Assignment 5

Chapter 22

Working Capital and Cash Management

Learning Objectives

• Explain why cash management is especially crucial in most sectors of the health industry.
• Explain what working capital is and why it is needed.
• Describe the activities covered in the cash budget that affect working capital.
• Describe the tools that an organization manager can use to manage receivables.
• List the external resources available to an organization for its short-term financing needs.
• List and explain the criteria that should be used when investing an organization’s cash in the short term.

Cash and Investment Management in Health Care

• Hospitals, compared with firms of similar size in other industries, have large sums of investment-eligible funds.
• 30% of total net income was derived from nonoperating sources (e.g., donations and investment income)
• Investment income is the predominant source of nonoperating revenue

Why Do Hospitals Hold Investments?

• Not-for-profit (NFP) firms need to set aside funds for plant and equipment replacement.

• –Investor-owned (IO) firms rely on issuance of new stockholders’ equity to finance replacement needs.

• Firms are beginning to self-insure all or a portion of their professional liability risk.
• Many firms receive gifts and endowments that can provide sources of investment.
• Many firms have funding requirements for pension plans and debt service associated with bond issuance.

• Main objective: To minimize the collection period and maximize payment period

FIGURE 22-1 Cash Conversion Cycle

Cash Budget

• Primary tool in cash planning
• Major purpose: to prepare accurate estimate of future cash flows for short-term financing or investment decisions
• Cash balances are affected by changes in working capital over time.

Working Capital

• Working capitalis the difference between current assets and current liabilities.

• –Current assets:

• Cash and investments, accounts receivable, inventories, other current assets

• –Current liabilities:

• Accounts payable, accrued salaries and wages, accrued expenses, notes payable, current position of long-term debt

Cash Budget, cont.

• The cash budget focuses on four major activities:

• –Purchasing of resources
• –Production/sale of service
• –Billing
• –Collection

• These activities represent intervals in the cash conversion cycle.

Cash Budget Activities

• Purchasing: Relates to acquisition of supplies and labor
• Production and sale: In the healthcare industry, there’s little distinction between production and sale (i.e., there is no inventory of products or services).
• Billing: Interval between the release/discharge of patient and generation of a bill
• Collection: Interval between generation of a bill and actual collection of the cash from the patient or third-party payer

Steps in the Cash Management Process

1. Understand and manage cash conversion cycle
2. Develop cash budget that accurately projects cash inflows and outflows
3. Establish firm’s minimum cash balance
4. Establish working capital loans when short-term financing is needed
5. Invest cash surplus to maximize expected yield

Working Capital Management

• Working capital management is related to short-term bank financing and investment of cash surpluses.
• Consider two major categories (receivables and accounts payable/accrued salaries) on the balance sheet and how they relate to working capital management

Accounts Receivable (A/R)

• Recall A/R represents revenue for services that have been performed but have yet to be paid
• Usually represent 40 to 50% of a hospital’s total current assets
• Management of accounts receivable focuses on:

• –Minimizing lost charges
• –Minimizing write-offs for uncollectable accounts
• –Minimizing the accounts receivable collection cycle

FIGURE 22-2 Accounts Receivable Collection Cycle in Days

Admission to Discharge

• On average, ~ 5 days
• Shortening this interval is not the main objective from an A/R viewpoint.
• However, with fixed prices per case, a reduced length of stay (LOS) is desirable from cost management viewpoint.
• To expedite later collection:

• –Determine if interim billings are possible for patients with long LOS
• –Use advance deposits for nonemergent admissions
• –Obtain insurance and eligibility information before admission for nonemergencies
• –Arrange for deductible portion of coverage for patients with Health Savings Account (HSA)

Discharge to Bill Completion

• Usually 10 days, but ideally should be reduced
• Acceleration of billing process can create a reduction in final payments
• To execute billing:

• –Implement timely billing to avoid “bottlenecks”
• –Develop educational programs to show the effects of late completion of medical charts by physicians

Bill Completion to Receipt by Payer

• Usually 2 days, but may be shorter where electronic claim submission is used
• To shorten the interval:

• –Consider electronic invoicing for large payers when possible (decreases mail time to zero)
• –Try to settle all outpatient accounts at the point of discharge of departure
• –Submit a bill for any deductible and copayments for inpatients at the point of discharge

Receipt by Payer to Mailing of Payment

• Usually 35 days, but varies by type of payer
• To shorten the interval:

• –Sell some accounts receivable (e.g., Medicare accounts)
• –Use discounts for prompt payments (e.g., 5%)
• –Create a system of fast response to third-party requests for additional data
• –Claim all bad debt of the Medicare deductible and copayment portion of hospital bills
• –Make frequent follow-up calls to patients to detect problems with bills

Payment Mailed to Receipt by Hospital

• Usually 2 days due to mail time
• Courier service could be used for government or large insurance payers
• Wire transfers between payer and the healthcare provider’s bank are also used (used by Medicare and Medicaid)

Receipt by Hospital to Deposit in Bank

• 1 or more days
• To shorten the interval, use lockbox arrangements: payments go directly to a post office box that is cleared at least once a day by bank employees
• Because there is usually a cost for the service, the hospital must determine whether improvement in the cash flow is worth the fee.

Accounts Payable and Accrued Salaries and Wages

• Not usually negotiated and vary directly with the level of operations
• Usually represent a sizable portion of a hospital’s financing
• Most firms prefer to slow these payments
• Consider ABC Medical Center Balance sheet:

• –$2,297,672 in accounts payable trade
• –$1,366,777 in accrued salaries and wages

Accounts Payable

Approaches to slow accounts payable (AP):

• –Delay payment until the actual due date
• –Stretch AP: delay payment until some time after the due date
• –Change the frequency of payroll (e.g., from weekly to biweekly)
• –Use banks in distant cities to pay vendors and employees: delays check clearing and creates “float” (difference between bank balance and checkbook balance)
• –Schedule deposits to checking accounts to match expected disbursements on a daily basis

Short-Term Financing Sources

• Commercial banks are predominant sources
• Other sources:
• –Single-payment loan
• –Line of credit
• –Revolving credit agreements
• –Term loans
• –Letters of credit

Single-Payment Loan

• Usually given for a specific purpose (e.g., purchase of inventory)
• Main types:
• –Discount arrangement: interest is computed and deducted from the face value of the note
• –Add-on note: interest is added to the final payment of the loan; borrower receives full value of the loan when the loan is originated

Line of Credit

• An agreement that permits a firm to borrow up to a specified limit during a defined loan period (e.g., $2 M to a hospital during over 1 year)
• Main types:
• –Committed: written agreement with terms and conditions; a commitment feeis charged by the bank to cover the costs and risks of the money it is legally required to lend
• –Uncommitted: no formal agreement on the part of the bank to loan money

Revolving Credit Agreements

• Similar to a line of credit, but issued for 2–3 years
• Most are renegotiated before maturity
• If renegotiation occurs more than 1 year before maturity, the loan may be stated as a long-term debt and it never appears as a current liability on the firm’s balance sheet.
• Interest rates are usually variable.

Term Loans

• Made for a specific period: usually 2–7 years
• Require periodic installment payments of the principal
• Frequently used to finance tangible assets that will produce income in the future (e.g., tomography scanner)
• The asset acquired may be pledged as collateral for the loan.

Letter of Credit

• A letter from a bank stating that a loan will be made if certain conditions are met
• Used by some hospitals as a method of bond insurance
• Guarantees payment of the loan if the hospital defaults

Investment of Cash Surpluses

• Cash surplus: money exceeding a minimum balance required to meet immediate operating expenses and minor contingencies of a firm, plus compensating balance required at its banks
• Consider surplus on ABC Medical Center balance sheet:
• –$1,216,980 in cash balance
• –$4,042,407 in short-term investments

Money Market Investments

• A portion of a firm’s investment funds
• Money market= market for short-term securities (e.g., U.S. Treasury bills, negotiable certificates of deposit, bankers’ acceptances, commercial paper, repurchase agreements, etc.)
• Maturity ranges from 1 day to 1 year
• Investment serves two roles:
• –Liquidityreserve that can be used if the firm experiences a need for these funds
• –Temporary investment of surplus funds that can result in a return

Short-Term Investments

• Main investment criteria for alternative investment strategies:
• Price stability
• Safety of principal
• Marketability
• Maturity
• Yield

Price Stability

• Very important factor, especially for money market investments
• Most money market investments can be sold at a guaranteed price.
• U.S. Treasury bills are the most credit-worthy investments, followed by other U.S. Treasury obligations and federal agency issues

Safety of Principal

• It is expected that the principal of an investment is not at risk.
• Treasury and federal agency obligations are low risk.
• Bank securities (e.g., negotiable certificates of deposit) and corporate obligations (e.g., commercial paper) may incur a loss of principal through default.
• Bank creditworthiness can be reviewed in Moody’s Bank and Finance Manual and Polk’s World Bank Directory.

Marketability

• Ability to sell a security quickly, with little price concession, before maturity
• To ensure its existence, an active secondary trading market must exist.
• Some commercial paper, especially of industrial firms, may be difficult to redeem before maturity.

Maturity

• A date when a note, bill, bond, etc. becomes due for repayment
• Relationship with the yield of a security can be summarized in a yield curve.
• –Yield curve: relationship between the interest rate and the time to maturity of debt
• Some firms use “riding the yield curve” strategy: Investments are made in longer-term securities that are sold before maturity.

Yield

• Measure of the investment’s return
• Usually affected by maturity, expected default risk of principal, marketability, and price stability
• Taxability issue: NFP firms have no incentive to invest in securities that are exempt from federal income taxes.