HAMG 2332-Hospitality Finance
Understanding Financial Statements

Why do we need to understand?
      Balance Sheet
      ...
Balance sheet
                                 - Assets
                                 - Liabilities
                   ...
Summary
   • Financial statements -useful to a variety of people.
   • Balance sheet -- must balance.
             - Asset...
Example Balance Sheet
_____________________________________________________________________________________
         Hillt...
Income Statement
Overview
    • Profit & Loss statement - summary of income & expenses during specific period.
    • Accou...
Summary
• Profit & Loss statement - aka income statement or P & L.
      - summary of income & expenses during specific pe...
Example Income Statement
_____________________________________________________________________________________
Hilltop Fer...
Ratios

Overview
   • Common size analysis.
   • Ratio analysis.
   • Profitability ratios.
   • Liquidity ratios.

Why An...
Profitability Ratios
    • Different measures of profitability — the gain from the resources used.
    • Earning on sales ...
• Lender’s contribution ratio:
Long-term debt = Lender’s contribution ratio
Net Worth
(Larger # is worse)
Efficiency Ratio...
Return on Investment
    • $ made on $ invested in business.
    • Made up of 3 areas.
                              - Pro...
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  1. 1. HAMG 2332-Hospitality Finance Understanding Financial Statements Why do we need to understand? Balance Sheet Income Statement Return on Investment Calculating ROI
  2. 2. Balance sheet - Assets - Liabilities - Owner’s Equity Financial Statements • Who needs financial statements anyway? - Lenders - Investors - Employees - Suppliers - Govt. - IRS, SEC Financial Statements - Criteria • Simple, easy to understand. • Reliable, accurate, consistent & timely. • Based on uniqueness of business. Keeping the Books • Numerous software packages available for posting to accounts and generating financial statements as needed. • Level of sophistication depends on needs of business. • Owner/Mgr. input, bookkeeper or entire accounting dept. Balance Sheet Summary of what business: - OWNS - OWES - OWNER’S INVESTMENT • For each asset there is an offsetting claim - Assets = Liabilities + Owners Equity • Like a snapshot or picture of the business at a specific point in time. • Assets - things of value business uses: - Current - cash or assets that can be converted to cash during normal operating cycle (1 yr.) • Current (or short-term): - Cash. - Accounts receivable - what customers owe you. - Inventory - items held for sale (valued at cost or mkt. Value - -whichever is LOWER). - Prepaid expenses. - Other - stocks, bonds, etc. • Long-term (Fixed assets) - assets w/ long life: - Land - entered at COST not mkt. value. - Buildings. - Equipment. • All fixed assets EXCEPT land depreciate (decrease in value) over time. • Other assets - stocks, bonds, goodwill. • Liabilities - money business owes others: - Current - fall due w/in 1 yr. - Accounts payable - money owed suppliers. - Notes payable - loans due w/in 1 yr. - Accruals : -- taxes payable. -- wages payable. -- no formal bill or invoice. - Long-term liabilities - fall due beyond 1 yr. • Net Worth (Owner’s Equity) - Owners receive what’s left over after liabilities are paid. • Example:
  3. 3. Summary • Financial statements -useful to a variety of people. • Balance sheet -- must balance. - Assets = Liabilities + Owners Equity • Like a picture of business at a specific point in time.
  4. 4. Example Balance Sheet _____________________________________________________________________________________ Hilltop Fertilizer, Inc. Balance Sheet December 31, 1996 _____________________________________________________________________________________ Assets Current Assets: Cash $ 50,000 Accounts receivable 150,000 Inventory 80,000 Prepaid expenses 10,000 Other 10,000 Total current assets 300,000 Fixed Assets: Land 20,000 Buildings 100,000 Less: Accumulated depreciation 50,000 Equipment 250,000 Less: Accumulated depreciation 130,000 Total fixed assets 190,000 Other assets 10,000 Total assets $500,000 Liabilities Current liabilities: Accounts payable 43,000 Notes payable 100,000 Taxes payable 5,000 Wages payable 2,000 Total current liabilities 150,000 Long-term liabilities: Mortgages 40,000 Other 10,000 Total long-term liabilities 50,000 Total liabilities 200,000 Net Worth Owner-invested capital: Common stock 200,000 Retained earnings 100,000 Total net worth 300,000 Total liabilities and net worth $500,000 Source: Downey, W.D. and S.P. Erickson, Agribusiness Management, McGraw-Hill, Inc. New York, NY, 1987.
  5. 5. Income Statement Overview • Profit & Loss statement - summary of income & expenses during specific period. • Accounting - Accrual - Cash Profit & Loss Statement • Income statement or P & L. • Summarizes income & expenses during a specific period. • What happened "between" balance sheets. • Assets - as they are "used up" they become an expense to the business - How? - Through expense called depreciation. - Not a cash expense, but can parallel loan payments if made. • Sales - $ value of products & services sold. - cash. - credit. • Cost of goods sold - Easy for retail firm - just purchases. - Manufacturing firm - more complicated. --> Raw materials. --> direct manufacturing costs. • Cost of goods sold o Must calculate change in inventories. Beginning Invt. - Ending Invt. = Net Invt. Change + Purchases = Cost of Goods Sold • Gross margin - Difference between total sales & COGS. - How do you raise it? • Operating expenses - costs associated w/ sales. - Mkting. Expenses: - - wages, commissions - - transportation - - advertising & promotion • Operating expenses, cont. - Administrative expenses - - auditing fees - - mgmt. salary - - office expenses - General expenses - - depreciation - - insurance - - taxes - - rent - - repairs - - utilities • Net operating profit - Difference between gross margin & operating expenses. • Net profit before taxes - Net operating profit + interest, dividends, etc. • Net profit after taxes (net profit) - Subtract Fed. & State taxes. • Accounting - Accrual basis -- Report revenues when earned. -- Report expenses when incurred. - Cash basis: -- Report revenues when received. -- Report expenses when paid.
  6. 6. Summary • Profit & Loss statement - aka income statement or P & L. - summary of income & expenses during specific period - like a movie or video
  7. 7. Example Income Statement _____________________________________________________________________________________ Hilltop Fertilizer, Inc. Income Statement --Year Ended December 31, 1996 Sales $1,000,000 Costs of goods sold 750,000 Gross margin 250,000 Operating expenses Salaries and wages, including benefits 75,000 Local taxes, licenses 5,000 Insurance 6,000 Depreciation 20,000 Rent and lease 7,000 Advertising and promotion 5,000 Office expense 2,000 Utilities 3,000 Maintenance and repair 17,000 Bad-debt loss 2,000 Supplies 4,000 Other 4,000 Total operating expense 150,000 Net operating profit 100,000 Interest expense 15,000 Other nonoperating income 5,000 Net profit before taxes 90,000 Profit taxes 40,000 Net profit after taxes $ 50,000 Source: Downey, W.D. and S.P. Erickson, Agribusiness Management, McGraw-Hill, Inc. New York, NY, 1987.
  8. 8. Ratios Overview • Common size analysis. • Ratio analysis. • Profitability ratios. • Liquidity ratios. Why Analyze Financials? • How successful business has been. • What problems/opportunities? • What alternatives/courses of action? How Often? • At least quarterly • Sometimes even monthly (usually depends on size of business). What Areas? • Cash position (liquidity). • Repayment ability (solvency). • Trends - Revenues - sales - Costs - production, overhead, wages - Production output. - Performance (output/labor input, etc.) What Areas? • Profitability. - Present - Trend • Use of Resources - ROI Benchmarks • Compare current period w/ similar past periods. • Industry standards or norms. Common Size Analysis • Express P & L & Balance Sheet as some % of: - Total sales. - Total assets. • Examples: - Labor as % of sales. - Advertising as % of sales. - Debt as % of sales. Ratio Analysis • Why? - Easy to calculate - Easy to make comparisons: -- Within firm. -- Between firms - Easily understood. - Communicate financial information to interested parties. • Limitations - Just indicate problems, don’t identify cause. - Problems if you change accounting methods. • Types of ratios: - Profitability - Liquidity - Solvency - Operational
  9. 9. Profitability Ratios • Different measures of profitability — the gain from the resources used. • Earning on sales ratio: Earnings (Net Operating Profit) = EOS Sales Reflects operative efficiency & pricing • Profit on sales ratio: Net Profit = POS Sales Compares profit relative to sales • Return to Equity ratio: Net Profit = Profit on Equity Capital Net Worth How good is the investment for the owners? • Gross margin: Sales - COGS = Gross Margin % Sales Reveals prices received & product mix. Will also be closely tied w/ inventory turnover Liquidity Ratios • Ability to meet short-term obligations. Current ratio: Total Current Assets = Current ratio Total Current Liabilities Ability to meet current bills & obligations. However,quick sale of assets may lower their value, SO . . . Acid ratio: Cash + Mktable securities + A/R = Acid ratio Total Current Liabilities Assets which can be turned into cash very quickly. • Summary • Common size analysis -- comparing w/ other firms in industry putting them on "equal" footing. • Ratio analysis - Profitability - Liquidity Overview • Solvency ratios. • Efficiency ratios. • Return on Investment. Solvency Ratios • Ability to meet long-term claims or debts. • Impacts how much the firm can borrow. • Debt to Equity ratio: Total Liabilities = D/E ratio Net Worth What % liabilities are of O.E. Many lenders - 1 as upper limit (larger # is worse) ie. Total liabilities cannot be >net worth • Owner’s contribution ratio: Net Worth = owner’s contribution ratio Total Net Assets Total Net Assets = Net Working Capital + Net Fixed Assets Red flag if this ratio is less than 50% (Smaller # is worse)
  10. 10. • Lender’s contribution ratio: Long-term debt = Lender’s contribution ratio Net Worth (Larger # is worse) Efficiency Ratios • Ratios that look at how effectively firm uses its resources. • Turnover ratio: Total Sales = Turnover Total Assets - Measure of intensity with which assets are used. - Need to compare to industry norms. - Higher turnover --> higher ROI. - How to improve? -- Use assets more efficiently. -- Increase prices. -- Sell ineffective assets. -- Reduce A/R (since it is an asset). • Inventory turnover ratio: Sales = Rate of turnover Ending Inventory Often times need to use average inventory. - Compare right figures Net Sales or COGS Inventory Inventory (retail price) (at cost) • Inventory turnover ratio: - Measures working capital management. - Too low -- interest burden, too much money tied up in inventory which is not moving quickly enough. - Too high -- lost sales opportunities, "out of stock" problems. • Average collection period: Accounts Receivable X 365 days Sales = Days Sales in Receivables. • Average collection period: - Measure of how quickly A/R is collected. - Too high -- a problem. - Too low -- potential lost sales. - Rule of thumb -- collection period should not exceed payment period by > 1/3. • Average collection period: Example: - Credit policy -- Net due in 30 days. - Calculated collection period shouldn’t exceed 40 days (30 days + 1/3 of collection period) Other Ratios • Labor cost, etc.: Labor Costs = Labor as % of sales Total Sales Others as needed Production efficiency -- measures of lost product, waste Production/hr., Rejects/day, etc.
  11. 11. Return on Investment • $ made on $ invested in business. • Made up of 3 areas. - Profits. - Return on assets. - Leverage. • Profits - the earnings generated from sales. - Plugged into ROI formula as: -- Net Profit/Sales • Return on Assets - Intensity of asset use. - Plugged into ROI formula as: -- Total Sales/Total Assets • Leverage - Use of outside funds to expand business. - Plugged into ROI formula as: - Total Assets/Net Worth Summary • Solvency ratios - ability to meet long-term claims or debts . • Efficiency ratios - how effectively firm uses its resources. • Return on Investment - $ made on $ invested.

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