Trouble Ahead? Look for These Five Red Flags in Your Restaurant Financial Statements

Trouble Ahead? Look for These Five Red Flags in Your Restaurant Financial Statements https://wahospitality.org/wp-content/uploads/2016/06/financial-statements-red.jpg

By Julie Eisenhauer, CPA

When the red warning light on the dashboard of your car goes on, it’s a very clear red flag that something is wrong and requires an urgent investigation and response. Unfortunately, financial statements and data that restaurant owners and operators review on a daily, weekly and monthly basis do not provide obvious flashing red lights or warning signals when the business may be headed for trouble. With financial statements, you need to keep a closer eye on how everything is working.

Financial statements tell a story and, when evaluated, can provide owners, operators and lenders with valuable information to assess the success and well-being of the business. Performing an analysis on ratios and comparing the results to an industry average, a budgeted goal or a ratio from a past period may reveal warning signs that the business could be headed for trouble.

Here are five key ratios restaurant and foodservice owners and operators should consider closely monitoring for red flags. For comparison purposes, the 2015 median value limited-service and full-service restaurant benchmark, reported by The Retail Owners Institute based on data from Risk Management Association Annual Statement Studies, is included.

CURRENT RATIO

Measures the ability to pay off short-term debt

Limited-Service Restaurant Benchmark

0.8

Full-Service Restaurant Benchmark

0.8

The current ratio is the ratio of current assets to current liabilities. Current assets are those assets that can be converted to cash within one year (i.e., cash, inventory and prepaid expenses). Current liabilities are obligations that are due within one year, such as accounts payable, accrued liabilities and short-term debt. This ratio measures whether the business has enough resources to pay its debts over the next 12 months. The higher the ratio, the larger the margin of safety to cover short-term obligations.

For example, if your business has current assets of $300,000 and current liabilities of $200,000, the current ratio equals 1.50. For every $1 of liabilities, the restaurant has $1.50 of current assets. There is a cushion of 50 cents for every dollar of current debt. A ratio of 1.0 is reasonable; however, restaurants typically have a lower current ratio because they maintain relatively small inventory levels and have quick cash turnover. A ratio under 0.8 is a red flag and warrants taking action as the business may have difficulties meeting current obligations.

INVENTORY TURNOVER

Measures the number of times inventory is sold or used in a year

Limited-Service Restaurant Benchmark

46.3

Full-Service Restaurant Benchmark

38.9

The inventory turnover is a common ratio used in the restaurant industry and is the cost of food or beverage sold divided by average food or beverage inventory. The turnover should be calculated separately for food and for beverages because food may have a shorter shelf life than beverages.

Although inventory may not be a significant portion of the restaurant business’s total assets, it is highly susceptible to theft and should be managed in order to minimize the cost of food and beverage. A low turnover may suggest that food is overstocked and could result in excessive spoilage cost. A high inventory turnover is desired as it means the restaurant is able to operate with a small investment in inventory. However, a high inventory turnover should be monitored as it may result in possible out-of- stock problems and the inability to provide desired food items to guests.

DEBT-TO-WORTH

Compares the business’s total debt to its net worth (owner’s equity)

Limited-Service Restaurant Benchmark

32.5

Full-Service Restaurant Benchmark

3.8

The debt-to-worth ratio is calculated by taking total debt and dividing it by total owner’s equity. A high ratio shows that a company has been aggressive in financing its growth with debt.

The beauty of this ratio is in the eye of the beholder. An owner may wish to maximize their return on investment by maximizing debt. A lender, however, would prefer a lower ratio because their credit risk is reduced if an owner’s equity increases relative to its debt. A red flag would exist if debt continued to increase and earnings were not sufficient to cover the cost of borrowed funds.

GROSS MARGIN

Represents the percentage of total sales the company retains after incurring the direct costs associated with the sales

Limited-Service Restaurant Benchmark

61.9%

Full-Service Restaurant Benchmark

59.9%

The gross margin percentage is calculated by taking total sales less direct costs of sales and dividing the result by total sales. It represents the percentage of total sales that the business has available to cover other costs and obligations such as general and administrative costs, occupancy costs and interest expense.

A percentage increase in gross margin results in an additional percentage growth to the bottom line.  Therefore, consistent monitoring and analysis of this ratio for changes from budget, prior periods or industry benchmarks can identify areas where a restaurant can improve and maximize its profit. A decline in this ratio may identify a red flag in direct costs or sales. Increasing food costs may be the result of excessive spoilage, inaccurate portions or theft. Increasing payroll costs may require closer monitoring and scheduling of labor. As costs continue to rise, do menu prices need to be adjusted?

OPERATING EXPENSES AS A PERCENTAGE OF SALES

Represents management’s ability to control operating expenses

Limited-Service Restaurant Benchmark

56.5%

Full-Service Restaurant Benchmark

55%

The operating expense ratio is calculated by dividing total operating expenses by sales. It measures how efficient a business is. A red flag is an operating expense ratio that increases over time because it represents a decline in operating efficiency from period to period. Significant deviations identified when comparing operating ratios at the account level to budget and/or prior periods should be investigated to determine the cause.

In Summary

Using these benchmarks, are your financial statements telling you a success story or are they sending up red flags that there may be a problem? It is important to note that, on a stand-alone basis, your ratios do not tell the complete story. They are useful, however, in identifying trouble spots when compared to an industry benchmark, a ratio from a past period or budget. Timely and consistent evaluation of these ratios will allow you to take corrective action to improve the financial strength of the business.

Julie Eisenhauer, CPA, is an audit shareholder at Clark Nuber PS, specializing in the hospitality industry. Reach her at jeisenhauer@clarknuber.com and follow her on Twitter @EisenhauerJulie.

(Source: Washington Restaurant & Lodging Magazine, June 2016)

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