Successful hotels generate profitable earnings. That’s no secret. However, the way you calculate such earnings can be confusing. Sometimes, you might not have all the financial information you need to calculate ROI accurately, for example. Fortunately, there’s a better profitability ratio.
These Three Profitability Ratios Are Common, But May Not Be the Most Accurate Measurement
Hoteliers everywhere study profit and loss statements and other profitability criteria. Each profitability ratio has merit and offers insights into the hotel’s financial performance. However, Return on Investment (ROI), Return on Equity (ROE), and Return on Sales (ROS) may not offer enough detail. However, earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) provide an excellent framework for gauging your hotel’s profitability, as you’ll see why.
First, let’s recap three popular profitability ratios.
Three Popular Profitability Ratios
1. Return on Investment (ROI)
How much did you invest vs. what did it deliver? That’s the basic understanding of ROI for most hoteliers.
ROI = (Operating Income / Invested Capital) x 100
Yet, ROI focuses on the owner’s or shareholder’s expectations rather than revenue. Revenue managers look at market demand and how it impacts room rental revenues.
2. Return on Equity (ROE)
This profitability ratio focuses on risk. Is your hotel at risk of being overleveraged?
ROE = (Annual Net Income / Net Equity) x 100
To fully understand the hotel’s position, you’ll need plenty of financial data, including how much capital the hotel has invested. What it takes to reach the optimal ROI and the net equity for ROE. There are two big problems with this profitability ratio.
- Not everyone has access to this type of data.
- This type of ratio is property specific, and you can’t use it to predict profitability across the industry.
3. Return on Sales (ROS)
Return on Sales measures the hotel’s performance and can compare similar competitors across a section.
ROS = (Operating Profit / Net Sales) x 100
When you average the typical profit margin of your hotel and compare it with similar properties, that can help hoteliers accurately understand the business operations so you can spot gaps.
For example, if your category has an average profit margin of 10%, and your hotel shows a ROS ratio of 4%. That gap in profitability indicates you can increase your margins by tightening up your operations. Revenue management helps you review your sales channels, production, costs, and room pricing to see how you can increase profitability and revenue.
As revenue managers, the Revenue Team by Franco Grasso recognizes that ROS (Return on Sale) accurately measures your hotel’s profitability. After all, ROS focuses on maximizing revenue through maximizing sales and profit. Yet, there’s another metric you can use that analyzes profitability via percentages and absolute values.
ROS vs. EBITDAR/EBITDA
EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, Restructuring, or Rent costs), more broadly known as Gross Operating Profit (GOP), is key in determining profitability. Some hotels use EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), which is the same as EBITDAR, but after deducting rent costs (if the property pays rent.)
It is a more complex ratio and gives an in-depth analysis of the property’s financial health.
For example, EBITDA illustrates the amount available to cover interest, taxes, and other costs while leaving an adequate profit margin. Typically, the more profitable the hotel, the higher the EBITDA, and a low or negative EBITDA indicates operating expenses are more than revenue.
EBITDA relies on the realities of daily operations to showcase a hotel’s financial health. It’s grounded in reality rather than hidden in adept accounting practices.
In summary: EBITDA = Revenue – Expenses (excluding tax, interest, depreciation, and amortization)
With EBITDA, hoteliers can forecast profitability based on the balance sheet. You can also use it to segment operations and forecast revenue in discrete areas such as spas or restaurants.
The following example only uses rooms as its cost and revenue center to keep things simple and demonstrate EBITDA.
3 Ways Revenue Management Practices Boost Your Hotel’s Profitability
Even if your hotel’s cost and revenue center are only rooms (not a restaurant, spa, or other destinations,) the EBITDA still relies on:
- 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.
Revenue management aims to maximize room revenue while considering market demand, the property’s location, the brand’s reputation, and other factors.
A well-executed revenue management strategy always results in a higher EBITDA for the hotel because it increases profit based on absolute values.
EBITDA Increases Hotel Profitability No Matter the Percentages
Without revenue management, your hotel’s annual revenue could be 1 million euros. Like every hotel, your variable costs include toiletries, utilities, sales commissions, laundry, etc. In many hotels, these variable costs run 30% of room revenue. Figure that 30% is 300,000 euros, and fixed costs (primarily staff) are 40%.
Subtract the operating expenses from the income, and your hotel has a gross operating profit or EBITDAR (Earnings Before Interest, Taxes, Depreciation, Amortization, Restructuring, or Rent costs) of 300,000 euros. Then you can deduct restructuring or rent costs (if any) for the EBITDA.
Perhaps you’re happy with the 300,000 euros of profit. Even so, if you’re like most hoteliers, you’re curious how you can boost revenue by 20% by using revenue management. Statistics show how much such a property can increase its revenue in the first year of implementing revenue management.
Revenue management principles focus on improving the profit absolute values, and it may increase variable costs but also revenue.
For example, a hotel without revenue management could earn 500,000 euros a year. With variable costs of 150,000 euros/year, that’s 30% of total revenue and fixed costs 40% of revenue or 200,000.
Such a hotel can implement strategic revenue management and increase its profitability. If the hotel boosted occupancy and revenue by 25%, it would earn 625,000 euros. If the fixed costs tend to remain the same, the variable costs may increase. Those variable costs grew by 35% going from 150,000 to 202,500. Yet, the property sees increased earnings and a higher EBITDA thanks to the incremental revenue increase of 52,500 to 125,000 euros.
Since revenue management focuses on profit maximization rather than cutting expenses, your property may see an increase in variable costs. It may even be a larger percentage increase than revenue. Yet, these hotels optimize room rates and still result in a higher EBITDA in absolute values (which is what really matters) and a profit boost. This principle stands even in the light of the recent rise in energy costs and inflation.
Hotel revenue management increases revenue and profits yearly. Of course, pandemics and other crises can change this. However, the principles still work even during a global crisis.
Hotels that Implemented Revenue Management Before and During the Pandemic Maintained Profitability
Revenue Team by Franco Grasso studied over 400 hotels during the pandemic and discovered the critical function of revenue management during such a crisis. Many hotels maintained growth and minimized losses despite the pandemic by staying on the revenue management course. They could maximize results when demand returned.
During the 2020 and 2021 worldwide shutdowns, many city hotels maintained revenue management strategies and broke even or remained profitable despite the pandemic.
If you’re ready to discover how your hotel can use revenue management principles to enhance profitability, download this free ebook.