December 13, 2022

Why Comparative Ratio Analysis Is Important for Restaurant Industry Valuation

By Audrey Tagliatela, Staff, Advisory Services

Why Comparative Ratio Analysis Is Important for Restaurant Industry Valuation Valuation

Comparative ratios are especially important to understand in restaurant valuation today because of the severe impact the COVID-19 pandemic had on the food and service industry. These ratios express potentially significant relationships and can easily reveal a company’s position in the industry, provided valuators understand the relevant industry and which ratios matter most. If a company’s ratios are not compared to industry ratios, peer group ratios, or guideline company ratios, it can be hard to interpret what the company’s ratios indicate.

Ratios can also be helpful when analyzing or creating projections. Drastic changes in future performance can be forecasted using a trend analysis to compare current ratios to past norms. A trend analysis can also show deterioration, as well as strengths and weaknesses. If you use a trend analysis to reveal a given company’s norms, you can compare them to industry norms to determine whether a company is performing to standards — and if not, why.1

It is not unusual for restaurants to have very different industry ratio averages compared to other operating industries. Many factors changed during the pandemic due to mandated closures and subsequent public health measures. For example, restaurants had to pivot to operate solely through takeout and delivery apps (even if they had never before offered such services), or they had to close until mandates were lifted. Even when restaurants began offering in-person dining again, many had to reconsider aspects of their operation, including adding patio seating so guests could dine outside or ensuring sufficient space existed between diners. These factors skewed many ratios. Even today, with the pandemic seemingly behind us, restaurants still face lasting repercussions including staffing shortages, higher-priced goods, and delivery issues.

Trends in the restaurant industry are also very important to understand in a comparative ratio analysis. The level of competition in the industry is very high, but so are the resulting risks. The restaurant industry is unique in that many restaurant costs can be controlled, meaning there are minimal fixed costs. Necessities like labor, food, and utilities can be controlled to a certain extent if owners or managers understand what percentage of revenue should be allocated to each of these expenses. But certain factors, such as inflation and a tight labor market, cannot be controlled. In a tight labor market, as exists currently, restaurants may need to pay workers higher wages. However, in normal economic conditions, wages can be a controlled cost. A manager who understands which costs need to be addressed most urgently can operate their restaurant closer to or better than industry standards.

Liquidity Ratios

Liquidity ratios measure a company’s ability to meet its short-term financial obligations. These ratios can also help determine whether a company has more assets than it needs for its operations, or if it is falling short. Higher liquidity can help restaurants weather cyclical industry changes.2 The current ratio is a very common liquidity ratio that indicates whether a company can pay its short-term liabilities on time. The current ratio norms vary by industry, which explains why restaurants’ current ratios can be very different from other companies. Typically businesses want a current ratio of 2.0, meaning the company has double the amount of current assets needed to pay its liabilities.3

However, the five-year average current ratio in the restaurant industry is 1.1, which indicates that restaurants on average do not have much more in current assets than current liabilities. 4 One of the main reasons for this is that restaurants do not tend to have high levels of accounts receivable. They generally reinvest cash into the business fairly quickly, leaving less cash on hand. During the pandemic, many restaurant managers realized the importance of having ample cash reserves to navigate unforeseen circumstances, such as unexpected supply chain issues or labor shortages. With this learning curve behind us, it would not be surprising if the industry’s current ratio trend increases over the next few years. In fact, many data sources have already shown an increase in the current ratio over the past two years, indicating the effect of the lessons learned during the pandemic.6, 7

Activity Ratios

Activity or turnover ratios measure how effectively a company employs its assets. These ratios address a firm’s ability to manage its assets in use and determine how it will invest current assets for future profit. One of the most important activity ratios for a restaurant is inventory turnover. A slow inventory turnover ratio can reveal whether a company has undesirable inventory, which can also hurt a company’s liquidity. Fast inventory turnover, however, may indicate a company is not purchasing enough inventory to cover sales.8 Restaurants rely on perishable goods, so it is important for managers and owners to gauge the right amount of inventory needed to avoid discarding inventory when it goes bad. If a restaurant is handling mostly fresh ingredients, managers should keep inventory turnover at around a week.

A good inventory turnover ratio can also indicate a manager or chef’s efficiency and skill at creating a wide variety of dishes from available inventory. Overall, restaurants that stock less inventory and feature menus that efficiently utilize that inventory are more profitable because they adequately use all inventory available.9

The working capital ratio is also very important for restaurants because it can be a key indicator of whether a restaurant is in danger of imminent failure. Working capital is the difference between the total amount of current assets and current liabilities. This can indicate whether management is planning correctly to maintain the right amount of working capital.

Profitability Ratios

Profitability ratios measure how effectively a company manages its expenses and profits, or controls its operating costs relative to its revenue stream. This is usually measured through profit margins, which show future risk of returns and investment risk. Profit margins are one of the most important financial ratios to examine when valuing a restaurant. They are the strongest indicator of costs necessary for a restaurant to generate revenue.10 However, profit margins can vary widely across the industry. For example, a high-end restaurant may be able to charge more for a meal, which would increase its profit margin; however, it likely would not attract as many customers as a lower-cost restaurant, which could reduce the profit margin conversely.

If a restaurant is not attracting enough customers, it needs to be more careful with expenses, even if it can charge higher prices for meals. The volume of competitors also influences profit margins because if there are too many restaurants serving similar food in one area, those restaurants may compete by lowering the price of food, which would in turn lower profit margins. Serving alcoholic beverages can increase restaurant profit margins because wine, beer, and cocktails can have favorable markups. Profit margins clearly suffered in 2020, dropping to around 3.6%, which is lower than the five-year average of 5%.11 Many restaurants relied on takeout and delivery to stay in business and managed to record sufficient profit margins, but now most restaurants have returned to normal as pandemic-related precautions have largely ended.

However, there are many conditions aside from those discussed above that could impact a restaurant’s profit margin. It is important, when valuing a restaurant, to understand how these conditions can impact profit margins and how to adjust costs or shift operations to achieve an improved profit margin based on these conditions — and it is important to compare ratios in this arena against the industry average.12

Conclusion

The above shows how important it is to understand both the external and internal influences that can impact a restaurant’s ratios. When an analyst values a restaurant, these ratios are critical to understanding how the business is run and if operations are efficient. Understanding these ratios and what they mean has become increasingly important during and after the pandemic because some changes to the industry will be permanent. If an analyst understands why these ratios are meaningful for valuation, it will be much easier to compare the subject restaurant to the overall industry and determine whether the restaurant is performing to industry standards.

Sources

  1. Valuing a Business, 6th Edition: The Analysis and Appraisal of Closely Held Companies, Shannon P. Pratt and ASA Educational Foundation, April 2021.
  2. American Society of Appraisers, BV201: Introduction to Business Valuation – Market Approach, Non-Authoritative © 2020.
  3. Valuing a Business, 6th Edition: The Analysis and Appraisal of Closely Held Companies, Shannon P. Pratt and ASA Educational Foundation, April 2021
  4. IBISWorld Industry Report #72211B: Single Location Full-Service Restaurants in the U.S. Thi Le, June 2022. © IBISWorld, Inc. .
  5. Business Reference Guide, Rule of Thumb: Restaurants – Full Service, © 2022 Business Brokerage Press, Inc. < https://www.businessrg.com/rot/rot-detail/restaurants-full-service/>
  6. The Risk Management Association, Report 722511 – Full-Service Restaurants, © 2022. < https://rmau.org/eMentor/industry/detail?indCode=722511&leftnavmenuid=3>
  7. Vertical IQ, Full-Service Restaurants, November 8, 2022 © 2022. < https://app.verticaliq.com/industries/592-full-service-restaurants>
  8. Valuing a Business, 6th Edition: The Analysis and Appraisal of Closely Held Companies, Shannon P. Pratt and ASA Educational Foundation, April 2021
  9. Rule of Thumb
  10. Sebastien Rankin, “The Complete Guide to Restaurant Profit Margins.” Lightspeed, March 23, 2021. .
  11. IBISWorld Industry Report #72211B: Single Location Full-Service Restaurants in the U.S. Thi Le, June 2022. © IBISWorld, Inc. .
  12. IBISWorld Industry Report #72211B: Single Location Full-Service Restaurants in the U.S. Thi Le, June 2022. © IBISWorld, Inc. .