HOSPITALITY RATIO ANALYSIS

Financial Statements provide a wealth of important information to investors, creditors, managers and other users. To be most meaningful, though, financial statements must be analyzed.

A major approach to analyzing financial statement is the use of ratio analysis. By themselves, ratios simply express numerical relationships between figures. For ratios to become meaningful and provide users with a basis for evaluating the financial statements, the computed ratios must be compared against some standard. There are basically three different standards that are that are used to evaluate the ratios computed for a given operation for the given period.

First, ratios can be compared to corresponding calculations from the prior period.

Second, industry averages provide another useful benchmark against which to compare ratios.

Third and best, ratios are compared against planned ratio goals. Individually each ratio reveals only a part of overall financial condition of an operation. Collectively, however these ratios communicate a great deal of information that may not be immediately apparent to someone simply reading the figures reported in financial statements.
 
Five common classes of ratios are as follows:

Liquidity
Solvency
Activity
Profitability
Operating.
 
Liquidity Ratios are divided into:

·      Current Ratio
·      Acid-Test Ratio
·      Accounts Receivable Ratio
·      Operating Cash Flows to Current Liabilities Ratio
 
Solvency Ratios are divided into:

·      Debt-Equity Ratio
·      Long-Term Debt to Total Capitalization Ratio
·      Number of times Interest Earned Ratio
·      Fixed Charge Coverage Ratio
·      Operating Cash Flows to Total Liabilities Ratio
 
Activity Ratios are:

·      Inventory turnover
·      Fixed Asset Turnover
·      Asset Turnover Ratio
·      Paid occupancy Percentage
·      Complimentary Occupancy Percentage
·      Average Occupancy per Room
·      Multiple Occupancy Percentage
 
Profitability Ratios are subdivided into following:

·      Profit Margin
·      Operating Efficiency Ratio
·      Return on Assets
·      Gross Return on Assets
·      Return on Equity
·      Earning per share
·      Price earning Ratio
·      Market Value to Book Value per Share Ratio
 
Operating Ratios are as under:

·      Average Room Rate
·      Revenue per available room
·      Average food service Check
·      Food cost percentage
·      Beverage cost percentage
·      Labor cost percentage.
 
Now, an insight into different types of Ratios:

 
a) Liquidity Ratios:

 
The ability of a hospitality firm to meet its current obligations is important in evaluating its financial position. Several ratios can be computed that suggest an answer to this question. Current Ratio is the ratio of total current assets to total current liabilities. Hence, a current ratio of $1.21 means that for every one dollar of current liabilities the Hotel has $1.21 of current assets. Thus, there is a cushion of $.21 every dollar of current debt.

Current Ratio = Current Assets / Current Liabilities

Acid-Test Ratio measures liquidity by considering ‘quick assets’ and near cash assets. Excluded from current assets are inventories and prepaid expenses. The difference between Current Ratio and Acid Test Ratio is a function of inventory amounts and prepaid expenses relative to current assets.

Acid Test Ratio = Cash, Marketable Securities and Accounts Receivable / Current Liabilities.

Accounts Receivable Turnover:  In the normal operating cycle, accounts receivable are converted into cash. The Account Receivable Turnover measures the speed of the conversion. The suppliers as well as the owners prefer a high account receivable turnover because this means that hospitality establishments will have more cash readily available to pay them.

Accounts Receivable Turnover = Total Revenue / Average Accounts Receivable

Operating Cash Flows to Current Liabilities Ratio includes operating cash flow from the statement of cash flow as the numerator and the average current liabilities from the balance sheet as the denominator.

Operating Cash Flow to Current Liability Ratio = Operating Cash Flows / Average Current Liabilities  

b) Solvency Ratios:
 
Solvency Ratios measure the hospitality enterprise’s degree of debt financing and are partial indicators of the establishment’s ability to meet its debt obligations. These ratios reveal the equity cushion that is available to absorb any operating losses.

Debt Equity Ratio is the most common solvency ratio and compares the hospitality establishment’s total debt to its net worth (owner’s equity). The debt equity ratios indicate the establishment’s ability to withstand adversity and meet its long-term debt obligations.

Debt Equity Ratio = Total Liabilities / Total Owner’s Equity
 
Long-term Debt to Total Capitalization Ratio is similar to the debt and owner’s equity, commonly called total capitalization. This ratio is similar to the debt equity ratio except that current liabilities are excluded from the numerator and long-term debt is added to the denominator of the debt-equity ratio. Current liabilities are excluded because current assets are normally adequate to cover them; therefore they are not a long-term concern.
 
Long Term Debt to Total Capitalization Ratio = Long term Debt / Long-term debt and Owner’s Equity

Number of Times Interest Earned Ratio is based on financial figures from the income statement and expresses the number of times interest expense can be covered by available ‘income’ (actually EBIT).

Number of times Interest Earned Ratio = E. B. I. T / Interest Expense

Fixed Charge Coverage Ratio is a variation of the number of times interest earned ratio and considers lease payments as well as interest expense. Those hospitality establishments that lease property equipment may find this ratio is more useful than the number of times interest earned ratio.

Fixed charge coverage ratio = E.B.I.T + Lease Expense / Interest Expense and Lease Expense
 
Operating Cash Flows to total Liabilities Ratio: This Solvency Ratio using figures from both the statement of cash flow and balance sheet, compares cash flow from operations to total liabilities. This ratio overcomes the deficiency of using debt at a point in time by considering cash flows for a period of time.
 
Operating cash flows to total liabilities ratio = Cash flows from operations / Average total liabilities

 
c.) Activity Ratios:

Activity ratios measure management’s effectiveness in using its resources. Management is entrusted with inventory and fixed assets to generate earnings for owners while providing products and services to guests. Management must adequately control the inventory to minimize its cost of sales.

Inventory Turnover shows how quickly inventory is moving. All things being the same, generally, the quicker the inventory turnover, the better, because inventory can be expensive to maintain.

Food Inventory Turnover = Cost of Food Used / Average Food Inventory

Beverage Turnover Ratio = Cost of Beverage Used / Average Beverage Inventory
 
All parties (owners, creditors and management) prefer high inventory turnover ratios to low ones. Too low an inventory turnover suggests that food is overstocked and in addition to the problems, the potential cost of spoilage may become a problem.

Fixed Asset Turnover measures management’s effectiveness in using fixed assets. A limitation of this ratio is that it places a premium on using older (depreciated) fixed assets, since their book value is low.

Fixed Asset Turnover = Total Revenue / Average Fixed Revenue
 
Asset Turnover Ratio examines the use of total assets in relation to total revenues. The limitations of fixed asset ratio are also inherent in this ratio to the extent that fixed assets make up total assets. For most hospitality establishments especially lodging businesses, fixed assets constitute the majority of operation’s total assets.
 
Following four ratios are viewed as excellent measures of management’s effectiveness in selling space:

Paid Occupancy Percentage is a key Indicator of management’s success in selling its product. A comparable ratio in food service operations is seat turnover, which is calculated by dividing number of people served by the number of seats available.

Annual Paid Occupancy Percentage = Paid Rooms Occupied / Available Rooms
 

Complimentary Occupancy Percentage is determined by dividing the number of complimentary rooms for a period by the number of rooms available.

Complimentary Occupancy Percentage = Complimentary Rooms / Rooms Available 
 

Average Occupancy per Room is the result of dividing the number of room guests by the number of rooms occupied. The average occupancy per room is generally highest for resort properties, where it can reach as high as 2.0 guests per room and is generally lowest for transient lodging properties.

Average Occupancy Per Room = No. of guests / No. of rooms Occupied 
 
Multiple Occupancy Percentage is also called, less accurately, double occupancy percentage. The owners, creditors and management prefer high occupancy ratios as they imply greater use of facilities.

d.) Profitability Ratios:
 
Profitability Ratios reflect the results of all areas of management’s responsibilities. All the information conveyed by liquidity, liquidity, solvency and activity ratios affects the profitability of the of the hospitality enterprise. The profitability ratios considered here measure management’s overall effectiveness as shown be returns on sales ( profit margin and operation efficiency ratio) , returns on assets ( return on assets and gross return on assets), and return on common stockholder’s equity.

Profit Margin is determined by dividing net income by total revenue. It is an overall measurement of management’s ability to generate sales and control expenses, thus yielding the bottom line.

Profit Margin = Net Income / Total Revenue
 
If the profit margin is lower than expected, then revenue and expenses should be reviewed. To identify the problem area, management should first analyze the operated departments margins. If the operated departments margins are satisfactory, the problem would appear to be with overhead expense.
 

Operating Efficiency Ratio is a better measure of management’s performance than the Profit Margin because, unlike the profit margin, it considers only those expenses that management can generally control. This ratio is the result of dividing income before fixed charges by total revenue.
 
Operating Efficiency Ratio = Income Before fixed Charges / Total Revenue
 
Return On Assets (ROA) ratio is a general indicator of the profitability of the hospitality enterprise’s assets. ROA compares bottom line profits to the total investment, that is, to the total assets. A very low ROA may result from inadequate profits or excessive assets. A very high ROA may suggest that older assets require replacement in the near future or that new assets need to be added to support growth revenues and profits.
 
Return On Assets = Net Income / Average Total Assets

Gross Return on Assets: The computation Gross Return On Assets, ignores any debt-financing by using income before interest and income taxes as its numerator. Interest is excluded because it is a financing cost, and income taxes are not considered because interest expense is deductible in calculating the operation’s tax liability.
 
Gross Return On Assets = Earnings Before Interest and Taxes / Average Total Assets

Return On Equity:  A key profitability ratio is Return on Equity ( ROE). This ratio compares the net income of the hospitality enterprise to the owner’s investment.

Return On Equity = Net Income / Average Owner’s Equity
  
Earnings per Share is usually shown on hospitality establishments income statements issued to external users.

Earnings per Share = Net Income / Average common shares outstanding
 
Price Earnings Ratio: Financial analysts often use the price earnings (PE) ratio in presenting investment possibilities in hospitality enterprise.

Price Earning Ratio = Market Price Per Share / Earning per Share
 
PE Ratio may vary significantly for different hospitality enterprises and depends on relative risk, stability of earnings, perceived earnings trends and perceived growth trends of the stock.

Market Value to Book Value Per Share Ratio: This ratio compares the value per share of stock as reflected by the market to the underlying value per share per accounting records.

Market Value to Book Value Per Share Ratio = Market Value Per Share / Book Value per Share

e.) Operating Ratios: 

Operating Ratios assist management in analyzing the operation of a hospitality establishment. Detailed information necessary for computing these ratios is normally not available to creditors or owners not actively involved in management. Operating ratios relate expenses to revenues and are useful for control purposes.

Mix of Sales: To determine sales mix, the departmental revenues are totaled and percentages of total revenues are calculated for each operated department. The sales mix of hospitality operation is best mix of hospitality operation is the best compared to the establishment’s objectives as revealed in the budget.

Average Room Rate is simply also called average daily rate or ADR. The best standard of comparison of use in evaluating an actual average room rate is the rate budgeted as the goal for the rooms department’s operation during the period. This average rate should also be calculated individually for each market segment: business, groups, tourists, airline crews, and other categories of guests served.

Average Room Rate =Rooms Revenue / Number of Rooms Sold
 
Revenue Per Available Room: The combination of paid occupancy percentage and ADR is called REV-PAR, and is calculated as follows:

REVPAR = Rooms Revenue / Available Rooms Or  Paid Occupancy Percentage X ADR.
 
Using REVPAR provides more complete information than using occupancy percentage or ADR separately.

Average Food and Service Check is determined by dividing total food revenues by the number of food covers sold during the period.

Average Food and Service Check =Total Food Revenue / Number of Food Covers
 

Food Cost Percentage compares the cost of food sold to food sales. Most managers rely heavily on this ratio for determining whether food costs are reasonable. A lower food cost percentage may indicate that the quality of food served is lower than desired, or that smaller portions are being served than are specified =by standard recipes. A food cost percentage in excess of the objective may be due to poor portion control, excessive food costs, theft, waste, spoilage, and so on.
 

Food Cost Percentage = Cost of Food Sold / Food Sales
 
Beverage Cost Percentage is obtained by dividing cost of beverage sold with beverage sales.

Beverage Cost Percentage = Cost of Beverages Sold / Beverage Sales
 
Labor Cost Percentage  is determined by dividing total labor costs by total revenue. The largest expense in hotels, motels, clubs and many restaurants is labor. The general labor cost percentage is simply a benchmark for making broader comparisons.

Labor Cost Percentage = Total Labor Cost / Department Revenue

Ratios are of varying usefulness to users. Management considers Operating Ratios to be the most useful class of ratios, followed by activity ratios. Owners are perceived to consider Profitability Ratios as the most useful class of ratios, followed by Solvency Ratios. Creditors are perceived to consider Solvency Ratios as the most useful class of ratios, followed by profitability ratios.