Five Benchmarks to Manage in Your Franchise
By: Mike McCraw
Across the wide range of franchise concepts – from restaurants and coffee shops to fitness studios, hotels, convenience stores, and more – common benchmarks are used to track, compare, and improve franchise businesses. Benchmarks, or key performance indicators (KPIs), are particularly useful in the multi-unit / franchise world: rich data is typically available for company performance within a territory, brand, or even an entire industry. Below is a deeper dive into the five key benchmarks that Founders views as critical for franchisors and franchisees to evaluate and work to improve.
Gross Profit Margin (GPM) is arguably one of the most important KPIs in a franchise system. Equal to (Revenue – Cost of Goods Sold) / (Revenue), a company’s GPM should be relatively consistent across locations and should stay stable or improve over time. Cost of Goods Sold (COGS), the direct labor and material costs associated with the production of goods and services, determines how profitable a company is before accounting for the operational expenses necessary to deliver the goods or services.
Typically a major cost for any consumer-services business, direct labor includes the wages of any person associated with production of what is being sold. For example, this would include the chefs at a restaurant, the baristas at a café, and the coaches at a fitness studio. Direct labor would not include the wages for those not involved in production, such as managers, janitorial staff, and or bookkeepers.
Another common component of COGS is direct materials, which includes anything bought for resale or used in combination to produce new goods or services. For example: the cost of coffee beans or other raw ingredients. Direct materials do not include things involved with delivering the goods or services, such as office supplies, cleaning supplies, or utility costs.
While rising labor and materials costs are threats over the long-term, the amount of direct labor and materials necessary to produce a certain good or service should not differ significantly by location or change over the short-term. If they do, this is a red flag showing that production or accounting processes are not consistent across business units and are therefore not easily comparable.
Revenue Per Available Seat Hour (RevPASH), a relatively new KPI, is helpful in understanding the operational efficiency of restaurants and beverage venues. It factors in revenue, capacity, and time, and is easily calculated by using (Total Revenue) / ((Number of Seats) * (Number of Hours Open)). The higher RevPASH the better, and this key benchmark can be evaluated over long periods of time, or at different times of the same day, such as lunch vs dinner time. RevPASH can be increase in three ways:
- Increase Revenue
The most straightforward way to increase RevPASH is by increasing revenue per customer through higher-priced offerings, or by selling more extraneous items such as beverages, appetizers, or desserts.
- Optimize Seating Arrangement
If a 4-person table is frequently occupied by just one or two customers, a restaurant may exchange it with two 2-person tables instead. This simple change doubles the operational capacity for the same amount of space. Since party size often varies between lunch and dinner hours, a variable table configuration can be beneficial.
- Improve Table Turnover
Improving operational efficiency is top of mind for any restaurant. The faster orders are taken and fulfilled, the more customers that can be served. Like #2 above, this should be evaluated at different times of the day. For example, if visits to your restaurant are longer at dinner time, you may want fewer servers and more bartenders on duty.
RevPASH is easily modified for other uses, such as Revenue Per Available Room (RevPAR) for the hotel industry or Revenue Per Available Seat (RevPAS) for the airline industry.
Payback Period is a useful tool that allows for high-level comparison both within a franchise system and across different industries and franchise concepts. Equal to (Initial Investment Amount) / (Average Annual Risk-Adjusted Free Cash Flows), the Payback Period, typically expressed in years, shows how long it will take for a franchisee to recoup his or her initial investment (and start earning a profit). This benchmark takes into account profitability and buildout costs.
This metric is of particular importance to early-stage franchisors, who are looking to sell potential franchisees on their concept. If a franchisee has the choice of recouping his or her initial investment amount in two years or three years, and both investments have equal long-term prospects, the rational investor will choose the option with a shorter Payback Period. The Payback Period is decreased by increasing profitability or decreasing buildout costs.
Additionally, franchises that require a smaller initial investment allow for the opportunity to be marketed to a wider group of potential franchisees. Every new franchise concept must be able to bring initial franchisees on board, and one of the most simple and effective pitches is a short-term, predictable Payback Period.
Debt-Service Coverage Ratio (DSCR) is a key metric used by capital lenders when assessing how much debt a business is capable of taking on without missing principal or interest payments. DSCR measures a company’s ability to meet its debt obligations with ongoing cash flows, and is calculated by using (EBITDA) / (Total Debt Service). A DSCR less than 1.0 indicates that the company cannot sustainably meet its debt obligations.
DSCR is important to understand for franchisees looking to rapidly open new units from the ground-up. While property values differ by location, it is crucial to have a targeted structural buildout cost. The lower the buildout costs, the more locations that can be opened with the same amount of debt.
An appropriate DSCR required by commercial lenders, along with all other KPIs involving debt repayment, is largely determined by macroeconomic conditions. When the overall economy is strong, lenders have reason to believe that individual businesses will continue to do well, compared to when the overall economy is struggling. In stronger economic times, lenders are reasonably inclined to allow a lower DSCR covenant, since confidence is higher that the debt will be repaid.
Leverage Ratio is a fundamental benchmark for any company or institution borrowing money and can be viewed by commercial lenders through both a fixed-point and ongoing lens. Average leverage ratios vary widely by industry, due to the level of capital expenditures and fixed assets required. Similar to DSCR, higher leverage ratios are permitted under strong macroeconomic conditions.
Fixed-Point Lens: Debt-to-Equity (D/E) Ratio
Commercial lenders assess the health of company’s balance sheet at a point in time by using (Short-Term Debt + Long-Term Debt) / (Total Equity). A high D/E ratio implies that the company has taken on a large amount of debt, which could lead to default or bankruptcy even if the company’s core operations are successful.
Ongoing Lens: Debt-to-TTM EBITDA Ratio
Lenders take great interest in how a business performs throughout the year, so the additionally evaluate leverage using (Short-Term Debt + Long-Term Debt) / (Trailing Twelve Months EBITDA). A company may have no problem meeting future debt obligations at its current level of profitability. However, if changes to operations or overall market conditions result in a sustained decrease in profit, that previously un-concerning debt load may become problematic.