Owner Equity – Are Earnings Enhancing Financial Position?

Have you heard of the concept of owner equity?

Or what is also known as capital.

Would you not want to know where your monthly hotel profit is eventually getting reflected?

If your response to the first question is “No,” it is time you understood this foundational concept.

I will lay out a case for:

• meaning of owner equity;
• examples of owner equity;
• owner equity formula (yes, there is one!).

More importantly, I will clarify why you should know about owner equity for your hotel’s long term health.

This Chapter 6 of Ultimate Guide on Hotel Balance Sheet Basics will cover:

Assets, Liabilities and Owner Equity

In earlier chapters in this Ultimate Guide, you learned about the Balance Sheet.

That the balance sheet shows the financial position of your hotel at the end of a month/period.

It does this through three major ingredients:

• assets,
• liabilities and
• owner equity.

Broadly, they show: 

• What a Business Owns and 
• What a Business Owes.

In earlier chapters, you learned about assets and liabilities.

In this Chapter 6, we will visit the powerful concept of owner equity.

You may ask a question as to what the big deal is about owner equity.

Great question!

Let me clarify with a metaphor.

I may begin by saying that: 

• not knowing about owner equity, 
• will be like traveling far and arriving somewhere, 
• but not knowing where!

You have no idea where you are at!

Not a good situation to be in.

Let us learn what owner equity is all about.

Owner Equity

Owner Equity or equity ownership may be termed as the OWNER’s Contribution.

You could say that it is what a business starts with.

It is the Owner’s capital.

Long before a business starts earning revenue, it has to:

• spend money to set up the business,
• have an office,
• incur administrative expenses.

All this requires cash flow.

So, this is how the business starts:

• with the Owner contributing Capital,
• in the form of cash.

With the cash the business can:

• purchase assets and 
• earn revenue.

So, now you will begin to see why it is such a big deal.

Without owner equity, you cannot acquire assets.

Of course, you could borrow to buy assets, but that is a different story.

If you do not purchase assets, you have no ability to earn revenue.

Everything begins with the generation of revenue.

Owner Equity has a few peculiarities about it.

• Capital contribution by the Owner cannot be taken back during the life time of the business.
• In other words, capital can be returned to the Owner only when the business closes down.
• Capital is an index of equity.
• Equity means a risk interest or ownership right in property.
• This simply means that Capital gives the Owner ownership right in the business.

In the case of a business:

• which is formed as a company or corporation,
• owner equity refers to the common stock issued (if any),
• by the company or corporation.

Let us quickly trace back to a question that I began this chapter with.

Would you not want to know where your monthly hotel profit is eventually getting reflected?

Now comes the most important role that owner equity plays in that monthly hotel profit.

When a business:

• generates revenue,
• incurs expenses and
• earns a profit,

that profit is added as Owner Equity of the business.

So, you could say that owner equity of a business consists over time of accumulated monthly profit.

Let us see how this relationship plays out.

I will be introducing two words:

• “performance” and
• “financial position” 

to paint a big picture overview.

Owner Equity & Profit and Loss Statement

The Profit and Loss Statement [or Income Statement as it is also known as] is a performance statement.

Performance is a word that is often misquoted and misunderstood.

Say, any of your professional colleagues from other hotels ask you:

How did your hotel perform in the past month?

What would you say?

Would you tell them about:

• occupancy in that past month?
• average daily rate achieved in that past month?
• total revenue achieved in that past month?
• gross operating profit achieved in that past month?

Do you see what I am getting at?

Performance is a generic word.

It can mean so many different things.

You could say that it also means different things at different times.

Why did I list those four in my questions earlier?

There is a reason for it.

Normally, performance can refer to business volume which is Occupancy.

Performance can refer to price achieved for rooms which are Average Daily Rates.

Yet another and in fact common reference to performance is revenue achieved which is Total Revenue.

Finally, you could be talking about the bottom line when referring to performance.

One powerful indicator of bottom line could be Gross Operating Profit.

Collectively, these four are known in the hotel industry as Key Performance Indicators.

Each of these KPIs, or Key Performance Indicators denote an important aspect of performance.

So, let us go back to the question that your colleagues were asking you.

Your response should be with a question:

Are you talking about 

• business volume,
• price,
• revenue or
• profit?

Let us now see what the main ingredients of performance are.

Performance Ingredients & Owner Equity

The most common ingredients for hotel performance are: 

• revenue, 
• expenses and 
• profit.

Revenue is known in the industry (and other industries too) as The Top Line.

This is because in a Profit and Loss Statement, the Total Revenue is often at the top.

The primary motivation of a hotel business (as any other business) is earning revenue.

Revenue is not produced on its own.

You look puzzled!

Let me explain.

Revenue does not happen by itself.

It is generated when two key ingredients come together.

These two ingredients are different from department to department.

And based on different types of revenue.

Let us assume we are talking about the hotel Rooms department.

How is Rooms department revenue achieved?

The two ingredients we talked about earlier are:

• price and 
• business volume.

In the case of the hotel Rooms department these are represented by

• Occupancy
• Average Daily Rate

So, see why just talking about performance without clarifying what it is will only lead to confusion.

The next ingredient for performance is expenses.

Expenses are the cost of doing business.

In other words it is what is incurred to earn revenue.

Expenses can be:

• Fixed or 
• Variable.

When we talk about Variable expenses, we are referring to expenses which change according to business volume.

In other words:

• in the case of the hotel Rooms department,
• variable expenses at 80% occupancy
• will be higher than at 40% occupancy.

The third and last ingredient is profit.

Profit is what is left after deducting all expenses (both fixed and variable) from all revenue.

So, there you are, the three ingredients of performance - revenue, expenses and profit.

How does Profit and Loss Statement relate to the other important financial statement, Balance Sheet?

And what is financial position?

Owner Equity in a Balance Sheet

The Balance Sheet broadly shows the long term financial position of the hotel

[See Chapter 1 for the Paradise Hotel Balance Sheet].

Again:

• if Profit and Loss Statement shows performance for a period of time (month normally),
• Balance Sheet shows the financial position at a point of time (say, end of the month).

The two statements have distinctively different roles.

However, they are closely related.

Some of the questions that your Balance Sheet answers are:

1. What was the balance of cash on hand at the end of the month/period?
2. What were the total borrowings for the hotel?
3. What was the mix of internal (equity) and external (borrowings) financing at the end of the month/period?
4. How much was owed to the hotel (accounts receivable) by the guests?
5. What amount of taxes was owed to the various government tax agencies?
6. What is the financial strength of the operation?

These are questions which your Profit and Loss Statement cannot answer.

Hence the need to read a Balance Sheet.

How are Performance and Owner Equity related?

The simple principle to understand is this:

When a business earns profit [revenue less expenses], that profit gets added to the Owner Equity.

Earlier, relating to the Profit and Loss Statement, you learned about revenue, expenses and profit.

Let us now see how that profit is added to the Owner Equity of the business.

When the business (hotel) earns revenue, it will get paid for that.

Thus revenue means cash inflow.

Similarly, when the business (hotel) incurs expenses it has to pay for those expenses.

So, expense means cash outflow.

Since: 

• revenue will (should) hopefully be higher than expenses,
• cash inflow will be higher than cash outflow,
• so profit is thus related to cash inflow (net of revenue inflow and expense outflow).

This is a key principle to understand.

Let us take a 7 Step process to understand how profit builds up assets, capital and value.

How Profit Builds Up Assets, Owner Equity and Value

STEP 1

Assume that you are given a simplified Balance Sheet and Profit and Loss Statement. [Visual 1].

These just show important headers.

Note that Balance Sheet is as of August 1, 2021 and Profit and Loss Statement is for August 2021.

This is important to understand.

Balance Sheet is as of a date while the Profit and Loss Statement is for the month.

For the moment, we have deliberately not assigned any amount which will be done in Step 2.

Now our question is: how does profit (or Net Income) build up assets, capital and value?

STEP 2

Let us now introduce some basic numbers.

To make the concept easy to understand, we will use just one number for each header.

We have taken a simplified Balance Sheet with one total each for Owner Equity (Capital), Liabilities and Assets.

The principles are the same nevertheless.

Next, we need to know about a universal principle that will help us understand the Balance Sheet better.

And that universal principle is the Fundamental Accounting Equation.

No, you do not have to be an accountant to understand it.

It really is quite simple I promise.

STEP 3

The Fundamental Accounting Equation is: Assets = Owner Equity + Liabilities.

This is why the two sides of a Balance Sheet have the same total - they balance, in a manner of speaking.

In Visual 3, this is $7,000,000 (Assets) = $5,000,000 (Owner Equity) + $2,000,000 (Liabilities).

You can see that from the Balance Sheet as of August 1 2021.

STEP 4

Let us now see:

• how the hotel operation business results for the month of August 2021 
• impact the financial position which is reflected in the Balance Sheet.

Assume that the hotel:

• earned total revenue of $1,500,000,
• incurred total expenses of $1,050,000
• resulting in a profit or Net Income of $450,000.

You could say that the hotel operation for August 2021 resulted in a profit of $450,000 (Visual 4).

Let us for simplicity sake, assume that all revenue was received in cash and all expenses paid in cash.

This means that profit or Net Income is equal to Cash Inflow.

This is the principle of cash flow which we have simplified.

In order to illustrate our question about improvement in the financial position.

Now we will see how:

• the hotel operation results for the month of August 2021
• impact the financial position which is reflected in the Balance Sheet.

So, we will build a Balance Sheet as of the end of the month of August 2021 (after the business results).

In other words as of 31st August 2021.

STEP 5

First, let us create a Balance Sheet at the end of August 2021.

This is before taking into account the business results of August 2021 from the Profit and Loss Statement [Visual 5].

This will be the same as in Visual 3.

Now, let us rearrange the two balance sheets and the profit and loss statement for better understanding.

STEP 6

Let us now build the Balance Sheet at the end of August 2021.

This time it is after taking into account the business results of August 2021 from the Profit and Loss Statement.

This will mean bringing in the business results for the month of August 2021 from the Profit and Loss Statement.

This Balance Sheet will be as of 31st August 2021.

Hotel Balance Sheets and Profit and Loss Statement Rearranged

In Visual 6, this is $7,450,000 (Assets) = $5,450,000 (Owner Equity) + $2,000,000 (Liabilities).

What changed from the Balance Sheet from 1st August 2021?

Well, the Profit of $450,000 got added to Owner Equity.

Since we assumed that:

• all revenue and expenses were received and paid in cash, 
• the profit is equal to cash generated from the August hotel operation business results.

So, Assets also went up by $450,000 [remember Cash is an asset].

Notice now how the Profit and Loss Statement is between two Balance Sheets.

STEP 7

The moral of the story is :

• when the results of the Profit and Loss Statement 
• are added to an opening balance sheet,
• you get the closing balance sheet.

That is the powerful relationship between these two financial statements.

But it is not just a closing balance sheet.

It is an improved balance sheet which is now richer by $450,000 [Visual 7].

This is the reason why the results of the month are so important.

In the above example:

• if the hotel had incurred a loss in the month of August 21,
• the closing balance sheet would be poorer than the opening balance sheet.

A richer balance sheet means:

• owner equity has gone up (to the extent of profit) and thus 
• financial position is better.

Hotel value will also go up when financial position improves.

Many hotel managers and even financial managers are not aware of this phenomenon.

So, you can see that capital is eventually how monthly hotel profit is reflected in.

In the detailed Paradise Hotel Balance Sheet above (with numbers), that capital is included in Retained Earnings.

Retained Earnings is nothing but past profit accumulations.

It is part of Owner Equity.

You can take action steps shown below based on your learning so far.

Action Steps You Can Take Right Now on Owner Equity

STEP 1

Go to your Hotel Financial Controller and ask him to show you the Balance Sheet for the hotel.

STEP 2

Identify Owner Equity in your hotel balance sheet and more specifically Retained Earnings.

STEP 3

Notice how Retained Earnings are laid out. Compare this with the previous month figure.

STEP 4

How much are Retained Earnings for your hotel? How do they compare with Owner Equity.

STEP 5

Ask yourself whether as a hotel manager you are managing your profit effectively enough to influence owner equity.

Other Chapters of Ultimate Guide on Hotel Balance Sheet Basics

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