Debt financing has become widely available to restaurant companies in recent years, and many operators have taken advantage of this source of capital to fund development.  This is a big difference compared with 30 years ago, when banks and other lenders shunned the industry and many companies had to grow within the limits of their cash flow or raise expensive equity. In many ways, the availability of debt is good because it reduces the need for equity and increases returns to investors. However, there is a downside to debt that could be harmful, especially to younger, growing companies. The benefits of debt are obvious. Here’s an example: If a restaurant costs $3 million to build and produces $600,000 in annual cash flow on $3 million in sales, it would generate a 20-percent return on investment. If an investor put up all the cost in equity, the return on equity would also be 20 percent. If the investor put up $2 million and the rest of the investment was borrowed at 8 percent, the return on equity would be 26 percent ($600,000 cash flow less $80,000 of interest, or $520,000 divided by the investment of $2 million). However, many operators fail to account for two things: 1) The debt has to be paid back, even if the loan is interest-only for a period of time; and 2) The risk profile of the company has increased significantly as a result of the debt. The first issue is easy to quantify. If the $1 million loan at 8 percent is amortized over five years, the annual debt service is approximately $250,000. Therefore, the true cash flow at the restaurant level is about $350,000, or 17.5 percent of the $2 million investment. After five years, there is no debt service, so the return on investment would jump to 30 percent in the sixth year and, over a 10-year life, the returns would be greater under the leveraged scenario than if the project was fully funded by equity. Further supporting the case for leverage is a net present value calculation. Under the above scenario, assuming a 10-percent discount rate, the net present value of the $2 million of equity invested ($1 million borrowed) is approximately $740,000, whereas the net present value of the $3 million equity investment is approximately $687,000. One could argue, however, that the risk profile of the $2 million investment is higher because of the leverage associated with the restaurant, so the discount rate should be higher. Even with only a 1-percent increase in the discount rate to reflect the higher risk, the net present value of the leveraged investment would be lower than that for the unleveraged investment. The increase in the risk profile is what most operators fail to fully appreciate, especially because most analysis is done at the restaurant level, not at the corporate level. That risk can manifest itself in several ways, including a decline in future sales and profitability or lower-than-expected sales of new restaurants. If either or both of those scenarios occur, a leveraged company can quickly come under significant financial stress. In the above example, the restaurant cash flow margin before debt service is 20 percent, and 11.7 percent after debt service. Assuming overhead costs of 4 percent, the corporate margins are 16 percent for the unleveraged restaurant and 7.7 percent for the leveraged one, equating to cash flow of $480,000 and $230,000, respectively. If sales decline by 5 percent, and assuming a 50-percent negative flow-through, cash flow after debt service would decline $75,000 under each financing scenario. In dollars, the leveraged restaurant would earn $155,000, or only about 5 percent of sales, while the unleveraged restaurant would still be earning more than $400,000. It doesn’t take too much imagination to think of a scenario where most, if not all, of the leveraged cash flow could disappear, especially in a highly competitive market or during an economic slowdown. For younger brands with less seasoned business models, the leverage risk is magnified because of less predictable sales at new restaurants. This analysis is not intended to suggest that debt should never be used to finance growth. Rather, restaurant operators — especially younger, rapidly growing companies — should fully understand the risk inherent in taking on debt and proceed cautiously. Analyze the impact on cash flows of a worst-case scenario, and then reduce that by another 10 percent. If there is still a good cushion, debt may be an excellent financing alternative. Look forward a few years and see who you will be working for as defined by what portion of your cash flow will be going to pay lenders in the form of interest and principal payments. If that proportion gets to be more than 50 percent, put the brakes on new debt if possible, because you are working for the banks more than half the time. Raising equity is difficult for smaller companies and dilution can be significant, even if equity capital is available. The reduced risk and greater margin of error in a difficult environment could justify the dilution. After all, it can be better to own a smaller percentage of a company that is performing well than a larger percentage of one that is performing poorly. – Source: NRN.

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