1. Chapter 3 Introduction
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 Quick 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 Debt to equity ratio Times interest earned
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 Return on assets Return on equity
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 Average Daily Rate (ADR) REVPAR
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?