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CHAPTER 12
Financial Ratios and Operating Indicators, Assessing Financial Performance
PROGRESS NOTES
After completing this chapter, you should be able to:
Explain the role of financial ratios in financial management.
Calculate and explain the difference between four profitability ratios.
Calculate and interpret three liquidity ratios.
Calculate and explain the meaning of three capital structure ratios.
Calculate and interpret three turnover ratios.
Explain how operating indicators are used to examine costs.
Overview: Financial Ratios
Income statements and balance sheets that report multiple years of information can identify whether net income is increasing, stable, or decreasing but shed little insight into what net income should be. Financial ratios and operating indicators explore the elements that produce net income. Financial ratios put net income, revenues, and expenses into context by relating them to assets and liabilities as well as exploring liquidity (ability to pay bills), capital structure (use of debt), and asset turnover (productivity).
Operating indicators extend the analysis by relating financial variables to output produced and inputs consumed. A prime goal is to examine the expense per output and its relationship to input costs, efficiency, and utilization. Determining whether managers are producing an appropriate return from the assets they are entrusted with requires comparing organizational performance with appropriate peer institutions.
Ratios are convenient and uniform measures that are widely used in healthcare financial management. Ratio analysis should be conducted as a comparative analysis; in other words, one ratio standing alone with nothing to compare it with does not mean very much. When interpreting ratios, the differences between time periods should be considered and the reasons for such differences should be sought. It is a good practice to compare results with equivalent computations from outside the organization—regional figures from similar institutions would be a good example. Caution and good judgment must always be exercised when working with ratios.
Financial ratios pull together two elements of the financial statements: one as the numerator and one as the denominator. To calculate a ratio, divide the bottom number (the denominator) into the top number (the numerator). Case 32, “Ratios and Operating Indicators,” requires the use of financial ratios and operating indicators to assess financial position. We highly recommend that you spend time with this case as it will add depth and background to the contents of this chapter.
In this chapter, we examine profitability, liquidity, capital structure, and turnover ratios. Table 12.1 sets out 13 widely used ratios in healthcare organizations: four profitability, three liquidity, three capital structure, and three turnover ratios.
TABLE 12.1 Thirteen Common Financial Ratios
Profitability Ratios
1. Operating Margin: Income from Operations
Total Operating Revenues
2. Total Margin: Net Income (Revenue and Gains in Excess of Expenses and Losses)
Total Revenues
3. Return on Assets: Net Income
Total Revenues
4. Return on Equity: Net Income
Net Worth (fund balance)
Liquidity Ratios
5. Current Ratio: Current Assets
Current Liabilities
6. Days Cash on Hand: Cash and Cash Equivalents
(Total Expenses – Depreciation) ÷ Days in Period (365)
7. Days in Accounts Receivable: Accounts Receivable
Operating Revenues ÷ Days in Period (365)
Capital Structure Ratios
8. Times Interest Earned: Net Income + Interest Expense
Interest Expense
9. Debt Service Coverage: Net Income + Interest Expense + Depreciation
Interest Expense + Current Maturities of Long-Term Debt
10. Equity Financing: Net Worth (fund balance)
Total Assets
Turnover Ratios
11. Total Asset Turnover: Total Revenue
Total Assets
12. Current Asset Turnover: Total Revenue
Current Assets
13. Fixed Asset Turnover: Total Revenue
Fixed Assets
We will examine the performance of the Westside Clinic for the years 2021 and 2022, Table 12.2 (i.e., the financial statements introduced in Chapter 11). In Chapter 11, we saw Westside generated $70,000 in net income in 2022. This chapter provides insight into why net income increased over 2021.
TABLE 12.2 Westside Clinic Income Statement and Balance Sheet
Income Statement Revenue For the December 31, 2021 Year Ending December 31, 2022
Net Patient Service Revenue $1,850,000 $1,950,000
Total Operating Revenue $1,850,000 $1,950,000
Operating Expenses
Salaries and wages $1,215,000 $1,262,000
Fringe benefits 347,000 363,000
Supplies 174,000 200,000
Depreciation 40,000 40,000
Interest 24,000 20,000
Total Operating Expenses $1,800,000 $1,885,000
Operating Income $50,000 $65,000
Nonoperating Gains (Losses)
Interest Income $2,000 $5,000
Net Nonoperating Gains $2,000 $5,000
Net Income $52,000 $70,000
Balance Sheet
Assets December 31, 2021 December 31, 2022
Current Assets
Cash and cash equivalents $145,000 $190,000
Accounts receivable (net) 300,000 310,000
Inventories 20,000 25,000
Prepaid Insurance 3,000 5,000
Total Current Assets $468,000 $530,000
Property, Plant, and Equipment
Equipment (net) $180,000 $190,000
Buildings (net) 300,000 285,000
Land 100,000 100,000
Net Property, Plant, and Equipment $580,000 $575,000
Investments 32,000 42,000
Total Assets $1,080,000 $1,147,000
Liabilities
Current Liabilities
Current maturities of long-term debt $48,000 $52,000
Accounts payable and accrued expenses 302,000 310,000
Total Current Liabilities $350,000 $362,000
Long-Term Debt 430,000 419,000
Less: Current maturities of long-term debt –48,000 –52,000
Net Long-Term Debt $382,000 $367,000
Total Liabilities $732,000 $729,000
Net Worth $348,000 $418,000
Total Liabilities and Net Worth $1,080,000 $1,147,000
Profitability Ratios
Profitability ratios measure the ability of managers to generate more revenue than is spent on resources (i.e., expenses). Nonprofit organizations may not call this result a profit, but the measurement ratios are still called profitability ratios, whether applied to for-profit or nonprofit organizations.
Operating Margin
The operating margin, which is generally expressed as a percentage, is operating income (loss) divided by total operating revenues:
Westside earned 3.33% on every dollar of revenue generated in 2022 (or $3.33 for every $100 of revenue, 3.33% × $100). This is a substantial improvement over 2021 when $2.70 was earned. The improvement was due to management’s ability to increase revenue by 5.4% while limiting expense growth to 4.7%. The operating margin is used for a number of managerial purposes and also sometimes enters into credit analysis (i.e., does the organization earn enough income to ensure its debts can be repaid?). It is so universal that many outside sources are available for comparative purposes. The result of the computation must still be carefully considered because of variables in each period being compared.
Total Margin
The total margin is net income divided by total revenues. Total margin measures the ability of managers to generate net income from all sources. The numerator is broadened to include nonoperating gains, and the denominator includes non-patient revenues. Westside has zero non-patient revenues, but many nonprofits have substantial nonoperating revenues.
Westside earned $3.59 for every $100 of revenue in 2022. This is a substantial improvement over the prior year when $2.81 was earned. The improvement was largely driven by the increase in the operating margin, but Westside also benefited from an additional $3,000 in interest income (nonoperating gain).
Return on Assets
The return on assets (ROA) is net income divided by total assets:
Westside is earning $6.10 on every $100 of assets. This is a substantial improvement over the prior year when $4.81 was earned. ROA is a broad measure to assess management’s use of assets. A high ROA indicates that management is fully utilizing assets, and a low ROA suggest underutilization of and/or overinvestment in assets. Some analysts use an alternative computation for ROA; they compute this ratio as earnings before interest and taxes (EBIT) divided by total assets.
Return on Equity (ROE)
The return on equity (ROE) is net income divided by net worth:
Westside is earning $16.75 on every $100 of equity, a substantial improvement over 2021 when $14.94 was earned. ROE is commonly used to assess management’s ability to create wealth for the owners of the organization. Figure 12.1 demonstrates how figures are taken from the income statement and balance sheet to calculate the profitability ratios for 2022.
Figure 12.1 Calculating the Profitability Ratios
Description
Figure 12.2 presents the operating margin, ROA, and ROE for the past four years.
Figure 12.2 Westside Clinic Profitability Ratios
Description
Based on the profitability ratios, we can conclude that management has done a good job generating net income form revenues, assets, and equity. Net income is not only adequate, it has increased over the past four years. We will explore liquidity, capital structure, and turnover ratios to identify how management is producing the reported net income.
Liquidity Ratios
Liquidity ratios reflect the ability of the organization to meet its current obligations. Liquidity ratios measure short-term sufficiency. That is, can the organization pay its obligations when they are due? In other words, does the organization have sufficient cash or assets that can be converted to cash?
Current Ratio
The current ratio equals current assets divided by current liabilities. While Westside’s balance sheet totals current assets and liabilities, many balance sheets do not, so you may have to add cash and cash equivalents, accounts receivable, inventory, and other current assets to obtain total current assets. For instance, consider this example:
Westside has $1.46 in current assets for every $1.00 in current assets it must pay, so paying short-term obligations should not be a problem. If the ratio were close to 1.00 or below 1.00, the institution may need to liquidate assets or acquire debt to pay its bills.
Days Cash on Hand
Days cash on hand equals unrestricted cash and investments divided by cash operating expenses divided by 365 (i.e., daily cash outlay that does not include depreciation or other expenses that do not require cash payment). Daily cash outlay = (Total Operating Expenses – Depreciation) ÷ 365, ($1,885,000 – 40,000) ÷ 365 = $5,054.79:
Based on spending an average of $5,055 per day, Westside could continue to pay its bills for the next 37.59 days with no additional cash inflow. The $45,000 increase in cash and cash equivalents is the primary reason why this ratio increased from 30.07 days in 2021.
Days in Accounts Receivable
Days in accounts receivable equals accounts receivable (net) divided by average daily net patient service revenues. Average daily net patient service revenues is net patient service revenues divided by 365 days (i.e., $1,950,000 ÷ 365 = $5,342.47):
Based on billing patients an average of $5,342 per day, Westside takes 58.0 days to collect the amounts owed for services provided. Collection is slightly faster than 2021 when it took 59.2 days to collect. Faster collection is desired as money in cash is preferable to accounts receivable and the older a receivable is, the more difficult it becomes to collect. Unpaid bills after 120 days or more often become bad debt. Days in accounts receivable is a common measure of billing and collection performance. There are many regional and national days in accounts receivables benchmarks to compare with your own organization’s performance.
Capital Structure Ratios
Liquidity ratios assess an organization’s ability to meet its short-term obligations, and capital structure ratios expand the focus to include the ability of the organization to pay the annual interest and principal obligations on its long-term debt. Capital structure ratios are also called solvency ratios as they also measure the ratio of assets funded by owners rather than through debt. Overreliance on debt will increase the cost of borrowing funds and in extreme cases may prevent an organization from obtaining additional debt (i.e., creditors do not loan money to those who cannot repay the debt).
Times Interest Earned
Times interest earned measures the ability of an organization to pay its annual interest expense, (Net income + Interest expense) ÷ Interest expense:
Westside has 4.5 times the amount of resources needed to meet its interest obligations. You can see that the predominant factor in this ratio is net income. Profitable organizations will have a ratio greater than 1.00 and should have sufficient resources to meet required interest payments. When an organization loses money, its ratio is less than 1.00, and it may have to sell assets or secure debt to meet its obligations.
Debt Service Coverage Ratio
The debt service coverage ratio is net income plus interest, depreciation, and amortization divided by maximum annual debt service (i.e., interest expense plus current maturities of long-term debt):
Description
Debt service coverage measures the ability of the organization to meet its interest and principal obligations, Westside has $1.81 in resources for every dollar of interest and principal due, an increase from $1.61 in 2021. Lending institutions vary on their requirements for debt service coverage. Lending agreements often have a provision requiring debt service coverage to be at or above a certain figure.
Equity Financing
The equity financing ratio is net worth divided by total assets:
The equity financing ratio measures the percent of total assets financed by owners rather than debt. In this organization, owners supplied 36% of assets versus 64% financed by creditors. In 2021, 32% of assets were financed by owners. The primary driver of the increase in the ratio was the $70,000 net income in 2022. A higher ratio indicating lower reliance on debt is less risky. Organizations with higher equity financing ratios will have lower interest and principal obligations but there is no set standard to assess performance.
Turnover Ratios
Turnover ratios measure the amount of revenue generated from assets (i.e., are managers effectively utilizing assets?). Overinvestment in assets results in less productive (i.e., idle) resources, lower revenues, and higher costs. Similarly, underinvestment may undermine an organization’s ability to provide effective care and increase costs.
Total Asset Turnover
Total asset turnover measures how many dollars of revenue are generated for each dollar invested in assets. Total asset turnover is total operating revenue divided by total assets:
Total asset turnover shows that each dollar of assets generates $1.70 in revenue and was basically equivalent to the $1.71 generated in 2021. Managers’ goals should be to maximize the revenue generated per dollar of asset (i.e., ensure assets are fully employed, neither overtaxed nor underemployed).
Current Asset Turnover
Current asset turnover assesses the use of current assets. It is possible that an excess of current assets is offset by underinvestment in fixed assets or vice versa and total asset turnover would appear appropriate despite poor use of assets. Current asset turnover is total operating revenue divided by current assets:
The current asset turnover ratio shows that Westside generates $3.68 in revenue for every dollar invested in current assets in 2022. The ratio is significantly lower than the $3.95 generated in 2021 and is due to large increases in cash and cash equivalents and inventory. This ratio should be used as a starting point to determine whether an organization is holding too much or too little in current assets.
Fixed Asset Turnover
Fixed asset turnover assesses the use of long-term assets. Fixed asset turnover is total operating revenue divided by fixed assets, total assets less current assets, $1,147,000 – 530,000 = $617,000:
The fixed asset turnover ratio shows that Westside generates $3.15 in revenue for every dollar invested in current assets in 2022. The ratio is higher than the $3.02 generated in 2021, suggesting more efficient use of fixed assets. This ratio should be used to determine whether an organization is holding too much or too little in current assets.
Table 12.3 uses arrows to indicate the change in the ratio. In general, higher ratios are desired; the exception is days in accounts receivable, where a lower number of days is desired. Overall, Westside’s management has improved performance in 11 of the 13 ratios, the exceptions being no change in total asset turnover and a lower current asset turnover. This concludes the description of profitability, liquidity, capital structure, and turnover ratios.
TABLE 12.3 Summary of Westside Clinic Financial Ratios
Description
Operating Indicators
Financial ratios provide an organizational view of performance, and operating indicators relate financial variables to nonfinancial variables to provide senior and department managers with a more organic view of performance. The following benchmarks are taken from Optum360°.1 Managers often follow expenses on the monthly expense reports and annual income statement. Managers should assess their expenses relative to the output of their organization and department. At the hospital level, an indicator such as total expense per admission provides little guidance for department managers, who need information that relates expenses to the resources used and their output.
Expense Indicators
Expense indicators relate resource costs to the primary output produced by the department. For example, a head nurse should track RN salaries (other employee salaries or supply expense) per patient day, the director of the clinical lab should track salary or supply expense per lab test (or RVU), and the director of physical therapy should track salary or supply expense per session. In a physician’s office, clinic, or emergency department, the physician (other salary, or supply) expense per visit should be tracked. After calculating the resource expense per output, managers should identify the components of cost (i.e., how much is due to the cost of inputs and the use of labor, supplies, equipment, and facilities?). Table 12.4 presents examples for a nursing unit and physician practice. For a more comprehensive review, see Ross (2018).2
TABLE 12.4 Operating Indicators
Description
Price Indicators
Price indicators examine how much is received for the services provided (outputs) and how much is paid for the resources used (inputs). Output price indicators require the revenue received for a service to be divided by the number of outputs produced.
Net price per inpatient discharge = I/P net revenues ÷ Total discharges = $10,154, 25th to 75th percentile range: $7,553 to $14,511
CMI and wage adjusted net price per discharge = I/P net revenues ÷ (total discharges × all patient CMI × wage index) = $6,688, 25th to 75th percentile range: $5,752 to $7,827
Gross price per ambulatory payment classification (APC) = Gross APC revenues ÷ Total APCs = $669, 25th to 75th percentile range: $430 to $1,075
Unit cost indicators examine input prices and costs per discharge by major expense to determine which factors, wages, fringe benefits, supplies, depreciation, interest, or other costs (i.e., total cost) for an input divided by number of units purchased.
Salary per FTE = Total salary and wages ÷ Total FTE = $59,380, 25th to 75th percentile range: $52,294 to $67,210, minimum: $50,276 Alabama, maximum: $77,081 Oregon
Pharmaceutical price: Total pharmaceutical expense ÷ total drugs purchased
One reason why the expense per output may be higher than necessary is the organization is paying too much for inputs. When unit cost indicators are higher than expected, the next step is to determine if managers can reduce input prices by better price negotiation and/or use of lower-priced inputs.
Efficiency Indicators
A second reason why the expense per output indicator may indicate costs are higher than necessary is more resources (i.e., variable expenses) are used than necessary. Efficiency indicators require the number of inputs used be divided by output (e.g., hours per patient day; hours per lab test, scan, therapy [lab, radiology, physical therapy]; hours per visit [physicians, clinics, emergency departments]).
Staff hours per discharge = (I/P FTE × 2080) ÷ I/P discharges = 131.1 hours, 25th to 75th percentile range: 101.0 to 194.3 hours
CMI adjusted staff hours per discharge = (I/P FTE × 2080) ÷ (I/P discharges × all patient CMI) = 75.2 hours, 25th to 75th percentile range: 62.9 to 92.8 hours
Outpatient staff hours per visit = (O/P FTE × 2080) ÷ O/P visits, range unavailable
When efficiency indicators are higher than expected, managers should examine the amount of time and/or supplies employees are using to treat patients. Changing processes (i.e., streamlining and eliminating error) is a common way to reduce time and supplies used.
Utilization Indicators
Similar to efficiency indicators, utilization indicators measure the amount of output produced from equipment and facilities (i.e., fixed expenses). Common utilization indicators include occupancy, average length of stay, procedures per surgical suite, scans per machine, and visits per exam or treatment room.
Occupancy = Total patient days ÷ (Licensed beds × 365)
Average length of stay = Total patient days ÷ Total discharges
Procedures per surgical suite = Total surgical procedures ÷ Number of surgical suites
Scans per machine = Total radiological procedures ÷ Number of imaging machines
Patients per exam room = Total patient visits ÷ Total exam rooms
Utilization indicators measure the output produced by a resource. While turnover ratios assess whether managers have over- or underinvested in equipment and facilities, utilization indicators highlight the specific type of investment and hence pinpoint where adjustments, increases or decreases in assets, should be made.
Table 12.4 shows that the head nurse should begin her examination of RN salaries by dividing salary by total patient days, $73.06. Is $73.06 an appropriate expense per output? Let’s assume it is high. The next step examines the cost per hour. Is the organization paying an appropriate wage for RNs? We’ll assume $36.53 is comparable to other organizations or the prevailing wage in the area. Next, the head nurse assesses the four hours of RN time per patient day. Let’s assume other organizations use less time by substituting lower-paid LPNs and/or CNAs. The head nurse may then want to examine how treatment is delivered (i.e., what tasks can be performed by and shifted to other personnel?). Finally, unit occupancy should be calculated. The unit is running at 75% occupancy, so the head nurse should consider if costs could be lowered by increasing utilization. Are inefficiencies created by working at lower output (e.g., operating at minimum staffing guidelines) but insufficient to keep workers fully employed? This discussion is limited; in the real world, providers must also consider intensity (how sick a patient is and how much care [resources] they require and reimbursement indicators (how much is received for the services provided).
Operating indicators explain the components of costs (i.e., if expenses are higher than comparable organizations, what factor(s) account for the higher cost?). Higher-than-necessary cost arises from using more labor or supplies per output, paying more for labor and supplies than other providers, and/or underutilization of equipment and facilities.
WRAP-UP
Summary
Financial ratios put accounting information in context by reporting amounts relative to each other (e.g., net income relative to total assets). This information is essential to evaluating and improving performance. Profitability ratios, operating margin, return on assets, and return on equity should be used to evaluate management. Are managers making decisions and taking actions that increase the net worth of the organization? Answering the question requires understanding an organization’s profitability ratios relative to similar organizations and trends. Are ratios higher than other organizations, and are they improving?
After profitability ratios are calculated and especially when the ratios are lower than other organizations and/or deteriorating, managers should investigate liquidity, capital structure, and turnover ratios to identify opportunities for improvement. The liquidity ratios may indicate opportunities in collecting patient revenues or paying liabilities that could increase an organization’s cash. Capital structure ratios may indicate opportunities to increase or decrease the use of debt to reduce financing expenses. Turnover ratios may indicate that assets are not producing sufficient revenues and the organization has overinvested in current and/or fixed assets. Managers should use this information to improve net income.
Operating indicators relate financial data to operational data such as output produced and resources used to illuminate what expenses produce. After identifying the cost per output, managers should be able to explain how the cost of inputs and utilization of labor, supplies, equipment, and facilities contribute to cost and if changes can improve performance.
Key Terms
Current Asset Turnover
Current Ratio
Days Cash on Hand
Days in Accounts Receivable
Debt Service Coverage Ratio
Equity Financing Ratio
Fixed Asset Turnover
Liquidity Ratios
Operating Indicators
Operating Margin
Profitability Ratios
Return on Assets
Return on Equity
Capital Structure Ratios
Total Asset Turnover
Total Margin
Turnover Ratios
Discussion Questions
Explain the role of profitability ratios. Why should net income be assessed relative to operating revenue, assets, and equity?
Explain the role of current ratios. Assuming days in accounts receivable are too high, why is this a problem, and what actions should managers take to reduce the number of outstanding days?
Explain the role of capital structure ratios. Assuming the equity financing ratio is higher than similar organizations, what actions should managers take?
Explain the role of turnover ratios. Assuming total asset turnover is lower than similar organizations, what actions should managers take to increase the ratio?
Explain how operating indicators are used to examine resource use.
Problems
The following table provides the income statement and balance sheet for the Hale Medical Group. Complete the ratio worksheet. Explain the change in the ratios that increased or decreased 20% or more from the prior year.
Description
The following table provides the income statement and balance sheet for Simpson Community Hospital (amounts in 000s). Complete the ratio worksheet. Explain the change in the ratios that increased or decreased 10% or more from the prior year.
Description
Notes
1. Optum360°, 2017 Almanac of Hospital Financial and Operating Indicators (Salt Lake City, UT: Author, 2016).
2. T. K. Ross, A Comprehensive Guide to Budgeting for Health Care Managers (Boston: Jones and Bartlett Learning, 2018).