L4 DIPLOMA IN HOSPITALITY MANAGEMENT & L4 DIPLOMA IN TOURISM MANAGEMENT

FINANCE IN TOURISM AND HOSPITALITY

Programme:
L4 Diploma in Hospitality
Management
LECTURE DELIVERY
L4 Diploma in Tourism
Management
Module:
Finance in Tourism and
Hospitality
Section:
8 Session Delivery Slides and
Notes
Date:
OCTOBER 2016
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FINANCE IN TOURISM AND HOSPITALITY

Assessment Criteria

5.1 Use a number of tools to analyse a given business performance to include basic sales,
liquidity, efficiency and financial ratios

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5.1 Use a number of tools to analyse a

given business’ performance to include
basic sales, liquidity and financial ratios
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FINANCE IN TOURISM AND HOSPITALITY

Financial Ratio Analysis

 Financial ratios are mathematical comparisons of financial statement
accounts or categories.

 These relationships between the financial statement accounts help investors,

creditors, and internal company management understand how well a
business is performing and those areas in need of improvement.

 Financial ratios are the most common and widespread tools used to analyse
a business' financial standing.

 Ratios are easy to understand and simple to compute. They can also be
used to compare different companies in different industries.

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Financial Ratio Analysis

 Ratios allow us to compare companies across industries, big and small, to identify
their strengths and weaknesses.

 Financial ratios are often divided up into four main categories. They are:

 Sales profitability

 Liquidity ratios

 Efficiency ratios

 Financial ratios

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Sales Profitability
 Profitability ratios compare income statement accounts and categories to
show a company's ability to generate profits from its operations.

 Profitability ratios focus on a company's return on investment in inventory

and other assets.

 These ratios basically show how well companies can achieve profits from
their operations.

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Sales Profitability
 There are two key ratios that investors and creditors consider when judging
how profitable a company.

1. Gross profit margin

2. Net profit margin

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Gross Profit Margin

 Gross margin ratio is a profitability ratio that compares the gross margin of a
business to the net sales.

 This ratio measures the profitability of a company when selling its inventory
or merchandise.

 In other words, the gross profit ratio is essentially the percentage markup on
merchandise from its cost.

 This is the pure profit from the sale of inventory that can go to paying
operating expenses.

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Gross Profit Margin - Formula

 Gross margin ratio (also known as Gross Profit Margin) is calculated by
dividing gross margin by net sales.

 The gross margin of a business is calculated by subtracting cost of goods

sold from net sales. Net sales equals gross sales minus any returns or
refunds. is calculated by dividing gross margin by net sales. Gross margin
ratio is calculated by dividing gross margin by net sales.

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Gross Profit Margin - Analysis

 Gross margin ratio is a profitability ratio that measures how profitably a company
can sell its inventory.

 It only makes sense that higher ratios are more favourable. Higher ratios mean the
company is selling their inventory at a higher profit percentage.

 High ratios can typically be achieved in two ways.

 One way is to buy inventory very cheap. If retailers can get a big purchase discount
when they buy their inventory from the manufacturer or wholesaler, their gross
margin will be higher because their costs are down.

 The second way retailers can achieve a high ratio is by marking their goods up
higher. This obviously has to be done competitively otherwise goods will be too
expensive and customers will shop elsewhere.

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Gross Profit Margin - Example

 Assume Jack's Clothing Store spent $100,000 on inventory for the year.
Jack was able to sell this inventory for $500,000. Unfortunately, $50,000 of
the sales were returned by customers and refunded. Jack would calculate
his gross margin ratio like this.

 Jack has a ratio of 78 percent. This is a high ratio in the apparel industry.
This means that after Jack pays off his inventory costs, he still has 78
percent of his sales revenue to cover his operating costs.

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Net Profit Margin

 The profit margin ratio, also called the return on sales ratio or net profit ratio,
is a profitability ratio that measures the amount of net income earned with
each dollar of sales generated by comparing the net income and net sales of
a company.

 In other words, the profit margin ratio shows what percentage of sales are
left over after all expenses are paid by the business.

 The return on sales ratio is often used by internal management to set

performance goals for the future.

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Net Profit Margin - Formula

 The profit margin ratio formula can be calculated by dividing net income by
net sales.

 Net sales is calculated by subtracting any returns or refunds from gross

sales.

 Net income equals total revenues minus total expenses and is usually the
last number reported on the income statement.

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Net Profit Margin - Analysis

 The profit margin ratio directly measures what percentage of sales is made
up of net income.

 In other words, it measures how much profit is produced at a certain level of

sales.

 This ratio also indirectly measures how well a company manages its
expenses relative to its net sales.

 That is why companies strive to achieve higher ratios.

 They can do this by either generating more revenues by keeping expenses

constant or keep revenues constant and lower expenses.

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Net Profit Margin - Example

 Anna's Tackle Shop is an outdoor fishing store that selling lures and other
fishing gear to the public. Last year Anna had the best year in sales she has
ever had since she opened the business 10 years ago. Last year Anna's net
sales were $1,000,000 and her net income was $100,000.

 Anna only converted 10 percent of her sales into profits. Contrast that with
this year's numbers of $800,000 of net sales and $200,000 of net income.

 This year Anna may have made less sales, but she cut expenses and was
able to convert more of these sales into profits with a ratio of 25 percent.

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Liquidity Ratios
 Liquidity ratios analyse the ability of a company to pay off both its current
liabilities as they become due as well as their long-term liabilities as they
become current.

 In other words, these ratios show the cash levels of a company and the
ability to turn other assets into cash to pay off liabilities and other current
obligations.

 Liquidity is not only a measure of how much cash a business has.

 It is also a measure of how easy it will be for the company to raise enough
cash or convert assets into cash.

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Liquidity Ratios
 There are two key ratios that investors and creditors consider when judging
the liquidity of a company.

1. Current ratio

2. Acid test ratio

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Current Ratio
 The current ratio is a liquidity and efficiency ratio that measures a firm's
ability to pay off its short-term liabilities with its current assets.

 The current ratio is an important measure of liquidity because short-term

liabilities are due within the next year.

 This means that a company has a limited amount of time in order to raise the
funds to pay for these liabilities.

 Current assets like cash, cash equivalents, and marketable securities can
easily be converted into cash in the short term.

 This means that companies with larger amounts of current assets will more
easily be able to pay off current liabilities when they become due without
having to sell off long-term, revenue generating assets.

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Current Ratio - Formula

 The current ratio is calculated by dividing current assets by current liabilities.
This ratio is stated in numeric format rather than in decimal format. Here is
the calculation:

 GAAP requires that companies separate current and long-term assets and
liabilities on the balance sheet. This split allows investors and creditors to
calculate important ratios like the current ratio. On U.S. financial statements,
current accounts are always reported before long-term accounts.

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Current Ratio - Analysis

 The current ratio helps investors and creditors understand the liquidity of a
company and how easily that company will be able to pay off its current
liabilities.

 This ratio expresses a firm's current debt in terms of current assets. So a

current ratio of 4 would mean that the company has 4 times more current
assets than current liabilities.

 A higher current ratio is always more favourable than a lower current ratio
because it shows the company can more easily make current debt payments.

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Current Ratio - Example

 Charlie's Skate Shop sells ice-skating equipment to local hockey teams. Charlie
is applying for loans to help fund his dream of building an indoor skate rink.
Charlie's bank asks for his balance sheet so they can analysis his current debt
levels. According to Charlie's balance sheet he reported $100,000 of current
liabilities and only $25,000 of current assets. Charlie's current ratio would be
calculated like this:

 Charlie only has enough current assets to pay off 25 percent of his current
liabilities. This shows that Charlie is highly leveraged and highly risky. Banks
would prefer a current ratio of at least 1 or 2, so that all the current liabilities
would be covered by the current assets. Since Charlie's ratio is so low, it is
unlikely that he will get approved for his loan.

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Acid Test Ratio (Quick Ratio)

 The quick ratio or acid test ratio is a liquidity ratio that measures the ability of a
company to pay its current liabilities when they come due with only quick assets.

 Quick assets are current assets that can be converted to cash within 90 days or in
the short-term. Cash, cash equivalents, short-term investments or marketable
securities, and current accounts receivable are considered quick assets.

 Short-term investments or marketable securities include trading securities and

available for sale securities that can easily be converted into cash within the next
90 days.

 Marketable securities are traded on an open market with a known price and readily
available buyers. Any stock on the New York Stock Exchange would be considered
a marketable security because they can easily be sold to any investor when the
market is open.

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Acid Test Ratio - Formula

 The quick ratio is calculated by adding cash, cash equivalents, short-term
investments, and current receivables together then dividing them by current
liabilities.

 Sometimes company financial statements don't give a breakdown of quick

assets on the balance sheet. In this case, you can still calculate the quick
ratio even if some of the quick asset totals are unknown. Simply subtract
inventory and any current prepaid assets from the current asset total for the
numerator. Here is an example.

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Acid Test Ratio - Analysis

 The acid test ratio measures the liquidity of a company by showing its ability
to pay off its current liabilities with quick assets.

 If a firm has enough quick assets to cover its total current liabilities, the firm
will be able to pay off its obligations without having to sell off any long-term
or capital assets.

 Since most businesses use their long-term assets to generate revenues,

selling off these capital assets will not only hurt the company it will also show
investors that current operations aren't making enough profits to pay off
current liabilities.

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Acid Test Ratio - Example

 Let's assume Carole's Clothing Store is applying for a loan to remodel the
storefront. The bank asks Carole for a detailed balance sheet, so it can
compute the quick ratio. Carole's balance sheet included the following
accounts:

Cash: $10,000
Accounts Receivable: $5,000
Inventory: $5,000
Stock Investments: $1,000
Prepaid taxes: $500
Current Liabilities: $15,000

The bank can compute Carole's quick ratio like this.

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Acid Test Ratio - Example

 Carole's quick ratio is 1.07. This means that Carole can pay off all of her
current liabilities with quick assets and still have some quick assets left over.

Now let's assume the same scenario except Carole did not provide the bank with
a detailed balance sheet. Instead Carole's balance sheet only included these
accounts:

Inventory: $5,000
Prepaid taxes: $500
Total Current Assets: $21,500
Current Liabilities: $15,000

Since Carole's balance sheet doesn't include the breakdown of quick assets, the
bank can compute her quick ratio like this:

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Efficiency Ratios
 Efficiency ratios also called activity ratios measure how well companies
utilise their assets to generate income.

 Efficiency ratios often look at the time it takes companies to collect cash from
customers or the time it takes companies to convert inventory into cash—in
other words, make sales.

 These ratios are used by management to help improve the company as well
as outside investors and creditors looking at the operations of profitability of
the company.

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Efficiency Ratios
 There are three key ratios that investors and creditors consider when judging
the efficiency of a company.

1. Accounts receivable turnover

2. Payables turnover

3. Inventory turnover

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Accounts Receivable Turnover

 What is accounts receivable? It's an efficiency ratio or activity ratio that
measures how many times a business can turn its accounts receivable into
cash during a period.

 In other words, the accounts receivable turnover ratio measures how many
times a business can collect its average accounts receivable during the year.

 A turn refers to each time a company collects its average receivables. If a

company had $20,000 of average receivables during the year and collected
$40,000 of receivables during the year, the company would have turned its
accounts receivable twice because it collected twice the amount of average
receivables.

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Accounts Receivable Turnover -

Formula
 Accounts receivable turnover is calculated by dividing net credit sales by the
average accounts receivable for that period.

 The reason net credit sales are used instead of net sales is that cash sales don't create
receivables. Only credit sales establish a receivable, so the cash sales are left out of the
calculation. Net sales simply refers to sales minus returns and refunded sales.

 The net credit sales can usually be found on the company's income statement for the year
although not all companies report cash and credit sales separately. Average receivables is
calculated by adding the beginning and ending receivables for the year and dividing by
two. In a sense, this is a rough calculation of the average receivables for the year.

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Accounts Receivable Turnover -

Analysis
 Since the receivables turnover ratio measures a business' ability to efficiently
collect its receivables, it only makes sense that a higher ratio would be more
favourable.

 Higher ratios mean that companies are collecting their receivables more
frequently throughout the year.

 For instance, a ratio of 2 means that the company collected its average
receivables twice during the year.

 In other words, this company is collecting its money from customers every
six months.

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Accounts Receivable Turnover -

Example
 Bill's Ski Shop is a retail store that sells outdoor skiing equipment. Bill offers
accounts to all of his main customers. At the end of the year, Bill's balance sheet
shows $20,000 in accounts receivable, $75,000 of gross credit sales, and
$25,000 of returns. Last year's balance sheet showed $10,000 of accounts
receivable.

 The first thing we need to do in order to calculate Bill's turnover is to calculate net
credit sales and average accounts receivable.

Net credit sales equals gross credit sales minus returns (75,000 – 25,000 =
50,000).

Average accounts receivable can be calculated by averaging beginning and

ending accounts receivable balances ((10,000 + 20,000) / 2 = 15,000).

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Accounts Receivable Turnover -

Example
 Finally, Bill's accounts receivable turnover ratio for the year can be like this.

 Bill's turnover is 3.33. This means that Bill collects his receivables about 3.3
times a year or once every 110 days. In other words, when Bill makes a credit
sale, it will take him 110 days to collect the cash from that sale.

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Accounts Payable Turnover

 The accounts payable turnover ratio is a liquidity ratio that shows a
company's ability to pay off its accounts payable by comparing net credit
purchases to the average accounts payable during a period.

 In other words, the accounts payable turnover ratio is how many times a
company can pay off its average accounts payable balance during the
course of a year.

 This ratio helps creditors analyse the liquidity of a company by gauging how
easily a company can pay off its current suppliers and vendors.

 Companies that can pay off suppliers frequently throughout the year indicate
to creditors that they will be able to make regular interest and principle
payments as well.

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Accounts Payable Turnover -

Formula
 The accounts payable turnover formula is calculated by dividing the total
purchases by the average accounts payable for the year.

 The total purchases number is usually not readily available on any general
purpose financial statement. Instead, total purchases will have to be
calculated by adding the ending inventory to the cost of goods sold and
subtracting the beginning inventory. Most companies will have a record of
supplier purchases, so this calculation may not need to be made.

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Accounts Payable Turnover -

Analysis
 Since the accounts payable turnover ratio indicates how quickly a company
pays off its vendors, it is used by suppliers and creditors to help decide
whether or not to grant credit to a business. As with most liquidity ratios, a
higher ratio is almost always more favourable than a lower ratio.

 A higher ratio shows suppliers and creditors that the company pays its bills
frequently and regularly. It also implies that new vendors will get paid back
quickly. A high turnover ratio can be used to negotiate favourable credit
terms in the future.

 As with all ratios, the accounts payable turnover is specific to different

industries. Every industry has a slightly different standard. This ratio is best
used to compare similar companies in the same industry.

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Accounts Payable Turnover -

Example
 Bob's Building Suppliers buys constructions equipment and materials from
wholesalers and resells this inventory to the general public in its retail store. During
the current year Bob purchased $1,000,000 worth of construction materials from his
vendors. According to Bob's balance sheet, his beginning accounts payable was
$55,000 and his ending accounts payable was $958,000.

 As you can see, Bob's average accounts payable for the year was $506,500
(beginning plus ending divided by 2). Based on this formula Bob's turnover ratio is
1.97. This means that Bob pays his vendors back on average once every six months
of twice a year. This is not a high turnover ratio, but it should be compared to others
in Bob's industry.
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Inventory Turnover
 The inventory turnover ratio is an efficiency ratio that shows how effectively
inventory is managed by comparing cost of goods sold with average
inventory for a period.

 This measures how many times average inventory is "turned" or sold during
a period. In other words, it measures how many times a company sold its
total average inventory dollar amount during the year. A company with
$1,000 of average inventory and sales of $10,000 effectively sold its
inventory 10 times over.

 This ratio is important because total turnover depends on two main

components of performance.

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Inventory Turnover - Formula

 The inventory turnover ratio is calculated by dividing the cost of goods sold
for a period by the average inventory for that period.

 Average inventory is used instead of ending inventory because many

companies' merchandise fluctuates greatly throughout the year. For
instance, a company might purchase a large quantity of merchandise
January 1 and sell that for the rest of the year. By December almost the
entire inventory is sold and the ending balance does not accurately reflect
the company's actual inventory during the year. Average inventory is usually
calculated by adding the beginning and ending inventory and dividing by
two..

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Inventory Turnover - Analysis

 Inventory turnover is a measure of how efficiently a company can control its
merchandise, so it is important to have a high turn. This shows the company
does not overspend by buying too much inventory and it does not waste
resources by storing non-salable inventory. It also shows that the company
can effectively sell the inventory it buys.

 This measurement also shows investors how liquid a company's inventory is.
Think about it. Inventory is one of the biggest assets a retailer reports on its
balance sheet. If this inventory can't be sold, it is worthless to the company.
This measurement shows how easily a company can turn its inventory into
cash.

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Inventory Turnover - Example

 Donny's Furniture Company sells industrial furniture for office buildings. During the
current year, Donny reported cost of goods sold on its income statement of
$1,000,000. Donny's beginning inventory was $3,000,000 and its ending inventory
was $4,000,000. Donny's turnover is calculated like this:

 Donny's turnover is .29. This means that Donny’s company only sold roughly a third
of its inventory during the year. It also implies that it would take Donny approximately
3 years to sell his entire inventory or complete one turn. In other words, Danny does
not have very good inventory control.

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Financial Ratios
 Efficiency ratios also known as Market ratios which are concerned with
shareholder audiences.

 They measure the cost of issuing stock and the relationship between return
and the value of an investment in a company's shares.

 One key ratio coming under the financial ratios is return on capital employed.

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Return on Capital Employed

(ROCE)
 Return on capital employed or ROCE is a profitability ratio that measures
how efficiently a company can generate profits from its capital employed by
comparing net operating profit to capital employed. In other words, return on
capital employed shows investors how many dollars in profits each dollar of
capital employed generates.

 ROCE is a long-term profitability ratio because it shows how effectively

assets are performing while taking into consideration long-term financing.
This is why ROCE is a more useful ratio than return on equity to evaluate the
longevity of a company.

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ROCE - Formula
 Return on capital employed formula is calculated by dividing net operating
profit or EBIT (Earnings Before Interest and Taxes) by the employed capital.

 If employed capital is not given in a problem or in the financial statement

notes, you can calculate it by subtracting current liabilities from total assets.
In this case the ROCE formula would look like:

 It isn't uncommon for investors to use averages instead of year-end figures

for this ratio, but it isn't necessary.

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ROCE - Analysis
 The return on capital employed ratio shows how much profit each dollar of
employed capital generates. Obviously, a higher ratio would be more
favourable because it means that more dollars of profits are generated by
each dollar of capital employed.

 For instance, a return of .2 indicates that for every dollar invested in capital
employed, the company made 20 cents of profits.

 Investors are interested in the ratio to see how efficiently a company uses its
capital employed as well as its long-term financing strategies. Companies'
returns should always be higher than the rate at which they are borrowing to
fund the assets. If companies borrow at 10 percent and can only achieve a
return of 5 percent, they are losing money.

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ROCE - Example
 Scott's Auto Body Shop customises cars for celebrities and movie sets. During
the year, Scott had a net operating profit of $100,000. Scott reported $100,000 of
total assets and $25,000 of current liabilities on his balance sheet for the year.

 Accordingly, Scott's return on capital employed would be calculated like this:

 As you can see, Scott has a return of 1.33. In other words, every dollar invested
in employed capital, Scott earns $1.33. Scott's return might be so high because
he maintains a low assets level.

 Companies with large cash reserves usually skew this ratio because cash is
included in the employed capital computation even though it isn't technically
employed yet.

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