Reading the Tea Leaves—Understanding the True Story Behind Restaurant Financials

Reading the Tea Leaves—Understanding the True Story Behind Restaurant Financials
Purchasing an existing restaurant or planning for a new one is a multi-faceted process that covers many different areas. Concept design, menu development, operational processes, marketing and promotion, hiring and training team members, physical layout, selecting suppliers and vendors, regulatory licensing and compliance—the list goes on—are all aspects of acquiring or starting a restaurant.
But one of the most important, and some might argue the singularly most important, aspects of this process is the financial planning for a newly purchased or recently opened restaurant. On the other hand, for a restaurateur or bar owner thinking about selling, being able to understand and explain financial performance to a prospective buyer is also critical.
Typically, the financial evaluation of a restaurant that is for sale or in the process of development starts with a review of operating financial statements that show how the restaurant operated, or pro forma statements that depict the operators educated guesses about how the restaurant will—or might—operate. In both cases, the financial statements or pro formas are big pieces of the restaurant puzzle and clearly deserve some time and effort spent to evaluate them.
There’s a lot of information hidden in a restaurant’s financial statements, far more than a cursory look at the numbers would reveal. Since reviewing financials is a critical element of the due diligence process of evaluating a restaurant business for purchase or preparing a restaurant for sale, reading between the lines of the financials is a critical skill.
What Was or What Will Be?
The first step is to understand what you’re really looking at. For an operating restaurant, the financial statements display recorded information about how the restaurant has actually operated during a specified period of time in the past. For a new restaurant, pro forma financial statements portray someone’s opinion about how the restaurant might operate in the future. Depending on the situation then, the operating statements display the past and pro forma statements project the future. Tax returns can also be used to evaluate the historical performance of a restaurant, but they often do not paint clear picture of what’s really going on in the business, particularly in terms of cash flows.
So how valuable is this information in evaluating a restaurant operation or planned restaurant concept? The answer is not very valuable at all, unless you know what you’re looking at, know what you’re looking for, and how to read between the lines.
Here are a few tips to help you along the way.
Content—What the Numbers Say
First, it’s important to understand what exactly you’re looking at. For the purposes of this discussion, we’ll focus on only one element of a set of typical financial statements, the Income or Profit and Loss statement (P&L). The other typical elements of a business financial statement are the balance sheet, cash flow statement, and shareholders’ equity statement, which we’ll cover in later blog posts.
If the restaurant is open, the P&L shows the revenue that the restaurant generated from all sources (food and beverages primarily, and then anything else that the restaurant sells), the costs of buying and producing everything that was sold, the labor costs paid to everyone who works in the restaurant, and then all other expenses such as rent, utilities, supplies and so forth.
The P&L for an operating restaurant is an historical document that shows what actually happened during the period in question, typically either monthly, quarterly or annually. The money that came in, minus the bills and people that were paid, and all other expenses results in the proverbial bottom line showing what was made (profits) or what was lost. Regardless of the time period covered however, the P&L for an operating restaurant reflects actual numbers.
There should be no guessing—or fudging—involved.
If the restaurant hasn’t opened yet, but instead is in the planning stages, management will typically produce a pro forma operating statement, which is based on assumptions and projections as opposed to actual financial performance. Although it might sound harsh, pro forma operating statements are essentially fiction. The delta between what’s reflected on a pro forma statement and the ultimate reality (what happens when the restaurant actually opens) can be and often is wildly different. The skill, experience, and importantly the intent of the person preparing the pro forma has a direct impact on the accuracy of the pro forma statements, as does the ultimately intended use.
Context—What the Numbers Mean
The true value of an actual P&L really depends not only on who prepared it, but also on who is looking at it. If you’re a manager, an owner, an investor or a professional advisor reviewing the performance of a restaurant you are affiliated with, the P&L is very valuable. This is of course provided that you know how to read one, which we’ll also cover in a subsequent post. The accuracy of a P&L is also highly dependent on the accuracy of the bookkeeping processes and the accounting systems used to produce them.
But if you are looking at a P&L as part of the due diligence process prior to buying or acquiring a restaurant, the P&L is much less valuable. The reason is simple: the restaurant will operate differently with you and your team in place than it does with the present management team.
You might do better—in which case the bottom line will increase. You might also do worse—in which case the bottom line will decline. Either way, the P&L provides a benchmark as to what can happen and even what might happen, but in no way does it show what WILL happen. In short, the historical P&L of the business you are considering buying is not an accurate predictor of how you will do at that location.
There’s a very logical and understandable reason for this. Operators buying or acquiring a new restaurant are doing so for a reason—they want to own the restaurant. And that means they want to operate it the way they want to operate it. They’re going to change it, and hopefully improve it. So historical financials can demonstrate revenues that the property was capable of generating at some point, which helps to establish potential capacity, but which is certainly not a guarantee of a level of performance. And the numbers put up by a restaurant in decline do not necessarily reflect what a new owner might be able to accomplish in the same space. Many of the problems that hamper an existing restaurant simply go away when a new owner—with more energy and fresh ideas—takes over.
For example, the fact that a restaurant that did $2,000,000 in sales, as reflected on last year’s P&L clearly shows that the restaurant, as configured, is capable of generating a healthy sales volume. But it does not automatically mean that if you buy the restaurant that you’ll generate that same level of sales. Conversely, if the P&L shows sales of $400,000 last year, it doesn’t necessarily mean that’s what your annual revenue will be. Maybe the old owners were tired, or bored, or just ready for another challenge. A new concept, more energy, interior remodeling, better trained staff and a fresh new menu could significantly increase revenue under your watch.
Caveat Emptor
If you are selling a restaurant, your financials are what they are. The key is to tell the story behind those numbers accurately but in such a way that a potential buyer understands what happened within the context of how those numbers might change with a brand new concept in place.
If you’re buying a restaurant, beware: the numbers are only part of the story. It’s important to be able to read between the lines of the financials to understand what’s really going on, and more importantly, to get a glimpse of what just might be possible.
Kerry Lohrman
Senior Vice President of Business Development
c: 484.535.0577
The Sofranko Group offers a comprehensive suite of hospitality services including operational and concept consulting, restaurant and bar brokerage, financing, and the purchase or sale of liquor licenses. If you are thinking of buying or selling a restaurant, we are available to help you to read between the lines and truly understand what the financials mean or what they should really say. To find out more, please give us a call.
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