Working Capital – Is Yours Enough for a Smooth Hotel Operation?

Is your working capital enough to run your hotel operation smoothly?

How would you know?

Working Capital is a Liquidity based Ratio.

Meaning it is a ratio closely related to cash resources.

You cannot run a hotel operation without steady input of cash.

If your liquidity runs low, you cannot run the hotel efficiently.

I will lay out a case for ensuring that you do not ignore this critical hotel financial ratio.

Along the way, we will answer questions like:

• What is Working Capital?
• How to calculate working capital.
• What are Short Term Assets and Liabilities?

and more.

Take a look at the infographic below on hotel liquidity ratios.

And more specifically to No 3 in hotel financial liquidity ratios.

This Chapter 4 of the Ultimate Guide on Hotel Financial Ratios will cover.

First, let us step back a bit to understand some concepts related to working capital.

Short Term Cash Requirements

For a hotel to run smoothly, it is important to have good cash flow.

Cash flow in the short term comes from earning revenue.

Earning revenue in turn requires you to have assets.

The primary function of an asset is to generate revenue.

What are 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 revenue.

Assets are an index of strength of a business.

This is because assets are used to generate revenue.

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.

Current Assets and Working Capital

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.

Why should we talk about current assets?

I am getting to that.

Before that, take a look at the Current Assets of Paradise Hotel below.

Current Assets Examples

See the Paradise Hotel Balance Sheet below:

What is Working Capital?

In Part 2 of this 12 part Ultimate Guide, you learned about liquidity.

Liquidity is the ability of an asset to be converted into cash.

Let us quickly revisit the current assets in a hotel balance sheet.

Why?

Because Working Capital has all to do with current assets (and more...).

For example, Current Assets (see below) are normally these three common types:

• Cash and Bank Balances
• Accounts Receivable
• Inventories

These feature prominently in a hotel balance sheet.

For an in depth discussion, read Part 2 of this Ultimate Guide on Accounts Receivables.

Working Capital

We learned about current assets earlier.

However, what is Working Capital?

Let me use a metaphor for this.

Assume you are driving an automobile.

Suddenly, the car stops running.

You discover you have run out of fuel.

You cannot proceed further without filling gas for your vehicle.

Working Capital is similar to that.

It is the short term capability to meet current obligations.

That capability comes from current assets.

Current Obligations are commonly known as Current Liabilities.

Current Liabilities are short term obligations.

Take a look at the Current Liabilities of Paradise Hotel.

Now you realize why we needed to know current assets and liabilities before working capital.

Working Capital compares short term capability with short term obligations.

Or in other words, current assets with current liabilities.

We will understand specific types of current liabilities shown above later in this post.

Working Capital is comparing your liquidity (current assets) with obligations (current liabilities).

We will also see why as a hotel manager you must know what this ratio is about.

Working Capital measures the extent of current asset to current liabilities.

In other words, the ratio (not exactly a ratio though) of:

• Cash, Accounts Receivables, Inventories and
• Accounts Payable, Notes Payable etc.

Higher the Working Capital, the better will be its capability to meet short term obligations.

In other words, higher the ratio, the better the liquidity.

Hotel Owners prefer a higher ratio since this means lesser investment in non-productive current assets.

It of course means balancing capability with current obligations or liabilities.

Hotel Management needs to balance:

• healthy current assets situation with
• moderate current liabilities.

Working Capital Formula

Working Capital is simply the difference between Current Assets and Current Liabilities.

The formula is:

Working Capital = Current Assets LESS Current Liabilities

Take a look again at the Current Assets and Current Liabilities of Paradise Hotel (shown before).

We have already seen what types of current assets there are.

Let us explain what current liabilities shown are.

• Accounts Payable - these are invoices payable to the hotel suppliers and vendors.
• Accrued Income Taxes - these are liabilities for any tax amount due.
• Accrued Expenses - these are specific expenses which have yet to be paid off.
• Current Portion of Long Term Debt - this refers to the portion of the long term debt which is due within the next 12 months.

In a way you could say you are measuring the extent of liquidity Vs obligations.

Let us now see the example with numbers using the Paradise Hotel shown above.

Example

The Current Assets and Current Liabilities for Paradise Hotel as of 12.31.2018 & 12.31.2019 are:

• Current Assets: 2018 - $221,000 2019 - $338,000
• Current Liabilities: 2019 - $214,000 2019 - $192,200

The Working Capital for Paradise Hotel as of 12.31.2018 is:

Current Assets LESS Current Liabilities OR

$221,000 Less $214,000 = $7,000

And for 12.31.2019 is:

$338,000 Less $192,200 = $145,800

Notice how 12.31.2018 Working Capital is quite low ($7,000).

On the other hand, 12.31.2019 Working Capital is very healthy ($145,800).

Notice that this healthy Working Capital is contributed by higher current assets.

This is thus a barometer of the balance between current assets and liabilities.

These are assets whose liquidity and levels have to be managed.

The indication is that 12.31.2018 shows working capital to be not very liquid.

Let us now see how it is useful to calculate working capital.

More importantly, how you can avoid some alarming situations shown below.

How is Working Capital useful?

For Paradise Hotel, you found the that Working Capital Ratio on 12.31.2018 is $7,000.

This is a low ratio.

What does “low” mean?

Low means that say, Paradise Hotel disposed off all their current assets to pay current liabilities.

They will then be left only with $7,000.

This is what “low” means.

It means that there is very little cushion against unforeseen obligations.

If such an obligation were to arise, Paradise Hotel may not be able to pay it.

If you remember, we said that higher the ratio the better the liquidity.

Working Capital is one of the best indicators of liquidity.

Liquidity is one of the key measures of short term solvency.

In other words, the ability to pay current liabilities with current assets.

Is the hotel able to cover its short term liabilities with its short term assets?

Or, how liquid are the hotel’s current assets?

And how quickly does the hotel collect its accounts receivables.

So, they are able to provide the cash necessary to pay liabilities.

This is the reason the Working Capital is critical.

Reasons Your Hotel Working Capital May Become Alarming

What are reasons you could avoid being in the situation Paradise Hotel finds itself in as of 12.31.2018?

First, manage your accounts receivables well.

Accounts Receivables being uncollected sales is critical for liquidity.

Second, manage your accounts payable, which are simply short term liabilities.

For Paradise Hotel, as of 12.31.2018 the hotel had high accounts payable and accrued expenses.

This is creating pressure on the working capital which is very low.

Third, do not have too much of money locked up in inventories.

In the case of Paradise Hotel, Inventories in both years are quite good.

Further you must ensure that you do not fall prey to some traps stated below.

Traps You Must Avoid with Working Capital

As we have said earlier, financial ratios are mere indicators.

It is critical that we understand how they are calculated.

Both Current Assets and Current Liabilities play a part in this ratio.

So, movement up or down must be taken into account.

Similarly, movement in accounts receivables and inventories must also be considered.

These movements have to be monitored each month and year.

However, it may get rectified in a later year.

You must therefore monitor the current assets and current liabilities closely.

This is to ensure they do not spiral out of control.

Inventories & Pre Opening Hotels

Another element of current assets and therefore working capital is inventories.

For hotels which are in pre opening stage, inventories tend to be higher.

This is because the hotel has not started operating.

Consequently, it may not have an accurate grasp of business volume.

Business Volume refers to:

• Occupancy for Rooms department and
• Covers Served for Food and Beverage department

Moreover, the hotel will want to avoid a stock out situation initially.

Therefore, it will keep higher than needed inventory levels.

In effect, it is even more critical for pre opening hotels to keep an eye on working capital.

Working Capital in Managed Hotels in Pre Opening Stage

Working Capital arrangements are critical for managed hotels.

They are even more vital during the pre-opening stages.

During the pre-opening stages, there is no revenue being generated.

This is because the hotel has not opened yet.

As a result, the hotel cannot generate its own cash flow.

Instead, the management must submit periodical working capital requirements to the owners.

Any error in the estimates made in the pre-opening stage will create a crisis.

Hotels do not want to find themselves in such situations.

Big Picture of Hotel Liquidity

At the end of the day, you must step back and take a big picture overview of liquidity.

Meaning, look at the liquidity picture in entirety.

And not just look at current assets or current liabilities individually.

The big picture will be how liquid the working capital is.

That will allow you to run your hotel operation without any cash resource crunch.

Chapters in this Ultimate Guide on Hotel Financial Ratios

This Ultimate Guide is a twelve part series which will cover the following key areas:

• CHAPTER 1 of 12 - Hotel Financial Ratios - Why should you care? [Already Published]
• CHAPTER 2 of 12 -Liquidity Ratios Intro - Acid Test Ratio [Already Published]
• CHAPTER 3 of 12 -Liquidity Ratios - Accounts Receivable Turnover Ratio [Already published]
• CHAPTER 4 of 12 -Liquidity Ratios - Working Capital [This Post]
• CHAPTER 5 of 12 -Solvency Ratios Intro - Net Worth
• CHAPTER 6 of 12 -Solvency Ratios - Debt Equity Ratio
• CHAPTER 7 of 12 -Activity Ratios - Inventory Turnover Ratio
• CHAPTER 8 of 12 - Profitability Ratios Intro - Gross Operating Profit
• CHAPTER 9 of 12 - Profitability Ratios - Return on Investment Ratio
• CHAPTER 10 of 12 - Profitability Ratios - Return on Equity Ratio
• CHAPTER 11 of 12 - Asset Management Ratios Intro - Asset Turnover Ratio, RevPAR
• CHAPTER 12 of 12 - How to Identify Warning Signs in Hotel Financial Ratios

Next Week

We will dive into the fourth of hotel financial ratios - Net Worth.

We will see:

• What net worth is.
• What is a Solvency Ratio?
• Why is this net worth considered so critical?
• How do you read and use net worth?

and more…

Sign Up for Speed Tips - Learn in Minutes!

Want to Learn in Minutes?

Sign Up for Speed Tips - Learn in Minutes Newsletter for tips, strategies, secrets straight to your InBox!

Related Posts