Navigating Franchisor Financials: What Every Prospective Franchisee Must Know About Item 21

Every prospective franchisee who expresses interest in a franchise opportunity should be given access to the Franchise Disclosure Document (FDD) within a certain period of time before signing an agreement to join the franchise network.

Whether you’re financially savvy or not, one of the most important items in the FDD is item 21. If this is news to you and you aren’t sure how to navigate what seems like complex and technical financial jargon, this post is for you.

Here, we help you understand the FDD in greater detail, with a specific focus on item 21. Let’s get started.

Understanding the Franchise Disclosure Document (FDD)

The Franchise Disclosure Document (FDD) is a document that a franchisor presents to a prospective franchisee around 14 days before an agreement is signed.

The FDD consists of 23 items or sections, each of which deals with every aspect of the franchise business.

These items are there to offer the franchisee greater knowledge into the franchise business so that they can make a more informed decision when investing in the franchise.

Further to this, it is important to know that there are certain franchise registration states, filing states, and non-registration states and not all of them have the same FDD disclosure requirements.

However, if you are planning on carrying out business in a franchise registration state, the FDD is a compulsory document and item 21 is a necessity. 

The significance of Item 21 in the FDD

When it comes to the significance of item 21 in the FDD, it is one of the most complex and important details that a franchisee should look at and consider before making their investment decision.

This item focuses on the financials of a franchisor’s financial statements. It includes information about the solvency of the franchise, its levels of debt, its assets and liabilities, cash flows, profitability and loss, income and expenditure, and more. Despite their initial complexity, these financial statements provide a true picture of whether the franchise business is financially healthy.

In addition to this, in franchise regulation states, item 21 is compulsory and it must contain audited financial statements of the last three years of the franchise’s operations. If the franchise business is younger than three years, there is what is called a phase-in period which enables the franchise to produce statements at the end of each completed financial year.

However, the crux of the matter is that item 21 on the FDD is your gateway to better understanding whether you are entering into a financially healthy franchise business opportunity or not. That’s why paying careful attention to the details and studying the financial statements under item 21 with your accountant or legal advisor is so important.

Analyzing the franchisor’s financial statements

Analyzing the franchisor’s financial statements alone can seem like a daunting task. However, there are three key considerations worth repeating for more emphasis below. Here’s what you should consider and know about these financial statements.

• The financial statements should be audited financial statements. This means that these statements must not only be prepared in terms of Generally Accepted Accounting Principles (GAAP) for the US, but also that they are audited by an independent certified public accountant using generally accepted United States auditing standards (GAAS).

• The statements should contain three years of financial data (unless the franchisor has less than three years of operating history). Regarding the latter, the phase-in approach mentioned above applies. Regarding the former, the last three years of operations must be recorded in the financial statements, which are compliant with GAAP standards and audited by an accredited independent public accountant.

• Finally, once you have access to this information, you should take the financial statements to your own accountant, who is experienced in franchising for evaluation.

The key components of financial statements

In analyzing financial statements for franchisees, prospective franchise buyers need to be aware of the three primary financial statements that appear in item 21. These are:

• The franchise balance sheet: When looking at the balance sheet, you are essentially looking at the franchise business’ worth at a particular point in time. In short, the balance sheet points to the financial condition or solvency of the franchisor. Some of the categories that the balance sheet includes are assets (both current, fixed, and intangible), liabilities (current and long-term debt), as well as stockholders’ equity that subtracts liabilities from assets to give the net worth of the franchise business.

• The franchise income statement: This financial statement reports a franchise business’ profitability and levels of loss. In essence, it offers insights into the business’ bottom line by looking at the total or net earnings. In this statement, you are likely to see information about the franchisor’s revenue, costs and expenses, income before taxes, provision before taxes, net income, and net income per share.

• The franchise cash flow statement: The final financial statement in item 21 is the statement of cash flows. This particular statement gives an immediate picture of how much cash or liquidity is available for the franchise business to fund its operating expenses and pay its debts. When you have access to this information, you will instantly be able to recognize whether the franchisor is operating on “solid financial footing”. 

What you usually want to see in a franchisor’s financial statement

Now that you know that there are three types of franchise financial statements, it’s time for you to read and be able to analyze them. 

When it comes to the franchise balance sheet, make sure that you are seeing increasing assets, increasing stockholders’ equity, greater cash than debt, debt that’s less than half of the total assets, or less than one-third of stockholders’ equity.

Meanwhile, when it comes to the income statement, you need to be looking out for criteria such as increasing profit, greater revenue from royalty payments and system income as opposed to franchise sales, increasing revenue trends (greater than 15%), increasing net income trends (also greater than 15%), etc.

All these criteria will signal to you that you’re dealing with a profitable franchisor and this is highly important for you because you want your investment to be sound.

Get legal and professional advice to help you interpret the statements

Interpreting financial statements can be complex. It’s advisable to seek guidance from legal and financial professionals who specialize in franchising, especially when it comes to getting a thorough and in-depth understanding of item 21 of the FDD.

You’re not alone and you don’t have to make any decision on your own. Getting professional help will only ensure that you’re making a sound investment in your business’ future.

It’s simply a matter of finding the right partner to help you determine whether your chosen franchise opportunity is worth it before you proceed to pay over your franchise fee. 

Conclusion 

When it comes to looking at item 21 of the FDD, we understand that it can be a complex field to navigate, especially without solid help at your side. We also understand that with so many franchise opportunities available on the market, it can be hard to come to a conclusive decision. 

That’s why we encourage you to explore our US franchise directory to help you get detailed information about franchise options that appeal to you and your professional aspirations. Don’t hesitate to get in touch with us if you need any advice or require any further information.

Our experienced team has over a decade of experience in franchising and we are confident that we can help you find the perfect opportunity that speaks to you the most.

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