HOSP4060 HOSPITALITY STRATEGY DESIGN & EXECUTION SEMINAR

THE ROLE OF FINANCIAL ANALYSIS

Another important aspect of analyzing a case study and writing a case study analysis is the role and use of financial information. A careful analysis of the company’s financial condition immensely improves a case write-up. After all, financial data represent the concrete results of the company’s strategy and structure. Although analyzing financial statements can be quite complex, a general idea of a company’s financial position can be determined through the use of ratio analysis. Financial performance ratios can be calculated from the balance sheet and income statement. These ratios can be classified into five different subgroups: profit ratios, liquidity ratios, activity ratios, leverage ratios, and shareholder-return ratios. These ratios should be compared with the industry average or the company’s prior years of performance. It should be noted, however, that deviation from the average is not necessarily bad; it simply warrants further investigation. For example, young companies will have purchased assets at a different price and will likely have a different capital structure than older companies. In addition to ratio analysis, a company’s cash flow posit ion is of critical importance and should be assessed. Cash flow shows how much actual cash a company possesses.

Profit Ratios

Profit ratios measure the efficiency with which the company uses its resources. The more efficient the company, the greater is its profitability. It is useful to compare a company’s profitability against that of its major competitors in its industry. Such a comparison tells whether the company is operating more or less efficiently than its rivals. In addition, the change in a company’s profit ratios over time tells whether its performance is improving or declining. A number of different profit ratios can be used, and each of them measures a different aspect of a company’s performance. The most commonly used profit ratios are gross profit margin, net profit margin, return on total assets, and return on stockholders’ equity.

Profit margin. Net profit margin is the percentage of profit earned on sales. This ratio is important because businesses need to make a profit to survive in the long run. It is defined as follows:

Profit Margin

=

Net Income

Revenues

Return on Assets. Return on assets (ROA) is an indicator of how profitable a company is relative to its total assets. ROA gives a manager, investor, or analyst an idea as to how efficient a company’s management is at using its assets to generate earnings. ROA is displayed as a percentage; the higher the ROA is, the better.

Net Income

Return on Assets = Total Assets

Liquidity Ratios

A company’s liquidity is a measure of its ability to meet short-term obligations. An asset is deemed liquid if it can be readily converted into cash. Liquid assets are current assets such as cash, marketable securities, accounts receivable, and so on. Two commonly used liquidity ratios are current ratio and quick ratio.

Current ratio. The current ratio measures the extent to which the claims of short-term creditors are covered by assets that can be quickly converted into cash. Most companies should have a ratio of at least 1, because failure to meet these commitments can lead to bankruptcy. The ratio is defined as follows:

Current Ratio

=

Current Assets

Current Liabilities

Activity Ratios

Activity ratios indicate how effectively a company is managing its assets. Inventory turnover and days sales outstanding (DSO) are particularly useful:

Inventory turnover. This measures the number of times inventory is turned over. It is useful in determining whether a firm is carrying excess stock in inventory. What counts as a “good” inventory turnover will depend on the industry in question. As a general rule, industries stocking products that are relatively inexpensive will tend to have higher inventory turnovers, whereas more expensive items—where customers usually take more time before making a purchase decision—will tend to have lower inventory turnovers. It is defined as follows:

Inventory Turnover

=

Cost of Goods Sold

Inventory

Leverage Ratios

A company is said to be highly leveraged if it uses more debt than equity, including stock and retained earnings. The balance between debt and equity is called the capital structure. The optimal capital structure is determined by the individual company. Debt has a lower cost because creditors take less risk; they know they will get their interest and principal. However, debt can be risky to the firm because if enough profit is not made to cover the interest and principal payments, bankruptcy can occur.

Three commonly used leverage ratios are debt-to-assets ratio, debt-to-equity ratio, and times-covered ratio.

Debt-to-assets ratio. The debt-to-asset ratio is the most direct measure of the extent to which borrowed funds have been used to finance a company’s investments. In other words, the company has more liabilities than assets. The lower the ratio, the more equity is available to the creditors. It is defined as follows:

Debt-to-Assets Ratio

=

Total Debt

Total Assets

Shareholder-Return Ratios

Shareholder-return ratios measure the return earned by shareholders from holding stock in the company. Given the goal of maximizing stockholders’ wealth, providing shareholders with an adequate rate of return is a primary objective of most companies. As with profit ratios, it can be helpful to compare a company’s shareholder returns against those of similar companies. This provides a yardstick for determining how well the company is satisfying the demands of this particularly important group of organizational constituents. Four commonly used ratios are total shareholder returns, price-earnings ratio, market to book value, and dividend yield.

Return on Stockholders Equity. Return on equity (ROE) is a measure of financial performance calculated by dividing net income by shareholders’ equity. Because shareholders’ equity is equal to a company’s assets minus its debt, ROE is considered the return on net assets. ROE is considered a measure of a corporation’s profitability in relation to stockholders’ equity. As a shortcut, investors can consider an ROE near the long-term average of the S&P 500 (14%) as an acceptable ratio and anything less than 10% as poor.

Return on Stockholders Equity = Net Income

Stockholders’ Equity

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