Owner Equity - Is Your Profit and Loss Enhancing Financial Position? - Hotel Financial Courses (2024)

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:

In earlier chapters in this Ultimate Guide, you learned that the Balance Sheet shows the financial position of your hotel at the end of a month/period.

It does this throughthree major ingredients:

• assets,
• liabilities and
• owner equity.

Broadly, they show:

• What a Business Ownsand
• 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.

What a Business Owns and Owes JPG

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 may be termed as the OWNER’s Contribution.

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

It is the Owner’s contribution.

Owner Equity in Balance Sheet

Long before a business starts earning revenues, 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 by the Owner during the life time of the business.
• In other words, the 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 abusiness:

• 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 ofa businessconsists 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.

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

Performance is a word that isoften misquotedandmisunderstood.

Profit and Loss Statement

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:

• occupancyin that past month?
• average daily rateachieved in that past month?
• total revenueachieved in that past month?
• gross operating profitachieved in that past month?

Do you see what I am getting at?

Performance is agenericword.

It can mean so manydifferent things.

You could say that it also meansdifferent thingsatdifferent times.

Whydid I list those four in my questions earlier?

There is areasonfor it.

Normally, performance can refer tobusiness volume which is Occupancy.

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

Yet another and in fact a more common reference to performance isrevenue achieved which is Total Revenue.

Finally, you could be talking about thebottom 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 theseKPIs, orKey Performance Indicators denote an important aspectof performance.

So, let usgo back to the questionthat your colleagues were asking you.

Yourresponse should be with a question:

Are you talking about

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

Let us now see what themain ingredients of performance are.

The mostcommon ingredientsfor 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 isoften at the top.

It is also a fact that theprimary motivationof a hotel business (as any other business) isearning revenue.

Revenue isnot producedon its own.

You look puzzled!

Let me explain.

Revenue does not happenby itself.

It is generatedwhen two key ingredientscome together.

These two ingredients aredifferentfromdepartmenttodepartment.

And based ondifferent types of revenue.

Let us assume we are talking about thehotel Rooms department.

Howis Rooms department revenue achieved?

Thetwo ingredientswe talked about earlier are:

• price and
• business volume.

In the case of the hotelRooms departmentthese are represented by

• Occupancy
• Average Daily Rate

So, now you can see why just talking aboutperformance without clarifyingwhat it is will only lead to confusion.

The next ingredient for performance isexpenses.

Expenses are thecost of doing business.

In other words it iswhat is incurred to earn revenue.

Expenses can be:

• Fixed or
• Variable.

When we talk aboutVariableexpenses, we are referring toexpenses which changeaccording tobusiness volume.

In other words:

• in the case of the hotel Rooms department,
• variableexpenses at80%occupancy
• will be higherthan at40%occupancy.

The third and last ingredient isprofit.

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

So, there you are, thethree ingredientsof performance - revenue, expenses and profit.

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

And what is financial position?

The Balance Sheetbroadlyshows thelong term financial position of the hotel

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

Financial Position Statement

Again:

• if the Profit and Loss Statement shows performancefor aperiod of time(month normally),
• the Balance Sheet shows the financial positionat apoint of time(say, end of the month).

The two statements havedistinctively different roles.

However, they areclosely related.

Some of thequestionsthat your Balance Sheetanswersare:

1. What was thebalance of cash on handat the end of the month/period?
2. What were thetotal borrowingsfor the hotel?
3. What was themix of internal(equity) andexternal(borrowings)financingat the end of the month/period?
4. How much wasowed to the hotel(accounts receivable) by the guests?
5. What amount oftaxeswas owed to the various government tax agencies?
6. What is thefinancial strengthof the operation?

These are questions which your Profit and Loss Statementcannot answer.

Hence theneed to read a Balance Sheet.

The simple principle to understand is this:

When a businessearns profit[revenue less expenses], thatprofit gets added to the Owner Equity.

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

Let us now seehow that profit is added to the Owner Equityof the business.

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

Thusrevenue 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 akey principle to understand.

Let us take a7 Step processto understandhow profit builds up assets, capital and value.

Simplified Balance Sheet / Profit and Loss Statement Headers without numbers

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

These just show important headers.

Note that theBalance Sheet is as of August 1, 2021and theProfit and Loss Statement is for the month of August 2021.

This isimportantto understand.

Balance Sheet isas of a datewhile the Profit and Loss Statement isfor the month.

For the moment, we havedeliberately not assigned any amountwhich 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 somebasic numbers.

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

Simplified Balance Sheet / Profit and Loss Statement Headers with numbers

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

Theprinciples are the samenevertheless.

Next, we need to know about auniversal principlethat willhelp us understandthe Balance Sheet better.

And that universal principle is theFundamental Accounting Equation.

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

It really isquite simpleI promise.

STEP 3

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

Fundamental Accounting Equation

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

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

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

STEP 4

Let us now see:

• how the hotel operation business resultsfor themonth of August 2021
• impact the financial positionwhich is reflected in the Balance Sheet.

Business Results for the month of August 2021

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

This means thatprofit or Net Income is equal to Cash Inflow.

This is theprinciple of cash flow which we have simplified 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 Sheetas of the end of the month of August 2021(after the business results) or in other wordsas of 31st August 2021.

STEP 5

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

However, 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.

Hotel Balance Sheet-How is it Related to the Hotel Profit and Loss Statement?

Now, let us rearrange the two balance sheetsand theprofit and loss statementfor better understanding.

STEP 6

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

This time it isafter taking into account the business resultsof August 2021 from the Profit and Loss Statement.

This will meanbringing in the business resultsfor the month of August 2021 from the Profit and Loss Statement.

This Balance Sheet will beas of 31st August 2021.

Hotel Balance Sheets and Profit and Loss Statement Rearranged

Hotel Balance Sheets and Profit and Loss Statement Rearranged

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

What changedfrom the Balance Sheet from 1st August 2021?

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

Since weassumed that all revenue and expenses were received and paid in cash, 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 :

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

That is thepowerful relationshipbetween these two financial statements.

But it is not just aclosing balance sheet.

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

Performance improves Financial Position at end of month

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

In the aboveexample:

• 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.

Aricher balance sheet means owner equity has gone up(to the extent of profit) and thusfinancial position is better.

Hotelvalue will also go upwhen financial position improves.

Many hotel managers and even financial managers arenot 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 the Owner Equity.

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

STEP 1

Goto your Hotel Financial Controller and ask him to show you theBalance Sheetfor the hotel.

STEP 2

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

STEP 3

Noticehow 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.