise opportunity.
3. Cash Flow Statement
The cash flow statement tracks the flow of money in and out of the business. It’s divided into sections like operating activities, investing activities, and financing activities. This statement demonstrates how the franchisor generates cash to pay debts and fund operation of the franchise business.
Aside from start-up franchisors, all franchisors—those who have been in business for two years or longer—are required to have their financial statements audited by an independent certified public accountant who follows the generally accepted accounting principles (GAAP). This rule is mandated by the Federal Trade Commission (FTC) Franchise Rule and requires a consent letter from the auditor.
Considerations for Start-Up Franchises
The financial disclosure requirements are more lenient for start-up franchisors because it’s a brand new company with less financial history and no parent company from which to draw financial history.
When a start-up franchisor first creates its FDD to sell franchises, it gets a phase-in exception for the first year. Therefore, it can fulfill the financial statement requirements in Item 21 by providing an unaudited opening balance sheet. Additionally, it must include an accountant’s consent document, which is a signed letter from the franchisor’s accountant permitting the inclusion of these financial statements in the FDD.
These auditing standards aim to build transparency and trustworthiness in the financial reports for prospective franchisees.
Why Item 21 Matters
When researching franchise opportunities, it’s important to be thorough, especially regarding money. That is where Item 21 of the FDD comes in. It provides financial transparency, a critical part of evaluating a franchise opportunity.
Studying the financial statements in Item 21 can reveal whether a franchise is stable and profitable. Closely examining numbers can help with the decision-making process. If you feel confident the franchisor is trustworthy and the business is solid, then you might be more inclined to develop the franchise relationship.
The business's financial condition also directly impacts the franchise's value and your potential return on investment (ROI).
Here are some things to look for in the FDD to assess the financial health of the franchise.
- Stability and Growth: A financially healthy franchise is more likely to be stable and capable of supporting its franchisees. This means they have the resources to provide training, marketing, and ongoing support, all essential for your success.
- Franchise Value: The better the franchisor's financial health, the more valuable the franchise is likely to be. Strong financials suggest that the business model works well, can attract more customers, and generate consistent revenue.
- Profitability and ROI: Understanding the franchisor’s profitability helps you gauge your potential ROI. If the franchisor makes good profits, then it’s a positive sign that you could be profitable with your franchise too. Conversely, if the financial statements show losses or inconsistent earnings, it could indicate potential risks and lower returns.
- Risk Assessment: Analyzing the financial statements helps you assess the risk involved. You can see if the franchisor has high debts, cash flow problems, or other financial issues that might affect their ability to support you.
How to Read and Evaluate Franchise Financial Statements
When you know what to look for and how to interpret the numbers, it’ll be easier to read the franchise financial statements.
Here’s a quick guide to help you through it.
Key Financial Metrics to Look For
First, focus on a few key financial metrics. Look at the revenue, net income, and profit margins. Revenue shows how much money the franchise brings in, while net income reveals the actual profit after expenses. Profit margins help you understand how efficiently the franchise converts revenue into profit.
Red Flags and Warning Signs
Keep an eye out for red flags. Significant year-over-year declines in revenue or profits can be a warning sign. High levels of debt relative to income might indicate financial instability. Also, be cautious if you see frequent changes in accounting practices, as this can sometimes mask underlying issues.
Analyzing Profitability, Liquidity, and Solvency
To get a complete picture, analyze the franchise’s profitability, liquidity, and solvency. Profitability shows how well the franchise generates profit relative to its revenue and expenses. Liquidity measures the franchise’s ability to cover its short-term obligations, which is crucial for day-to-day operations. Solvency looks at the franchise's long-term financial health, indicating whether the franchise can meet its long-term debts and obligations.
Comparing Financial Performance Across Different Franchises
Comparing the financial performance of different franchises can also provide valuable insights. Look at franchises in the same industry to see how they stack up against each other. This comparison can help you understand industry standards and identify which franchises are performing well and which might be struggling.
Follow the Numbers
Understanding Item 21 financial statements in the FDD is necessary for anyone looking to invest in a franchise. By thoroughly reviewing these documents, you can learn more about the franchise’s financial condition and make a well-informed decision.
Remember, the numbers don’t lie—they’re your best friend when it comes to assessing your potential success and stability of your investment. If you feel you need help reviewing these documents, a franchise attorney or broker can help. They can walk you through them and carefully explain what they mean, along with the obligations of the franchisor regarding transparency.
Ready to explore franchise opportunities and see what’s out there? Check out the Franchise Directory on BizBuySell. It’s a great resource to help you find the perfect franchise and take the next step toward owning your own business.