Chapter 5 Financial Statement Analysis

Andrew, Damitio, Schmidgall Financial Management for the Hospitality Industry

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Three Approaches to Financial Statement Analysis

Horizontal analysis

Vertical analysis Ratio analysis

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Horizontal Analysis
1. 2.

Compares two financial statements Shows dollar and percentage differences

Illustration: Cash 2009 2010 $10,000 $15,000 Differences Dollar % + $5000 50%

3.

When reviewing financial statements focus on significant differences!

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Vertical Analysis
1. Financial statements reduced to

percentages 2. Balance sheet:

a. Assets = 100% b. Liabilities & OE = 100%

3. Income statement:

net revenue = 100%

Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

ALPHA Co. Illustration Dollars % Net revenue $100,000 100% Cost of sales 35,000 35 Labor costs 30,000 30 Other expenses 30,000 30 Net income $5,000 5%

BETA Co. Dollars % $500,000 100% 200,000 40 150,000 30 190,000 28 $10,000 2%

Which company has the best performance? Why?

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Ratio Analysis

Comparing two related numbers from financial statements Expressed as $, %, times, days, etc. Purposes for managers: Express goals for business Track performance of the operation Communicate financial performance Result must be compared to a standard
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

Standards
Budget

Prior period Industry average

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Classes of Ratios
Liquidity can the firm meet its short-term
obligations? Solvency can the firm meet its long-term obligations? Activity how is management using the propertys assets? Profitability how profitable is the business? Operating how efficient is management in running the business?
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

Liquidity Ratios

Current Ratio indicates relationship between current assets and current liabilities Formula: CR = Current Assets/Current Liabilities

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Acid-Test Ratio
Acid-Test Ratio:
Quick Assets Current Liabilitie s

A more stringent measure than the CR as

inventories and prepaid expenses are excluded

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Accounts Receivable Turnover

This ratio shows the number of times the average accounts receivable have been collected. AR T/O: Total revenue/Average accounts receivable Note: When comparing figures from a stock statement (balance sheet) and a flow statement (income statement) use an average for the figures from the balance sheet!

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Average Collection Period (ACP)

ACP is another to view the collection of AR ACP = 365/AR T/O Expresses average number of days receivables are outstanding

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Operating Cash Flows to Current Liabilities Ratio

Purpose of ratio is compare operating cash flows to current debt. (Cash pays the bills, not CA!) OCF to CL Ratio = OCF/Average CL

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Liquidity Evaluation Illustration

Selected liquidity ratios for AW Corporation are as follows:
CR Acid-test AR T/O OCF to CL 2008 1.4 1.2 12 70% 2009 1.45 1.25 11 72% 2010 1.5 1.3 10 74%

Evaluate the change in liquidity for AW corporation

Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Evaluation
The current and acid-test ratios are increasing throughout the 2008-2010 period. The AR T/O is decreasing resulting in relatively more accounts receivable outstanding. ACP was 30.4 days at the end of 2008 and increased to 36.5 days at the end of 2010. This increase should be further investigated. Operating cash flows are increasing overtime in relation to the current obligations. Overall liquidity is improving; however, there is some concern regarding accounts receivable.
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Solvency Ratios

Two major perspectives balance sheet and income statement Balance sheet Debt-equity LTD to total capitalization Income statement Number of times interest earned (TIE) Fixed charge coverage SCF: OCF to total liabilities ratio
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

Debt-Equity Ratio

Shows amount of debt for each $1 of owners equity DE Ratio: total liabilities/total owners equity

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Long-Term Debt to Total Capitalization Ratio

Total capitalization = LTD + Owners Equity Shows LTD as % of total capitalization LTD to Total Cap. Ratio = LTD/LTD + OE

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Number of Times Interest Earned (TIE)

Indicates the number of times interest can be covered with income TIE = EBIT/Interest Expense

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Fixed Charge Coverage Ratio

Lease expense is added to the numerator and denominator of the TIE ratio FCC Ratio = (EBIT + Lease Expense)/ (Interest + Lease Expense)

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Operating Cash Flows to Total Liabilities Ratio

Uses figures from Balance Sheet and SCF OCF to TL Ratio = OCF/Average TotalLiabilities

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Solvency Evaluation Illustration

BC, Inc., has solvency ratios for 2008 2010 as follows:
Debt-Equity LTD to Total Cap. Ratio TIE FCC Ratio OCF to TL Ratio 2008 70% 41% 4 times 3 times 20% 2009 60% 38% 4.2 times 2.8 times 22% 2010 50% 33% 4.4 times 2.6 times 24%

Evaluate the changing solvency of BC, Inc. over the three years
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Evaluation
Both the debt-equity and LTD to total capitalization ratios reveal relatively less debt to equity over the three years. The increasing TIE and OCF to TL ratios suggest an increasing ability to pay the longterm liabilities. The decreasing fixed charge average ratio suggests lease expense (and most likely the number of leases) are increasing over time. Overall solvency has improved and in part this has happened by switching to leasing as a means of finance.
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Activity Ratios

Inventory Turnover Property and Equipment Turnover Asset Turnover Non-financial ratio: occupancy

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Inventory Turnover
This ratio shows how quickly inventory
is moving

A separate turnover should be

determined for each type of inventory, i.e., food, beverage, gift shop etc.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Food Inventory Turnover

Food Inventory Turnover =

Cost of Food Used Average Food Inventory

Cost of Food Used: BI + purchases EI

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Food Inventory Holding Period (FIHP)

Provides the average number of days inventory is held prior to sale FIHP =
365 Food Inventory Turnover

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Property and Equipment Turnover (PET)

Measures managements effectiveness in using property and equipment PET =
Total Revenue Average Property and Equipment

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Asset Turnover Ratio

Measures managements use of all assets Asset Turnover Ratio:
Total Revenue Average Total Assets

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Paid Occupancy Percentage

A non-financial key indicator of managements success in selling rooms Paid occupancy % =
Rooms Sold Rooms Available

Rooms sold include all rooms occupied except for complimentary rooms
Rooms available include rooms that could be sold and generally exclude out-of-order rooms
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

Activity Evaluation Illustration

The Dirk Companys activity ratios over a three year period were as follows:
Food inventory T/O Property and equipment T/O Asset turnover Paid occupancy % 2008 12 2 1 72% 2009 13 2.1 1.1 71% 2010 14 2.2 1.2 70%

How has managements use of the companys resources changed over the three year period?

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Evaluation
Food inventory is turning more quickly from 2008 through 2010 as is both property and equipment and total assets. This result is considered good. Paid occupancy is declining slightly. Management appears to be selling few rooms; however, the ADR (price per room) could be a major factor. This requires additional management attention.
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Profitability Ratios

These ratios measure the overall effectiveness of management Major ratios include: Profit Margin Operating Efficiency Ratio Return on Assets Return on Equity EPS PE Ratio
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

Profit Margin

Measures the profits from sales Profit Margin =
Net Income Total Revenue

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Operating Efficiency Ratio

Measures managements performance based on expenses they control Operating Efficiency Ratio:
Income after Undi stributed Operating Expenses Total Revenue

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Return on Assets (ROA)

Indicator of profitability compared to the firms assets ROA =
Net Income Average Total Assets

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Return on Equity (ROE)

Measures profitability of firm compared to owners investment ROE =
Net Income Average Owners' Equity

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Earnings per Share (EPS)

Shows the amount earned per each share of owners common stock EPS =
Net Income Average Common Shares Outstanding

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Price Earnings Ratio (PE)

Reflects the relationship between the market price per share and the EPS

PE =

Market price per share EPS

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Profitability Evaluation Illustration

The Mellow Motel Corporations profitability ratios for 2008 through 2010 were as follows:
2008 6% 30% 12% 15% $2.00 10 2009 6.5% 29% 13% 16% $2.10 11 2010 7% 28% 14% 17% $2.20 12

Profit Margin Operating Efficiency Ratio ROA ROE EPS PE

Evaluate the corporations changing profitability over the three-year period.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Evaluation
Profit margin is increasing each year even though the operating efficiency ratio is in decline. ROA, ROE, and EPS are increasing each year. This suggests that greater profits are being achieved by relative reductions in fixed charges such as interest expense and depreciation. The market appears to be reacting favorably to these changes since the PE ratio has increased from 10 times in 2008 to 12 times in 2010. The market price at the end of 2008 was $20 and at the end of 2010 it was $26.40.
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Operating Ratios
Assist management in analyzing the

operations of the business Major ratios covered include

Average daily rate (ADR) REVPAR Food Cost Percentage Labor Cost Percentage

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Average Daily Rate (ADR)

Reveals average price per room sold ADR =
Rooms Revenue Number of Rooms Sold

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

REVPAR

Measures a combination of paid occupancy % and ADR REVPAR = Paid OCC % X ADR

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Food Cost Percentage

Key food service ratio that compares the cost of product (food) sold to product (food) sales Food Cost % =
Cost of Food Sold Food Sales

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Labor Cost Percentage

Reveals the relationship between

labor costs and revenue Labor cost generally is the highest single cost of a hospitality organization Labor costs include salaries, wages, fringe benefits, and payroll taxes Ratio should be computed for each profit center of the operation
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

Labor Cost %

Labor Cost % =

Department al Labor Costs Department al Revenues

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Evaluation of Operations Illustration

The Wisker Restaurant Inn has selected operating ratios for 2008-2010 as follows:
2008 $85 $59.50 34% 30% 2009 $86 $59.34 33.5% 29.5% 2010 $87 $59.16 33% 29%

ADR REVPAR Food Cost % Labor Cost %

Evaluate the operating activities of the Wisker Restaurant & Inn over the three-year period based on the above four ratios
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Evaluation

First, one should be very careful when evaluating any aspect of business with so few ratios. Even so, these four ratios suggest Prices are increasing but the amount per room available is
decreasing from 2008 through 2010. This appears to suggest some price resistance and management should undertake further evaluation. Both food cost and labor cost percentages are decreasing over the three year period. If quality is not sacrificed this is good from a financial perspective.

Andrew, Damitio, Schmidgall Financial Management for the Hospitality

2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Limitations of Ratio Analysis

Only indicators Must be based on two related numbers Most useful when compared to a standard Be careful when comparing financial ratios of different firms

Are they in the same industry? Are they using the same or similar
accounting procedures?
Andrew, Damitio, Schmidgall Financial Management for the Hospitality 2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Summary

Financial analysis includes horizontal, vertical and ratio analysis Ratios can be used to efficiently communicate, control and set targets Major classes of ratios include liquidity, solvency, activity, profitability, and operating Ratios vary in importance to major user groups Ratios must be compared to a standard to be meaningful
2007 Pearson Education, Inc. Upper Saddle River, NJ 07458

Andrew, Damitio, Schmidgall Financial Management for the Hospitality