Financial Reports: What They Mean & How to Read Them
"My place is full, but I have no idea if I'm making money." When I hear operators say this, I know they are not managing their businesses efficiently. On the other hand, I have some clients who are so dedicated to the financial end of the business they know how many covers are necessary to break-even. Some operators even know how many guests will order appetizers, desserts and bottles of wine.
It is not hard to track and calculate the above information. However, if operators receive this information in a timely fashion, they will be able to quickly identify problem areas and respond accordingly. Operators can recognize problem areas simply by reading the financial statements. Once they can read that information, they can begin identifying the "red flags."
The Income Statement and Balance Sheet are the two types of financial statement reports that allow operators to pinpoint weaknesses and problem areas. The Income Statement and Balance Sheet should be prepared and reviewed monthly.
The Income Statement
The Income Statement shows how the restaurant performs over a period of time (i.e. a week, month or year). It takes all restaurant expenses into account, from prepaid expenses to expenses paid in the future. Overall, theIncome Statement tells the operator if the business is making a profit. From there, the operator can begin making changes in policy and implementing strategies that will help the restaurant achieve its goals. Should new sales programs be implemented? Is food cost in line with menu prices? Is the restaurant hitting its budgets? Can the owner(s) make distributions to the partners? These are some of the key questions that need to be addressed. The basic formula for an Income Statement is:Sales - Cost of Goods Sold - Expenses = Profit/Loss
The Income Statement is everyoneís favorite financial statement to review because it reveals the nature of the restaurantís success. Restaurant financial statements should be broken down into the following categories:
- Employee Benefits
- General and Administrative
- Other Income
If sales and expenses are broken down into specific categories, the operator can easily compare and analyze his or her restaurant to industry standard percentages. A sample Income Statement for our case study restaurant, Gary's Tavern, follows on the next page. Gary's Tavern is on pace to gross over $3.0 million dollars annually. All costs are shown as a percentage of sales as well, so the operator can easily target problem areas. These areas can be investigated and changes can be made to maximize profits. When reading the Income Statement, operators need to focus on the following percentages:
|Cost of goods sold||25% to 39%|
|Payroll||25% to 37%|
|Benefits||4% to 6%|
|Operating/Controllable expenses||7% to 13%|
|Occupancy expenses||5% to 14%|
|General and administrative expenses||1% to 5%|
|EBITDA||19% to (1.5)%|
(EARNINGS BEFORE INTEREST, TAXES, DEPRECIATION & AMORTIZATION.)
The above industry wages have a wide variance. The challenge to every operator is knowing the ideal percentages for restaurants of similar type and concept and achieving high net profit percentages. Gary's Tavern is in industry range for every category and shows an above average EBITDA (Earnings Before Interest, Taxes Depreciation & Amortization) just under 13%.
Is it possible to add another few percentage points to the bottom line? A one percentage point drop in cost of goods sold or payroll would result in an additional $36,000 a year! To maximize cash flow and profitability, the operator needs to identify areas where Gary's Tavern can improve. Once the problem areas are identified, the operator can implement strategies to increase Gary's Tavern earning potential.
|M-T-D % Y-T-D % M-T-D % Y-T-D %|
|GENERAL & ADMINISTRATIVE|
|DUES & SUBSCRIPTIONS||100||0.03%||1,100||0.04%||90||0.03%||990||0.04%|
|LICENSES & PERMITS||100||0.03%||1,500||0.05%||90||0.03%||1,350||0.05%|
|TOTAL GENERAL & ADMINISTRATIVE||7,375||2.45%||83,525||2.80%||6,638||2.43%||75,173||2.69%|
|TOTAL DEPRECIATION & INTEREST||9,250||3.07%||105,075||3.52%||9,275||3.39%||105,683||3.78%|
|NET PROFIT/(LOSS) BEFORE TAXES||11,318||3.76%||270,835||9.08%||24,627||9.00%||288,946||10.35%|
The health of a restaurant can be analyzed from the Balance Sheet at any point in time (i.e. today, last month or tomorrow). The Balance Sheet allows operators to forecast short and long-term cash flow. As important as it is to review the Balance Sheet, few restaurants ever bother to prepare it. By checking the accuracy of the Balance Sheet, an operator can ensure the accuracy of the Income Statement. The Balance Sheet lists all the assets, liabilities and equity of the restaurant. The formula for the Balance Sheet is:Assets = Liabilities + Equity
In the simplest terms, assets are what the business owns such as equipment, inventory or cash. Liabilities are what the business owes such as vendor bills, loans, notes and leases. Even a gift certificate is a liability because the restaurant owes someone a meal at a future date. Equity is the ownership of the business. The most common form of equity is stock. Whoever owns the stock owns the equity. (For example, the 5 million shareholders of Microsoft own the company. Bill Gates just owns the largest number of shares).
It is important that assets and liabilities are properly classified on the Balance Sheet. To get a clearer picture of the business, an operator should break down the Balance Sheet into sub categories. The breakdown is explained as follows:
- Current Assets: assets with life less than a year (i.e. cash, credit card receivables, inventory and prepaid expenses).
- Fixed Assets: assets with a life greater than a year that directly attribute to producing revenue (i.e. equipment, computers, furniture and leasehold improvements).
- Other Assets: assets with a life longer than a year that are not directly involved in the production of revenue (i.e. security deposits, trademarks and artwork).
- Current Liabilities: debts due within one year (i.e. accounts payable, accrued expenses, short-term loans and even gift certificates).
- Long Term Liabilities: debts due that extend beyond one year (i.e. notes payable or long-term leases).
There is so much information to be gained from the Balance Sheet. For example, a restaurant that has large debts may have major cash flow problems. Identifying the current debts from the long-term debts on theBalance Sheet help determine the short and long term cash needs, as well as the businessí potential success. Restaurateurs who take on large debts upon opening could be shooting themselves in the foot. The restaurant may show large profits based on the Income Statement, but the restaurant may not have money because it is paying out the outstanding debt (which is revealed in the Balance Sheet).
Most restaurants are set up as Partnerships or Sub Chapter S corporations. These entities pass the profits on to the individual ownersí personal income tax returns. Note, if a large tax liability develops, there would be no funds available to make a distribution to cover these taxes.
The Balance Sheet of Gary's Tavern is shown on the next page. Gary's Tavern was financed with a lot of debt (see liabilities section of the Balance Sheet). There is a total notes payable of $775,000 (sum of the notes payable current portion and notes payable long-term portion) and $175,000 of this balance is due every year. Accumulative interest is shown at the bottom of the Income Statement (interest payments are in excess of $4,000 a month). The first $232,000 of Gary's Tavern net cash flow will be used to amortize and service its debt. The following illustrates the funds paid back to Gary's Tavern investors:
Interest: $ 57,000
To gain an even better understanding of the financial condition of Gary's Tavern, a ratio analysis should be calculated. The following key ratios should be used when reading the Balance Sheet:
- Current Ratio = Current Assets (CA)/Current Liabilities (CL)
Current ratio should be 1:1 or greater. Gary's Tavern's ratio is .9:1. This ratio measures the current health of the business and indicates short-term cash flow. To get a better sense of its liquidity and cash flow constraints, the quick ratio is a better indicator.
- Quick Ratio = Current Assets-Inventory/Current Liabilities
Gary's Tavern's ratio is .2:1. This ratio indicates the liquidity of the business and should be .7:1 or better. Gary's Tavern may have too much money tied up in inventory. This could affect cash flow as well as purchasing power with vendors.
- Working Capital Ratio = Total Assets/Total Liabilities
Working capital ratio should be 1:1 or greater. Gary's Tavern's ratio is 1.55:1. Long-term cash flow does not appear to be a problem.
- Debt to Equity Ratio = Total Debt/Total Equity
Gary's Tavern ratio is 1.8:1. This ratio determines if a business is undercapitalized. Gary's Tavern may be slightly over-leveraged.
- AP (Accounts Payable) to Sales Ratio = Accounts Payable/Sales
AP to Sales should be 50% of sales. This ratio measures how current a restaurant is with vendors and indicates future cash flow. Gary's Tavern's ratio is 68%. This is a high ratio and may indicate short-term cash flow concerns.
Based on the Balance Sheet and Income Statement analysis, Gary's Tavern is a successful restaurant. It has strong profits and controls a majority of its costs. However, it does have some cash flow constraints due to the large inventory on hand and the amortization of debt. To free up funds immediately, Gary's Tavern should shrink inventory and maximize its bottom line profits. If sales drop off, it may have trouble meeting its debt service. Without an accurate Balance Sheet, this kind of crucial financial information would tend to be overlooked.