Borrowing for Your Franchise

In my previous post, I listed four financial skills that I think every franchisee — frankly, every business owner — should have. In this post, I will talk about the impact of borrowing to finance your franchise. It is imperative that franchisees understand the impact borrowing can have on cash flows.

If you have to borrow a substantial amount to get your business up and running, you will also have to service the debt. One of the most common financial complaints I hear from franchisees who are struggling is that they aren’t making any money even though the profit and loss statement shows healthy income. This is usually because they borrowed so heavily to start the business that most of the cash flow is going to service debt payments. This is not necessarily a bad thing if you understand what you are doing and you have planned accordingly. If the business cash flow can service the debt, you are potentially getting a great return on your investment. Let’s look at a simple example:

Becky Borrower needs $400,000 to open a Bob’s Burger Barn (BBB) franchise. She borrows $300,000 for 5 years at 10% interest. Her monthly debt payment is just over $6,300. If her BBB franchise generates $500,000 in sales and profits of $100,000 (20%), she will only net about $23,000 after debt and before taxes. It doesn’t sound good.

On the other hand, Becky Borrower only invested $100,000 and generated a return on that investment of roughly 23%! And if we assume that the business is worth more or less what Becky paid for it, then she is in pretty good shape as long as she planned for the debt payments and doesn’t need the cash flow for living expenses.

Let’s compare Becky Borrower to Calvin Cashpayer. As his name would suggest, Calvin paid all cash for his franchise. He generates the same results ($500,000 in sales, $100,000 in profits). Since Calvin Cashpayer has no debt service, other than taxes and depreciation, his income is going to be a lot closer to his cash flow. Interestingly, his return on investment is actually slightly lower than Becky’s. He invested $500,000 and generated $100,000 for a 20% return. If Becky had negotiated a lower interest rate (say a 6% SBA loan), she would have seen a pre-tax return of almost 30% on cash invested and still she wouldn’t have a lot of cash in the bank.

I mention this because in my experience, Calvin Cashpayer would be thrilled with the business and Becky Borrower would be ticked. Becky is actually getting a better ROI but franchisees in highly leveraged situations usually didn’t plan to service the debt they needed to invest in the franchise.

There isn’t a right way or a wrong way to do this. Borrowing can be the right decision, but only if you plan to service the debt and understand that it will have a significant impact on your cash flow.

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