Trouble Ahead? 5 Red Flags in Your Restaurant Financial Statements

Posted on Nov 1, 2019

Effective inventory management and menu pricing are common challenges for owners of restaurants of all sizes. To be successful, owners must manage expenses, monitor cost fluctuations, improve ordering processes and respond with timely menu price increases.

Preparing a profit and loss statement, and understanding how to interpret the results of the statement, provides an owner information needed to make effective operating decisions in a timely manner. This article defines what a profit and loss statement is, its key components, and warning signs.

What is a profit and loss statement?

The profit and loss statement (also called a P&L, income statement, statement of income, or statement of operations) is a financial report that represents a company’s ability to generate income through their business operations. The statement is a thorough presentation of all revenues and expenses over a period of time. It is used as a management tool to analyze, forecast and evaluate the success of the business. Profit and loss statements include the following components:

Sales

For restaurants, sales is the revenue earned from sales of food and beverage to customers. Sales analyzed by menu item, month-to-month and year-over-year, is a trend analysis technique that is used to identify patterns and predict future events. This analysis can highlight times when business could slow and when it may be busy – assisting owners and managers in making accurate inventory purchasing and labor scheduling decisions.

Cost of sales

Cost of sales, (often referred to as cost of goods sold or COGS), include the direct costs of making and selling the food and beverage. These costs include food, beverage and labor of those directly involved in making and serving the food and beverage to customers. These are variable costs that fluctuate in proportion to the volume of food and beverage sold.

Gross profit

Gross profit is the profit a restaurant makes after deducting the direct costs associated with making and selling its menu items. It is calculated by subtracting the cost of sales from revenue (sales). The gross profit is what is left to pay the overhead and general and administrative expenses of the business. It reflects how efficient the restaurant is in using its labor and food/beverage costs in producing its menu items. Gross profit should be analyzed month-to-month and year-over-year. Declines in gross profit may be an indicator of serious problems. For example, a change in gross profit can be caused by changes in sales prices, volume of sales, price of food and beverage and labor hours incurred.

Operating expenses

Operating expenses are generally fixed or semi-variable costs. Operating expenses are paid regardless of the amount of restaurant sales made. These costs are restaurant expenses that are not directly associated with the production and sale of the menu items. These typically include rent, insurance, management salaries and utilities. It is important to monitor overhead costs as they directly impact the bottom line. Analyze operating expenses month-to-month and year-over-year. For those expenditures that are increasing, evaluate why they are increasing and investigate possible cost-saving opportunities.

Net profit or loss

Net profit or loss is calculated by taking gross profit and subtracting operating expenses. It is the measure of profitability after accounting for all costs. Net profit or loss is also referred to as the “bottom line,” as it is traditionally presented as the bottom line of the profit and loss statement.

Red flags to look for in your restaurant financial statements

When the warning light on the dashboard of your car goes on, it’s a very clear red flag something is wrong that requires an urgent investigation and response. Unfortunately, financial statements and data that restaurant owners and operators review on a daily, weekly and monthly basis do not provide obvious flashing red lights or warning signals when the business may be headed for trouble. With financial statements, one needs to take a closer look.

The following section describes five key ratios and red flags for restaurant and food service owners and operators to monitor. For comparison purposes, we’ve included the 2018 median value limited-service and full-service restaurant benchmarks, reported by The Retail Owners Institute based on data from Risk Management Association Annual Statement Studies.

Current ratio

Current ratio measures the ability to pay off short-term debt.

  • Limited-Service Restaurant Benchmark – 0.8
  • Full-Service Restaurant Benchmark – 0.8

The current ratio is the ratio of current assets to current liabilities. Current assets are those assets that can be converted to cash within one year (i.e., cash, inventory, prepaid expenses). Current liabilities are obligations that are due within one year, such as accounts payable, accrued liabilities and short-term debt. This ratio measures whether the business has enough resources to pay its debts over the next 12 months. The higher the ratio, the larger the margin of safety to cover short-term obligations.

For example, if your business has current assets of $300,000 and current liabilities of $200,000, the current ratio equals 1.50. For every $1 of liabilities, the restaurant has $1.50 of current assets. There is a cushion of 50 cents for every dollar of current debt. A ratio of 1.0 is reasonable; however, restaurants typically have a lower current ratio because they maintain relatively small inventory levels and have quick cash turnover. A ratio under 0.8 is a red flag and warrants taking action as the business may have difficulties meeting current financial obligations.

Inventory turnover

Inventory turnover measures the number of times inventory is sold or used in a year.

  • Limited-Service Restaurant Benchmark – 56.9
  • Full-Service Restaurant Benchmark – 56.8

The inventory turnover is a common ratio used in the restaurant industry. It is the cost of food or beverage sold divided by the average food or beverage inventory. The turnover should be calculated separately for food and for beverages because food may have a shorter shelf life than beverages.

Although inventory may not be a significant portion of the restaurant business’ total assets, it is highly susceptible to theft and should be managed to minimize the cost of food and beverage. A low turnover may suggest that food is overstocked and could result in excessive spoilage cost. A high inventory turnover is desired as it means the restaurant is able to operate with a small investment in inventory. However, a high inventory turnover should be monitored as it may result in possible out-of-stock problems and the inability to provide desired food items to guests.

Debt-to-worth

Debt-to-worth compares the business’ total debt to its net worth (owner’s equity).

  • Limited-Service Restaurant Benchmark – 61.5
  • Full-Service Restaurant Benchmark – 3.8

The debt-to-worth ratio is calculated by taking total debt and dividing it by total owner’s equity. A high ratio shows that a company has been aggressive in financing its growth with debt.

The benchmarks vary so widely because the limited-service restaurant respondents to the benchmark survey presented more debt in their 2017 financial statements than the full-service restaurant respondents. This appears to be an anomaly compared to prior years, as this benchmark ratio was 30.2 in 2016 and 32.5 in 2015.

The beauty of this ratio is in the eye of the beholder. An owner may wish to maximize their return on investment by maximizing debt. A lender, however, would prefer a lower ratio because their credit risk is reduced if an owner’s equity increases relative to its debt. A red flag would exist if debt continued to increase and earnings were not sufficient to cover the cost of borrowed funds.

Gross margin

Gross margin represents the percentage of total sales the company retains after incurring the direct costs associated with the sales.

  • Limited-Service Restaurant Benchmark – 63.4%
  • Full-Service Restaurant Benchmark – 62.1%

The gross margin percentage is calculated by taking total sales less direct costs of sales and dividing the result by total sales. It represents the percentage of total sales that the business has available to cover other costs and obligations such as general and administrative costs, occupancy costs and interest expense.

A percentage increase in gross margin results in an additional percentage growth to the bottom line. Therefore, consistent monitoring and analysis of this ratio for changes from budget, prior periods, or industry benchmarks can identify areas where a restaurant can improve and maximize its profit. A decline in this ratio could be a red flag in direct costs or sales. Increasing food costs may be the result of excessive spoilage, inaccurate portions or theft. Increasing payroll costs may require closer monitoring and scheduling of labor. As costs continue to rise, do menu prices need to be adjusted?

Operating expenses as a percentage of sales

Operating expenses as a percentage of sales represents management’s ability to control operating expenses.

  • Limited-Service Restaurant Benchmark – 56.9%
  • Full-Service Restaurant Benchmark – 56.8%

The operating expense ratio is calculated by dividing total operating expenses by sales. It measures how efficient a business is. A red flag is an operating expense ratio that increases over time, because it represents a decline in operating efficiency from period-to-period. Significant deviations identified when comparing operating ratios at the account level to budget and/or prior periods should be investigated to determine the cause.

Summary

It is important to note that, on a stand-alone basis, these ratios don’t tell the complete story. The ratios are useful in identifying red flags when they are compared to an industry benchmark, a ratio from a past period or the budget. Timely and consistent evaluation of these ratios allows owners and operators to take corrective action to improve the financial strength of the business.

Are your financial statements telling you a success story, or are they sending up red flags that there may be a problem? How do your operations compare to these industry benchmarks?

© Clark Nuber PS, 2019. All Rights Reserved

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This article or blog contains general information only and should not be construed as accounting, business, financial, investment, legal, tax, or other professional advice or services. Before making any decision or taking any action, you should engage a qualified professional advisor.

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