You are on page 1of 33

# Ratio Analysis 1.

2. Turnover

eg.
3.

## Per-Unit eg. Average Rate Per Room Numerator/Denominator eg. 2:1

4.

Ratio Comparison
Ratios are meaningful if compared with a standard or base figure/judge each ratio against a predetermined standard for the period of time.

Ratio Categories
1.
2. 3. 4.

Liquidity Ratios
Solvency Ratios Profitability Ratios Turnover Ratios

Liquidity Ratios For the analysis of a firms ability to meet short-term obligations as they become due.

Liquidity Ratios
1.
2. 3.

Current Ratio
Quick Ratio Accounts Receivable Ratio a. % of Revenue b. Accounts Receivable Turnover c. Average Collection Period

Current Ratio
Indicative of a firms ability to meet its short-term debts without difficulty. Current Ratio = Current Assets/Current Liability General rule of thumb is 2:1 to provide for safety margin; especially firms with large current assets tied up in inventories. Hotels current ratio acceptable: >= 1.5 Restaurants current ratio acceptable: , = 1.1 A balance should be struck; as too low a ratio short-term liquidity problem too high a ratio sacrifices profitability for safety; because money tied up in working capital are money not earning income.

## Quick (Acid-Test) Ratio

As inventories are relatively non-liquid/cannot be converted quickly into cash, it is not taken into consideration for quick ratio. Quick Ratio = Current Assets Relatively Non-Liquid Assets/Total Current Liabilities Generally, quick ratio should not be < 1.0. In hotel & restaurant business, quick ratio < 1.0 is considered reasonable & accepted because its inventories are easily converted & relatively high turnover.

## Accounts Receivable Ratio

Accounts receivable represents the portion of revenue which have not been converted to cash and are therefore, not available for payment of current obligation

## Accounts Receivable as a % of Total Revenue

Accounts Receivable as a % of Total Revenue = Average A/C Receivable/Total Revenue x 100% Average A/C Receivable = A/C Receivable (Begin Bal.) + A/C Receivable (End Bal.)/2 Average % is about 4-10% of annual total revenue, but differs greatly between cash only & charge only operations.

## Accounts Receivable Turnover

Accounts Receivable Turnover = Total Revenue/Average Accounts Receivable Represents the rapidity & efficiency of converting accounts receivable into cash. The rate varies depending on: volume of charge/credit transactions efficiency of accounts being collected The rate varies from 10-30 times a year. The hospitality norm is 12 times a year. This means the average amount of accounts receivable is converted into cash 12 times a year.

## Accounts Receivable Average Collection Period

= 365 days/Turnover Rate or Accounts Receivable as a % of Total Revenue x 365 days More meaningful & accurate if only charge sales/credit sales is used for calculations. The lower the collection period, the more efficient collection policy; & increased collection period indicates necessity in the review of : collection procedure credit policy

Solvency Ratios
Referred to as Net Worth Ratio Net Worth = Total Tangible Asset (Total Assets Intangible Items such as Goodwill) Total Liabilities = Total Shareholders Equity Total Assets can be financed either by Debts (Liabilities) or Equity (Shares & Retained Earnings) Solvency ratios shows the balance between these 2 methods of financing. It indicates the ability of the firm to meet its debt obligations when they are due, including principal & interest on long-term borrowings.

## Main Solvency Ratios

1. 2. 3. Total Assets : Total Liabilities Total Liabilities : Total Assets Total Liabilities : Total Shareholders Equity

Leverage

Amount of long term debts used to finance the assets of the firm, as compared to the amount of owners equity (shareholders equity).

## Total Assets : Total Liabilities

It is interpreted as there are \$__ in assets for @ \$1.00 in liabilities. Creditors prefers to see a ratio as high as possible 2:1 or more. The higher the ratio the more secure it is for creditors to recover the full amount owed by firm in the event of Bankruptcy or Liquidation due mainly to Asset Shrinkage. Ratio is calculated on book value, therefore hotel/food service business 1:1 ratio may be acceptable, in consideration of fair market value.

## Total Liabilities : Total Assets

@ \$1.00 of asset being financed by \$-- of debt. As ratio increases, more difficult to raise capital by borrowings. As ratio increases, risk becomes higher for lender. Hospitality firms traditionally been financed with ratio 0.60-0.90. Book value is used for calculations.

## Total Liabilities : Total Equity (Leverage Ratio)

For @ \$1.00 shareholders invested, creditors have invested \$ --. The ratio represents creditors financing of the business relative to the financing by the owners. If the cost of borrowing funds is < the earnings, which can be generated from the use of borrowed funds, it is advantageous to employ leverage. As ratio increases, the risk becomes higher for creditors. Generally, cost of debt (interest rate) is closely related to risk factor. At a 1:1 ratio, total asset value can decline by 50% before creditors run a serious risk.. Although creditors prefer a debt:equity ratio that is not too high, hospitality operations are generally more profitable to have it as high as possible.

The higher the debt-to-equity ratio, the higher will be the owners return on equity.
If Income (before interest) as a percentage of debt is greater than the interest rate to be paid on the debt. However If income declines, the more highly levered a company is, the sooner it will be in financial difficulty.

Profitability Ratios
There is a significant difference between annual profit & profitability. Profit is an absolute term which is expressed as a monetary amount. Profitability is a relative measure of profits as they relate to other factors. Such as the ability to generate profits from the available resources & the adequacy of profits in relation to: revenue assets owners investment in the business

## Main Profitability Ratios

1. 2. 3. 4. 5. 6. Return on Assets Net Return on Assets Number of Times Interest Earned Net Income to Revenue Return to Equity Other Profitability Ratios - Earnings/Share - Dividends Rate/Share - Book Value/Share

## Return on Assets (ROA)

= Income before interest & tax/Average total assets x 100% Measure effectiveness in the use of organizations assets

## Net Return on Assets

= Net income after tax/Average total assets x 100% Nature of hospitality business requires a major investment in assets for operations, thus it is important to have effective usage of the assets to generate enough earnings to cover cost of financing and to provide adequate return to the owners.

Net Return on Assets is useful to assess the likelihood of obtaining more debt financing for expansion purpose versus to evaluate the advisability of seeking equity financing. Because dividend is paid out from earnings after income tax. With equity financing for expansion etc.., shareholders do not anticipate good dividend yield. Calculations are based on book value, therefore, with fair market value, the ratio is likely to decrease. Management needs to improve operating performance to convince equity financing.

## Number of Times Interest Earned

= Income before interest & tax/Interest expense A way of looking at margin of safety in meeting debt interest payments. The amount which profit could decline & still meet interest obligation. If ratio is 2 times a year or higher is considered satisfactory.

## Net Income to Revenue (Profit Margin)

= Net income after tax/Revenue x 100% Need not reflect profitability of company; only reflect managements ability to control cost & generate satisfactory level of income. Profitability is generally related to investment.

= Net income after tax/Average shareholders equity x 100% The ratio shows effectiveness of management use of equity funds. A good ratio should relate to opportunity cost & risk involved.

## Other Profitability Ratios

Earnings/Share = NI After Tax/Average No. of Shares Outstanding Dividends Rate/Share Book Value/Share These ratios are of high concern to those buying & selling publicly traded stocks in open market, but of less concern to the internal management of company. Management are responsible to shareholders in producing satisfactory net return. Net return is generally measured by earnings/share which can determine the desirability of stocks to investors. Stock market investors generally measure the value of a share by its price earning ratio: market price per share/earnings per share.

Turnover Ratios

Used in the assessment of usage of certain groups of assets. It indicates the number of times that an activity occurs over a period, therefore helps t evaluate mangers capability in using & controlling these assets.

1. 2. 3.

## Inventory Turnover Ratio

Inventory Turnover Ratio = Cost of Sale/Average Inventory The ratio measures effective usage of inventory. Industry turnover norm: Food Inventory: 2 4 times/month Beverage Inventory: 1 1 times/month Each organization should establish its own standard; at which level the danger of running out of stock is minimal & possibly no overinvestment in inventory tying up money that could gainfully used to earn additional income.

Any change in turnover rate should be investigated as to its cause: Increased ratio: possibly due to too little investment in inventory & this may affect production efficiency & sales. Decreased ratio: it could mean more money being tied up in inventory & not producing a return. The ratio is generally affected by : Mode of operation Location of operation Method of purchase Storage facility Availability of fund & credit

## Working Capital Turnover

Working Capital Turnover = Revenue/Average Working Capital The ratio measures effective usage of working capital The ratio varies: Restaurants : can be as low as 10 times/year Hotels : can be as high as 50 times/year Generally: Too low turnover means too much working capital Inefficient use of fund. Too high turnover means to little working capital Cash problems if revenue declines.

## Fixed Asset Turnover

Fixed Asset Turnover = Revenue/Total Average Fixed Assets The ratio assesses the effective use of fixed assets in generating revenue. Average turnover rate: Hotel Industry: - 2 times/year Food Service Industry: 4 5 times/year Food Service industry has greater flexibility & able to have better control of this ratio, as it is better able to increase service volume during meal period.