As a finance guy, I tend to be conservative when investing. It's in my DNA. I spent 22 years in corporate finance ending with a CFO role with Universal Music Group, the largest music recording company in the world. So numbers and risk adverseness are in my DNA.
When people talk of leverage, it can have various meanings to each investor, and to me prior to this bad economy, I avoided debt due to the risks and high rates.
The purpose of this article is to show you the math related to leveraging and why there has never been a better time to leverage your restaurant purchase.
The slow economy has made restaurant values relatively cheap by beating down the cash flow multiples that one pays for a business along with beating down the profits of the restaurant business as well, causing a double-whammy to the restaurant's price.
CASH FLOW MULTIPLES BEAT DOWN
The cash flow multiples are driven by buyer perception of the future. When the future looks grim, people believe cash flow will decrease, as a result they reduce the multiples they're willing to pay for a business. Said another way a buyer may say "yeah that's good and dandy that you made $100,000 last year, but because of the slow economy, I think you're only going to make $70,000 next year." This has a result of lower the multiple paid for the business. The buyer may be willing to pay 2.5 times, but it is 2.5 times for what he or she expects, which is $70,000 a year which is $175,000. But the seller is thinking 2.5 times $100,000 or $250,000. In essence the real multiple is $175,000/$100,000 in this case or 1.75 times. We saw this behavior during 2008 through 2013 economy.
And when the economy is weak, sales tend to decrease and costs tend to increase unless the margins are well managed. Again, as illustrated above, the buyer knows this and is thinking $75,000 while the owner is thinking $100,000 of cash flow. But if the seller wants to sell, then he too to come to reality of the situation and price his business accordingly.
THE MATH IN MORE DETAIL
Let me illustrate this with some more numbers. Let's assume a restaurant before the slow economy was earning $150,000 a year owner cash flow. And because people's expectations when the economy was strong were good, they would pay 2.7 time or more for a restaurant business with good books and record. At SellingRestaurants we sold hundreds of them at those multiples from 2004 to 2008. This restaurant was then worth about $405,000.
Let's fast forward. Today the market has beat down the cash flow multiples because the buyer's expectations of the future is weak, and the way they reduce risk is by reducing the cash flow multiple they're willing to pay. So today the multiple could be closer to 2.2 times and at one point the multiples were below 2 times (keep in mind each region in the U.S. and international countries commands different multiples). To make matters worse, since sales are down and costs are up, the owner's cash flow for that same restaurant is now $100,000. So the value of the restaurant today is $220,000, a cool $185,000 less than a few years ago.
EFFECTS OF LEVERAGE
So keep up with me here. You buy this restaurant for $220,000 with an SBA loan and a total of 20% down plus closing costs. That would be about $58,000 down in total out of your pocket. After debt payments of principal and interest you'd net about $77,000 a year from this business.
Here is where it gets fun and interesting. Let's say the economy turns-up, as many are finally saying it is. This allows you to raise prices on the menu. It will drive more traffic to your business if you're doing a good job of providing great food, good prices and great service. So now the restaurant is earning $150,000 again. And more important, the buyers are more optimistic and the cash flow multiples have been driven-up to the 2.7 times again. The value of the restaurant is now $405,000.
So with $58,000 out of your pocket, you've not only increase your equity by $185,000 or 3.2 times what you put down, you've also increased you income by $50,000 and the restaurant after debt service is now returning you $127,000 on a $58,000 investment. More than a 200% return on investment. Of course, some would pay themselves a fair wage and reduce that number by that amount, but it would still be more than a 100% return!
THAT'S LEVERAGE! IT'S A BEAUTIFUL THING IN AN UP ECONOMY!
We at SellingRestaurants feel obligated to educate the public, our customers and our clients with information that can help them make more intelligent buying and selling decisions.