Hotel Financial Statements - Balance Sheet Relation with Profit and Loss Statement

Have you ever wondered how hotel financial statements are related to each other?

More specifically how Balance Sheet can strengthen the financial position of your hotel?

You might have focused only on the hotel operation and its performance.

However, is it strengthening or dragging down the financial position?

Would you know that?

The solution is closer than you could have imagined.

And it is impacted by your hotel business results.

I will lay out a strong case for how your hotel performance can enhance or drag down its financial position.

Unfortunately, it is a relationship which few hotel managers are aware of or clear about.

This Chapter 7 of Ultimate Guide on Hotel Balance Sheet Basics will cover:

Hotel Balance Sheet Vs 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 the occupancy?

Would you tell them the average daily rate?

Would you tell them the total revenue achieved?

Would you tell them about the gross operating profit?

Do you see what I am getting at?

Performance is a generic word.

It can mean so many different things.

It can also mean 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 a more common reference to performance is revenue achieved which is Total Revenue.

Finally, you could be talking about the bottom line when referring to performance and one 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, as Key Performance Indicators are called, 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.

Hotel Financial Statements - Profit and Loss Statement & Performance Ingredients

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.

It is also that the primary motivation of a hotel 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, now you can 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?

Before going there,  let us find out some serious shortcomings of the Profit and Loss Statement.

It will help you understand better the relationship between the two hotel financial statements - Balance Sheet and Profit and Loss Statement.

Shortcomings of Profit and Loss Statement

The Profit and Loss Statement is a performance statement.

But this performance is historical.

What do I mean by that?

It means that the Profit and Loss Statement is merely a record of past transactions.

We do not know the following important factors from this historical record of performance:

• How good is this performance in terms of potential to achieve more?
• Why are certain expenses the same as or similar to last year while others are increasing or decreasing?
• What are wastage and redundancies that can be avoided?
• How can we set targets for future years based on this historical performance?
• What degree of control can be exercised on these revenues and expenses through decision making for the future?
• Is there any relationship between the revenue achieved and expenses incurred and if so how can we leverage that for future improvements?
• Are we able to understand cause-effect relationship in revenues and expenses from this historical record?
• How can we create more accurate budgets and forecasts for the future in order to get a better handle on our performances from this historical record?

As you can see, these are major questions which are largely left unanswered by the historical nature of the Hotel Profit and Loss Statement.

Meaningful decisions cannot be taken merely based on what is existing in these statements.

Decision making requires a point of reference which is indicative of situations in the future.

The Profit and Loss Statement unfortunately cannot deliver here.

Further, the Profit and Loss Statement does not tell you anything about the financial position.

More importantly, it cannot!

Because it is only a performance statement.

For financial position, you will have to reach for the Balance Sheet.

Look at it this way.

Would you not want to pay attention to something that your hotel owners are forever concerned about?

I do not want to sound like a doomsday merchant.

However, it is worth spending some time with the venerable hotel balance sheet.

It may well make you wiser.

How, you ask skeptically?

Let us see how.

Hotel Financial Statements - Balance Sheet

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

To reiterate a critical difference:

• Profit and Loss Statement shows performance for a period of time (month normally) while 
• Balance Sheet shows 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 Hotel 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 Hotel Profit and Loss Statement cannot answer.

Hence the need to read a Hotel Balance Sheet.

Hotel Financial Statements - Balance Sheet & Financial Position Ingredients

Hotel 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
• capital.

Broadly, they show What a Business Owns and What a Business Owes.

Let us take assets first.

Hotel Balance Sheet - Assets

Assets are What the Business Owns

They are the resources of the hotel.

The primary function of an asset is to generate revenue.

Without assets, a business cannot generate revenues.

Assets are an index of strength of a business.

This is because assets are used to generate revenues.

So, you could say that the capacity of a business to generate revenue will be based on the type and extent of assets owned by it.

Assets can be short term or long term.

Short term assets are those whose life is less than a period of 12 months.

These are known as Current Assets.

Long term assets are those whose life is more than a period of 12 months.

These are known as Fixed Assets.

Examples

Current Assets can be:

• Inventories 
• Accounts Receivable, 
• deposits paid on advance 

and so forth.

Inventories can be of: 

• food, beverage,
• operating equipment,
• general supplies,
• cleaning supplies,
• printing and stationery

and so forth.

Fixed Assets are:

• Property
• Building
• Plant and Machinery
• Equipment

and so forth.

Since assets are used to generate revenue and revenue is related to cash inflows, assets are also related to cash inflows.

This applies to both current and fixed assets.

Let us look at Liabilities.

Hotel Balance Sheet - Liabilities

If Assets are What the Business Owns, Liabilities are What the Business OWES.

Liabilities are what the business owes to outside parties.

In other words, liabilities are claims that outside parties have on the business for goods delivered or services rendered.

When you incur expenditure for the business but DO NOT PAY FOR IT IMMEDIATELY, you are creating a liability for the business.

Simply put, it means you will have to pay later, normally 30 days later.

So, liabilities are expenses incurred but not YET paid for.

In a nutshell, you could say that expenses are incurred:

• by immediately paying cash or
• by creating a liability to pay for later.

Liabilities represent claims that outside parties have on the business for payment of their goods and services.

They thus constitute risk for the business.

Liabilities are an index of risk for the business.

Businesses incur expenditure by creating liabilities.

However, say they are not able to pay them back.

Therefore, the business is at risk of being shut down (in extreme cases).

Just like assets, Liabilities may be short term or long term.

Short term liabilities are those which are payable within a period of 12 months.

These are known as Current Liabilities.

Long term liabilities are those that are payable after 12 months.

Examples

Short term or Current Liabilities are:

• Invoices payable to suppliers or vendors for goods delivered or services rendered for operational expenditure.
• Salaries and Wages (payroll) payable each month to employees are also considered Current Liabilities.
• These are of course normally payable each calendar month or depending upon the pay period.

Long term liabilities are Term loans payable to banks or financial institutions.

These are normally payable in 10 years or even longer than that.

Liabilities are related to cash outflow.

These are payable in cash and the business has to plan for and arrange that.

Let us now come to Capital.

Hotel Balance Sheet - Capital or Owner Equity

Capital may be termed as the OWNER’s Contribution.

Capital is what a business starts with.

It is the Owner’s contribution.

A business starts earning revenues on a certain day.

However, long before that, 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 Owner contributing Capital in the form of cash.

With the cash the business can purchase assets and earn revenues.

Capital contribution by the Owner cannot be taken back by the Owner during the life time of the business.

Or, 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, equity refers to the common stock issued (if any) by the company or corporation.

A business generates revenues, incurs expenses and earns a profit.

That profit is added to the Capital of the Owner of the business.

I will explain this important principle visually in the next section.

Hotel Financial Statements - Performance and Financial Position Relationship

The simple principle to understand is this:

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

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

Let us now see how that profit is added to the Capital 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 revenues will (should) hopefully be higher than expenses:

• cash inflow will be higher than cash outflow,
• so profit is 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 the month of 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 assumed a simplified Balance Sheet with just one total each for 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 = Capital + Liabilities.

This is the reason 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 (Capital) + $2,000,000 (Liabilities).

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

STEP 4

Let us now see bring in the hotel operation business results for the month of August 2021.

We will see the impact on 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, make an assumption.

That all revenue was received in cash and all the expenses paid in cash.

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

This is the principle of cash flow.

We have simplified it to illustrate our main question on improvement in financial position.

Now we will see how hotel operation results for August 2021 impact financial position which is reflected in the Hotel Balance Sheet.

So, we will build a Hotel Balance Sheet.

This will be as of the end of the month of August 2021 (after the business results)

Or, in other words as of 31st August 2021.

STEP 5

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

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

This will be the same as in Visual 3.

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

STEP 6

We will now build the Balance Sheet at the end of August 2021 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.

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

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

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

Remember we assumed that all revenues and expenses were received and paid in cash.

So, the profit is all the 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 that:

• when results of Profit and Loss Statement are added to opening hotel balance sheet, 
• you get the closing hotel 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 hotel 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, say, the hotel had incurred a loss in the month of August 21.

The closing hotel balance sheet would be poorer than the opening balance sheet.

A richer balance sheet means:

• capital or 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.

Key Takeaways

What did you think of performance and financial position concepts?

Have you understood how performance and financial position are two different but related concepts?

Is the relationship between hotel balance sheet and profit and loss statement clear?

Is there anything else you are not clear about in this Chapter 7 of Ultimate Guide on Hotel Balance Sheet Basics.

Comment in the section below and I will respond.

Other Chapters of Ultimate Guide on Hotel Balance Sheet Basics

Sign up for Speed Tips - Learn in Minutes for more tips straight to your inbox.