As a hotelier, you know that generating profitable earnings is the key to a successful hotel.
NB: This is an article from Revenue Team by Franco Grasso, one of our Expert Partners
However, understanding your profitability ratios isn’t always straightforward because you may not have all the information you need to understand your hotel’s ROI or ROE. Other profitability ratios may give you the insights you need to produce the biggest profits. Read on to discover the critical revenue management practice that grows hotel profits.
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How to Analyze Three Profitability Ratios
Whether you’re a hotel owner, GM, or revenue manager, it’s helpful to understand how profitability ratios work. They can share insights into the overall hotel’s performance, which are especially important for bank loans.
There are three primary profitability ratios; ROI, ROE, and ROS. However, a fourth, EBITDA, gives the best framework to assess your hotel’s profitability using percentages.
Profitability Ratios: The Big Three
- Return on Investment (ROI)
Every business person is familiar with the concept of ROI. The high-level overview is to divide your operating income by invested capital and multiply it by 100.
ROI = (Operating Income / Invested Capital) x 100
However, ROI is often subjective based on the owner’s or shareholders’ expectations. Revenue managers focus on market demand and how that impacts room rental pricing.
- Return on Equity (ROE)
Return on Equity measures your risk; e.g., is your ROE higher than the return on government bonds?
ROE = (Annual Net Income / Net Equity) x 100
This is another profitability ratio you may encounter; again, it tends to be more subjective.
If you want to analyze your hotel’s ROI or ROE, you need a strong understanding of the hotel’s financial position. You’ll need to know how much capital the hotel has invested to reach the optimum ROI percentage point, and you’ll need to know the net equity for ROE. Not everyone has clear access to these types of numbers.
Additionally, such numbers are property specific and don’t give accurate insight when extrapolating across the industry.
- Return on Sales (ROS)
Return on Sales measures the hotel’s performance and can compare similar size competitors within the same sector.
ROS = (Operating Profit / Net Sales) x 100
The ROS is a helpful comparison tool because it averages the typical profit margin your hotel earns. When hoteliers review the profit margin, it gives core insights into business operations when you compare them to similar hotels.
Consider if your sector has an average profit margin of 10%, yet your hotel shows a ROS ratio of 4%. That raises red flags that there are gaps in your hotel operations and room for improvement. You could review product pricing, sales channels, or production costs to discover those gaps from a revenue management perspective.
As revenue managers, the Franco Grasso Revenue Team (FGRT) recognizes that ROS (Return on Sale) accurately measures your hotel’s profitability. ROS focuses on maximizing revenue through maximizing sales and profit. However, a better representation is another metric for hoteliers to use for analyzing profitability.
ROS vs. EBITDAR/EBITDA
Compare ROS to EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, Restructuring or Rent costs), more broadly known as Gross Operating Profit (GOP), and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), the same as EBITDAR but after deducting rent costs (in case the property is not owned and pays a rent).
It’s a mouthful, but the complexity of this ratio gives a more detailed picture of the property’s financial health.
EBITDA indicates how much money is available to handle costs like interest, taxes, etc., and still leave a profit margin. In general, the healthiest businesses have higher EBITDA, while a low or negative EBITDA suggests operating costs are more than revenues which is not sustainable.
EBITDA is essential because it gives a big picture view of a business’s health through daily operations rather than clever accounting practices which can obscure the reality of operations.
In summary: EBITDA = Revenue – Expenses (excluding tax, interest, depreciation, and amortization)
Hoteliers can forecast EBITDA or calculate it based on a hotel’s balance sheet.
Of course, in the hotel industry, many discrete areas can impact revenue. For example, destination restaurants and spas can be segmented separately. For a simple example, let’s apply the EBITDA ratio to a hotel using only rooms as its cost and revenue center.
How Revenue Management Increases Your Hotel’s Profitability
In a hypothetical property where rooms are your only consideration, there are still several factors in play with the EBITDA:
- Room Revenue (Revenue Management)
- Variable costs * ideally, these are approximately 30% of total sales
- Fixed costs *are less easily generalized since they are contingent on many factors. They should not surpass 40/45% of total sales.
*Cost optimization is a delicate balance between total cost reduction without compromising service quality with an eye on profit increases.
A strong revenue management strategy seeks to maximize room revenue using factors to your property’s location, brand reputation, and market conditions.
When revenue management is well-implemented, the result is always a higher EBITDA for increased profit based on absolute values.
Revenue Management at Work
Imagine your property’s annual revenue shows 1 million euros without revenue management. This property has typical variable costs (room toiletries, laundry, utilities, sales commissions, etc.) of 30% of room revenue at 300,000 euros and fixed costs (mainly staff) at 40%. Subtract the operating expenses from the income, and you have a gross operating profit or EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, Restructuring, or Rent costs) of 300,000 euros. After deducting restructuring or rent costs (if any), you can obtain the EBITDA.
However, statistics show that such a property can boost revenue by 20% in the first year by using revenue management to implement appropriate strategies. Revenue management helps hotels balance increased variable costs with a greater profit percentage.
There’s a myth that revenue management increases variable costs due to greater occupancy and reduces operation margins. In reality, smart revenue management may increase variable costs and revenue at the same time, so profit grows.
For example, imagine a property without revenue management. This hypothetical property earns 500.00 euros a year with variable costs of 150.000 euros (30% of total revenue.) Fixed costs are 200.000 euros (40% of revenue.)
By implementing revenue management, the property increases occupancy and revenue by 25% earning the property 625.000 euros. The fixed costs remain the same, and the variable costs increase by 35% (from 150.000 to 202.500.) However, the variable costs’ increase is largely offset by the incremental revenue increase (52.500 to 125.000.) This results in a higher EBITDA and higher earnings.
Revenue management always considers profit percentages in the right perspective, which means that your hotel might increase variable costs by a larger percentage than revenue. However, they still result in a higher EBITDA in absolute value, which means an increase in overall profitability. This principle stands even in the light of the recent rise in energy costs and inflation.
Hotels practicing revenue management increase revenue and profits yearly (barring pandemics and other unforeseen crises.)
Which brings to mind the question of what about crises? How does revenue management work during a global crisis? The answers may surprise you.
How Revenue Management through the Pandemic Maintained Profitability
As you know, the hotel industry struggled as the world shut down due to the pandemic. However, the FGRT study of over 400 hotels demonstrated how critical revenue management is during global crises. Some of these hotels still showed growth and positioned themselves to maximize results when demand returned.
Revenue management helped these hotels stay the course during the lockdowns and minimize losses. During the 2020 and 2021 shutdowns, many city hotels maintained revenue strategies and broke even or remained profitable despite the pandemic.
In this free ebook, you will discover ten revenue management principles successful revenue managers implement. Hotel revenue management is more than technology.