Chapter 3 Introduction

1. Chapter 3Introduction • This chapter will provide a review of the major financial statements and selected key ratios used in the industry. • Financial statements reviewed: • Income statements • Balance sheet • Statement of retained earnings • Statement of cash flows

2. Income Statement • Details revenues and expenses for a period of time • Income statements can be as detailed as necessary for use by managers and investors: • Summary for outside users • Detailed departmental statements for insiders

3. Uniform System of Accounts • Widely used format for income statements in the hospitality industry • Focuses primarily on departmental performance • Revenues and expenses specifically attributable to that department • Undistributed operating expenses include items like marketing and maintenance

4. Uniform System For Restaurants • Restaurants also follow a specific format. • First expense shown is cost of goods sold for both food and beverage. • This is followed by other expenses. • Not completed on a departmental basis like hotels because the restaurant is really only one department.

5. Review of Balance Sheet • Shows financial position of an organization at a particular point in time • Assets, liabilities, and owner’s equity • Current items listed first • “Current” meaning convertible to cash or paid in cash within a year • Retained earnings are not the same as cash

6. Relationship Between Balance Sheet and Income Statement • Assets used to generate revenue and cash flow: • For a hospitality business this is land, building, and equipment. • Liabilities are related to expenses. • Accrued wages and accounts payable • Retained earnings will increase with net income, less any dividends declared. • This is the link to the income statement.

7. Statement of Retained Earnings • Often consolidated into a consolidated statement of owner’s equity • Basic calculation • Balance at beginning of period • Plus: net income • Less: dividends declared • Equals: ending balance • There is no cash in retained earnings. • It is simply accrued earnings less dividends declared to the shareholders.

8. Statement of Cash Flows • Its purpose is to show where cash flow came from and where it went during a period of time. • Three major sections of the statement: • Operating activities • Investing activities • Financing activities • Recent accounting scandals have placed a premium on a company’s ability to earn cash flows.

9. Statement of Cash Flows • Why has this become so important? • Balance sheet uses estimates. • Enron “hid” debt from its balance sheet. • Worldcom categorized expenses as “investments” (assets). • Income statement is completed on accrual basis (when do we recognize the revenue). • Cash flows represent the actual flows of cash and are more difficult to “invent.”

10. Validity of Financial Statements • Who is responsible? • Management is responsible for the accounting and financial reporting systems. • Auditors are there to assess if the statements make a fair representation of firm position and performance. • Investors learned a hard lesson in 2000–01 about financial statements and are aware of the need for change. Some potential remedies include: • Rotating auditors regularly • CEOs taking responsibility for veracity of financial statements

11. Ratio Analysis • Ratio analysis is used to take existing financial accounting information and generate new information. • Ratios on their own are not very meaningful. • Various ratios of a hospitality organization can be compared to industry averages. However: • Which segment of the hospitality industry? • Which companies are included in the industry averages? • Are there enough firms in the average to make the ratios meaningful? • Do all the firms use the same accounting methods?

12. Classes of Ratios • Liquidity—ability to meet current debts • Turnover—management’s effectiveness regarding the management of assets • Solvency—ability to meet long-term debts or the extent of long-term financing • Profitability—how profitable the operation is • Activity—involves key measures of operating performance • Investor—those ratios of special significance to outside investors

13. Liquidity Ratios • Current ratio • Current assets/current liabilities • Quick ratio • Cash + marketable securities + accts. rec. current liabilities • Working capital = current assets less current liabilities • Does current ratio always have to be greater than 1?

14. Turnover Ratios • Inventory turnover • Cost of sales / average inventory • Appropriate range for this number • Asset turnover • Revenue / total assets • Revenue per dollar of assets • Can management manipulate this figure?

15. Solvency Ratios • Debt ratio • Total debt / total assets • Debt to equity ratio • Total debt / total equity • Hotel industry often has high debt • Times interest earned • EBIT / interest expense • Gives lender a measure of “cushion” (how much earnings are available to pay interest)

16. Profitability Ratios • Profit margin • Net income / total revenue • Return on assets • Measure amount of profit for every $1 in assets • Net income / total assets • Also a function of profit margin and asset turnover • Net income / total revenue x total revenue / total assets • Return on equity • Net income / stockholder’s equity

17. Activity Ratios • Occupancy percentage • Occupied room nights key figure used in forecasting • Average Daily Rate (ADR) • REVPAR • Occupancy x ADR • Food cost percentage • Cost of food sold / food revenue • Beverage cost percentage • Cost of beverage sold / beverage revenue

18. Investor Ratios • P/E Ratio—price to earnings (net income) • Used by many investors as a buy/sell indicator • Dividend payout ratio • % of earnings paid to shareholders • Dividend yield • Annual dividend / market price per share • Not a holding rate of return for the stock

19. Limitations of Ratio Analysis • Be careful not to label ratios by themselves as “good” or “bad.” • Different users of ratios have different perspectives. • Example: Lenders vs. owners regarding the current ratio • Ratios may tell you there is a problem, but they don’t tell you what the problem is. • Example: high food cost • Why?