Research by Numbers How to understand a franchise's financial statements.

Many individuals, when they first consider making an investment into a franchise, assume that every franchisor must meet stringent financial requirements before they can market their franchise opportunity. To the contrary: With the exception of those states that require the registration of a franchisor's Uniform Franchise Offering Circular (UFOC), no government entity actually reviews the offering circular before a prospective franchisee sees it. Even in those states that do require pre-sale registration, financially weak companies may still be able to offer franchises, although the state could require them to hold the franchise fee in escrow until the franchisee's location is open for business or until after some other post-sale event has occurred. And even if the franchisor is insolvent, it may still offer franchises to the public outside of the registration states.

In other words, you need help. For the unsophisticated investor or the person who does not engage the services of a certified public accountant as part of their franchise opportunity review team, the lack of any fiscal quality control over the offering of franchises could cause significant problems.

When you invest in a franchise, naturally you hope the franchisor will remain in business for as long as you are a franchisee and quite a bit longer. The franchisor promises to provide you with services that help you get the business up and running, as well as those you need throughout the life of your franchise. These promises were part of the written bargain contained in the franchise agreement. Often the franchisor will exceed its written obligations; in fact, many franchisors do. Some of the most satisfied franchisees are those of systems where the franchisor under-promises and over-delivers. These franchisees often cite the additional services as the reason they recommend the franchise to others.

Unless the franchisor is financially sound, continually growing the number of domestic locations in the system each year, improving profits at the franchisor level and increasing unit sales and profitability of the franchisees, it may not be able to meet either its written obligations or provide some of those other services franchisees have come to depend on. Indeed, unless the franchisor is profitable and growing, they might not be there for the long haul, and the entire system--including your investment--will suffer.

Certainly, you should always evaluate the unit earnings, if they're provided in Item 19 of the UFOC. But Item 19 only provides some guidance on the performance of the local operations. Keep in mind that the system is really only healthy when the franchisor is financially strong. Therefore, you must look closely at the franchisor's financial statements and get an understanding of whether the franchisor can provide the services you'll require.

For a more in-depth examination, take a look at Item 21 of the UFOC. It contains financial information on the company, including:

• A balance sheet for the past two years
• A statement of earnings for the past three years
• A statement of cash flows for the past three years
• A statement of stockholders' equity

The financial statements will be audited by a CPA firm and contain extensive notes that provide explanations about the franchisor and its financial condition not found anywhere else in the offering document. When you examine the financial statements and notes in conjunction with the disclosure document and other information you obtained during your due diligence, you'll start to get a clear picture of the strength of the franchisor and your risk in becoming a franchisee in that system.

The first thing you should look for in the financial statements is the opinion letter from the auditors. Does the letter indicate any ongoing concern or other issues? Look at the balance sheet--what is the franchisor's net worth? Can it meet its obligations? Are its liquid assets sufficient to meet not only its current obligations but, more important, those obligations it's making to you?

Look at the franchisor's statement of earnings. Even if the company is profitable and has improved earnings over the three years shown, look closely at where it's getting its income. If the majority of its earnings are coming from franchise sales, verify that the locations generating those franchise fees are actually opening as scheduled. Look at the income from royalty and other continuing fees. Are they increasing each year? If the locations that generated the franchise fees are not opening, and the royalty income is not increasing, you have a clear indication that something may be amiss or that the company's long-term viability is questionable. Is a significant portion of the revenue coming from the sale of franchises overseas or in the United States?

Frequently, franchisors don't break out the details of where their revenue comes from and may simply list the information as "Franchise Fees." Ask the franchisor for a breakdown of that figure. It's important that you see a progression of increasing revenue from royalties and other continuing sources of income.

Some franchisors can readily provide the breakdown to you. If they can't or won't, you or your accountant should estimate that information by multiplying the franchise fee by the number of new locations in the system, adjusted for any changes in the deferred income from the balance sheet. When that product is subtracted from the Franchise Fees line on the income statement, you're generally left with a rough estimate of the continuing royalty income. The notes to the financial statements will generally provide you with additional information about various line items in the financial statements. Knowing what to look for is key to identifying whether the franchisor will be there for the long haul.

Do you need an accountant to work in conjunction with you and your lawyer in examining the franchise opportunity? The short answer is yes. Most important, you need an accountant who understands how to examine a franchise system's financial statement. Some CPAs may not understand the nuances of a franchisor's financial statements, as much of the value in the assets of a franchisor don't appear on their balance sheet. Why? Because the bricks-and-mortar assets are on the franchisee's balance sheets. The franchisor's asset is the future royalty and other income streams that will occur as the franchisees prosper and send their payments to the franchisor.

Even mature franchisors occasionally get into financial difficulties; some have even failed. If you take your time and do a thorough review of a franchisor's financial and other information, you can limit your risk considerably.

Michael H. Seid is managing director of Michael H. Seid & Associates, a West Hartford, Connecticut- and Troy, Michigan-based management consulting firm specializing in the franchise industry. Seid co-wrote Franchising for Dummies (IDG Books) with Dave Thomas, the late founder of Wendy's, and serves on the International Franchise Association's Board of Directors.

Kay Marie Ainsley, managing director of Michael H. Seid & Associates, consults with companies on the appropriateness of franchising; assists franchisors with systems, manuals and training programs; and is a frequent speaker and author of numerous articles on franchising.

The opinions expressed in this column are those of the author, not of Entrepreneur.com. All answers are intended to be general in nature, without regard to specific geographical areas or circumstances, and should only be relied upon after consulting an appropriate expert, such as an attorney or accountant.