CompleteReview Questions 1-10 at the end of "HospitalityIndustry Managerial Accounting," Ch. 5.

5Ratio AnalysisChapter 5 Outline

Ratio Standards

Purposes of Ratio Analysis

What Ratios Express

Classes of Ratios

Liquidity Ratios

• Current Ratio
• Acid-Test Ratio
• Operating Cash Flows to Current Liabilities Ratio
• Accounts Receivable Turnover
• Average Collection Period
• Working Capital Turnover Ratio

Solvency Ratios

• Solvency Ratio
• Debt-Equity Ratio
• Long-Term Debt to Total Capitalization Ratio
• Number of Times Interest Earned Ratio
• Fixed Charge Coverage Ratio
• Debt Service Coverage Ratio
• Operating Cash Flows to Total Liabilities Ratio

Activity Ratios

• Inventory Turnover
• Property and Equipment Turnover
• Asset Turnover
• Paid Occupancy Percentage
• Complimentary Occupancy
• Average Occupancy per Room
• Multiple Occupancy
• Seat Turnover

Profitability Ratios

• Profit Margin
• Operating Efficiency Ratio
• Gross Operating Profit per Available Room
• Return on Assets
• Gross Return on Assets
• Return on Owners Equity
• Return on Common Stockholders Equity
• Earnings per Share
• Price/Earnings Ratio
• Viewpoints Regarding Profitability Ratios
• Profitability Evaluation of Segments

Operating Ratios

• Mix of Sales
• Average Room Rate
• Revenue per Available Room
• Revenue per Available Customer
• Average Food Service Check
• Food Cost Percentage
• Beverage Cost Percentage
• Labor Cost Percentage

Limitations of Ratio Analysis

Usefulness of Financial Ratios

Computer Applications

Competencies

• 1.Identify standards against which the results of ratio analysis may be compared. (pp. 201202)
• 2.Explain the function and purposes of ratio analysis. (pp. 202204)
• 3.Identify common classes of ratios and describe the general purpose of each. (pp. 204205)
• 4.Calculate common liquidity ratios and describe how creditors, owners, and managers view them. (pp. 205214)
• 5.Calculate common solvency ratios and describe how creditors, owners, and managers view them. (pp. 215220)
• 6.Calculate common activity ratios and describe how creditors, owners, and managers view them. (pp. 220228)
• 7.Calculate common profitability ratios and describe how creditors, owners, and managers view them. (pp. 228236)
• 8.Calculate common operating ratios and explain how managers use them to evaluate operational results. (pp. 236243)
• 9.Summarize the limitations of ratio analysis, describe the usefulness of financial ratios, and explain how computers can be used in ratio analysis. (pp. 243246)

Financial statements issued byhospitality establishments contain a lot of financial information. A thorough analysis of this information requires more than simply reading the reported facts. Users of financial statements need to be able to interpret the reported facts to discover aspects of the hospitality propertys financial situation that could otherwise go unnoticed. This is accomplished throughratio analysis, which is the comparison of related facts and figures, most of which appear on the financial statements. A ratio gives mathematical expression to a relationship between two figures and is computed by dividing one figure by the other figure. By bringing the two figures into relation with each other, ratios generate new information. In this way, ratio analysis goes beyond the figures reported in a financial statement and makes them more meaningful, more informative, and more useful. In particular, ratio analysis generates indicators for evaluating different aspects of a financial situation.

Ratio analysis can provide users of financial statements with answers to such questions as:

• 1.Is there sufficient cash to meet the establishments obligations for a given time period?
• 2.Are the profits of the hospitality operation reasonable?
• 3.Is the level of debt acceptable in comparison with the stockholders investment?
• 4.Is the inventory usage adequate?
• 5.How do the operations earnings compare with the market price of the hospitality propertys stock?
• 6.Are accounts receivable reasonable in light of credit sales?
• 7.Is the hospitality establishment able to service its debt?

In this chapter, we will first explain the different kinds of standards against which ratios are compared in order to evaluate the financial condition of a hospitality operation. We will also discuss the variety of functions or purposes that ratio analysis serves in interpreting financial statements and the ways in which different ratios are expressed in order to make sense of the information they provide. The remainder of the chapter is devoted mostly to a detailed discussion of the ratios most commonly used in the hospitality industry.

Ratio Standards

Ratio analysis is used to evaluate the favorableness or unfavorableness of various financial conditions. However, the computed ratios alone do not say anything aboutwhat is good or bad, acceptable or unacceptable, reasonable or unreasonable. By themselves, ratios are neutral and simply express numerical relationships between related figures. In order to be useful as indicators or measurements of the success or well-being of a hospitality operation, the computed ratios must be compared against some standard. Only then will the ratios become meaningful and provide users of financial statements with a basis for evaluating the financial conditions.

There are basically three different standards that are used to evaluate the ratios computed for a given operation for a given period: ratios from a past period, industry averages, and budgeted ratios. Many ratios can be compared with corresponding ratios calculated for the prior period in order to discover any significant changes. For example, paid occupancy percentage (discussed later in this chapter) for the current year may be compared with paid occupancy percentage of the prior year in order to determine whether the lodging operation is succeeding in selling more of its available rooms this year than it had previously. This comparison may be useful in evaluating the effectiveness of the propertys current marketing plans.

Industry averages provide another useful standard against which to compare ratios. After calculating the return on investment (discussed later in this chapter) for a given property, investors may want to compare this with the average return for similar properties in their particular industry segment. This may give investors an indication of the ability of the propertys management to use resources effectively to generate profits for the owners in comparison with other operations in the industry. In addition, managers may want to compare the paid occupancy percentage or food cost percentage for their own operation with industry averages in order to evaluate their abilities to compete with other operations in their industry segment. Published sources of average industry ratios are readily available.

While ratios can be compared against results of a prior period and against industry averages, ratios are best compared against planned ratio goals. For example, in order to more effectively control the cost of labor, management may project a goal for the current years labor cost percentage (also discussed in this chapter) that is slightly lower than the previous years levels. The expectation of a lower labor cost percentage may reflect managements efforts to improve scheduling procedures and other factors related to the cost of labor. By comparing the actual labor cost percentage with the planned goal, management is able to assess the success of its efforts to control labor cost.

Different evaluations may result from comparing ratios against these different standards. For example, a food cost of 33 percent for the current period may compare favorably with the prior years ratio of 34 percent and with an industry average of 36 percent, but may be judged unfavorably when compared with the operations planned goal of 32 percent. Therefore, care must be taken when evaluating the results of operations using ratio analysis. It is necessary to keep in mind not only which standards are being used to evaluate the ratios, but the purposes of the ratio analysis as well.

Purposes of Ratio Analysis

Managers, creditors, and investors often have different purposes in using ratio analysis to evaluate the information reported in financial statements.

Ratios help managers monitor the operating performances of their operations and evaluate their success in meeting a variety of goals. By tracking a limited number of ratios, hospitality managers are able to maintain a fairly accurate perception of the effectiveness and efficiency of their operations. In a food service operation, most managers compute food cost percentage and labor cost percentage in order to monitor the two largest expenses of their operations. In lodging operations, occupancy percentage is one of the key ratios that managers use on a daily basis. Management often uses ratios to express operational goals. For example, management may establish ratio goals as follows:

• Maintain a 1.25 to 1 current ratio.
• Do not exceed a debt-equity ratio of 1 to 1.
• Maintain return on owners equity of 15 percent.
• Maintain property and equipment turnover of 1.2 times.

These ratios, and many more, will be fully explained later in this chapter. The point here is to notice that ratios are particularly useful to managers as indicators of how well goals are being achieved. When actual results fall short of goals, ratios help indicate where a problem may be. In the food cost percentage example presented earlier in which an actual ratio of 33 percent compared unfavorably against the planned 32 percent, additional research is required to determine the cause(s) of the 1 percent variation. This one percent difference may be due to cost differences, sales mix differences, or a combination of the two. Only additional analysis will determine the actual cause(s). Ratio analysis can contribute significant information to such an investigation.

Creditors use ratio analysis to evaluate the solvency of hospitality operations and to assess the riskiness of future loans. For example, the relationship of current assets to current liabilities, referred to as the current ratio, may indicate an establishments ability to pay its upcoming bills. In addition, creditors sometimes use ratios to express requirements for hospitality operations as part of the conditions set forth for certain financial arrangements. For example, as a condition of a loan, a creditor may require an operation to maintain a current ratio of 2 to 1.

Investors and potential investors use ratios to evaluate the performance of a hospitality operation. For example, the dividend payout ratio (dividends paid divided by earnings) indicates the percentage of earnings paid out by the hospitality establishment. Potential investors primarily interested in stock growth may shy away from investing in properties that pay out large dividends.

Ratios are used to communicate financial performance. Different ratios communicate different results. Individually, ratios reveal only part of the overall financial condition of an operation. Collectively, however, ratios are able to communicate a great deal of information that may not be immediately apparent from simply reading the figures reported in financial statements.

Finally, rather than evaluating a ratio for a single period, consider the same ratio over a period of time. Consider a monthly food cost percentage of 31 percent, 31.3 percent, 31.7 percent, 32 percent, and 32.2 percent over five months. From a cost perspective, the trend of this ratio should cause management to pause and consider what might be causing this change.

What Ratios Express

In order to understand the information communicated by the different kinds of ratios used in ratio analysis, it is necessary to understand the various ways in which ratios express financial information. Different ratios are read in different ways. For example, many ratios are expressed aspercentages.An illustration is the food cost percentage, which expresses the cost of food sold in terms of a percentage of total food sales. If total food sales for a given year are $430,000, while the cost of food sold is $135,000, then the result of dividing the cost of food sold by the total food sales is .314. Because the food cost percentage is a ratio expressed as a percentage, this figure is multiplied by 100 to yield a 31.4 percent food cost. Another example is paid occupancy percentage, resulting from rooms sold divided by rooms available for sale. If a lodging property has 100 rooms available for sale and sells only 50 of them, then 50 divided by 100 yields .5, which is then multiplied by 100 to be expressed as a percentage (50 percent).

Some other ratios are expressed on aper unit basis.For example, the average breakfast check is a ratio expressed as a certain sum per breakfast served. It is calculated by dividing the total breakfast sales by the number of guests served during the breakfast period. Thus, on a given day, if 100 guests were served breakfast and the total revenue during the breakfast period amounted to $490, then the average breakfast check would be $4.90 per meal ($490 100).

The proper way to express still other ratios is as aturnoverof so many times. Seat turnover is one such ratio, determined by dividing the number of guests served during a given period by the number of restaurant seats. If the restaurant in the previous example had a seating capacity of 40 seats, then seat turnover for the breakfast period in which it served 100 guests would be 2.5 (100 40). This means that, during that breakfast period, the restaurant used its entire seating capacity 2.5 times.

Finally, some ratios are expressed as acoverageof so many times. The denominator of such a ratio is always set at 1. The current ratio, determined by dividing current assets by current liabilities, is one of the ratios expressed as a coverage of so many times. For example, if a hospitality operation reported current assets of $120,000 and current liabilities of $100,000 for a given period, then the operations current ratio at the balance sheet date would be 1.2 to 1 (120,000 100,000). This means that the hospitality operation possessed sufficient current assets to cover its current liabilities 1.2 times. Put another way, for every $1 of current liabilities, the operation had $1.20 of current assets.

The proper way to express the various ratios used in ratio analysis depends entirely on the particular ratio and the nature of the significant relationship it expresses between the two facts it relates. The ways in which different ratios are expressed are a function of how we use the information that they provide. As we discuss the ratios commonly used in the hospitality industry, pay attention to how each is expressed.

Classes of Ratios

Ratios are generally classified by the type of information that they provide. Five common ratio groupings are as follows:

• 1.Liquidity
• 2.Solvency
• 3.Activity
• 4.Profitability
• 5.Operating

Liquidity ratiosreveal the ability of a hospitality establishment to meet its short-term obligations.Solvency ratios, on the other hand, measure the extent to which the enterprise has been financed by debt and is able to meet its long-term obligations.Activity ratiosreflect managements ability to use the propertys assets, while severalprofitability ratiosshow managements overall effectiveness as measured by returns on sales and investments. Finally,operating ratiosassist in the analysis of hospitality establishment operations.

The classification of certain ratios may vary. For example, some texts classify the inventory turnover ratio as a liquidity ratio, but this text and some others consider it to be an activity ratio. Also, profit margin could be classified as an operating ratio, but it is generally included with the profitability ratios.

Knowing the meaning of a ratio and how it is used is always more important than knowing its classification. We will now turn to an in-depth discussion of individual ratios. For each ratio discussed, we will consider its purpose, the formula by which it is calculated, the sources of data needed for the ratios calculation, and the interpretation of ratio results from the varying viewpoints of owners, creditors, and management.

Exhibits 1through4, financial statements of the hypothetical Grand Hotel, will be used throughout our discussion of individual ratios.

Liquidity Ratios

The ability of a hospitality establishment to meet its current obligations is important in evaluating its financial position. For example, can the Grand Hotel meet its current debt of $214,000 as it becomes due? Several ratios can be computed that suggest answers to this question.

Current Ratio

The commonest liquidity ratio is thecurrent ratio, which is the ratio of total current assets to total current liabilities and is expressed as a coverage of so many times. Using figures fromExhibit 1, the 20X2 current ratio for the Grand Hotel can be calculated as follows:

Exhibit 1Balance Sheets

This result shows that for every $1 of current liabilities, the Grand Hotel has $1.58 of current assets. Thus, there is a cushion of $.58 for every dollar of current debt. A considerable shrinkage of inventory and receivables could occur before the Grand Hotel would be unable to pay its current obligations. By comparison, the 20X1 current ratio for the Grand Hotel was 1.15. An increase in the current ratio from 1.15 to 1.58 within one year is considerable and would no doubt please creditors. However, would a current ratio of 1.58 please all interested parties?

Exhibit 2Income Statements

Exhibit 3Statement of Cash Flows

Owners/stockholders normally prefer a low current ratio to a high one, because stockholders view investments in most current assets as less productive than investments in noncurrent assets. Since stockholders are primarily concerned with profits, they prefer a relatively low current ratio.

Creditors normally prefer a relatively high current ratio, as this provides assurance that they will receive timely payments. A subset of creditors, lenders of funds, believe adequate liquidity is so important that they often incorporate a minimum working capital requirement or a minimum current ratio in loan agreements. Violation of this loan provision could result in the lender demanding full payment of the loan.

Exhibit 4Statement of Retained Earnings and Other Information

Management is caught in the middle, trying to satisfy both owners and lenders while, at the same time, maintaining adequate working capital and sufficient liquidity to ensure the smooth operation of the hospitality establishment. Management is able to take action affecting the current ratio. In the case of the Grand Hotel, a current ratio of 2 could be achieved by selling $90,000 worth of short-term investments on the last day of 20X2 and paying current creditors.¹Other possible actions to increase a current ratio include:

• Obtaining long-term loans.
• Obtaining new owners equity contributions.
• Converting noncurrent assets to cash.
• Deferring declaring dividends and leaving the cash in the business.

An extremely high current ratio may mean that accounts receivable are too high because of liberal credit policies and/or slow collections, or it may indicate that inventory is excessive. Since ratios are indicators, management must follow through by analyzing possible contributing factors.

Acid-Test Ratio

A more stringent test of liquidity is theacid-test ratio.The acid-test ratio measures liquidity by considering only quick assetscash and near-cash assets. Excluded from current assets are inventories and prepaid expenses in determining the total quick assets. In many industries, inventories are significant and their conversionto cash may take several months. The extremes appear evident in the hospitality industry. In some hospitality operations, especially quick-service restaurants, food inventory may be entirely replenished twice a week. On the other hand, the stock of certain alcoholic beverages at some food service operations may be replaced only once in three months.

The difference between the current ratio and the acid-test ratio is for the most part a function of the amount of inventory relative to current assets. In some operations, the difference between the current ratio and the acid-test ratio will be minor, while in others, it will be significant. Using relevant figures fromExhibit 1, the 20X2 acid-test ratio for the Grand Hotel is computed as follows:

The 20X2 acid-test ratio reveals quick assets of $1.44 for every $1.00 of current liabilities. This is an increase of .44 times over the 20X1 acid-test ratio. Although the acid-test ratio was 1.0 for 20X1, the Grand Hotel was not in difficult financial straits. Many hospitality establishments are able to operate efficiently and effectively with an acid-test ratio of 1 or less, for they have minimal amounts of both inventory and accounts receivable.

The viewpoints of owners, creditors, and managers toward the acid-test ratio parallel those held toward the current ratio. That is, owners of hospitality operations prefer a low ratio (generally less than 1), creditors prefer a high ratio, and management is again caught in the middle.

Operating Cash Flows to Current Liabilities Ratio

A fairly new ratio made possible by the statement of cash flows isoperating cash flows to current liabilities.The operating cash flows are taken from the statement of cash flows, while current liabilities come from the balance sheet. This measure of liquidity compares the cash flow from the firms operating activities to its obligations at the balance sheet date that must be paid within twelve months. Using the relevant figures fromExhibits 1and3, the 20X2 operating cash flows to current liabilities ratio is computed as follows:

The 20X2 ratio of 88.2 percent shows that only $.882 of cash flow from operations was provided by the Grand Hotel during 20X2 for each $1.00 of current debt at the end of 20X2. The prior years ratio was 118 percent. This dramatic change should cause management to consider reasons for the change and be prepared to take appropriate action.

All users of ratios would prefer to see a high operating cash flow to current liabilities, as this suggests operations are providing sufficient cash to pay the firms current liabilities.

Accounts Receivable Turnover

In hospitality operations that extend credit to guests, accounts receivable is generally the largest current asset. Therefore, in an examination of a propertys liquidity, the quality of its accounts receivable must be considered.

In the normal operating cycle, accounts receivable are converted to cash. Theaccounts receivable turnovermeasures the speed of the conversion. The faster the accounts receivable are turned over, the more credibility the current and acid-test ratios have in financial analysis.

This ratio is determined by dividing revenue by average accounts receivable. A refinement of this ratio uses only charge sales in the numerator; however, quite often charge sales figures are unavailable to outsiders (stockholders, potential stockholders, and creditors). Regardless of whether revenues or charge sales are used as the numerator, the calculation should be consistent from period to period. Average accounts receivable is the result of dividing the sum of the beginning-of-the-period and end-of-the-period accounts receivable by two. When a hospitality operation has seasonal sales fluctuations, a preferred approach (when computing theannualaccounts receivable turnover) is to sum the accounts receivable at the end of each month and divide by 12 to determine the average accounts receivable.

Exhibit 5uses relevant figures fromExhibits 1and2to calculate the 20X2 accounts receivable turnover for the Grand Hotel. The accounts receivable turnover of 11.76 indicates that the total revenue for 20X2 is 11.76 times the average receivables. This is lower than the Grand Hotels 20X1 accounts receivable turnover of 13.68. Management would generally investigate this difference. The investigation may reveal problems, or that changes in the credit policy and/or collection procedures significantly contributed to the difference.

Although the accounts receivable turnover measures the overall rapidity of collections, it fails to address individual accounts. This matter is resolved by preparing an aging of accounts receivable schedule that reflects the status of each account. In an aging schedule, each account is broken down to the period when the charges originated. Like credit sales, this information is generally available only to management.Exhibit 6illustrates an aging of accounts receivable schedule.

Since few hospitality establishments charge interest on their accounts receivable, the opportunity cost of credit sales is the investment dollars that could be generated by investing cash. However, credit terms are extended with the purpose of increasing sales. Therefore, theoretically, credit should be extended to the point where the bad debt and additional collection costs of extending credit to one more guest equal the additional profit earned by extending credit to one more guest.

Exhibit 5Accounts Receivable Turnover

Exhibit 6Aging of Accounts Receivable Schedule

Owners prefer a high accounts receivable turnover, as this reflects a lower investment in nonproductive accounts receivable. However, they understand how a tight credit policy and an overly aggressive collections effort may result in lower sales. Nonetheless, everything else being the same, a high accounts receivable turnover indicates that accounts receivable are being managed well. Suppliers, like owners, prefer a high accounts receivable turnover, because this meansthat hospitality establishments will have more cash readily available to pay them. Long-term creditors also see a high accounts receivable turnover as a positive reflection of management.

Management desires to maximize the sales of the hospitality operation. Offering credit helps maximize sales. However, management also realizes that offering credit to maximize sales may result in more accounts receivable and in selling to some less creditworthy customers. One result of managements decision to offer credit is a lower accounts receivable turnover. On the other hand, while management may see a lower accounts receivable turnover as a consequence of higher sales, it should not lose sight of the fact that it also must maintain the operations cash flowthat is, it must effectively collect on the credit sales.

Average Collection Period

A variation of the accounts receivable turnover is theaverage collection period, which is calculated by dividing the accounts receivable turnover into 365 (the number of days in a year). This conversion simply translates the turnover into a more understandable result. For the Grand Hotel, the average collection period for 20X2 is as follows:

The average collection period of 31 days means that on an average of every 31 days throughout 20X2, the Grand Hotel was collecting all its accounts receivable. The 31 days is a four-day increase over the 20X1 average collection period of 27 days.

What should be the average collection period? Generally, the time allowed for average payments should not exceed the terms of sale by more than 7 to 10 days. Therefore, if the terms of sale aren/30 (entire amount is due in 30 days), the maximum allowable average collection period is 37 to 40 days.

The above discussion assumes that all sales are credit sales. However, many hospitality operations have both cash and credit sales. Therefore, the mix of cash and credit sales must be considered when the accounts receivable turnover ratio uses revenue, rather than credit sales, in the numerator. This is accomplished by allowing for cash sales. For example, if sales are 50 percent cash and 50 percent credit, then the maximum allowable average collection period should be adjusted. An adjusted maximum allowable average collection period is calculated by multiplying the maximum allowable average collection period by credit sales as a percentage of total sales.

In the previous example of a maximum allowable collection period of 37 to 40 days and 50 percent credit sales, the adjusted maximum allowable averagecollection period for the Grand Hotel in 20X2 was 18.5 to 20 days (37 to 40 days .5). Generally, only management can make this adjustment, because the mix of sales is unknown by other interested parties.

Exhibit 7Working Capital Turnover

The average collection period preferred by owners, creditors, and management is similar to their preferences for the accounts receivable turnover, because the average collection period is only a variation of the accounts receivable turnover. Therefore, owners and creditors prefer a lower number of days, while management prefers a higher number of days (as long as cash flow is sufficient).

Working Capital Turnover Ratio

The final liquidity ratio presented here is theworking capital turnover ratio, which compares working capital (current assets less current liabilities) to revenue. For most businesses, the higher the revenue, the greater the amount of working capital required. Thus, as the revenue rises, working capital is expected to rise also.Exhibit 7uses relevant figures fromExhibits 1and2to calculate the working capital turnover ratio in 20X2 for the Grand Hotel.

For the Grand Hotel, a working capital turnover of 17.70 means that working capital of $76,400 was used 17.70 times during the year. Everything else being the same, the lower the current ratio, the greater the working capital turnover ratio. Therefore, those establishments in segments of the hospitality industry with virtually no credit sales and a low level of inventory will generally have an extremely high working capital ratio.

Owners prefer this ratio to be high, as they prefer a low current ratio, thus low working capital. Creditors prefer a lower working capital turnover ratio than owners, because they prefer a relatively high current ratio. Managements preferences fall between owners and creditors. Management desires to maintain an adequate amount of working capital to cover unexpected problems, yet management also desires to maximize profits by using available funds to make long-term investments.

Exhibit 8Return on Equity

Solvency Ratios

Solvency ratios measure the degree of debt financing by a hospitality enterprise and are partial indicators of the establishments ability to meet its long-term debt obligations. These ratios reveal the equity cushion that is available to absorb any operating losses. Primary users of these ratios are outsiders, especially lenders, who generally prefer less risk rather than more risk. High solvency ratios generally suggest that an operation has the ability to weather financial storms.

Owners like to use debt instead of additional equity to increase their return on equity already invested. This process is commonly referred to asfinancial leverage.Financial leverage is used when the return on the investment exceeds the cost of the debt used to finance an investment. When using debt to increase their leverage, owners are, in essence, transferring part of their risk to creditors.

As a further explanation of the concept of leverage, let us consider the following example. Assume that total assets of a lodging facility are $100, earnings before interest and taxes (EBIT) are $50, and interest is 15 percent of debt. Further assume that two possible combinations of debt and equity are $80 of debt and $20 of equity, and the reverse ($80 of equity and $20 of debt). Further assume a tax rate of 40 percent. The return on equity for each of the two combinations is calculated inExhibit 8.

The calculations inExhibit 8reveal that each $1 invested by stockholders in the high debt/low equity combination earns $1.14, while every $1 invested by stockholders in the low debt/high equity combination earns only $.35.

This class of ratios includes two groupsthose based on balance sheet information and those based on income statement information. The first three ratiosto be examined (the solvency ratio, the debt-equity ratio, and long-term debt to total capitalization ratio) are based on balance sheet information. The following two ratios, the number of times interest earned ratio and the fixed charge coverage ratio, are based on information from the income statement. The final ratio relates operating cash flows to total liabilities.

Solvency Ratio

A hospitality enterprise is solvent when its assets exceed its liabilities. Therefore, thesolvency ratiois simply total assets divided by total liabilities. The solvency ratio in 20X2 for the Grand Hotel is determined as follows:

Thus, at the end of 20X2, the Grand Hotel has $1.78 of assets for each $1.00 of liabilities or a cushion of $.78. The Grand Hotels assets could be discounted substantially ($.78 $1.78 = 43.8 percent) and creditors could still be fully paid. The Grand Hotels solvency ratio at the end of 20X1 was 1.65 times. The 20X2 ratio would be considered more favorable from the perspective of creditors.

The greater the leverage (use of debt to finance the assets) used by the hospitality establishment, the lower its solvency ratio. Owners prefer to use leverage in order to maximize their return on their investments. This occurs as long as the earnings from the creditor-financed investment exceed the cost of the establishments borrowing. Creditors, on the other hand, prefer a high solvency ratio, as it provides a greater cushion should the establishment experience losses in operations. Managers must satisfy both owners and creditors. Thus, they desire to finance assets so as to maximize the return on owners investments, while not unduly jeopardizing the establishments ability to pay creditors.

Debt-Equity Ratio

Thedebt-equity ratio, one of the commonest solvency ratios, compares the hospitality establishments debt to its net worth (owners equity). This ratio indicates the establishments ability to withstand adversity and meet its long-term debt obligations. Figures fromExhibit 1can be used to calculate the Grand Hotels debt-equity ratio for 20X2:

The Grand Hotels debt-equity ratio of 1.27 to 1 at the end of 20X2 indicates for each $1 of owners net worth, the Grand Hotel owed creditors $1.27. The debt-equity ratio for 20X1 for the Grand Hotel was 1.54 to 1. Thus, relative to its net worth, the Grand Hotel reduced its 20X1 debt.

Owners view this ratio similarly to the way they view the solvency ratio. That is, they desire to maximize their return on investment by using leverage. The greater the leverage, the higher the debt-equity ratio. Creditors generally would favor a lower debt-equity ratio because their risk is reduced as net worth increases relative to debt. Management, as with the solvency ratio, prefers a middle position between creditors and owners.

Long-Term Debt to Total Capitalization Ratio

Still another solvency ratio is the calculation of long-term debt as a percentage of the sum of long-term debt and owners equity, commonly called total capitalization. This ratio is similar to the debt-equity ratio except that current liabilities are excluded in 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. Figures fromExhibit 1can be used to calculate the 20X2long-term debt to total capitalization ratiofor the Grand Hotel:

Long-term debt of the Grand Hotel at the end of 20X2 is 46.24 percent of its total capitalization. This can be compared to 51.88 percent at the end of 20X1. Creditors would prefer the lower percentage because it would indicate a reduced risk on their part. Owners, on the other hand, would prefer the higher percentage because of their desire for high returns through the use of leverage.

Number of Times Interest Earned Ratio

Thenumber of times interest earned ratiois based on financial figures from the income statement and expresses the number of times interest expense can be covered. The greater the number of times interest is earned, the greater the safety afforded the creditors. Since interest is subtracted to determine taxable income, income taxes are added to net income and interest expense (earnings before interest and taxes, abbreviated as EBIT) to form the numerator of the ratio, while interest expense is the denominator. Figures fromExhibit 2can be used to calculate the 20X2 number of times interest earned ratio for the Grand Hotel:

The result of 5.08 times shows that the Grand Hotel could cover its interest expense by over five times. The number of times interest earned ratio in 20X1 for the Grand Hotel was 5.36 times. This two-year trend suggests a slightly riskier position from a creditors viewpoint. However, in general, a number of times interest earned ratio of greater than 4 reflects a sufficient amount of earnings for a hospitality enterprise to cover the interest expense of its existing debt.

All parties (owners, creditors, and management) prefer a relatively high ratio. Owners are generally less concerned about this ratio than creditors, as long as interest obligations are paid on a timely basis and leverage is working to their advantage. Creditors, especially lenders, also prefer a relatively high ratio, because this indicates that the establishment is able to meet its interest payments. To the lender, the higher this ratio, the better. Management also prefers a high ratio. However, since an extremely high ratio suggests leverage is probably not being optimized for the owners, management may prefer a lower ratio than do lenders.

The number of times interest earned ratio fails to consider fixed obligations other than interest expense. Many hospitality firms have long-term leases that require periodic payments similar to interest. This limitation of the number of times interest earned ratio is overcome by the fixed charge coverage ratio.

Fixed Charge Coverage Ratio

Thefixed charge coverage ratiois a variation of the number of times interest earned ratio that considers leases as well as interest expense. Hospitality establishments that have obtained the use of property and equipment through leases may find the fixed charge coverage ratio to be more useful than the number of times interest earned ratio. This ratio is calculated the same as the number of times interest earned ratio, except that lease expense (rent expense) is added to both the numerator and denominator of the equation.

Exhibit 9uses figures fromExhibit 2to calculate the 20X2 fixed charge coverage ratio for the Grand Hotel. The result indicates that earnings prior to lease expense, interest expense, and income taxes cover lease and interest expense 4.06 times. The Grand Hotels fixed charge coverage ratio for 20X1 was 4.18 times. The change of 0.12 times reflects a minor decrease in the Grand Hotels ability to cover its fixed costs of interest and lease expense. The viewpoints of owners, creditors, and management are similar to the views they hold regarding changes in the number of times interest earned ratio.

Debt Service Coverage Ratio

Thedebt service coverage ratiomeasures the extent to which a property generates sufficient adjusted net operating income (net operating income less cash transfersto replacement reserves) to cover its debt obligations, including both interest and principal payments.

Exhibit 9Fixed Charge Coverage Ration

Exhibit 10Debt Service Coverage Ration

The ratio is calculated as follows:

Figures fromExhibits 2and3are used to calculate the 20X2 debt service coverage ratio for the Grand Hotel inExhibit 10. The result for 20X2 indicates that the debt payment could be made 3.74 times. This is a slight improvement over the debt service coverage ratio of 3.62 times for 20X1. All users of financial information prefer this ratio to be relatively high.

Operating Cash Flows to Total Liabilities Ratio

The final solvency ratio presented in this chapter uses figures from both the statement of cash flows and the balance sheet by comparing operating cash flows to average total liabilities. Both the debt-equity and long-term debt to total capitalization ratios are based on static numbers from the balance sheet. This ratio overcomes the deficiency of using debt at a point in time by considering cash flow for a period of time.

Figures fromExhibits 1and3are used to calculate the 20X2operating cash flows to total liabilities ratiofor the Grand Hotel as follows:

The 20X1 operating cash flows to total liabilities ratio is 34.4 percent; thus, the Grand Hotels ability to meet its long-term obligations with operating cash flows has deteriorated from 20X1 to 20X2.

All users of financial information prefer this ratio to be relatively high; that is, the cash flow from operations should be high relative to total liabilities, given that the amount of debt used is optimal.

Activity Ratios

Activity ratios measure managements effectiveness in using its resources. Management is entrusted with inventory and fixed assets (and other resources) to generate earnings for owners while providing products and services to guests. Since the fixed assets of most lodging facilities constitute a large percentage of the operations total assets, it is essential to use these resources effectively. Although inventory is generally not a significant portion of total assets, management must adequately control it in order to minimize the cost of sales.

Inventory Turnover

Theinventory turnovershows how quickly the inventory is being used. All things being the same, generally, the quicker the inventory turnover the better, because inventory can be expensive to maintain. Maintenance costs include storage space, freezers, insurance, personnel expense, recordkeeping, and, of course, the opportunity cost of the funds tied up in inventory. Inventories held by hospitality operations are highly susceptible to theft and must be carefully controlled.

Inventory turnovers should generally be calculated separately for food supplies and for beverages. Some food service operations will calculate several beverage turnovers based on the types of beverages available.

Exhibit 11Condensed Food and Beverage Department Statement

Exhibit 11is a condensed food and beverage department statement of the Grand Hotel, with food and beverage operations for 20X2 shown separately. Figures from this statement will be used to illustrate the food and beverage turnover ratios.

Exhibit 12calculates the 20X2 food inventory turnover for the Grand Hotel. The food inventory turned over 12.2 times during 20X2, or approximately once per month. The speed of food inventory turnover generally depends on the type of food service operation. A quick-service restaurant generally experiences a much faster food turnover than does a fine-dining establishment. In fact, a quick-service restaurant may have a food inventory turnover in excess of 200 times for a year. A norm used in the hotel industry for hotels that have several different types of restaurants and banquets calls for food inventory to turn over four times per month.

Although a high food inventory turnover is desired because it means that the food service establishment is able to operate with a relatively small investment in inventory, too high a turnover may indicate possible stockout problems. Failure to provide desired food items to guests may not only immediately result in disappointed guests, but may also result in negative goodwill if this problem persists. Too low an inventory turnover suggests that food is overstocked, and, in addition to the costs to maintain inventory previously mentioned, the cost of spoilage may become a problem.

Exhibit 13uses figures fromExhibit 11to calculate the 20X2 beverage turnover for the Grand Hotel. The beverage turnover of 4.67 means that the beverage inventory of $6,000 required restocking approximately every 78 days. This iscalculated by dividing 365 days in the year by the beverage turnover of 4.67. Not all beverage items are sold evenly; thus, some items would have to be restocked more frequently. A norm used in the hotel industry for hotels having several different types of lounges and banquets calls for beverage inventory to turn over 1.25 times per month or 15 times per year.

Exhibit 12Food Inventory Turnover

Exhibit 13Beverage Turnover

All parties (owners, creditors, and management) prefer high inventory turnovers to low ones, as long as stockouts are avoided. Ideally, as the last inventory item is sold, the shelves are being restocked.

Exhibit 14Property and Equipment Turnover

Property and Equipment Turnover

Theproperty and equipment turnover(sometimes called the fixed asset turnover) is determined by dividing average total property and equipment into total revenue for the period. A more precise measurement would be to use only revenues related to property and equipment usage in the numerator. However, revenue by source is not available to many financial analysts, so total revenue is generally used.

This ratio measures managements effectiveness in using property and equipment. A high turnover suggests the hospitality enterprise is using its property and equipment effectively to generate revenues, while a low turnover suggests the establishment is not making effective use of its property and equipment and should consider disposing of part of them.

A limitation of this ratio is that it places a premium on using older (depreciated) property and equipment, since their book value is low. Further, this ratio is affected by the depreciation method employed by the hospitality operation. For example, an operation using an accelerated method of depreciation will show a higher turnover than an operation using the straight-line depreciation method, all other factors being the same.

Exhibit 14uses figures fromExhibits 1and2to calculate the 20X2 property and equipment turnover ratio for the Grand Hotel. The turnover of 1.68 reveals that revenue was 1.68 times the average total property and equipment. For 20X1, the Grand Hotels property and equipment turnover was 1.62 times. The change of .06 times, although minor, is viewed as a positive trend.

All parties (owners, creditors, and management) prefer a high property and equipment turnover. Management, however, should resist retaining old and possibly inefficient property and equipment, even though they result in a high propertyand equipment turnover. The return on assets ratio (discussed under profitability ratios) is a partial check against this practice.

Exhibit 15Asset Turnover

Asset Turnover

Another ratio to measure the efficiency of managements use of assets is theasset turnover. It is calculated by dividing total revenue by average total assets. The two previous ratios presented, inventory turnover and property and equipment turnover, concern a large percentage of the total assets. The asset turnover examines the use of total assets in relation to total revenue. Limitations of the property and equipment ratio are also inherent in this ratio to the extent that property and equipment make up total assets. For most hospitality establishments, especially lodging businesses, property and equipment constitute the majority of the operations total assets.

Exhibit 15uses figures fromExhibits 1and2to calculate the 20X2 asset turnover ratio for the Grand Hotel. The asset turnover of 1.21 indicates that each $1 of assets generated $1.21 of revenue in 20X2. The asset turnover ratio for 20X1 was 1.23. Thus, there was virtually no change for the two years.

As with the property and equipment turnover, all concerned parties (owners, creditors, and management) prefer this ratio to be high, because a high ratio means effective use of assets by management, subject to the limitations of using old (depreciated) assets as discussed previously.

Both the property and equipment turnover and the asset turnover ratios are relatively low for most hospitality segments, especially for hotels and motels. The relatively low ratios are due to the hospitality industrys high dependence on fixedassets and its inability to quickly increase output to meet maximum demand. It is common for many hotels and motels to turn away guests four nights a week due to excessive demand, and operate at an extremely low level of output (less than 50 percent) the three remaining nights.

Exhibit 16Paid Occupancy Percentage

Five additional measures of managements ability to efficiently use available assets are paid occupancy percentage, complimentary occupancy, average occupancy per room, multiple occupancy, and seat turnover. Although these ratios are not based on financial information, they are viewed as excellent measures of managements effectiveness in selling space, whether it be rooms in a lodging facility or seats in a food service establishment.

Paid Occupancy Percentage

Paid occupancyis a major indicator of managements success in selling its product. It refers to the percentage of rooms sold in relation to rooms available for sale in hotels and motels. In food service operations, it is commonly referred to as seat turnover, and is calculated by dividing the number of people served by the number of seats available. Seat turnover is commonly calculated by meal period. In most food service facilities, different seat turnovers are experienced for different dining periods. The occupancy percentage for lodging facilities and the seat turnovers for food service facilities are key measures of facility utilization.

Using the Other Information listed inExhibit 4, the annual paid occupancy of the Grand Hotel can be determined by dividing total paid rooms occupied by available rooms for sale. If the Grand Hotel had 80 rooms available for sale each day, its paid occupancy percentage for 20X2 is calculated as indicated inExhibit 16.

The Grand Hotels 20X2 annual paid occupancy percentage of 71.92 percent was an improvement over the 20X1 annual occupancy percentage of 70.21 percent, when 20,500 rooms were sold. This percentage does not mean that every day 70.21 percent of the available rooms were sold, but rather that on the average 70.21 percent were sold. For example, a hotel experiencing 100 percent paid occupancyMonday through Thursday and 33 percent paid occupancy Friday through Sunday would end up with a combined result of 71.29 percent.

There are many factors affecting paid occupancy rates in the lodging industry, such as location within an area, geographic location, seasonal factors (both weekly and yearly), rate structure, and type of lodging facility, to mention a few.

Among other uses, the paid occupancy percentage allows hotel operators to track their operating results by computing their hotels market penetration. The calculation of market penetration also depends on something called market share.Market sharerefers to the number of rooms in a hotel calculated as a percentage of the total rooms in the hotels market setthat is, the total number of rooms available within a hotels market area. Assume the Brymon Lodge has 100 rooms and directly competes with four other lodging properties with a total of 900 rooms. Thus, the market set has 1,000 rooms and the market share for the Brymon Lodge would be 10 percent. If research shows that the market set has an aggregate occupancy of 65 percent, then, on a daily basis, an average of 650 rooms are sold by hotels in that market set. The market share on a daily basis for the Brymon Lodge would be 65 rooms per day.

Market penetrationis the percentage of demand for rooms for a hotel within a particular market set. It is calculated by dividing the total rooms occupied in the hotel by that hotels fair share of demand. For example, assume that for the month of June, the Brymon Lodge sold 1,860 rooms. The fair share for June for the Brymon Lodge is 1,950 rooms, determined by multiplying the 10 percent market share of 650 rooms by 30 days. The Brymon Lodges June sales of 1,860 rooms are only 95.38 percent (1,860 rooms divided by 1,950 rooms) of its fair share of demand.

The result for the Brymon Lodge is likely unacceptable. Hotels strive to equal or exceed their competitors and achieve a market penetration of 100 percent or better. What could have gone wrong? There could be many factors, including:

• Location.
• Wrong franchise.
• Wrong data regarding the market set.
• Lack of marketing effort.
• Lack of sales effort.
• Wrong amenity mix.
• Reputation problems.

Complimentary Occupancy

Complimentary occupancy, as stated in theUniform System of Accounts for the Lodging Industry, is determined by dividing the number of complimentary rooms for a period by the number of rooms available. Using figures from the Other Information section ofExhibit 4, the 20X2 complimentary occupancy for the Grand Hotel is calculated as follows:

Average Occupancy per Room

Another ratio to measure managements ability to use the lodging facilities is theaverage occupancy per room. This ratio is the result of dividing the number of guests by the number of rooms occupied. Generally, as the average occupancy per room increases, the room rate also increases.

Using figures from the Other Information section ofExhibit 4, the 20X2 average occupancy per room for the Grand Hotel can be calculated as follows:

The Grand Hotels 20X2 average occupancy per room was 1.14 guests. The 20X1 average occupancy per room was slightly higher at 1.15 guests.

The average occupancy per room is generally the highest for resort properties, where it can reach levels in excess of two guests per room, and is lowest for transient lodging facilities.

Multiple Occupancy

Another ratio used to measure multiple occupancy of rooms ismultiple occupancy, sometimes less accurately calleddouble occupancy.This ratio is similar to the average occupancy per room. It is determined by dividing the number of rooms occupied by more than one guest by the number of rooms occupied by guests.

Using figures from the Other Information section ofExhibit 4, the multiple occupancy of the Grand Hotel for 20X2 can be calculated as follows:

The multiple occupancy for the Grand Hotel during 20X2 indicates 11.81 percent of the rooms sold were occupied by more than one guest. The 20X1 multiple occupancy for the Grand Hotel was 11.62 percent; therefore, a minor increase in multiple occupancy has occurred.

Owners, creditors, and management all prefer high occupancy ratiospaid occupancy percentage, average occupancy per room, and multiple occupancy. The higher the occupancy ratios, the greater the use of the facilities. These ratios are considered to be prime indicators of a lodging facilitys level of operations. Occupancy ratios are generally computed on a daily basis and are recorded on the daily report of operations.

Seat Turnover

A nonfinancial ratio used to measure the occupancy of a food service facility isseat turnover.The greater the seat turnover, the greater the use of the food service facility. This ratio is calculated by dividing the number of people served (some-times calledcovers) by the number of seats in the food service facility. Assume the Grand Hotel has a single food service outlet with 100 seats. Assume further that the 56,000 food covers (seeExhibit 4) in 20X2 were served in the 100-seat facility. The 20X2 seat turnover is calculated as follows:

The seat turnover of 1.53 means that each seat was used 1.53 times during the measured unit or period (in this case, per day). This compares favorably to the facilitys seat turnover of 1.52 times for 20X1. Seat turnover would be computed for each meal period each day.

Of course, to compute and use the seat turnover ratio, food service operations must track the actual number of covers served. This can be more complex than it sounds, because it often isnotsimply a matter of counting every customer. Managers must define what the operation considers to be a cover. Must a cover purchase a full meal? Is someone who orders only a cup of coffee or only a dessert counted as a cover? The definition of a cover may even vary by meal period. The results of seat turnover calculations will depend on the definition chosen.

Profitability Ratios

Profitability ratios reflect the results of all areas of managements responsibilities. All the information conveyed by liquidity, solvency, and activity ratios affect the profitability of the hospitality enterprise. The primary purpose of most hospitality operations is the generation of profit. Owners invest for the purpose of increasing their wealth through dividends and through increases in the price of capitalstock. Both dividends and stock price are highly dependent upon the profits generated by the operation. Creditors, especially lenders, provide resources for hospitality enterprises to use in the provision of services. Generally, future profits are required to repay these lenders. Managers are also extremely interested in profits because their performance is, to a large degree, measured by the operations bottom line. Excellent services breed goodwill, repeat customers, and other benefits that ultimately increase the operations profitability.

The profitability ratios we are about to consider measure managements overall effectiveness as shown by returns on sales (profit margin and operating efficiency ratio), returns on assets (return on assets and gross return on assets), return on owners equity (return on owners equity and return on common stockholders equity), and the relationship between net income and the market price of the hospitality establishments stock (price earnings ratio).

Profit Margin

Hospitality enterprises are often evaluated in terms of their ability to generate profits on sales.Profit margin, a key ratio, is determined by dividing net income by total revenue. It is an overall measurement of managements ability to generate sales and control expenses, thus yielding the bottom line. In this ratio, net income is the income remaining after all expenses have been deducted, both those controllable by management and those directly related to decisions made by the board of directors.

Using figures fromExhibit 2, the 20X2 profit margin of the Grand Hotel can be determined as follows:

The Grand Hotels 20X2 profit margin of 10.85 percent has remained nearly constant from the 20X1 figure of 10.87 percent.

If the profit margin is lower than expected, then expenses and other areas should be reviewed. Poor pricing and low sales volume could be contributing to the low ratio. To identify the problem area, management should analyze both the overall profit margin and the operated departmental margins. If the operated departmental margins are satisfactory, the problem would appear to be with overhead expense.

Operating Efficiency Ratio

Theoperating efficiency ratio(also known as thegross operating profit margin ratio) is a better measure of managements performance than the profit margin. This ratio is the result of dividing gross operating profit by total revenue. Gross operating profit is the result of subtracting expenses generally controllable bymanagement from revenues. Nonoperating expenses include management fees and fixed charges. These expenses are directly related to decisions made by the board of directors, not management. Fixed charges are expenses relating to the capacity of the hospitality firm, including rent, property taxes, insurance, and depreciation. Although these expenses are the result of board of directors decisions and thus beyond the direct control of active management, management can and should review tax assessments and insurance policies and quotations, and make recommendations to the board of directors that can affect the facilitys total profitability. In calculating the operating efficiency ratio, interest expense, and income taxes are also excluded, since these are beyond the control of management.

Using figures fromExhibit 2, the 20X2 operating efficiency ratio of the Grand Hotel can be calculated as follows:

The operating efficiency ratio shows that nearly $.31 of each $1 of revenue is available for fixed charges, interest expense, income taxes, and profits. The Grand Hotels operating efficiency ratio was 30.39 percent for 20X1.

The next group of profitability ratios compares profits to either assets or owners equity. The result in each case is a percentage and is commonly called a return.

Gross Operating Profit per Available Room

Gross operating profit per available room (GOPAR)measures managements ability to produce profits by generating sales and controlling the operating expenses over which they have the most control. GOPAR is determined as follows:

This ratio may be useful in relating gross operating profits on a proportional basis across properties within a competitive set of comparable property groups. Because GOPAR is calculated before any deduction for management fees, this ratio can be used to compare comparable properties that are operated by a third-party management company with owner-operated properties.

Using figures forExhibits 2and16, the Grand Hotels 20X2 GOPAR is $14.23 ($415,000 29,200). This compares favorably with its GOPAR for 20X1 of $13.53.

Return on Assets

Thereturn on assets (ROA)ratio is a general indicator of the profitability of the hospitality enterprises assets. Unlike the two preceding profitability ratios drawn only from income statement data, this ratio compares bottom line profits to the total investment, that is, to the total assets. It is calculated by dividing net incomeby average total assets. This ratio, or a variation of it, is used by several large conglomerates to measure the performances of their subsidiary corporations operating in the hospitality industry.

Exhibit 17Return on Assets

Using figures fromExhibits 1and2, the Grand Hotels 20X2 return on assets is calculated inExhibit 17. The Grand Hotels 20X2 ROA is 13.09 percent, which means there was 13.09 cents of profit for every dollar of average total assets. The 20X1 ROA was 13.36 percent. Therefore, there was a slight decline in ROA from 20X1 to 20X2.

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 additional assets need to be added to supp