Their initial response is exactly the outcome you should expect and illustrates the level of caution that you should exercise in approaching any restaurant venture.
It seems everyone wants to open a restaurant. The majority of people should never do so, and many of those that have opened restaurants should get out as quickly as possible. The restaurant business is not for the faint of heart. Everyone has a misconception about the success of restaurants, the simplicity of managing them, and the skills required to succeed.
Just this morning I was asked to review a projection that a prospective client prepared that borders on lunacy in the optimism of the financial results. They estimate an EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) of 37.15 percent on weekly volume of $4,000, capital expenditures of $200,000, and 1,650 feet of high-end retail space. I forgot to mention that the concept is, of course, pizza!
In talking with the bankers, they—of course— with their limited banking experience with restaurants, could not recognize that the above scenario simply will not work. They don’t understand cash flow deals. The majority of independent operators and first-time restaurateurs are styled around cash flow deals (you don’t own the real estate and the resale value of your assets is significantly less than your cost). Bankers don’t like what they can’t understand because they can’t explain it to the loan committee. In the above example, the EBITDA is what we refer to as cash flow. EBITDA is standard terminology for cash flow before debt service. The bank is generally looking for this amount to represent one-and-a-half times your debt service (principal and interest). Going back to the above example the 37.15 percent is the EBITDA line. Unfortunately, it is based on sales of only $4,000/week. Annually this represents $78,000 (4,000/week times 52 times 37.15 percent). Debt service on the $200,000 would be approximately $53,000. This satisfies the traditional loan coverage ratio of 1.5/1.0 (78,000 divided by 53,000).
Now, with a projection based on the above you have gone a long way in bringing your banker to the point of interest. The banker gets excited about any business that generates 37.15 percent EBITDA (unheard of for any business, not just restaurants). Unfortunately when he/she takes the deal to the loan committee, someone is going to challenge this deal. The reality of it is that there is no way this deal should be approved. Yes, on the surface this deal is viable, but if you know the restaurant business you easily recognize the flaws in the outcome.
You simply cannot operate a restaurant of this size, at the prescribed physical location, with the anticipated volume and expect anywhere in the neighborhood of 37.15 percent EBITDA. It simply will not and cannot happen. You might do it for a day or even a week, but you can’t do it for the term of the loan. This is why it is so critical for you to gather relevant information on the metrics of the business you seek to open. There are volumes of data available, industry and trade publications not to mention the hordes of business owners that would gladly share information, and then of course there are consultants and advisors to the industry that offer this service.
There are a hundred reasons why this deal will not work, but let’s just work through the ones presented. The rent on 1,650 sq. feet of high-end retail space will average anywhere from $2,500 – $4,500/month representing anywhere from 10 to 26 percent of revenue. Generally, rent for this business format averages 4 to 8 percent. The only way to cover the 10 percent would be if you don’t borrow the money for the capital expenditures. But, if that’s the only way for your deal to cash flow, then why are you doing it? What return on investment can you expect if you can’t even service debt? This brings us to the second glaring fact. Why risk $200,000 for a business that only generates $4,000/week?
Generally, for a cash flow business you should expect to generate a 3 to 1 ratio of sales to capital expenditures. This has become a significant problem with many franchisees in the past 10 years where the franchisor has developed a prototype that represents the brand yet the metrics of the business simply do not support the monument to the brand. The same outcome, of course, prevails in the non-franchised arena due to competitive pressures. You must look successful to be successful, the adage says.
Now, as you can deduce, it all evolves around sales volume. This is why it is critical that you objectively gather facts about your business format, complete a thorough competitor analysis, and possess a better-than-average understanding of the business itself. If you don’t understand the business, stay on the porch! Surround yourself with advisors knowledgeable about your business, you won’t have the time to teach them and operate the business at the same time. As stated, “if you don’t understand the business” don’t be the majority owner, you have no idea of the thousands of rational reasons why things are not working that you will hear, and you won’t have the knowledge to segment the bull from the facts. The restaurant business requires more than money. Clearly you must have a passion to succeed, to multi-task and to make decisions on the fly.
A tale-tell sign of the soundness of your concept would be for you to bank the deal. If you can convince a banker to fund the business at 80 percent of your start-up and capital expenditures, then maybe you have a thoroughly thought out business strategy. By all means, proceed and give us a call to help keep you focused on the business metrics.
Want to find out more on the financial side of running your pizzeria? Mike Roberts and Michael R. Sassano of The Horne Group will cover the money issues that matter at their New York Pizza Show seminar, November 2, 2004. Get an expert opinion on such vital concerns as the break-even line for a pizza store; a typical pizzeria’s cash flow; price points for profitability; adjusting for changing labor and food cost; the true cost of pizza delivery; formatting financial statements to make them easier to understand and other related issues that affect your bottom line.