Biz Finance CHP 3B - Ratio Analysis

FINANCIAL
ACCOUNTING
CHAPTER 3
© 2009 John
This Wiley & isSons
document Managerial
the property of Reliance College and is protected by domestic and international law. It may not be distributed or used in any form without an explicitly written permission Accounting
from Reliance College for the Hospitality Industry
Hoboken, NJ 07030 Dopson & Hayes
Chapter 3
Ratio Analysis
© 2009 John Wiley & Sons Managerial Accounting for the Hospitality Industry
Hoboken, NJ 07030 2 Dopson & Hayes
Objectives
 Learning outcomes:
 Upon completing this course, students should able to :-
 Purpose and Value of Ratios
 Types of Ratios and hospitality ratios
 Comparative Analysis of Ratios
 Ratio Analysis Limitations
Hoboken, NJ 07030 Dopson & Hayes
This document is the property of Reliance College and is protected by domestic and international law. It may not be distributed or used in any form without an explicitly written permission from Reliance College
Learning Outcomes
 State the purpose and value of calculating and using
ratios to analyze the health of a hospitality business.
 Distinguish between liquidity, solvency, activity,
profitability, investor, and hospitality-specific ratios.
 Compute and analyze the most common ratios used in
the hospitality industry.
Percentages
 A ratio is created when you divide one number by
another.
 A special relationship (a percentage) results when the
numerator (top number) used in your division is a part of
the denominator (bottom number).
 To convert from common form to decimal form, move
the decimal two places to the left, that is, 50.00% =
0.50.
 To convert from decimal form to common form, move
the decimal two places to the right, that is, 0.50 =
50.00%.
Value of Ratios to Stakeholders
 All stakeholders who are affected by a business’s
profitability will care greatly about the effective operation
of a hospitality business. These stakeholders may
include:
 Owners
 Investors
 Lenders
 Creditors
 Managers
Value of Ratios to Stakeholders
 Each of these stakeholders may have different points of view
of the relative value of each of the ratios calculated for a
hospitality business.
 Owners and investors are primarily interested in their return
on investment (ROI), while lenders and creditors are mostly
concerned with their debt being repaid.
 At times these differing goals of stakeholders can be
especially troublesome to managers who have to please their
constituencies.
 One of the main reasons for this conflict lies within the
concept of financial leverage.
Financial Leverage
 Financial leverage is most easily defined as the use of debt to
be reinvested to generate a higher return on investment (ROI)
than the cost of debt (interest).
go figure!
To illustrate, assume a hospitality manager:
Borrows $10,000 to be repaid at 10% interest

Reinvests the same $10,000 in an investment that gains 12% ROI
And thus, creates a surplus of 2% gain
In this case, borrowing $10,000 and reinvesting the same $10,000 at a higher
rate of return earns a net gain of 2% after the debt is repaid. The manager, in
this case, has leveraged debt to secure a gain.
Financial Leverage
 Because of financial leverage, owners and investors generally
like to see debt on a company’s balance sheet because if it is
reinvested well, it will provide more of a return on the money
they have invested.
 Conversely, lenders and creditors generally do not like to see
too much debt on a company’s balance sheet because the
more debt a company has, the less likely it will be able to
generate enough money to pay off its debt.
Ratio Comparisons
 Ratios are most useful when they compare a company’s
actual performance to a previous time period, competitor
company results, industry averages, or budgeted (planned for)
results.
 When a ratio is compared to a standard or goal, the resulting
differences (if differences exist) can tell you much about the
financial performance (health) of the company you are
evaluating.
Types of Ratios
 Managerial accountants working in the hospitality industry
use:
 Liquidity Ratios
 Solvency Ratios
 Activity Ratios
 Profitability Ratios
 Investor Ratios
 Hospitality Specific Ratios
 Most numbers for these ratios can be found on a company’s
income statement, balance sheet, and statement of cash flows.
Figure 6.1 Condensed Income Statement
Blue Lagoon Water Park Resort

Condensed Income Statement
For the Period: January 1 through December 31, 2010
Income Statement
Revenue 25,201,800
Cost of Sales 2,854,080
Payroll and Related Expenses 8,877,600
Other Expenses 5,934,240
Gross Operating Profit 7,535,880
Rent, Property Taxes, and Insurance 1,760,400
Depreciation and Amortization 1,260,000
Net Operating Income 4,515,480
Interest 1,272,000
Income Before Income Taxes 3,243,480
Income Taxes 1,297,390
Net Income 1,946,090
Figure 6.2 Balance Sheet

Balance Sheet
December 31, 2010
Assets
Current Assets
Cash 2,314,750
Marketable Securities 3,309,600
Net Receivables 1,053,950
Inventories 1,497,200
Total Current Assets 8,175,500
Investments 5,023,500
Property and Equipment
Land 7,712,550
Building 22,290,500
Furnishings and Equipment 7,289,000
Less Accumulated Depreciation 4,668,900
Net Property and Equipment 32,623,150
Other Assets 669,800
Total Assets 46,491,950
Liabilities and Owners’ Equity
Current Liabilities
Accounts Payable 1,438,100
Notes Payable 1,319,900
Other Current Liabilities 1,264,600
Total Current Liabilities 4,022,600
Long-Term Liabilities
Long-Term Debt 14,577,400
Total Liabilities 18,600,000
Owners’ Equity
Common Stock 3,000,000
Paid in Capital 18,775,100
Retained Earnings 6,116,850
Total Owners’ Equity 27,891,950
Total Liabilities and Owners’ Equity 46,491,950
Figure 6.3 Statement of Cash Flows

Statement of Cash Flows
December 31, 2010
Net Cash Flow from Operating Activities

Net Income 1,946,090
Adjustments to reconcile net income to net
cash flow from operating activities
Depreciation 1,260,000
Decrease in Net Receivables 601,350
Increase in Inventories (600,000)
Decrease in Accounts Payable (600,000)
Decrease in Other Current Liabilities (550,000) 111,350
Net cash flow from operating activities 2,057,440
Net Cash Flow from Investing Activities

Decrease in Marketable Securities 800,000
Increase in Investments (800,000)
Increase in Furnishings and Equipment (2,225,345)
Increase in Other Assets (81,000)
Net cash flow from investing activities (2,306,345)
Net Cash Flow from Financing Activities

Decrease in Notes Payable (784,355)
Increase in Long-Term Debt 755,650
Increase in Capital Stock
(Common Stock + Paid in Capital) 1,000,000
Dividends Paid (778,440)
Net cash flow from financing activities 192,855
Net decrease in cash during 2010 (56,050)

Cash at the beginning of 2010 2,370,800
Cash at the end of 2010 2,314,750
Supplementary Disclosure of Cash Flow

Information:
Cash paid during the year for:
Interest 1,272,000
Income Taxes 1,297,390
Figure 6.4 Statement of Retained Earnings and Investor Information

December 31, 2010
Statement of Retained Earnings

Retained Earnings, December 31, 2009 4,949,200
Net Income for 2010 1,946,090
Subtotal 6,895,290
Cash Dividends Paid in 2010 778,440
Retained Earnings, December 31, 2010 6,116,850
Investor Information
Dividends paid to common shareholders $778,440
Common shares outstanding 1,000,000
Market price per share $25.00
Earnings per share $1.95
Dividends per share $0.78
Liquidity Ratios
 Liquidity is defined as the ease at which current assets can be
converted to cash in a short period of time (less than 12
months).
 Liquidity ratios have been developed to assess just how
readily current assets could be converted to cash, as well as
how much current liabilities those current assets could pay.
Liquidity Ratios
 Three widely used liquidity ratios and working capital are:
 Current Ratio
 Quick (Acid-Test) Ratio
 Operating Cash Flows to Current Liabilities Ratio
 Working Capital
Liquidity Ratios
Ratio Name Definition Source of Data Formula
Current Ratio Current ratio shows Numerator: Balance Sheet Current Assets
the firm’s ability to Current Liabilities
cover its current Denominator: Balance Sheet
liabilities with its
current assets.
Quick Quick ratio shows Numerator: Balance Sheet Cash + marketable securities + accounts receivable
(Acid-Test) Ratio the firm’s ability to Current liabilities
cover its current Denominator: Balance Sheet
liabilities with its or
most liquid current
assets. Current assets – (inventories + prepaid expenses)
Current liabilities
Operating Cash Operating cash Numerator: Statement of cash flows Operating cash flows
Flows to Current flows to current Current liabilities
Liabilities Ratio liabilities ratio Denominator: Balance sheet
shows the firm’s
ability to cover its
current liabilities
with its operating
cash flows.
Working Capital Working capital is Balance Sheet Current assets – Current liabilities
the difference
between current
assets and current
liabilities.
Solvency Ratios
 Solvency ratios help managers evaluate a company’s ability
to pay long term debt.
 Solvency ratios are important because they provide lenders
and owners information about a business’s ability to
withstand operating losses incurred by the business. These
ratios are:
 Solvency Ratio
 Debt to Equity Ratio
 Debt to Assets Ratio
 Operating Cash Flows to Total Liabilities Ratio
 Times Interest Earned Ratio
Solvency Ratios
Solvency Ratio Solvency ratio shows the firms Numerator: Balance Sheet Total assets
ability to cover its total Total liabilities
liabilities with its total assets. Denominator: Balance Sheet
Debt to Equity Debt to equity ratio compares Numerator: Balance Sheet Total liabilities
Ratio total liabilities to owners’ Total owners’ equity
equity. Denominator: Balance Sheet
Debt to Assets Debt to assets ratio shows the Numerator: Balance Sheet Total liabilities
Ratio percentage of assets financed Total assets
through debt. Denominator: Balance Sheet
Operating Cash Operating cash flows to total Numerator: Statement of cash Operating cash flows
Flows to Total liabilities ratio shows the firm’s flows Total liabilities
Liabilities Ratio ability to cover its total
liabilities with its operating Denominator: Balance sheet
cash flows.
Times Interest Times interest earned shows Numerator: Income statement Earnings Before Interest and Taxes (EBIT)
Earned Ratio the firm’s ability to cover Interest Expense
interest expenses with Denominator: Income statement
earnings before interest and
taxes.
Activity Ratios
 The purpose of computing activity ratios is to assess
management’s ability to effectively utilize the company’s
assets.
 Activity ratios measure the “activity” of a company’s selected
assets by creating ratios that measure the number of times
these assets turn over (are replaced).
 This assesses management’s efficiency in handling
inventories and long-term assets.
Activity Ratios
 These ratios are also known as turnover ratios or efficiency
ratios.
 In this section you will learn about the following activity
ratios:
 Inventory Turnover
 Property and Equipment (Fixed Asset) Turnover
 Total Asset Turnover
Inventory Turnover
 Inventory turnover refers to the number of times the total
value of inventory has been purchased and replaced in an
accounting period.
 In restaurants, we calculate food and beverage inventory
turnover ratios.
 See Go Figure! for calculations (after Figure 6.5)
 The obvious question is, “Are the food and beverage turnover
ratios good or bad?”
 The answer to this question is relative to the target (desired)
turnover ratios.
Figure 6.5 Condensed Food and Beverage Department Schedule

Condensed Food and Beverage Department Schedule
For the Period: January 1 through December 31, 2010
Food Beverage
Sales 7,200,000 2,880,000
Cost of sales:
Beginning inventory 120,000 60,000
+ Purchases 2,160,400 436,440
- Ending inventory 90,000 45,000
= Cost of goods consumed** 2,190,400 451,440
- Employee meals 52,000 0
= Cost of goods sold** 2,138,400 451,440
Gross profit 5,061,600 2,428,560
Operating expenses:
Payroll and related expenses 2,188,800 534,960
Other expenses 532,800 201,600
Total expenses 2,721,600 736,560
Department income 2,340,000 1,692,000
**The discussion of cost of goods sold and cost of goods consumed will be
explained later in this chapter in the Hospitality-Specific Ratios section.
go figure!
For example, assume the Blue Lagoon food and beverage manager desires to
turn over food inventory 26 times per year. This means that food inventory will
be replaced every two weeks (52 weeks per year/26 times = 2 weeks). The
following shows situations in which actual food inventory turnover is above and
below the Blue Lagoon target of 26 times.
Blue Lagoon food inventory turnover:
Actual turnover (low) 20.9 times

Target turnover 26.0 times
Actual turnover (high) 32.0 times
A low turnover (20.9 times) might have occurred because sales were less than
expected, thus causing food to move slower out of inventory (bad). It could also
mean that the food and beverage manager decided to buy more inventory each
time (thus, making purchases fewer times) because of discount prices due to
larger (bulk) purchases (good).
A high turnover (32.0 times) might have occurred because sales were higher
than expected, thus causing food to move faster out of inventory (good). It could
also mean that significant wastage, pilferage, and spoilage might have occurred
causing food to move out of inventory faster, but not due to higher sales (bad).
Activity Ratios
Food Inventory Food inventory turnover shows the Numerator: Income statement Cost of food consumed
Turnover Ratio speed (# of times) that food inventory Average food inventory*
is replaced (turned) during a year Denominator: Balance sheet
*(Beginning food inventory
+ Ending food inventory)/2
Beverage Inventory Beverage inventory turnover shows Numerator: Income statement Cost of beverage consumed
Turnover Ratio the speed (# of times) that beverage Average beverage inventory**
inventory is replaced (turned) during a Denominator: Balance sheet
year **(Beginning beverage inventory
+ Ending beverage inventory)/2
Property and Equipment Property and equipment turnover ratio Numerator: Income statement Total Revenue
(Fixed Asset) Turnover shows management’s ability to Net Property and Equipment
Ratio effectively use net property and Denominator: Balance sheet
equipment to generate revenues.
Total Asset Turnover Total asset turnover shows Numerator: Income statement Total Revenue
Ratio management’s ability to effectively Total Assets
use total assets to generate revenues. Denominator: Balance sheet
Profitability Ratios
 It is the job of management to generate profits for the
company’s owners, and profitability ratios measure how
well management has accomplished this task.
 There are a variety of profitability ratios used by
managerial accountants:
 Profit Margin
 Gross Operating Profit Margin (Operating
Efficiency)
 Return on Assets
 Return on Owner’s Equity
Profitability Ratios
Profit Margin Profit margin shows management’s Numerator: Income statement Net income
ability to generate sales, control Total revenue
expenses, and provide a profit. Denominator: Income statement
Gross Operating Profit Gross operating profit margin shows Numerator: Income statement Gross operating profit
Margin management’s ability to generate Total revenue
(Operating Efficiency sales, control expenses, and provide a Denominator: Income statement
Ratio) gross operating profit.
Return on Assets Ratio Return on assets shows the firm’s Numerator: Income statement Net income
ability to use total assets to generate Total assets
net income. Denominator: Balance sheet
Return on Equity Ratio Return on equity shows the firm’s Numerator: Income statement Net income
ability to use owners’ equity to Total owners’ equity
generate net income. Denominator: Balance sheet
Ratio Analysis Limitations
 One weakness inherent in an over-dependency on financial
ratios is that ratios, by themselves, may be less meaningful
unless compared to those of previous accounting periods,
budgeted results, industry averages, or similar properties.
 Another limitation is that financial ratios do not measure a
company’s intellectual capital assets such as brand name,
potential for growth, and intellectual or human capital when
assessing a company’s true worth.

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FINANCIAL

To illustrate, assume a hospitality manager:

Borrows $10,000 to be repaid at 10% interest

Blue Lagoon Water Park Resort

Blue Lagoon Water Park Resort

Liabilities and Owners’ Equity

Total Liabilities and Owners’ Equity 46,491,950

Blue Lagoon Water Park Resort

Net Cash Flow from Operating Activities

Net Cash Flow from Investing Activities

Net Cash Flow from Financing Activities

Net decrease in cash during 2010 (56,050)

Supplementary Disclosure of Cash Flow

Blue Lagoon Water Park Resort

Statement of Retained Earnings

Blue Lagoon Water Park Resort

Blue Lagoon food inventory turnover:

Actual turnover (low) 20.9 times

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