Student Study Notes - Chapter 6

Student Study Notes - Chapter 6

Purpose and Value of Ratios

·  Ratios are important in a variety of fields. This is especially true in the hospitality industry. If you are hospitality manager with a foodservice background, you already know about the importance of ratios. For examples of how ratios are used in foodservice, see Go Figure! in the text.

·  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).

·  In fraction form, a percentage is expressed as the part, or a portion of 100. Thus, 10 percent is written as 10 “over” 100 (10/100). In its common form, the “%” sign is used to express the percentage. If we say 10%, then we mean “10 out of each 100”. The decimal form uses the (.) or decimal point to express the percent relationship. Thus, 10% is expressed as 0.10 in decimal form. The numbers to the right of the decimal point express the percentage.

·  Each of these three methods of expressing percentages is used in the hospitality industry. To determine what percent one number is of another number, divide the number that is the part by the number that is the whole (see Go Figure! in the text).

·  Many people become confused when converting from one form of percent to another. If that is a problem, remember the following conversion rules:

·  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%.

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

·  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.

·  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). For an illustration of financial leverage, see Go Figure! in the text.

·  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.

·  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.

Types of Ratios

·  The most common way to classify ratios is by the information they provide the user. Managerial accountants working in the hospitality industry refer to:

·  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. (See Figures 6.1, 6.2, 6.3, and 6.4).

·  Definitions, sources of data, formulas and examples of each ratio are summarized at the end of this section in the Ratio Summary Tables.

·  Some managers use averages in the denominators of some ratios to smooth out excessive fluctuations from one period to the next. With the exception of inventory turnover, the ratios in this chapter will not use averages in the denominators.

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.

·  In this section we will examine three widely used liquidity ratios and working capital. These are:

·  Current Ratio

·  Quick (Acid-Test) Ratio

·  Operating Cash Flows to Current Liabilities Ratio

·  Working Capital

Current Ratio

·  One of the most frequently computed liquidity ratios is the current ratio.

·  When current ratios are:

·  Less than 1: The business may have a difficult time paying its short term debt obligations because 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 should be in a good position to pay its bills as they come due.

·  It might seem desirable for every hospitality business to have a high current ratio (because then the business could easily pay all of its current liabilities). That is not always the case.

·  While potential creditors would certainly like to see a business in a position to readily pay all of its short-term debts, investors may be more interested in the financial leverage provided by short-term debts.

·  The current ratio is so important to a hospitality business that lenders will frequently require that any business seeking a loan maintain a minimum current ratio during the life of any loan it is granted.

Quick (Acid-Test) Ratio

·  Another extremely useful liquidity ratio is called the quick ratio. The quick ratio is also known as the acid-test ratio.

·  The main difference between the current ratio formula and the quick ratio formula is the inclusion (or exclusion) of inventories and prepaid expenses. The purpose of the quick ratio is primarily to identify the relative value of a business’s cash (and quickly convertible to cash) current assets.

·  Investors and creditors view quick ratios in a manner similar to that of current ratios. Investors tend to prefer lower values for quick ratios, while creditors prefer higher ratios.

Operating Cash Flows to Current Liabilities Ratio

·  The operating cash flows to current liabilities ratio relies on the operating cash flow portion of the overall statement of cash flows for its computation. It utilizes information from the balance sheet and the statement of cash flows.

·  In general, investors and creditors view the operating cash flows to current liabilities ratio in a manner similar to that of the current and quick ratios.

Working Capital

·  A measure that is related to the current and quick ratios is working capital. Although not a true ratio because it does not require that one number is divided by another number, it is a measure that many lenders require.

·  Because of financial leverage, investors tend to prefer lower values for liquidity ratios, while creditors prefer higher values.

Solvency Ratios

·  Just as liquidity ratios address the ability of a business to pay its short term debt, 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:

·  Solvency Ratio

·  Debt to Equity Ratio

·  Debt to Assets Ratio

·  Operating Cash Flows to Total Liabilities Ratio

·  Times Interest Earned Ratio

Solvency Ratio

·  A business is considered solvent when its assets are greater than its liabilities. The solvency ratio compares a business’s total assets to its total liabilities.

·  This ratio is really a comparison between what a company “owns” (its assets) and what it “owes” those who do not own the company (liabilities).

·  Creditors and lenders prefer to do business with companies that have a high solvency ratio (between 1.5 and 2.00) because it means these companies are likely to be able to repay their debts. Investors, on the other hand, generally prefer a lower solvency ratio, which may indicate that the company uses more debts as financial leverage.

Debt to Equity Ratio

·  The debt to equity ratio is a measure used by managerial accountants to evaluate the relationship between investments that have been made by the business’s lenders and investments that have been made by the business’s owners.

·  From a lender’s perspective, the higher the lender’s own investment (relative to the actual investment of the business’s owners) the riskier is the investment.

·  Owners seek to maximize their financial leverage and create total liabilities to total equity ratios in excess of 1.00.

Debt to Assets Ratio

·  The debt to assets ratio compares a business’s total liabilities to its total assets.

·  As with the other solvency ratios, more debt will be favored by investors because of financial leverage and less debt will be favored by lenders to ensure repayment of loans.

Operating Cash Flows to Total Liabilities Ratio

·  The operating cash flows to total liabilities ratio compares the cash generated by operating activities to the amount of total liabilities.

·  In nearly all cases, both owners and lenders would like to see this ratio kept as high as possible because a high ratio indicates a strong ability to repay debt from the business’s normal business operations

Times Interest Earned Ratio

·  The times interest earned ratio compares interest expense to earnings before interest and taxes (EBIT). Earnings before interest and taxes (EBIT) are labeled as net operating income on the USALI.

·  The higher this ratio, the greater the number of “times” the company could repay its interest expense with its earnings before interest and taxes.

Activity Ratios

·  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), thus assessing management’s efficiency in handling inventories and long-term assets. As a result, 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

Inventory Turnover

·  Inventory turnover refers to the number of times the total value of inventory has been purchased and replaced in an accounting period. In restaurants, we will calculate food and beverage inventory turnover ratios (refer to Figure 6.5)

·  The obvious question is, “Are the food and beverage turnover ratios good or bad?” The answer to this question is relative to the target (desired) turnover ratios. For a discussion of food and beverage turnover ratio analysis, see Go Figure! in the text.

·  A low turnover could occur because sales are less than expected, thus causing food to move slower out of inventory (bad). It could also mean that the food and beverage manager decided to buy more inventory each time (thus, making purchases fewer times) because of discount prices due to larger (bulk) purchases (good).

·  A high turnover could occur because sales are higher than expected, thus causing food to move faster out of inventory (good). It could also mean that significant wastage, pilferage, and spoilage might have occurred causing food to move out of inventory faster, but not due to higher sales (bad).

Property and Equipment (Fixed Asset) Turnover

·  The property and equipment (fixed asset) turnover ratio is concerned with fixed asset usage. Fixed assets consist of the property, building(s) and equipment actually owned by the business.

·  A simple example will explain how to interpret this ratio. Assume that there is a fryer in the kitchen which generates $50,000 worth of revenue per year. A new fryer is purchased that generates revenues of $100,000 per year. The new fryer would have a fixed asset turnover ratio two times higher than that of the old fryer. The new fryer is more effective at generating revenues than the old fryer.

·  The term “net” in any calculation generally means that something has been subtracted. When calculating the net property and equipment turnover ratio, “net” refers to the subtraction of accumulated depreciation.

·  Creditors, owners, and managers like to see this ratio as high as possible because it measures how effectively net fixed assets are used to generate revenue.

Total Asset Turnover

·  The total asset turnover ratio is concerned with total asset usage. Total assets consist of the current and fixed assets owned by the business.

·  Restaurants may have higher ratios than hotels because hotels typically have more fixed assets (thus making the denominator larger and the ratio smaller).

·  Creditors, owners, and managers like to see this ratio as high as possible because it measures how effectively total assets are used to generate revenue.

Profitability Ratios

·  It is the job of management to generate profits for the company’s owners, and profitability ratios measure how well management has accomplished this task.

·  Profits must also be evaluated in terms of the size of investment in the business that has been made by the company’s owners.

·  There are a variety of profitability ratios used by managerial accountants:

·  Profit Margin

·  Gross Operating Profit Margin (Operating Efficiency)

·  Return on Assets

·  Return on Owner’s Equity

Profit Margin