Health care finance week 4

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Part IV: Report and Measure Financial Results

CHAPTER 11 FINANCIAL & OPERATING RATIOS AS

PERFORMANCE MEASURES

Health Care Finance by Judith J. Baker and R.W. Baker.

The Importance of Ratios

• Ratios are important because they are so widely used.

• Financial ratios are especially important because they are used for credit analysis.

• See Appendix 25-A for multiple examples of financial ratios as used for credit analysis and financing purposes.

The Importance of Ratios

• 3 types of ratios: liquidity, solvency, and profitability

• These three types include eight basic ratios that are widely used in health care organizations.

• Liquidity — current ratio; quick ratio; days cash on hand; days receivables.

• Solvency — debt service coverage; liabilities to fund balance.

• Profitability — operating margin; return on total assets.

Liquidity Ratios

• Current Ratio — A measure of short-term debt-paying ability (but it must be carefully interpreted).

• Computed as:

current ratio =

current assets/current liabilities.

• (Also see practice exercises for this chapter.)

Liquidity Ratios

• Quick Ratio — An even more severe test of short-term debt-paying ability (it also must be carefully interpreted).

• Computed as:

quick ratio = cash & cash equivalents + net receivables / current liabilities

• Also see practice exercises for this chapter.

Liquidity Ratios

• Days Cash on Hand (DCOH) — Indicates cash on hand in relation to amount of daily operating expenses.

• Computed as:

DCOH = unrestricted cash & cash equivalents / cash operating expenses / # of days in period.

• Also see practice exercises for this chapter

• Days Receivables — Represents number of operating days in receivables (a measure of worth as well as performance).

• Computed as:

days receivables = net receivables / net credit revenues / # of days in period

• Also see practice exercises for this chapter.

Liquidity Ratios

Solvency Ratios

• Debt Service Coverage (DSCR) — Represents the ability to meet required debt service (this ratio is universally used in credit analysis).

• Computed as:

DSCR = change in unrestricted net assets (net income) + interest, depreciation, and amortization / maximum annual debt service

• Also see practice exercises for this chapter.

Solvency Ratios

• Liabilities to fund balance — Represents the relationship of liabilities to fund balance (or liabilities to net worth). A quick indicator of bad debt.

• Computed as:

liabilities for fund balance = total liabilities / unrestricted net assets (fund balances) or (net worth)

• Also see practice exercises for this chapter.

Profitability Ratios

• Operating Margin (expressed as a percentage) — Represents the relationship of operating revenues to operating income. A multi-purpose measure, used for many managerial purposes; sometimes also used for credit analysis

• Computed as:

operating margin = operating income (loss) / total operating revenues.

• Also see practice exercises for this chapter.

• Return on total assets (expressed as a percentage) — Represents the yield received in relation to total assets. A broad measure in common use.

• Computed as:

return on total assets = earnings before interest and taxes (EBIT) / total assets.

• Also see practice exercises for this chapter

Profitability Ratios

Importance of Ratios

• Remember, ratio analysis should be conducted as a comparative analysis.

• When interpreting ratios, the differences between periods must be considered, and the reasons for such differences should be sought.

Current Ratio

1. Current Ratio

470,000 Current Assets

345,000 Current Liabilities

= 1.362

Quick Ratio

2. Quick Ratio

190,000+ 250,000 Cash and Cash Equivalent + Net Receivables 345,000 Current Liabilities

= 1.275

Health Care Finance by Judith J. Baker and R.W. Baker.

Days Cash on Hand Ratio

Step 1

1,885,000

(40,000)

1,845,000

3. Days Cash on Hand (DCOH)

Step 2

Unrestricted Cash and Cash Equivalents

1,845,000 Cash Operating Expenses divided by # days in period (365)

For the Year Ending 365

December 31, 20x2 = 5,055

Step 3

190,000

5,055

= 37.5 days

Health Care Finance by Judith J. Baker and R.W. Baker.

Days Receivable Ratio

Step 1 4. Days Receivables

2,000,000 Percent of Credit Revenues

x 90% Information obtained elsewhere

1,800,000

Step 2

Net Receivables

1,800,000 Net Credit Revenue divided by # days in period (365)

365

= 4931

Step 3

250,000

4931

= 50.7 days

Health Care Finance by Judith J. Baker and R.W. Baker.

Return on Total Assets

December 31, 20x2

Step 1 5. Return on Total Assets (%)

120,000

(20,000)

100,000 EBIT (Earnings Before Interest and Taxes)

Total Assets

Step 2

100,000

963,000

= 10.03%

Health Care Finance by Judith J. Baker and R.W. Baker.

Operating Margin Ratio

6. Operating Margin (%)

115,000

2,000,000 Operating Income (Loss)

= .0575% Total Operating Revenues

Health Care Finance by Judith J. Baker and R.W. Baker.

Liabilities to Fund Balance Ratio

Total Liabilities 7. Liabilities to Fund Balance

545,000

418,000 Total Liabilities

= 1.304 Unrestricted Fund Balance

Health Care Finance by Judith J. Baker and R.W. Baker.

Debt Service Coverage Ratio

Step 1 8. Debt Service Coverage Ratio (DSCR)

December 31, 20x2

Change in Unrestricted Net Assets (net income) 120,000 Change in Unrestricted Net Assets (net income)

plus Depreciation-Amortization 20,000 plus Depreciation-Amortization

plus Interest 40,000 plus Interest

Maximum Annual Debt Service 180,000 Maximum Annual Debt Service

Step 2

180,000 Maximum Annual Debt Service

72,000 Information derived elsewhere

= 2.5

Practice Exercise 11-I: Liquidity Ratios Solution

• Current Ratio = 2.33 to 1

• Quick Ratio = 2.167 to 1

Assignment Exercise 11-I: Liquidity Ratios Solution

• Current Ratio = 1.824.1

• Quick Ratio = 1.468 to 1

• Days Cash on Hand = 13.35 days

• Days in Receivables = 79.44 days

Practice Exercise 11-II: Solvency Ratios Solution

• Debt Service Coverage Ratio = 5.1

• Liabilities to Fund Balance Ratio = 2.5

Assignment Exercise 11-II: Solvency Ratios Solution

• Debt Service Coverage Ratio = 4.939

• Liabilities to Fund Balance Ratio = 0.526

Practice Exercise 11-III: Profitability Ratios Solution

• Operating Margin = 44.4%

• Return on Total Assets = 8.3%

Assignment Exercise 11-III: Profitability Ratios Solution

• Operating Margin = 0.484 or 48.4%

• Return on Total Assets = 0.065 or 6.5%