The profitability of a business is its ability to generate earnings through its management during a specific time period.
To measure the profitability of the company, there are a number of techniques called profitability ratios (or indexes).
These profitability ratios measure the performance of a business’s management results, and they provide a basis for assessments to be made by those who review our financial statements.
It is very important to be acquainted with these indexes, and to become familiar with how they are calculated, since they are given a great deal of attention especially in any dealings with banks.
Main business profitability ratios
Let’s define the 3 main business profitability ratios:
- ROI (Return on Investment) = Profitability of a business’s invested capital
- ROE (Return on Equity) = Profitability of own capital invested by business owner
- ROS (Return on Sales) = Profitability of sales
1) ROI (Return on Investment) indicates the profitability of a business’s invested capital.
The capital invested in the business is equal to net working capital plus fixed assets. This index is very important for the business owner, as it is useful to determine the return on capital invested in the business (both own and borrowed). ROI is calculated through an operation in which the operating income (or operating earnings) is used in the numerator and the net invested capital is used in the denominator, the first is divided by the latter and then multiplied by 100, thus obtaining the percentage of return on invested capital.
ROI = (Operating Income / Invested Capital) x 100
2) The second index (ROE = Return on Equity) measures the profitability of the resources that the business owner has personally invested in the company as equity or risk capital.
Of course, the result of this index is the return on risk capital; it goes without saying that ROE should at the very least equal the return on government bonds, with the addition of a premium ranging between 4-5%, plus the addition of a further premium related to the specific risk of the business and the sector (starting at 3% and potentially reaching up to 20%).
ROE = (Annual Net Income / Net Equity) x 100
3) The third index is ROS (Return on Sales), which gauges the average profitability of sales and is a very interesting index, particularly for making comparisons with businesses operating in the same sector. It is obtained by dividing operating profit by annual net sales:
ROS = (Operating Profit / Sales Revenue) x 100
This index is essential, because it measures the average profit margin a business achieves from its earnings – before taxes and financial expenses – and allows to obtain indications about the standard of one’s operational management. For instance, if sales profitability in one’s sector is 10% and one’s business has a ROS ratio of 4%, this would signify that there are critical issues to be addressed which might concern, for example, prices and/or sales channels or production costs.
How to measure hotel profitability
To answer the question “How is a hotel’s profitability measured?”, and analyzing the three business profitability ratios from a hotel perspective, it is clear that the first two require background knowledge of the financial situation to account for investments (e.g. invested capital for ROI and net equity for ROE).
In addition to this, it is impossible – given the very nature of the factors that make up these ratios – to provide general criteria and/or measures.
The ratio that we of the Franco Grasso Revenue Team use to assess the profitability of managing a hotel is ROS (Return on Sales): it indicates, as previously mentioned, the average profit margin.
We use this index as the starting point for the profitability analysis of a hotel, because we consider it the most suitable for our practices in providing Revenue Management services to our hotel clients, since the denominator (and partly also the numerator) is represented by the figure on which we intervene more directly and that we increase the most (sales volume).
We can compare ROS to EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization), which is also a profitability ratio and naturally highlights a business’s earnings based solely on its ordinary management performance, before interests (financial management), taxes (tax management), depreciation of assets and amortization.
EBITDA is more important than profit for financial analysts because it allows to get a clear picture of whether the company is able to generate wealth through operational management, therefore excluding accounting maneuvers made by company administrators (amortization and provisions, but also financial management) which do not always present a correct view of the business performance.
if EBITDA = Operating revenue – Operating costs * and ROS = Operating income – Operating costs * / Total room revenue it follows that ROS = EBITDA /Total sales
* In the Operating Costs, we include fixed costs as well – although they do not belong in the same cost pool – because they represent a key parameter from an entrepreneurial point of view.
Of course, EBITDA can be calculated upon final balance, or it can be projected.
Each of its components is dependent upon the combined action of various factors:
Room Revenue (Revenue Management)
Variable costs * (should account for approximately 30% of total sales)
Fixed costs *, which are hardly generalizable, as they are dependent on contingent situations (should not exceed 40/45% of total sales).
* Revenue Controlling determines the reduction of total costs – fixed and variable – as a means to increase revenue (in addition to the reorganization of the operational flowchart).
Room Revenue is in turn dependent on the Revenue Penetration Index:
we can assume that a 50-room hotel centrally located in Valencia can achieve a RatePar (selling price per available room) of 50 € (of course, if managed with our Revenue Management).
Therefore, Room Revenue will be (365 x 50) x 50 € = 912,500 € *
Note = * In this context, when we mention room revenue, we always refer to the selling price, which is therefore equal to total room sales on BB, VAT included.
Considering that, in traditional management practices, variable costs + fixed costs should have an overall impact of 70/75% (variable costs 30% + fixed costs 40/45%), we deduce that the average operating income should be around € 228,125 (roughly 25%).
The profitability of a 50-room hotel in Valencia (which properly implements Revenue Management, Revenue Controlling and has standard fixed costs) equals € 228,125 per year, naturally before interests (financial management), taxes (tax management), depreciation of assets and amortization.
If this 50-room hotel were located in Rome, the relative RatePar – linked to the Revenue Penetration Index – would be higher; it is likely that fixed and variable costs would also be higher, but their incidence in ABSOLUTE terms would be lower, and therefore EBITDA would be higher, as well.
In the case of a proper implementation of Revenue Management, as we have observed in our facilities, the incidence of fixed costs on total sales is likely to decrease as productivity increases, while the impact of variable costs can indeed surge in percentage terms but in absolute terms (which is what matters) will always lead to an increase in absolute value of the EBITDA and therefore of the OPERATING PROFIT.
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