Ten Restaurant Financial Red Flags

By John Nessel, Restaurant Resource Group
Reprinted from Restaurant Startup & Growth Magazine

After 35 years in the restaurant industry, twenty as an independent owner/operator and the last fifteen as a consultant, I have both observed and experienced just about every type of financial problem imaginable. As all restaurant veterans already know, this is a business that is very unforgiving when it comes to achieving bottom line profits. Based on the Restaurant Industry Operations Report published by The National Restaurant Association (and Deloitte & Touche LLP), average pre-tax profit margins range from 2-6% (2% for Full Service and 6% for Limited Service restaurants). Not only is there little room for financial management missteps, the problem is compounded by the lack of business experience and basic financial skills that most startup restaurateurs bring to the table. Unlike many other small business' that employ full or part time financial personnel, most restaurant owners cannot afford that luxury, and spend their days jumping from one operational task (or crisis) to another with the financial management of the restaurant not receiving the attention that it requires.
In my role as a consultant I have developed an informal "punch list" of basic financial information that I request from new clients as well as a review of their basic financial procedures prior to getting started. This information usually provides me with what I need to assess the current financial health, and often the future prospects of the business. It does so in part by raising a number of "Red Flags" or indicators that point to where the current problems are and where future problems are likely to emerge. It also allows me to implement a plan so that I can quickly offer the kind of support that will give them the best chance to survive and hopefully thrive well into the future. 

One thing needs to be made clear at the outset. No amount of consulting support or improved financial skills and procedures can solve a restaurant's financial problems if they result from inadequate sales. Many of your restaurant's fixed expenses cannot be brought into line (as a reasonable percentage of sales, that is) if your gross revenues are too low. Moreover, all of your efforts to maintain an accurate accounting system with well prepared financial reports which permit proactive day-to-day management, will be for naught if your revenues are not sufficient for the business to be profitable. Therefore, we will focus on those red flags that hopefully can be corrected by the improved procedures or management of your existing revenues, or at worst, by helping to quantify the additional revenues that will be required.

1. Absence of a well organized and implemented accounting system.

The first and most important piece of information that I request when evaluating the financial health of a restaurant is a copy of it's accounting software file (most typically a QuickBooks backup file). Printed copies of basic financial statements (Profit & Loss and Balance Sheet) are not adequate for this task because they do not verify the accuracy of the numbers presented. Only by reviewing how all the financial transactions are actually "posted" to the General Ledger can I determine the degree of accuracy of the numbers produced. Since you cannot manage what you cannot count, a restaurant who's accounting system (or lack thereof) is not properly setup and/or implemented most often results in the restaurant owner "flying blind". While I have dealt with a few restaurants that are profitable in spite of having a poorly implemented accounting system, my experience is that the degree that the business is being proactively managed is directly correlated to how well the owner is managing his "books". The most common problem I see is a Chart of Accounts that does not reflect industry standards, and whose operating results cannot be compared to others. You can download a free QuickBooks Chart of Accounts import file by clicking here.

Since all the other "Red Flags" discussed in this article cannot be accurately identified or evaluated if the accounting system is not setup and implemented properly this task should be the restaurant owner's primary concern if he or she desires to create a viable business (click here for an overview of the Restaurant Operators Complete Guide to QuickBooks). Make sure to have the support of an accountant or restaurant financial consultant before you open to insure that you give yourself a chance to succeed. If you are already open and suspect that your accounting system is in need of first aid, then do yourself a favor and get some help as soon as possible. As I said earlier, I have rarely seen a financially successful restaurant that did not have its accounting and financial controls in order.  

2. Key operating expenses too high relative to gross sales 

Restaurant food & beverage purchases plus labor expenses (wages plus employer paid taxes and benefits) account for 62 to 68 cents of every dollar in restaurant sales. The combined total of these two cost categories, referred to as your restaurant's "Prime Cost", are where the battle for restaurant profitability is truly waged. This is not simply because they represent the largest percentage of your total expenses, but also because you have the ability to control them. Unlike utility and insurance expenses that are relatively fixed, you can directly impact your food cost percentage by more effective purchasing, product handling and menu pricing. Similarly, hiring practices, scheduling, and even the layout of your kitchen and the way your menu items are selected can favorably impact labor costs. The bottom line is this, when I see a restaurants Prime Cost percentage exceed 68-70%, a red flag is raised. Unless the restaurant can compensate for these higher costs by having, for example, a very favorable rent expense (e.g. less than 4% of sales) it is very difficult, and perhaps impossible, to be profitable. While we are on the subject of rent expense it is useful to point out that on a national basis a restaurant's occupancy expense (this includes not only rent but also real estate taxes, property insurance and common area charges) is the single highest expense after its "Prime Costs", and averages around 6-7% of sales. As a fixed expense the only way that you can reduce this ratio is to increase sales. When I see this number exceeding 8% of sales another red flag is raised. In this case I divide the restaurant's annual occupancy cost by 6 or 7% to determine the sales level that will be required to keep occupancy expenses in line with industry norms.  

3. Menu items not accurately documented, costed and updated 

The most common method of menu item pricing that I have observed over the years is what I will call the comparative approach. Simply check a few other restaurants that you compete with, find a similar item on their menu, and then price your item accordingly. Now its one thing to document and cost out all your menu items and then to determine what your selling price will be by taking into account that of your competitors, but its quite another to price solely off of them. The truth is that it takes a lot of discipline and time to carefully and accurately document and cost (and re-cost periodically as your vendor prices change) your menu items. Moreover, you need to be well organized, and have some reasonable math aptitude to deal with detail required to convert product prices from the way you purchase them to recipe units for costing purposes. But how can you possibly manage your restaurants food costs if you do not even know what each and every item is costing you? All you are left with is the "Let's raise the price" mentality. And while that may work in the short run, there are unquestionably better ways to proactively manage your food costs than that!  

There are a variety of menu costing software products on the market, but they are of no value if you are not committed to first learning how to use them and then to continue to maintain them day in and out. An Excel based program is often the best solution (EZchef Software is a customized Excel Windows based menu costing and analysis program with links to all your inventory items, and is available at www.ezchef.com.)

4. Food & beverage inventory levels not counted and costed at the end of each accounting period or recorded in your accounting software  

Most independent restaurant operators confuse their monthly food and beverage purchases with their monthly usage. By this I mean that they review their monthly P&L (Profit and Loss) and assume that the food purchased during the month divided by the food sales for the same period equals the cost of goods sold for food! Not so. Without knowledge of the beginning and ending inventories you can never calculate an accurate food cost. For a restaurant with food sales of $50,000/month, an inventory difference of $1000 between the beginning and end of the month, can translate into a variance of 2%. This disparity represents half the total annual profit of a typical full service restaurant! You simply cannot manage your food costs if you do not know what they are, and you cannot know what they are if you do not count and record you inventory variances. Once again, use a simple Excel spreadsheet to document, price, and total your food and beverage inventories, and then make sure to account for the changes between periods by making an appropriate accounting entry (read Count and Account for Your Month Ending Food & Beverage Inventory To Produce Accurate Profit and Loss Statements and click here for simple Excel tools for recording and counting your inventories as well as many other management tasks.

5. Food and beverage inventory levels too high relative to corresponding sales 

This red flag is not as obvious as some of the others but can be just as serious an obstacle to your restaurants profitability. A restaurant that carries too much food inventory will inevitably have higher food costs than it would otherwise. Too much food sitting in your walk-in cooler, your freezer and your dry goods shelves will result in excess waste, over-portioning, reduced product utilization, theft and will also tie up your most valuable assetů.cash! But how do you determine how much inventory is too much or what the ideal amount of inventory is? A typical full service restaurant should have on average no more than 7 days of inventory (that number can be reduced by a few days for quick service restaurants). Follow this simple calculation to find out how many days of food inventory you have: 

Multiply your average monthly food sales by your food cost %. Now divide that number (your average monthly food usage) by 30 (days/month) 

$50,000 Food Sales/Month X 30% = $15,000 (Food Usage)

$15,000 / 30 days = $500/day of food usage 

If your counted food inventory is $5,000 then divide that by your daily food usage to get the number of days of inventory on hand:  $5,000/$500 =10 days 

Reduce your inventory appropriately and watch your food costs drop along with it. 

Follow the same procedure for your alcoholic beverage inventories and use the following as guidelines: 

Liquor:  15+ days (bars and clubs will carry more inventory than restaurants)

Beer:    7-10 days

Wine:    15+ days (more for restaurants that specialize in wine and/or carry many varieties)  

6. Daily & weekly financial operating data not collected, reviewed or acted upon. 

If you want to be financially successful as an independent restaurant operator you need to be more like the chains when it comes to proactive management of your business. Every chain restaurant generates some type of daily and weekly report that summarizes, in a simple and easy to view format, all the key daily and weekly operating data including sales (by category), labor (by department), food and beverage purchases as well as beginning and ending inventories, and other fixed expenses allocated on a daily basis to produce a weekly estimate of the restaurant's net profit. You do not have the luxury of an IT staff like the chains to create these systems, but with some discipline you can collect this information and use it to identify problems as they happen. It is very difficult to make the corrections that are needed in your employee scheduling and product purchasing when all you have to go on is a monthly P&L that is not available to you till the middle of the following month. These corrections need to be made immediately when you have a clear understanding of what scheduling and purchasing decisions were made (or not) that produced the results that you attempting to improve upon. The good news is that all the information that you need is readily available to you from your daily POS reports and vendor bills. Once again, use an Excel spreadsheet to organize this information and present it to key managers in the restaurant so they can be held accountable (click here for a link to a library of customized spreadsheets to accomplish this).  

7. Inaccurate posting of financial information to your accounting system

One of the most common errors that I find when reviewing a restaurant's accounting procedures is that many different types of financial entries are posted to the wrong accounts. This results in financial reports that are both inaccurate and misleading. Some of the most common errors I see are a restaurant's daily cash and credit receipts being recorded as income as opposed to assets; no recognition of discounts or complimentary meals; inaccurate posting of sales tax collected; gift certificate sold recorded as revenue and not as a liability; employee wages and employer paid payroll taxes combined as wages; recording capital expenses as ordinary expenses; posting insurance down-payments and installment payments as expenses in the month paid rather than using "prepaid" accounts to distribute them evenly over the year. Click here to view and purchase the Restaurant Operators Complete Guide to QuickBooks.

Granted, these transactions are not easily comprehended by the typical independent owner, but that's why it's so important to seek professional financial help in making sure that your accounting system is setup properly from the start. If you are "flying blind" your chances of financial success will be greatly diminished, and if you cannot make a reasonable profit then all your efforts at producing a great dining experience for you customers will be for naught.  

8. Current liabilities sufficiently greater than current assets as to impair future ability to pay bills

After recording all your weekly sales and vendor bills go to your Balance Sheet and divide your current assets (e.g. cash, credit card receipts in transit, accounts receivable, food and beverage inventories) by your current liabilities (e.g. vendor bills, sales tax, lease payments and short term loans due). Using the following example  

Current Assets= $32,000

Current Liabilities = $28,000

Current Ratio = $32,000/$28,000 = 1.14 

This means that there is $1.14 of current assets for every $1.00 of current liabilities, and it's a rough measure of your ability to pay your outstanding bills. In most industries a ratio of 1:1 is considered to be reasonable. Restaurants typically have lower ratios because they maintain relatively small inventory levels combined with a quick cash turnover (meals are paid for the same day as they are served). Well-established and professionally run restaurants will typically have ratios over 1:1. Younger and less established restaurants will almost always be below 1:1. If your ratio is below 0.7:1 than you should be concerned. While restaurants can survive for long periods with lower ratios than this, it indicates that without an increase in either sales or working capital you and your business are looking to rocky times ahead.  

9. Owner relying on online bank balance to determine available cash to pay bills

This is an easy red flag to spot, and indicates to me either the lack of a properly functioning accounting system or a basic financial misunderstanding of how to manage cash flow. Here is the reason why. Your online balance tells you how much cash you have at that moment of time only. It does not account for previously written checks that have not yet cleared your account, or for cash or credit card deposits "in transit". You need to confidently rely on your Balance Sheet to tell you how much cash you have in your bank account, and this means that you need to accurately record all your sales and corresponding deposits, as well as all your bills and corresponding payments on a timely basis.

10. Overall lack of understanding as to how to read and interpret period ending Financial Statements

Aside from not having a well organized and implemented accounting system in place (Red Flag #1), the most serious financial red flag that I observe is the typical independent restaurant owners lack of understanding how to read and interpret the three fundamental financial reports readily available by all accounting software programs: 1) Profit and Loss Statement, 2) Balance Sheet and 3) Statement of Cash Flows.  I cannot possibly do justice to this topic here, but it is critical to point out the importance to all new and existing owners of obtaining the basic financial skills that will be required for you to succeed. Get some help from your accountant, hire a consultant, take an accounting course, bring in a friend with the necessary skills, just make sure to do something. While I must admit that I have had some clients over the years that succeed in spite of themselves, they are the exception! To be successful in this business as an independent operator you need to make sure that your financial skills are the equal of your culinary and management skills. Without all three skills working in tandem you are not giving yourself the opportunity to succeed that you deserve.

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