Making Financial Decisions
LU 1
Horizontal and vertical analysis
The three types of statements are a great source of information on how your
business is performing. To draw accurate comparisons from your statements, there
are three types of analyses you can use to compare data in the statements:
Horizontal analysis
Base year analysis
Vertical analysis
In the horizontal analysis you compare results (revenues, expenses, accounts)
from two years with each other. You can do this either in absolute numbers ($$) or
in relative numbers (%). If on your balance sheet in year 2XX2 you had € 200,- cash
on your bank account, and in 2XX3 you had € 250,- cash on your bank account, you
can use horizontal analysis to say that your cash increased with € 50,- (absolute),
which is an increase of 25% (relative). You can do this for any type of cost, income
or account, just be careful to compare apples with apples. Comparing the cash of
year X with the accounts receivable of year Y does not make a lot of sense.
The base year analysis is similar to the horizontal analysis, only you can use this
analysis to compare multiple years to one specific year, the base year. All accounts
or streams in this year are considered 100%. The difference between the base year
and the other years is reflected in relative (%) numbers.
Lastly, the vertical analysis (also known as the common-size analysis) is used to
compare accounts or revenues/costs as part of the whole. This means you compare
it to the total: e.g. total revenue, total operating expenses, total current liabilities. In
this analysis, the total equals 100%.
Ratio Analysis
,Liquidity ratios
Current Ratio = Current Assets / Current Liabilities
Owners/stockholders normally prefer a low current ratio to a high one, because
stockholders view investments in most current assets as less productive than
investments in noncurrent assets
Creditors normally prefer a relatively high current ratio, as this provides assurance
that they will receive timely payments
Management is caught in the middle trying to please both
Increasing current ratio:
Obtaining long-term loans
Obtaining new owner’s equity contributions
Converting noncurrent assets to cash
Deferring declaring dividends and leaving the cash in the business
Acid-test ratio: Quick assets (minus inventories and prepaid expenses) /
Current Liabilities
Operating Cash Flows to Current Liabilities Ratio = Operating Cash Flows (Net cash from
operations) / Average current liabilities
All users of ratios would prefer to see a high operating cash flow to current liabilities, as
this suggests operations are providing sufficient cash to pay the firm’s current liabilities
Accounts Receivable Turnover = measures the speed of the conversion of
accounts receivable = Total Revenue / Average Accounts Receivable
Owners prefer a high accounts receivable turnover, as this reflects a lower investment
in nonproductive accounts receivable.
Suppliers, like owners, prefer a high accounts receivable turnover, as this means that
hospitality establishments will have more cash readily available to pay them.
Long-term creditors also see a HART as a positive reflection of management.
Management desires to maxims the sales of the hospitality operation. Offering credit
helps maximize revenue.
Average Collection Period = 365 / Accounts Receivable Turnover
Working Capital Turnover Ratio = compares working capital (current assets –
current liabilities) to revenue = Revenue / Average Working Capital
Owners prefer this ratio to be high, as they prefer a low current ratio, thus low
working capital.
Creditors prefer low as they prefer a relatively high current ratio.
Management is in between
, Solvency Ratios
Return on equity (RoE) = net income / equitySolvency ratio = total assets / total
liabilities
The greater the leverage (use of debt to finance the assets), used by the hospitality
establishment, the lower its solvency ratio.
Owners prefer to use leverage in order to maximize their return on their investments.
Creditors prefer high solvency ratio, as it provides a greater cushion should the
establishment experience losses in operations.
Managers must satisfy both.
Debt-equity ratio = total liabilities / total owner’s equity
Indicates the establishment’s ability to withstand adversity and meet its long-term debt
obligations
Owners view this ratio similarly to the way they view the solvency ratio. They desire
to maximize their ROI by using leverage.
Creditors want the opposite due to less risk.
Management is again in middle position.
Long-term debt to total capitalization ratio = long-term debt / long-term debt
and owner’s equity - Percentage Number of Times Interest Earned Ratio
Expresses the number of times interest expense can be covered. The greater the number
of times interest is earned, the greater the safety afforded the creditors.
Income statement solvency ratio = Earnings before income tax / Interest
Expense
Activity Ratios
= Measure the management’s effectiveness in using its resources.
Management is entrusted with inventory and fixed assets (and other resources) to
generate earning for owners while providing products and services to guests. Since the
fixed assets of most lodging facilities constitute a large percentage of the operation’s
total assets, it is essential to use these resources effectively.
Inventory Turnover = shows how quickly the inventory is being used.
The quicker the inventory turnover the better, because inventory can be expensive to
maintain. (e.g. storage space, freezers, insurance etc.) Should generally be calculated
separately for food supplies and for beverages. Although a high food inventory turnover
is desired because it means that the food service establishment is able to operate with a
relatively small investment in inventory, too high a turnover may indicate possible
stockout problems
Food Inventory Turnover = Cost of Food used / Average Food Inventory
(beginning and ending inventory divided by 2)
Property and Equipment Turnover (fixed asset turnover) = total revenue /
average property and equipment
A high turnover suggests the hospitality enterprise is using its property and equipment
effectively to generate revenues, while a low turnover suggests the opposite
LU 1
Horizontal and vertical analysis
The three types of statements are a great source of information on how your
business is performing. To draw accurate comparisons from your statements, there
are three types of analyses you can use to compare data in the statements:
Horizontal analysis
Base year analysis
Vertical analysis
In the horizontal analysis you compare results (revenues, expenses, accounts)
from two years with each other. You can do this either in absolute numbers ($$) or
in relative numbers (%). If on your balance sheet in year 2XX2 you had € 200,- cash
on your bank account, and in 2XX3 you had € 250,- cash on your bank account, you
can use horizontal analysis to say that your cash increased with € 50,- (absolute),
which is an increase of 25% (relative). You can do this for any type of cost, income
or account, just be careful to compare apples with apples. Comparing the cash of
year X with the accounts receivable of year Y does not make a lot of sense.
The base year analysis is similar to the horizontal analysis, only you can use this
analysis to compare multiple years to one specific year, the base year. All accounts
or streams in this year are considered 100%. The difference between the base year
and the other years is reflected in relative (%) numbers.
Lastly, the vertical analysis (also known as the common-size analysis) is used to
compare accounts or revenues/costs as part of the whole. This means you compare
it to the total: e.g. total revenue, total operating expenses, total current liabilities. In
this analysis, the total equals 100%.
Ratio Analysis
,Liquidity ratios
Current Ratio = Current Assets / Current Liabilities
Owners/stockholders normally prefer a low current ratio to a high one, because
stockholders view investments in most current assets as less productive than
investments in noncurrent assets
Creditors normally prefer a relatively high current ratio, as this provides assurance
that they will receive timely payments
Management is caught in the middle trying to please both
Increasing current ratio:
Obtaining long-term loans
Obtaining new owner’s equity contributions
Converting noncurrent assets to cash
Deferring declaring dividends and leaving the cash in the business
Acid-test ratio: Quick assets (minus inventories and prepaid expenses) /
Current Liabilities
Operating Cash Flows to Current Liabilities Ratio = Operating Cash Flows (Net cash from
operations) / Average current liabilities
All users of ratios would prefer to see a high operating cash flow to current liabilities, as
this suggests operations are providing sufficient cash to pay the firm’s current liabilities
Accounts Receivable Turnover = measures the speed of the conversion of
accounts receivable = Total Revenue / Average Accounts Receivable
Owners prefer a high accounts receivable turnover, as this reflects a lower investment
in nonproductive accounts receivable.
Suppliers, like owners, prefer a high accounts receivable turnover, as this means that
hospitality establishments will have more cash readily available to pay them.
Long-term creditors also see a HART as a positive reflection of management.
Management desires to maxims the sales of the hospitality operation. Offering credit
helps maximize revenue.
Average Collection Period = 365 / Accounts Receivable Turnover
Working Capital Turnover Ratio = compares working capital (current assets –
current liabilities) to revenue = Revenue / Average Working Capital
Owners prefer this ratio to be high, as they prefer a low current ratio, thus low
working capital.
Creditors prefer low as they prefer a relatively high current ratio.
Management is in between
, Solvency Ratios
Return on equity (RoE) = net income / equitySolvency ratio = total assets / total
liabilities
The greater the leverage (use of debt to finance the assets), used by the hospitality
establishment, the lower its solvency ratio.
Owners prefer to use leverage in order to maximize their return on their investments.
Creditors prefer high solvency ratio, as it provides a greater cushion should the
establishment experience losses in operations.
Managers must satisfy both.
Debt-equity ratio = total liabilities / total owner’s equity
Indicates the establishment’s ability to withstand adversity and meet its long-term debt
obligations
Owners view this ratio similarly to the way they view the solvency ratio. They desire
to maximize their ROI by using leverage.
Creditors want the opposite due to less risk.
Management is again in middle position.
Long-term debt to total capitalization ratio = long-term debt / long-term debt
and owner’s equity - Percentage Number of Times Interest Earned Ratio
Expresses the number of times interest expense can be covered. The greater the number
of times interest is earned, the greater the safety afforded the creditors.
Income statement solvency ratio = Earnings before income tax / Interest
Expense
Activity Ratios
= Measure the management’s effectiveness in using its resources.
Management is entrusted with inventory and fixed assets (and other resources) to
generate earning for owners while providing products and services to guests. Since the
fixed assets of most lodging facilities constitute a large percentage of the operation’s
total assets, it is essential to use these resources effectively.
Inventory Turnover = shows how quickly the inventory is being used.
The quicker the inventory turnover the better, because inventory can be expensive to
maintain. (e.g. storage space, freezers, insurance etc.) Should generally be calculated
separately for food supplies and for beverages. Although a high food inventory turnover
is desired because it means that the food service establishment is able to operate with a
relatively small investment in inventory, too high a turnover may indicate possible
stockout problems
Food Inventory Turnover = Cost of Food used / Average Food Inventory
(beginning and ending inventory divided by 2)
Property and Equipment Turnover (fixed asset turnover) = total revenue /
average property and equipment
A high turnover suggests the hospitality enterprise is using its property and equipment
effectively to generate revenues, while a low turnover suggests the opposite
