Ten Restaurant Financial Red
Flags
By
John Nessel
Restaurant Resource
Group
After 25 years
in the restaurant industry, fifteen as an independent owner/operator
and the last ten as a consultant, I have both observed and
experienced
just about every type of financial problem imaginable. As all
restaurant veterans already know, this is a business that is very
unforgiving when it comes to achieving bottom line profits. Based on
the 2010 Restaurant Industry Operations Report published by The
National Restaurant Association (and Deloitte & Touche LLP), average pre-tax profit margins range from
2-6% (2% for
Full Service and 6% for Limited Service restaurants). Not only is
there little room for financial management missteps, the problem is
compounded by the lack of business experience and basic financial
skills that most startup restaurateurs bring to the table. Unlike
many other small business’ that employ full or part time financial
personnel, most restaurant owners cannot afford that luxury, and
spend their days jumping from one operational task (or crisis) to
another with the financial management of the restaurant not
receiving the attention that it requires.
In my role as
a consultant I have developed an informal “punch list” of basic
financial information that I request from new clients as well as a
review of their basic financial procedures prior to getting started.
This information usually provides me with what I need to assess the
current financial health, and often the future prospects of the
business. It does so in part by raising a number of “Red Flags” or
indicators that point to where the current problems are and where
future problems are likely to emerge. It also allows me to implement
a plan so that I can quickly offer the kind of support that will
give them the best chance to survive and hopefully thrive well into
the future.
One thing
needs to be made clear at the outset. No amount of consulting
support or improved financial skills and procedures can solve a
restaurant’s financial problems if they result from inadequate
sales. Many of your restaurant’s fixed expenses cannot be brought
into line (as a reasonable percentage of sales, that is) if your
gross revenues are too low. Moreover, all of your efforts to
maintain an accurate accounting system with well prepared financial
reports which permit proactive day-to-day management, will be for
naught if your revenues are not sufficient for the business to be
profitable. Therefore, we will focus on those red flags that
hopefully can be corrected by the improved procedures or management
of your existing revenues, or at worst, by helping to quantify the
additional revenues that will be required.
1. Absence of a well organized and
implemented accounting system.
The first and most important piece of information that I request
when evaluating the financial health of a restaurant is a copy of
it’s accounting software file (most typically a QuickBooks backup
file). Printed copies of basic financial statements (Profit & Loss
and Balance Sheet) are not adequate for this task because they do
not verify the accuracy of the numbers presented. Only by reviewing
how all the financial transactions are actually “posted” to the
General Ledger can I determine the degree of accuracy of the numbers
produced. Since you cannot manage what you cannot count, a
restaurant who’s accounting system (or lack thereof) is not properly
setup and/or implemented most often results in the restaurant owner
“flying blind”. While I have dealt with a few restaurants that are
profitable in spite of having a poorly implemented accounting
system, my experience is that the degree that the business is being
proactively managed is directly correlated to how well the owner is
managing his “books”. The most common problem I see is a Chart of
Accounts that does not reflect industry standards, and whose
operating results cannot be compared to others. You can download a
free QuickBooks 2010 Chart of Accounts import file at
www.rrgconsulting.com/restaurant_coa.htm)
Since all the other “Red Flags” discussed in this article cannot be
accurately identified or evaluated if the accounting system is not
setup and implemented properly this task should be the restaurant owner’s
primary concern if he or she desires to create a viable business (click
here for an overview of the Restaurant Operators Complete
Guide to QuickBooks).
Make sure to have the support of an accountant or restaurant
financial consultant before you open to insure that you give
yourself a chance to succeed. If you are already open and suspect
that your accounting system is in need of first aid, then do
yourself a favor and get some help as soon as possible. As I said
earlier, I have rarely seen a financially successful restaurant that
did not have its accounting and financial controls in order.
2. Key operating expenses too high relative
to gross sales
Restaurant food
& beverage purchases plus labor expenses (wages plus employer paid
taxes and benefits) account for 62 to 68 cents of every dollar in
restaurant sales. The combined total of these two cost categories,
referred to as your restaurant’s “Prime Cost”, are where the battle
for restaurant profitability is truly waged. This is not simply
because they represent the largest percentage of your total
expenses, but also because you have the ability to control them.
Unlike utility and insurance expenses that are relatively fixed, you
can directly impact your food cost percentage by more effective
purchasing, product handling and menu pricing. Similarly, hiring
practices, scheduling, and even the layout of your kitchen and the
way your menu items are selected can favorably impact labor costs.
The bottom line is this, when I see a restaurants Prime Cost
percentage exceed 70%, a red flag is raised. Unless the restaurant
can compensate for these higher costs by having, for example, a very
favorable rent expense (e.g. less than 4% of sales) it is very
difficult, and perhaps impossible, to be profitable. While we are on
the subject of rent expense it is useful to point out that on a
national basis a restaurant’s occupancy expense (this includes not
only rent but also real estate taxes, property insurance and common
area charges) is the single highest expense after its “Prime Costs”,
and averages around 6-7% of sales. As a fixed expense the only way
that you can reduce this ratio is to increase sales. When I see
this number exceeding 8% of sales another red flag is raised. In
this case I divide the restaurant’s annual occupancy cost by 6 or 7% to
determine the sales level that will be required to keep occupancy
expenses in line with industry norms.
3. Menu items not accurately documented,
costed and updated
The most
common method of menu item pricing that I have observed over the
years is what I will call the comparative approach. Simply check a
few other restaurants that you compete with, find a similar item on
their menu, and then price your item accordingly. Now its one thing
to document and cost out all your menu items and then to determine
what your selling price will be by taking into account that of your
competitors, but its quite another to price solely off of them. The
truth is that it takes a lot of discipline and time to carefully and
accurately document and cost (and re-cost periodically as your
vendor prices change) your menu items. Moreover, you need to be well
organized, and have some reasonable math aptitude to deal with
detail required to convert product prices from the way you purchase
them to recipe units for costing purposes. But how can you possibly
manage your restaurants food costs if you do not even know what each
and every item is costing you? All you are left with is the “Let’s
raise the price” mentality. And while that may work in the short
run, there are unquestionably better ways to proactively manage your
food costs than that!
There are a
variety of menu costing software products on the market, but they
are of no value if you are not committed to first learning how to
use them and then to continue to maintain them day in and out. A
simple Excel spreadsheet is often the best solution (a customized
Excel menu costing and analysis program with links to your all your
inventory items is
available at
http://www.rrgconsulting.com/page/RRG/PROD/SFTW/EZChef.)
4. Food & beverage inventory levels not
counted and costed at the end of each accounting period or recorded
in your accounting software
Most
independent restaurant operators confuse their monthly food and
beverage purchases with their monthly usage. By this I mean that
they review their monthly P&L (Profit and Loss) and assume that the
food purchased during the month divided by the food sales for the
same period equals the cost of goods sold for food! Not so. Without
knowledge of the beginning and ending inventories you can never
calculate an accurate food cost. For a restaurant with food sales of
$50,000/month, an inventory difference of $1000 between the
beginning and end of the month, can translate into a variance of 2%.
This disparity represents half the total annual profit of a typical
full service restaurant! You simply cannot manage your food costs if
you do not know what they are, and you cannot know what they are if
you do not count and record you inventory variances. Once again, use
a simple Excel spreadsheet to document, price, and total your food
and beverage inventories, and then make sure to account for the
changes between periods by making an appropriate accounting entry
(read
Count and Account for Your Month Ending Food & Beverage Inventory
To Produce Accurate Profit and Loss Statements and find a simple
Excel tool for recording and counting your inventories at
www.rrgconsulting.com/spreadsheets.htm)
5. Food and beverage inventory levels too
high relative to corresponding sales
This red flag
is not as obvious as some of the others but can be just as serious
an obstacle to your restaurants profitability. A restaurant that
carries too much food inventory will inevitably have higher food
costs than it would otherwise. Too much food sitting in your walk-in
cooler, your freezer and your dry goods shelves will result in
excess waste, over-portioning, reduced product utilization, theft
and will also tie up your most valuable asset….cash! But how do you
determine how much inventory is too much or what the ideal amount of
inventory is? A typical full service restaurant should have on
average no more than 7 days of inventory (that number can be reduced
by a few days for quick service restaurants). Follow this simple
calculation to find out how many days of food inventory you have:
Multiply your
average monthly food sales by your food cost %. Now divide that
number (your average monthly food usage) by 30 (days/month)
$50,000 Food
Sales/Month X 30% = $15,000 (Food Usage)
$15,000 / 30
days = $500/day of food usage
If your counted
food inventory is $5,000 then divide that by your daily food usage
to get the number of days of inventory on hand: $5,000/$500 =10
days
Reduce your
inventory appropriately and watch your food costs drop along with
it.
Follow the same
procedure for your alcoholic beverage inventories and use the
following as guidelines:
Liquor: 15+
days (bars and clubs will carry more inventory than restaurants)
Beer:
7-10 days
Wine: 15+
days (more for restaurants that specialize in wine and/or carry many
varieties)
6. Daily & weekly financial operating data
not collected, reviewed or acted upon.
If you want to
be financially successful as an independent restaurant operator you
need to be more like the chains when it comes to proactive
management of your business. Every chain restaurant generates some
type of daily and weekly report that summarizes, in a simple and
easy to view format, all the key daily and weekly operating data
including sales (by category), labor (by department), food and
beverage purchases as well as beginning and ending inventories, and
other fixed expenses allocated on a daily basis to produce a weekly
estimate of the restaurant’s net profit. You do not have the luxury
of an IT staff like the chains to create these systems, but with
some discipline you can collect this information and use it to
identify problems as they happen. It is very difficult to make the
corrections that are needed in your employee scheduling and product
purchasing when all you have to go on is a monthly P&L that is not
available to you till the middle of the following month. These
corrections need to be made immediately when you have a clear
understanding of what scheduling and purchasing decisions were made
(or not) that produced the results that you attempting to improve
upon. The good news is that all the information that you need is
readily available to you from your daily POS reports and vendor
bills. Once again, use an Excel spreadsheet to organize this
information and present it to key managers in the restaurant so they
can be held accountable (customized spreadsheet options for this
task can be found at
www.rrgconsulting.com/spreadsheets.htm.
7. Inaccurate posting of financial
information to your accounting system
One of the most
common errors that I find when reviewing a restaurant’s accounting
procedures is that many different types of financial entries are
posted to the wrong accounts. This results in financial reports that
are both inaccurate and misleading. Some of the most common errors I
see are a restaurant’s daily cash and credit receipts being recorded
as income, no recognition of discounts or complimentary meals,
inaccurate posting of sales tax collected, gift certificate sold
recorded as revenue and not as a liability, employee wages and
employer paid payroll taxes combined as wages, recording capital
expenses as ordinary expenses, posting insurance down-payments and
installment payments as expenses in the month paid instead of using
“prepaid” accounts to spread them evenly over the year. Granted,
these transactions are most likely not easily comprehended by the
typical independent owner. That is why it’s so important to seek
professional financial help in making sure that your accounting
system is setup properly from the start. If you are “flying blind”
your chances of financial success will be greatly diminished, and if
you cannot make a reasonable profit then all your efforts at
producing a great dining experience for you customers will be
irrelevant.
8. Current liabilities sufficiently greater
than current assets as to impair future ability to pay bills
After recording
all your weekly sales and vendor bills go to your Balance Sheet and
divide your current assets (e.g. cash, credit card receipts in
transit, accounts receivable, food and beverage inventories) by your
current liabilities (e.g. vendor bills, sales tax, lease payments
and short term loans due). Using the following example
Current Assets=
$32,000
Current
Liabilities = $28,000
Current Ratio =
$32,000/$28,000 = 1.14
This means that
there is $1.14 of current assets for every $1.00 of current
liabilities and is a rough measure of your ability to pay your
outstanding bills. In most industries a ratio of 1:1 is considered
to be reasonable. Restaurants typically have lower ratios because
they maintain relatively small inventory levels combined with a
quick cash turnover (meals are paid for the same day as they are
served). Well-established and professionally run restaurants will
typically have ratios over 1:1. Younger and less established
restaurants will almost always be below 1:1. If your ratio is below
.7:1 than you should be concerned. While restaurants can survive for
long periods with lower ratios than this, it does typically indicate
that without an increase in either sales or working capital that you
and your business are looking to rocky times ahead.
9. Owner relying on online bank balance to
determine available cash to pay bills
This is an easy red flag to
spot, and indicates to me either the lack of a properly functioning
accounting system or a basic financial misunderstanding of how to
manage cash flow. Here is the reason why. Your online balance tells
you how much cash you have at that moment of time only. It does not
account for previously written checks that have not yet cleared your
account or for cash or credit card deposits “in transit”. You need
to confidently rely on your Balance Sheet to tell you how much cash
you have in your bank account, and this means that you need to
accurately record all your sales and corresponding deposits as well
as all your bills and corresponding payments on a timely basis.
10. Overall lack of understanding as to how
to read and interpret period ending Financial Statements
Aside from not
having a well organized and implemented accounting system in place
(Red Flag #1), the most serious financial red flag that I observe is
the typical independent restaurant owners lack of understanding how
to read and interpret the three fundamental financial reports
readily available by all accounting software programs: 1) Profit and
Loss Statement, 2) Balance Sheet and 3) Statement of Cash Flows.
I cannot possibly do justice to this topic here, but it is critical
to point out the importance to all new and existing owners of
obtaining the basic financial skills that will be required for you
to succeed. Get some help from your accountant, hire a consultant,
take an accounting course, bring in a friend with the necessary
skills, just make sure to do something. While I must admit that I
have had some clients over the years that succeed in spite of
themselves, this is the exception. To be successful in this business
as an independent operator you need to make sure that your financial
skills are the equal of your culinary and management skills. Without
all three skills working in tandem you are not giving yourself the
opportunity to succeed that you deserve.
 |
John Nessel
is the President of Restaurant Resource Group, a Boston-based
consultancy providing financial tools and support services to
independent restaurants and the hospitality industry. He can
be reached at
john@rrgconsulting.com |
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