Ratio Analysis

1. Ratio Analysis 1

2. Chapter Outline • Purpose and Value of Ratios • Types of Ratios • Comparative Analysis of Ratios • Ratio Analysis Limitations 2

3. 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. • Why managerial accountants in the hospitality industry useratios developed from numbers found on their income statements, balance sheets, andstatements of cash flows, as well as other operating data, to create ratios that really helpthem better understand and manage their businesses. 3

4. 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%. 4

5. 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 5

6. 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. 6

7. 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). 7

8. 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. 8

9. 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. 9

10. 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. 10

11. 11

12. 12

13. 13

14. 14

15. Purpose & Value of Ratios • Ratios are important in a variety of fields. This is especially true in the hospitality industry.If you are a hospitality manager with a foodservice background, you already know about the importance of ratios. 15

16. 16

17. 17

18. Most Commonly Used Ratios • Many managers feel that ratios are most useful when they compare a company’s actualperformance to a previous time period, competitor company results, industry averages, orbudgeted (planned for) results. • In this chapter you will learn about the most commonlyused ratios. • You will also learn that, when a ratio is compared to a standard or goal, theresulting differences (if differences exist) can tell youmuch about the financial performance(health) of the company you are evaluating. 18

19. Liquidity Ratios • Solvency Ratios • Activity Ratios • Profitability Ratios • Investor Ratios • Hospitality-Specific Ratios 19

20. 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. 20

21. 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 21

22. Current Ratio • One of the most frequently computed liquidity ratios is the current ratio. 22

23. 23

24. The higher the current ratio, the more current assets a business has available to coverits current liabilities. Current ratios can be interpreted in the following manner: • When current ratios are: • Lessthan1: The businessmay have a difficult time paying its short-term debt obligationsbecause of a shortage of current assets. • Equal to 1: The business has an equal amount of current assets and current liabilities. • Greater than 1: The business has more current assets than current liabilities and shouldbe in a good position to pay its bills as they come due. 24

25. Quick (Acid-Test) Ratio • Another extremely useful liquidity ratio is called the quick ratio. The quick ratio is alsoknown as the acid-test ratio. 25

26. As you can see, the main difference between the current ratio formula and the quickratio formula is the inclusion (or exclusion) of inventories and prepaid expenses. • Thecomputation for the current ratio includes inventories and prepaid expenses, while thecomputation for the quick ratio does not. • This is because the purpose of the quick ratio isprimarily to identify the relative value of a business’s cash (and quickly convertible to cash)current assets. • Specifically, cash is already cash, marketable securities can easily be sold toproduce cash, and accounts receivable can be collected to provide cash. 26

27. Operating Cash Flows to Current Liabilities Ratio • The third liquidity ratio to be examined is the operating cash flows to current liabilitiesratio. • This ratio relies on the operating cash flow portion of the overall statement of cashflows for its computation. It utilizes information from the balance sheet and the statementof cash flows. 27

28. 28

29. The operating cash flows to current liabilities ratio seeks to provide an answer to thequestion, ‘‘What portion of our current liabilities can be paid with the cash generated by ourown operations?’’ • Clearly, if a business cannot generate enoughmoney (cash) from its ownoperations activity to pay its short-term debts, itwill need to seek additionalmoney throughinvesting or financing activities. • If, however, a business can generate enough of its owncash to pay its short-term debts, it will not be forced to raise or borrow additional funds. 29

30. Working Capital • A measure that is related to the current and quick ratios is working capital. Although nota true ratio because it does not require that one number be divided by another number, itis a measure that many lenders require. 30

31. The Blue Lagoon has $4,152,900 in working capital. • Although working capital can be calculated for all hospitality businesses, new businessesare usually required by lenders to obtain a target working capital to maintain start-up loans. • This is because lenders want to be sure that new businesses will have enough resources to paycurrent obligations, especially during the uncertainty and risk of the first year of operations. • Because of financial leverage, investors tend to prefer lower values for liquidity ratios,while creditors prefer higher values.As a result, it will be your responsibility as a professionalhospitality manager to understand liquidity ratios well, and to balance the legitimate needs of both these groups. 31

32. Liquidity Ratios 32

33. 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. • People dont actually go into business thinking they will lose money, but somehospitality businesses do lose money. 33

34. As a rule, • those businesses with higher solvency ratiovalues are better able to withstand losses than businesses with lower solvency ratiovalues. • These ratios are: • Solvency Ratio • Debt to Equity Ratio • Debt to Assets Ratio • Operating Cash Flows to Total Liabilities Ratio • Times Interest Earned Ratio 34

35. Solvency Ratio • this ratio, is really a comparison between whata company ‘‘owns’’ (its assets) and what it ‘‘owes’’ those who do not own the company(liabilities). 35

36. A ratio of ‘‘1.00’’ would mean that assets equal liabilities. • Values over 1.00indicate that a company owns more than it owes, • Values less than 1.00 indicate acompany owes more than it owns. • Creditors and lenders prefer to do business with companies that have a high solvencyratio (between 1.5 and 2.00) because itmeans these companies are likely to be able to repaytheir debts. • Investors, on the other hand, generally prefer a lower solvency ratio, whichmayindicate that the company uses more debts as financial leverage. 36

37. Debt to Equity Ratio • Evaluates therelationship between investments that have been made by the business’s lenders andinvestments that have been made by the business’s owners. • Most restaurants and hotels are considered to befairly risky investments, and lenders are cautious when considering loaning money to them. 37

38. The result is that lenders usually look favorably on projects that yield relatively low (lessthan 1.00) ratios of this type. • All other things being equal, a company that can generate andretain earnings (as part of owners’ equity) will be able to reduce this ratio, thus reducingrisk to potential lenders. • Owners, not surprisingly, often seek to maximize their financialleverage and create total liabilities to total equity ratios in excess of 1.00. 38

39. Debt to Assets Ratio • The debttoassets ratio is simply a comparison of a business’s total liabilities to its total assets. • more debtwill be favored by investors because of financial leverage • less debt will be favored bylenders to ensure re-payment of loans. 39

40. Operating Cash Flows to Total Liabilities Ratio • The operating cash flows to total liabilities ratio utilizes information from the balancesheet and the statement of cash flows to compare the cash generated by operating activitiesto the amount of total liabilities it has incurred. • The Blue Lagoon can cover its total liabilities 0.11 times (less than one time) with its operating cash flows. 40

41. In nearly all cases, bothowners and lenders would like to see this ratio kept as high as possible • high ratioindicates a strong ability to repay debt from the business’s normal business operations. • This is a relatively low ratio for the Blue Lagoon and should be examined carefully by managersfor possible areas of improvement. 41

42. Times Interest Earned Ratio • The times interest earned ratio compares interest expense to earnings before interest andtaxes. 42

43. This ratio indicates the strength a company has to repay the interest on its debts. • Thehigher this ratio, the greater the number of ‘‘times’’ the company could repay its interestexpense with its earnings before interest and taxes • ratio less than two, it indicates a real weakness in a company’s ability to meet itsinterest payment obligations. • four or more, indicates sufficient strengthon the part of the business to make its interest payments in a timely manner. • five ormore, may indicate that the company is underleveraged, that is, its abilityto borrowmoney (and repay it!)may be an underutilized financing activity of the business. 43

44. Solvency Ratios 44

45. 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 45

46. 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. • In the restaurant business, for example, the efficient turnover of inventories is a criticalmanagement task. This is so because a large amount of the inventory (food and beverages)in most restaurants is subject to spoilage or reduced product quality if too much inventory is kept on hand. 46

47. Inventory Turnover • Inventory turnover refers to the number of times the total value of inventory has beenpurchased and replaced in an accounting period. • Each time the cycle is completed once,you are said to have ‘‘turned’’ the inventory. • For example, if you usually keep $100 worth oforanges on hand at any given time and your monthly usage of oranges is $500, you wouldhave replaced (turned) your orange inventory five times in the month. • Although inventoryturnover can be computed for all types of inventories in all types of businesses, the examplesused in this section will be based on a restaurant’s food and beverage inventories. 47

48. From: Figure 6.5 48

49. 49

50. 50