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CHAPTER

639

FINANCIAL CONDITION ANALYSIS

Introduction

One of the most important characteristics of a healthcare organization is its financial condition: Does the business have the financial capacity to perform its mission? Many judgments about financial condition are made on the basis of financial statement analysis, which focuses on the data contained in a busi- ness’s financial statements. Financial statement analysis is applied to historical data, which reflect the results of past managerial decisions, and to forecasted data, which constitute the road map for the business’s future. Thus, managers use financial statement analysis both to assess current condition and to plan for the future.

Although financial statement analysis provides a great deal of important information regarding financial condition, it fails to provide much insight into the operational causes of that condition. Thus, financial statement analysis is often supplemented by operating indicator analysis, which uses operat- ing data not usually found in an organization’s financial statements—such as occupancy, patient mix, length of stay, and productivity measures—to help identify factors that contributed to the assessed financial condition. Through operating indicator analysis, managers are better able to identify and implement strategies that ensure a sound financial condition in the future.

Financial statement analysis The process of using data contained in financial statements to make judgments about a business’s financial condition.

Operating indicator analysis The process of using operating indicators to help explain a business’s financial condition.

17 Learning Objectives After studying this chapter, readers will be able to

• Explain the purposes of financial statement and operating indicator analyses.

• Describe the primary techniques used in financial statement and operating indicator analyses.

• Conduct basic financial statement and operating indicator analyses to assess the financial condition of a business.

• Describe the problems associated with financial statement and operating indicator analyses.

• Describe how key performance indicators (KPIs) and dashboards can be used to monitor financial condition.

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Financial condition analysis involves a number of techniques that extract information contained in a business’s financial statements and elsewhere and combine it in a form that facilitates making judgments about the organization’s financial condition and operations. Often the end result is a list of organizational strengths and weaknesses. In this chapter, several analytical techniques used in financial condition analyses, some related topics, and the problems inherent in such analyses are discussed. Along the way, you will discover that financial condition analysis generates a great deal of data. A significant problem in assessing financial condition is separating the important from the unimportant and presenting the results in a simple, easy-to-understand, easy-to-monitor format. Thus, we close the chapter with some ideas about data presentation. In addition to the chapter content, the Chapter 17 Supplement discusses four topics: market value ratios, common size analysis, percentage change analysis, and economic value added (EVA).

Financial Statement Analysis

As you learned in chapters 3 and 4, generally accepted accounting standards require businesses to prepare four financial statements: (1) the income state- ment, (2) the statement of changes in equity, (3) the balance sheet, and (4) the statement of cash flows. Taken together, these statements give an accounting picture of an organization’s operations and financial position. Because financial statement data are well organized and easily understood, such statements pro- vide a logical starting place for analyzing an organization’s financial condition.

In much of this chapter, Riverside Memorial Hospital, a 450-bed not- for-profit facility, is used to illustrate financial condition analysis. Although a hospital is being used to illustrate the techniques, they can be applied to any health services setting. Simplified versions of Riverside’s three primary financial statements are contained in exhibits 17.1, 17.2, and 17.3. Riverside’s income statements and balance sheets (exhibits 17.2 and 17.3) will be examined in later sections when we discuss ratio analysis and other tools that are used to help interpret the data. For now, our focus is on the statement of cash flows, which can be interpreted without the aid of additional data or tools.

The statement of cash flows (Exhibit 17.1), first described in Chapter 4, provides such information as whether the firm’s core operations are prof- itable, how much capital the firm raised and how this capital was used, and what impact operating and financing decisions had on the firm’s cash position.

The top part shows cash generated by and used in operations during 2015. For Riverside, operations provided $9,098,000 in net cash flow. The income statement reported $6,474,000 in operating income and $4,130,000 in depreciation, for $10,604,000 in operating cash flow. But as part of its operations, Riverside invested $1,297,000 in current assets (receivables and

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inventories) and reduced its spontaneous liabilities (payables and accruals) bal- ance by $209,000. The end result, net cash flow from operations, is $10,604,000 − $1,297,000 − $209,000 = $9,098,000.

The next section of the statement of cash flows focuses on investments in fixed assets and securities. Riverside spent $4,293,000 on capital expenditures in 2015. Is that a large or small amount? The top part of the statement of cash flows reports a depreciation expense for 2015 of $4,130,000, so the hospital spent only slightly more than its depreciation expense on new fixed assets. Thus, it is likely that the capital expenditures were more to replace worn-out and obsolete assets than to add a significant amount of new property and equip- ment. In addition to fixed-asset investments, Riverside invested $2,000,000 in short-term securities, for a total cash outflow from investing of $6,293,000.

Riverside’s financing activities, as shown in the third section, high- light the fact that the hospital received $2,098,000 in nonoperating income (unrestricted contributions and investment income) and used $2,150,000 + $3,262,000 + $323,000 = $5,735,000 in cash to pay off previously incurred long-term debt, short-term debt, and capital lease obligations.

EXHIBIT 17.1 Riverside Memorial Hospital: Statement of Cash Flows, Year Ended December 31, 2015 (in thousands)

Cash flows from operating activities: Operating income $ 6,474 Adjustments: Depreciation 4,130 Increase in accounts receivable (1,102) Increase in inventories (195) Decrease in accounts payable (438) Increase in accrued expenses 229 Net cash flow from operations $ 9,098

Cash flows from investing activities: Investment in property and equipment ($ 4,293) Investment in short-term securities ( 2,000) Net cash flow from investing ($ 6,293)

Cash flows from financing activities: Nonoperating income $ 2,098 Repayment of long-term debt (2,150) Repayment of notes payable (3,262) Capital lease principal repayment (323) Net cash flow from financing ($ 3,637)

Net increase (decrease) in cash and equivalents ($ 832)

Beginning cash and equivalents 3,095

Ending cash and equivalents $ 2,263

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When the three major sections are totaled, Riverside had a $9,098,000 − $6,293,000 − $3,637,000 = $832,000 net decrease in cash (i.e., net cash outflow) during 2015. The bottom of Exhibit 17.1 reconciles the 2015 net cash flow with the ending cash balance shown on the balance sheet. Riverside began 2015 with $3,095,000; experienced a cash outflow of $832,000 dur- ing the year; and ended the year with $3,095,000 − $832,000 = $2,263,000 in its cash and equivalents account, as verified by the value reported on the balance sheet (Exhibit 17.3).

Riverside’s statement of cash flows shows nothing unusual or alarm- ing. It does show that the hospital’s operations were inherently profitable, at least in 2015. Had the statement showed an operating cash drain, Riverside’s managers would have had something to worry about; if it continued, such a drain could bleed the hospital to death. The statement of cash flows also provides easily interpreted information about Riverside’s financing and fixed- asset investing activities for the year. For example, Riverside’s cash flow from operations was used primarily to purchase replacement fixed assets, to invest in short-term securities, and to pay off notes payable and long-term debt. Again, such uses of operating cash flow do not raise any red flags regarding the hospital’s financial actions.

Managers and investors must pay close attention to the statement of cash flows. Financial condition is driven by cash flows, and the statement gives a good picture of the annual cash flows generated by the organization. An examination of Exhibit 17.1 (or better yet, a series of such exhibits going back the last five years and projected five years into the future) would give River- side’s managers and creditors an idea of whether or not the hospital’s opera- tions are self-sustaining—that is, whether the business generates the cash flows necessary to pay its bills, including those associated with the capital employed. Although the statement of cash flows is filled with valuable information, the bottom line tells little about the business’s financial condition because operat- ing losses can be covered by financing transactions such as borrowing or selling new common stock (if investor owned), at least in the short run.

1. What are the four required financial statements? 2. What type of financial performance information is provided in the

statement of cash flows? 3. What is the difference between net income and cash flow, and

which is more meaningful to a business’s financial condition? 4. Does the fact that a business’s cash position has improved provide

much insight into the year’s financial results?

SELF-TEST QUESTIONS

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Financial Ratio Analysis

The next step in most financial condition analyses is to examine the business’s other financial statements. We analyzed Riverside’s statement of cash flows first because this statement is formatted in a way that facilitates interpretation without further data manipulation. Now we examine the income statement and balance sheet. Although these statements contain a wealth of financial information, it is difficult to make meaningful judgments about financial condi- tion by merely examining the statements’ raw data. To illustrate, one medical group practice may have $5,248,760 in long-term debt and interest charges of $419,900, while another may have $52,647,980 in debt and interest charges of $3,948,600. The true burden of these debts, and each practice’s ability to pay the interest and principal due on them, cannot be easily assessed without additional data analyses, such as those provided by ratio analysis.

Ratio analysis combines data to create single numbers that have eas- ily interpreted significance (for our purposes, numbers that measure various aspects of financial condition). Financial ratio analysis is ratio analysis applied to the data contained in a business’s financial statements (income statement and balance sheet). In the case of the debt and interest payments described above, ratios could be constructed that relate each practice’s debt to its assets and the interest it pays to the income it has available for payment.

Unfortunately, an almost unlimited number of financial ratios can be constructed, and the choice of ratios depends in large part on the nature of the business being analyzed, the purpose of the analysis, and the availability of comparative data. Generally, ratios are grouped into categories to make them easier to interpret. In the paragraphs that follow, the data presented in exhibits 17.2 and 17.3 are used to calculate an illustrative sampling of 2015 financial ratios for Riverside Memorial Hospital, which are then compared with hospital industry average ratios.

Industry average ratios are available from many sources. For example, Optum360 publishes an annual almanac that provides hospital industry data on 76 financial and operating indicator ratios. The ratios are reported in several groupings, such as by hospital size and geographic location. (For information about the 2016 edition, visit www.optumcoding.com/Product/43409/.) The industry average ratios presented in this chapter are for illustrative use only and hence should not be used for making real-world comparisons.

Note that in a real analysis, many more ratios would be calculated and analyzed. Also, although a hospital is used to illustrate ratio analysis, the specific ratios used in any analysis depend on the type of healthcare provider. Some ratios are more meaningful for hospitals, some for managed care organizations, some for medical practices, and so on.

Ratio analysis The process of creating and analyzing ratios from financial statement and other data to help assess a business’s financial condition.

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Profitability Ratios Profitability is the net result of a large number of managerial policies and deci- sions, so profitability ratios provide one measure of the aggregate financial performance of a business.

Total Margin The total margin, often called the total profit margin or just profit margin, is net income divided by all revenues, including both operating revenues and nonoperating income:

Total margin = Net income

Total revenues =

$8,572 $114,148

= 0.075 = 7.5%.

Industry average = 5.0%.

Note that total revenues are defined as net operating revenues plus nonoperating income, so Total revenues = $112,050 + $2,098 = $114,148. Riverside’s total margin of 7.5 percent shows that the hospital makes 7.5 cents on each dollar of revenue. The total margin measures the ability of the

Profitability ratios A group of ratios that measure different dimensions of a business’s profitability.

2015 2014

Revenues: Patient service revenue $ 106,502 $ 95,398 Less: Provision for bad debts 3,328 3,469 Net patient service revenue $ 103,174 $ 91,929 Premium revenue 5,232 4,622 Other revenue 3,644 6,014

Net operating revenues $ 112,050 $102,565

Expenses: Nursing services $ 58,285 $ 56,752 Dietary services 5,424 4,718 General services 13,198 11,655 Administrative services 11,427 11,585 Employee health and welfare 10,250 10,705 Malpractice insurance 1,320 1,204 Depreciation 4,130 4,025 Interest expense 1,542 1,521

Total expenses $ 105,576 $ 102,165 Operating income $ 6,474 $ 400 Nonoperating income 2,098 1,995

Net income $ 8,572 $ 2,395

EXHIBIT 17.2 Riverside

Memorial Hos- pital: State-

ments of Opera- tions (Income Statements), Years Ended

December 31, 2015 and 2014 (in thousands)

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organization to generate revenues from all sources and to control expenses. With all else the same, the higher the total margin, the lower the expenses relative to revenues. Riverside’s total margin is well above the industry average of 5.0 percent, indicating good expense control. How good? The industry data source also reports quartiles; for total margin, the upper quartile was 8.4 percent, meaning that 25 percent of hospitals had total margins higher than 8.4 percent. Although Riverside’s total margin was better than average, it was not as good as the top 25 percent of hospitals.

Although industry average figures are discussed in detail later in the chapter, it should be noted here that the industry average is not a magic number that all businesses should strive to achieve. Some well-managed businesses will be above the average, while other good firms will be below it. However, if a business’s ratios are far removed from the average for the industry, its managers should be concerned about why this difference occurs. Note also that according to standard practice, we are calling the comparative data averages, but in real- ity they are median values. Median values are better for comparisons because they are not biased by extremely high or low values in the industry data set.

2015 2014

Cash and equivalents $ 2,263 $ 3,095 Short-term investments 4,000 2,000 Net patient accounts receivable 21,840 20,738 Inventories 3,177 2,982 Total current assets $ 31,280 $ 28,815 Gross property and equipment $ 145,158 $140,865 Accumulated depreciation 25,160 21,030 Net property and equipment $ 119,998 $ 119,835

Total assets $ 151,278 $148,650 Accounts payable $ 4,707 $ 5,145 Accrued expenses 5,650 5,421 Notes payable 2,975 6,237 Total current liabilities $ 13,332 $ 16,803 Long-term debt $ 28,750 $ 30,900 Capital lease obligations 1,832 2,155 Total long-term liabilities $ 30,582 $ 33,055 Net assets (equity) $ 107,364 $ 98,792

Total liabilities and net assets $ 151,278 $148,650

EXHIBIT 17.3 Riverside Memorial Hospital: Balance Sheets, December 31, 2015 and 2014 (in thousands)

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Riverside’s relatively high total margin could mean that the hospital’s charges are relatively high, its costs are relatively low, it has relatively high nonoperating revenue, or a combination of these factors is at play. A thor- ough operating indicator analysis would help pinpoint the cause, or causes, of Riverside’s high total margin.

Operating Margin Another useful margin ratio is the operating margin, which is defined as oper- ating income divided by patient-related (operating) revenues:

Operating margin = Operating income

Net operating revenues =

$6,474 $112,050

= 0.058 = 5.8%.

Industry average = 3.5%.

The advantage of operating margin is that it focuses on core business activities and hence removes the influence of financial gains and losses, which are unrelated to operations and often are transitory. Riverside’s total margin was 7.5 percent, while its operating margin was only 5.8 percent, compared to the industry average of 3.5 percent. Removing nonoperating income (pri- marily unrestricted contributions and investment returns) lowers profitability, but Riverside’s core operations are more profitable than the industry average, which is good news. Note, though, that the format of many healthcare orga- nizations’ financial statements makes this ratio difficult to determine without additional information. Furthermore, the definition of operating margin varies depending on data availability.

Return on Assets The ratio of net income to total assets measures the return on total assets, often just called return on assets (ROA):

Return on assets Net income Total assets

$8, 572 $151, 278

0.057 5.7%.

Industry average 4.8%.

= = = =

=

Riverside’s 5.7 percent ROA, which means that each dollar of assets generated 5.7 cents in profit, is well above the 4.8 percent average for the hospital industry. ROA tells managers how productively, in a financial sense, a business is using its assets. The higher the ROA, the greater the net income for each dollar invested in assets and hence the more productive the assets. ROA measures both a business’s ability to control expenses, as expressed by the total margin, and its ability to use its assets to generate revenue.

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Return on Equity The ratio of net income to total equity (net assets) measures the return on equity (ROE):

Return on equity Net income Total equity

$8, 572 $107, 364

0.080 8.0%.

Industry average 8.4%.

= = = =

=

Riverside’s 8.0 percent ROE is slightly below the 8.4 percent industry average. The hospital was able to generate 8.0 cents of income for each dol- lar of equity investment, while the average hospital produced 8.4 cents. ROE is especially meaningful for investor-owned businesses because owners are concerned with how well the business’s managers are using owner-supplied capital, and ROE answers this question. For not-for-profit businesses such as Riverside, ROE tells its board of trustees and managers how well, in financial terms, its community-supplied capital is being used.

Riverside’s 2015 margin measures and ROA were above the industry averages, yet the hospital’s ROE is below the average. As we explain later in the section on Du Pont analysis, this seeming inconsistency is a result of the hospital’s low use of debt financing.

Liquidity Ratios One of the first concerns of most managers, and the major concern of a firm’s creditors, is the business’s liquidity. Will the business be able to meet its cash obligations as they come due? Liquidity ratios are designed to answer that question. Riverside has debts totaling more than $13 million (i.e., its current liabilities) that must be paid off within the coming year. Will the hospital be able to make these payments? A full liquidity analysis requires the use of a cash budget, which we discussed in Chapter 16. However, by relating the amount of cash and other current assets to current obligations, ratio analysis provides a quick, easy-to-use, rough measure of liquidity.

Current Ratio The current ratio is calculated by dividing current assets by current liabilities:

= = =

=

Current ratio Current assets

Current liabilities $31,280 $13,332

2.3, or 2.3 times.

Industry average 2.0.

The current ratio tells managers that the immediate liquidation of Riv- erside’s current assets at book value would provide $2.30 of cash for every

Liquidity ratios Ratios that measure the ability of a business to meet its cash obligations as they come due.

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$1 of current liabilities. If a business is getting into financial difficulty, it will begin paying its accounts payable more slowly, building up short-term bank loans (notes payable), and so on. If these current liabilities rise faster than current assets, the current ratio will fall, and this could spell trouble. Because the current ratio is an indicator of the extent to which short-term claim obli- gations are covered by assets that are expected to be converted to cash in the near term, it is a commonly used measure of liquidity.

Riverside’s current ratio is slightly above the average for the hospital industry. Because current assets should be converted to cash in the near future, it is highly probable that these assets could be liquidated at close to their stated values. With a current ratio of 2.3, the hospital could liquidate current assets at only 43 percent of book value and still pay off current creditors in full. (To determine the minimum proportion of current assets that must be converted to cash to meet current obligations, divide the number 1 by the current ratio. For Bayside, 1 ÷ 2.3 = 0.43, or 43 percent. This proportion is confirmed by noting that 0.43 × $31,280,000 = $13,332,000, the amount of current liabilities.)

Days Cash on Hand The current ratio measures liquidity on the basis of balance sheet accounts and hence is a static measure of liquidity. However, the true measure of a business’s liquidity is whether it can meet its payments as they come due, so liquidity is more related to cash inflows and outflows than it is to assets and liabilities. The days-cash-on-hand ratio moves closer to those factors that truly determine liquidity:

=

= = =

=

Days cash on hand Cash and equivalents + Short-term investments

(Expenses – Depreciation) / 365

$2,263 + $4,000 ($105,576 – $4,130) / 365

$6,263 $277.93

22.5 days.

Industry average 30.6 days.

The denominator of the equation estimates average daily cash expenses by stripping out noncash expenses (depreciation) from reported total expenses and then dividing by 365, the number of days in a year. The numerator is the cash and securities that are available to make those cash payments. Because Riverside’s days cash on hand is lower than the industry average, its liquidity position as measured by days cash on hand is worse than that of the average hospital.

For Riverside, the two measures of liquidity, current ratio and days cash on hand, give conflicting results. Perhaps the average hospital has a greater proportion of cash and equivalents and short-term investments in its current

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assets mix than does Riverside. More analysis would be required to make a supportable judgment concerning Riverside’s liquidity position. Remember, though, that the cash budget, which we discussed in Chapter 16, is the primary tool used by managers to ensure liquidity.

Debt Management (Capital Structure) Ratios The extent to which an organization uses debt financing, or financial leverage, is an important measure of financial performance for several reasons. First, by raising funds through debt, owners of for-profit businesses can maintain control with a limited investment. For not-for-profit organizations, debt financing allows more services to be provided than if the organization were solely financed with contributions and earnings. Next, creditors look to equity capital to provide a margin of safety; if the owners (or community) have provided only a small proportion of total financing, the risks of the enterprise are borne mainly by its creditors. Finally, if a business earns more on investments financed with borrowed funds than it pays in percentage interest, its ROE is increased.

Debt management ratios fall into two categories:

1. Capitalization ratios. These ratios use balance sheet data to determine the extent to which borrowed funds have been used to finance assets.

2. Coverage ratios. Here, income statement data are used to determine the extent to which fixed financial charges are covered by reported profits.

The two sets of ratios are complementary, so most financial statement analyses examine both types.

Capitalization Ratio 1: Total Debt to Total Assets (Debt Ratio) The ratio of total debt to total assets (total liabilities and equity), called the debt ratio, measures the percentage of total capital provided by creditors:

= = =

=

Debt ratio Total debt Total assets

$43, 914 $151, 278

0.290, or 29.0%.

Industry average 42.3%.

For this ratio, debt typically is defined as all debt, including current liabilities. In essence, debt is defined here as everything on the capital side of the balance sheet except equity. However, as illustrated by the next ratio discussed, capitalization ratios have several variations, many of which use dif- ferent definitions of what constitutes debt.

Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors’ losses in the event of bankruptcy and liquida- tion. Conversely, owners of for-profit firms may seek high leverage either to

Debt management ratios A group of ratios that measure the extent of a business’s financial leverage (capital structure).

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leverage up returns or because selling new stock would mean giving up some degree of control. In not-for-profit organizations, managers may seek high leverage to offer more services.

Riverside’s debt ratio is 29.0 percent. This means that its creditors have supplied somewhat less than one-third of the business’s total financing. Put another way, each dollar of assets was financed with 29 cents of debt, and consequently, 71 cents of equity. (The equity ratio is defined as 1 − Debt ratio, so Riverside’s equity ratio is 71 percent.) Because the average debt ratio for the hospital industry is more than 40 percent, Riverside uses significantly less debt than the average hospital. The low debt ratio indicates that the hospital would find it relatively easy to borrow additional funds, presumably at favorable rates.

Note that the debt-to-equity ratio, defined as Total debt ÷ Total equity, is a close relative of the debt ratio. These ratios are transformations of one another and provide the same information but with a different twist. Both the debt ratio and debt-to-equity ratio increase as a business uses a greater proportion of debt financing, but the debt ratio rises linearly and approaches a limit of 100 percent, while the debt-to-equity ratio rises at a faster rate and approaches infinity. Lenders, in particular, prefer to use the debt-to-equity ratio rather than the debt ratio because it tells them how much capital credi- tors have provided to the organization per dollar of equity capital. The higher this ratio, the riskier the creditors’ position. Other analysts tend to prefer the debt ratio because it makes it easier to visualize the liabilities and equity mix on the balance sheet.

Capitalization Ratio 2: Debt-to-Capitalization Ratio The debt-to-capitalization ratio, which is long-term debt divided by long-term capital (long-term debt plus equity), focuses on the proportion of debt used in a business’s permanent (long-term) capital structure. This ratio is also called the long-term-debt-to-capitalization ratio or just capitalization ratio. (Note that we have included capital lease obligations in our definition of long-term debt because such obligations are similar in nature to long-term debt.)

= +

= =

=

Debt-to-capitalization ratio Long-term debt

Long-term debt Equity $30,582

$30,582 + $107,364 0.222, or 22.2%.

Industry average 34.6%.

Many analysts believe that the debt-to-capitalization ratio best reflects the capital structure of a business. This belief is based on the fact that most businesses use as much spontaneous free credit (current liabilities less short-term bank loans) as they can get. Furthermore, short-term interest-bearing debt typically is used only to fund temporary current asset needs. Thus, the “true”

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capital structure of a business—the one that reflects its target structure—is best reflected by a ratio that focuses on permanent (long-term) financing.

Riverside’s debt-to-capitalization ratio is 22.2 percent, compared to the industry average of 34.6 percent. This low use of debt financing in Riverside’s permanent capital mix confirms the conclusion made earlier that the hospital has unused debt capacity.

Coverage Ratio 1: Times Interest Earned Ratio The times interest earned (TIE) ratio is determined by dividing earnings before interest and taxes (EBIT) by interest charges. EBIT is used in the numerator because it represents the amount of accounting income that is available to pay interest expense. For a not-for-profit organization, which does not pay taxes, EBIT = Net income + Interest expense, whereas for a for-profit business, EBIT = Net income + Interest expense + Taxes. Riverside’s TIE ratio is 6.6:

= = +

= =

=

TIE ratio EBIT

Interest expense $8, 572 $1, 542

$1, 542 $10,114 $1, 542

6.6.

Industry average 4.0.

The TIE ratio measures the number of dollars of accounting income (as opposed to cash flow) available to pay each dollar of interest expense. In essence, it is an indicator of the extent to which income can decline before it is less than annual interest costs. Failure to pay interest can bring legal action by the firm’s creditors, possibly resulting in bankruptcy.

Riverside’s interest is covered 6.6 times, so it has $6.60 of accounting income to pay each dollar of interest expense. Because the industry average TIE ratio is four times, the hospital is covering its interest charges by a relatively high margin of safety. Thus, the TIE ratio reinforces the previous conclusions based on the debt and debt-to-capitalization ratios—namely, that the hospital could easily expand its use of debt financing.

Coverage ratios are often better measures of a firm’s debt utilization than capitalization ratios because coverage ratios discriminate between low-interest rate debt and high-interest rate debt. For example, a medical group practice might have $10 million of 4 percent debt on its balance sheet, while another might have $10 million of 8 percent debt. If both practices have the same income and assets, both would have the same debt ratio. However, the group that pays 4 percent interest would have lower interest charges and hence would be in bet- ter financial condition than the group that pays 8 percent. This difference in financial condition is captured by the TIE ratio.

Coverage Ratio 2: Cash Flow Coverage Ratio Although the TIE ratio is easy to calculate, it has three major deficiencies. First, leasing is a common form of financing, and the TIE ratio ignores lease

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payments, which, like debt payments, are contractual obligations. Second, many debt contracts require that principal payments be made over the life of the loan, rather than only at maturity. Thus, most organizations must meet fixed financial charges associated with debt financing besides interest pay- ments. Finally, the TIE ratio ignores the fact that accounting income, whether measured by EBIT or net income, does not reflect the actual cash flow avail- able to meet a business’s fixed payments. These deficiencies are corrected in the cash flow coverage (CFC) ratio, which shows the amount by which cash flow covers fixed financial requirements. Here is Riverside’s 2015 CFC ratio assuming the hospital had $1,368,000 of lease payments and $2,000,000 of required debt principal repayments:

= + +

+ + −

= + +

+ + − = =

=

T CFC ratio

EBIT Lease payments Depreciation expense Interest expense Lease payments Debt principal / (1 )

$10,114 $1, 368 $4,130 $1, 542 $1, 368 $2, 000 / (1 0)

$15, 612 $4, 910

3.2.

Industry average 2.3.

Like its TIE ratio, Riverside’s CFC ratio exceeds the industry standard, indicating that Riverside is better at covering total fixed payments with cash flow than is the average hospital. This fact should be reassuring both to credi- tors and to management as it reinforces the view that Riverside has untapped debt capacity.

You may be wondering why there is a (1 − T ) term applied to the debt principal. The reason is that investor-owned firms must make principal repayments with after-tax dollars and hence must earn more pretax dollars to both pay taxes and make the principal repayment. The grossed-up amount, which results from dividing by 1 − T, gives the amount of pretax dollars that are needed to cover the required principal repayments. Thus, the calculation, which contains pretax dollars in the numerator, now has pretax dollars in the denominator and hence is consistent in format.

Asset Management (Activity) Ratios The next group of ratios, the asset management ratios, is designed to mea- sure how effectively a business’s assets are being utilized. These ratios help answer whether the amount of each type of asset reported on the balance sheet seems reasonable, too high, or too low in view of current (or projected) operating levels. Riverside and other hospitals must borrow or raise equity capital to acquire assets. If they have too many assets for the volume of ser- vices provided, their capital costs will be too high and their profits will be depressed. Conversely, if the level of assets is too low, volume may be lost or vital services not offered.

Asset management ratios Financial statement analysis ratios that measure how effectively a firm is managing its assets.

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Fixed Asset Turnover Ratio The fixed asset turnover ratio, also called the fixed asset utilization ratio, mea- sures the utilization of property and equipment, and it is the ratio of total (all) revenues to net fixed assets (property and equipment):

Fixed asset turnover = Total revenues Net fixed assets

= $114,148 $119,998

= 0.95.

Industry average = 2.2.

Note that total revenues include both operating and nonoperating revenues: $112,050 + $2,098 = $114,148. Also, net fixed assets are listed on the bal- ance sheet as net property and equipment.

Riverside’s ratio of 0.95 indicates that each dollar of fixed assets gener- ated 95 cents in total revenue. This value compares poorly with the industry average of 2.2 times, indicating that Riverside is not using its fixed assets as productively as is the average hospital. (The lower-quartile value for the industry is 1.1; thus, Riverside falls in the bottom 25 percent of all hospitals in its fixed-asset utilization.)

Before condemning Riverside’s management for poor performance, it should be pointed out that a major problem arises from the use of the fixed asset turnover ratio for comparative purposes. Recall that most asset values listed on the balance sheet reflect historical costs rather than current market values. Inflation and depreciation have caused the values of many assets that were purchased in the past to be seriously understated. Therefore, if an old hospital that had acquired much of its plant and equipment years ago is compared to a new hospital with the same physical capacity, the old hospital, because of a much lower book value of fixed assets, would report a much higher turnover ratio. This difference in fixed-asset turnover is more reflective of the inability of financial statements to deal with inflation than of any inefficiency on the part of the new hospital’s managers.

Total Asset Turnover Ratio The total asset turnover ratio measures the turnover, or utilization, of all of a business’s assets. It is calculated by dividing total (all) revenues by total assets:

= = =

=

Total asset turnover Total revenues

Total assets $114,148 $151,278

0.75.

Industry average 0.97.

Again, note that total revenues include both operating and nonoperating revenues.

Each dollar of total assets generated 75 cents in total revenues. River- side’s total asset ratio is below the industry average, but not as far below as its

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Riverside’s physical assets are newer than those of the average hospital. Thus, the hospital is offering more up-to-date facilities than average, and it will probably have fewer capital expenditures in the near future. On the other hand, Riverside’s net fixed asset valuation will be relatively high, which, as pointed out earlier, biases the hospital’s fixed asset and total asset turnover ratios downward. This fact raises serious questions about the interpretation of the turnover ratios calculated previously.

Comparative and Trend Analyses When conducting financial ratio analysis, the value of a particular ratio, in the absence of other information, reveals almost nothing about a business’s financial condition. For example, if it is known that a nursing home management company has a current ratio of 2.5, it is virtually impossible to say whether this is good or bad. Additional data are needed to help interpret the results of this ratio analy- sis. In the discussion of Riverside’s financial ratios, the focus was on comparative analysis—that is, the hospital’s ratios were compared with the average ratios for the industry. Another useful ratio analysis tool is trend analysis, in which the trend of a single ratio is analyzed over time. Trend analysis gives clues about whether a business’s financial situation is improving, holding constant, or deteriorating.

It is easy to combine comparative and trend analyses in a single graph such as the one shown in Exhibit 17.4. Here, Riverside’s ROE (the solid lines) and industry average ROE data (the dashed lines) are plotted for the past five years. The graph shows that the hospital’s ROE was declining faster than the industry average from 2011 through 2014, but that it rose above the industry average in 2015. Other ratios can be analyzed in a similar manner.Comparative

analysis The comparison of key financial and operational measures of one business with those of comparable businesses or industry averages. Also called benchmarking.

Trend analysis A ratio analysis technique that examines the value of a ratio over time to see if it is improving or deteriorating.

1. What is the purpose of ratio analysis? 2. What are two ratios that measure profitability? 3. What are two ratios that measure liquidity? 4. What are two ratios that measure debt management? 5. What are two ratios that measure asset management? 6. How can comparative and trend analyses be used to help interpret

a ratio?

SELF-TEST QUESTIONS

fixed asset turnover ratio. Thus, relative to the industry, the hospital is using its current assets better than its fixed assets. Such judgments can be confirmed by examining Riverside’s current asset turnover. In 2015, Riverside’s current asset turnover ratio (Total revenues ÷ Total current assets) is 3.6, compared to the industry average of 3.4, so the hospital is slightly above average in its utilization of current assets.

Days in Patient Accounts Receivable Days in patient accounts receivable is used to measure effectiveness in manag- ing receivables. This measure of financial performance, which is sometimes classified as a liquidity ratio rather than an asset management ratio, has many names, including average collection period (ACP) and days’ sales outstanding (DSO). It is computed by dividing net patient accounts receivable by average daily patient revenue to find the number of days that it takes an organiza- tion, on average, to collect its receivables. In theory, the denominator of this ratio should focus on revenues other than immediate cash payments, but this information generally is unavailable, so net patient services revenue is used. Also, note that premium and other revenue has not been included in the calculation because such revenue typically is collected either before or at the time services are provided, and hence does not affect receivables.

=

= = =

=

Days in patient accounts receivable Net patient accounts receivable

Net patient service revenue / 365

$21,840 $103,174 / 365

$21,840 $282.67

77.3 days.

Industry average 64.0 days.

Riverside is not doing as well as the average hospital in collecting its receivables. The lower quartile value is 78.7 days, so a large number of hos- pitals are doing worse. Still, as was discussed in the revenue cycle section of Chapter 16, it is important that businesses collect their receivables as soon as possible. Clearly, Riverside’s managers should strive to increase the hospital’s performance in this key area.

Average Age of Plant The average age of plant gives a rough measure of the average age in years of a business’s fixed assets (net property and equipment):

= = =

=

Average age of plant Accumulated depreciation

Depreciation expense $25,160 $4,130

6.1 years.

Industry average 9.1 years.

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Riverside’s physical assets are newer than those of the average hospital. Thus, the hospital is offering more up-to-date facilities than average, and it will probably have fewer capital expenditures in the near future. On the other hand, Riverside’s net fixed asset valuation will be relatively high, which, as pointed out earlier, biases the hospital’s fixed asset and total asset turnover ratios downward. This fact raises serious questions about the interpretation of the turnover ratios calculated previously.

Comparative and Trend Analyses When conducting financial ratio analysis, the value of a particular ratio, in the absence of other information, reveals almost nothing about a business’s financial condition. For example, if it is known that a nursing home management company has a current ratio of 2.5, it is virtually impossible to say whether this is good or bad. Additional data are needed to help interpret the results of this ratio analy- sis. In the discussion of Riverside’s financial ratios, the focus was on comparative analysis—that is, the hospital’s ratios were compared with the average ratios for the industry. Another useful ratio analysis tool is trend analysis, in which the trend of a single ratio is analyzed over time. Trend analysis gives clues about whether a business’s financial situation is improving, holding constant, or deteriorating.

It is easy to combine comparative and trend analyses in a single graph such as the one shown in Exhibit 17.4. Here, Riverside’s ROE (the solid lines) and industry average ROE data (the dashed lines) are plotted for the past five years. The graph shows that the hospital’s ROE was declining faster than the industry average from 2011 through 2014, but that it rose above the industry average in 2015. Other ratios can be analyzed in a similar manner.Comparative

analysis The comparison of key financial and operational measures of one business with those of comparable businesses or industry averages. Also called benchmarking.

Trend analysis A ratio analysis technique that examines the value of a ratio over time to see if it is improving or deteriorating.

1. What is the purpose of ratio analysis? 2. What are two ratios that measure profitability? 3. What are two ratios that measure liquidity? 4. What are two ratios that measure debt management? 5. What are two ratios that measure asset management? 6. How can comparative and trend analyses be used to help interpret

a ratio?

SELF-TEST QUESTIONS

For Your Consideration How Many Ratios Are Enough?

In our discussion of financial statement ratio analysis, we discussed 14 ratios that are com- monly used to help interpret financial statement data. Although that may seem like a lot of ratios, our discussion just scratched the surface. For example, one of the most widely used sets of comparative data for hospitals, the Almanac of Hospital Financial and Operating Indicators, pub- lished annually by Optum360, provides data on more than 30 financial ratios.

Without too much additional work, you could probably compile a list of 50 financial ratios. Yet studies have shown that about 90 percent of the information contained in financial statements can be uncovered using 10 or so carefully selected ratios.

How many ratios do you think are enough? Does it matter how the ratios are selected? Is there a cost to using more ratios than necessary? What is the disadvantage of generating too much data?

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Tying the Financial Ratios Together: Du Pont Analysis

Financial ratio analysis provides a great deal of information about a business’s financial condition, but it does not provide an overview, nor does it tie any of the ratios together. Du Pont analysis, so named because managers at the Du Pont Company developed it, provides an overview of a business’s financial condition and helps managers and investors understand the relationships among several ratios. The analysis decomposes return on equity, one of the most important measures of a business’s profitability, into the product of three other ratios, each of which has an important economic interpretation. The result is the Du Pont equation:

= × ×

= × ×

ROE Total margin Total asset turnover Equity multiplier Net income Total equity

Net income Total revenues

Total revenues Total assets

Total assets Total equity

.

Du Pont analysis A financial statement analysis tool that decomposes return on equity into three components: profit margin, total asset turnover, and equity multiplier.

Return on Equity (ROE)

Industry

Year Riverside Lower Quartile Median Upper Quartile

2011 12.5% 2.6% 8.6% 13.3% 2012 10.0 2.5 8.6 13.3 2013 6.7 2.8 7.2 12.0 2014 2.4 4.1 7.2 12.1 2015 8.0 3.8 7.4 12.3

2011 2012 2013 2014 2015

Lower Quartile

Median

Upper Quartile

5

10

15

ROE (%)

EXHIBIT 17.4 Riverside Memorial Hospital:

ROE Analysis, 2011–2015

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Riverside’s 2015 data are used to illustrate the Du Pont equation:

$8,572 $107,364

$8,572 $114,148

$114,148 $151,278

$151,278 $107,364

8.0% 7.5% 0.75 1.4

5.6% 1.4.

= × ×

= × ×

= ×

In the Du Pont equation, the product of the first two terms on the right side is return on assets (ROA), so the equation can also be written as ROE = ROA × Equity multiplier. Riverside’s 2015 total margin was 7.5 per- cent, so the hospital made 7.5 cents profit on each dollar of total revenue. Furthermore, assets were turned over (or created revenues) 0.75 times during the year, so the hospital earned a return of 7.5% × 0.75 = 5.6% on its assets. This value for ROA, when rounded, is the same as was calculated previously in our ratio analysis discussion.

If the hospital used only equity financing, its 5.6 percent ROA would equal its ROE. However, creditors supplied 29 percent of Riverside’s capital, while the equity holders (the community) supplied the rest. Because the 5.6 percent ROA belongs exclusively to the suppliers of equity capital, which comprises only 71 percent of total capital, Riverside’s ROE is higher than its 5.6 percent ROA. Specifically, ROA must be multiplied by the equity multi- plier, which shows the amount of assets working for each dollar of equity capital, to obtain the ROE of 8.0 percent. This 8.0 percent ROE could be calculated directly: ROE = Net income ÷ Total equity = $8,572 ÷ $107,364 = 8.0%. However, the Du Pont equation shows how total margin, which measures expense control; total asset turnover, which measures asset utilization; and financial leverage, which measures debt utilization, interact to determine ROE.

Key Equation: Du Pont Analysis

The Du Pont equation decomposes a business’s return on equity (ROE) into the product of three other ratios:

ROE = Total margin × Total asset turnover × Equity multiplier.

The value of this equation stems from the fact that the total margin mea- sures expense control, the total asset turnover measures asset utilization, and the equity multiplier measures debt utilization. Du Pont analysis is particularly useful when the equation can be compared with both bench- mark equations and previous years’ results.

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Riverside’s managers use the Du Pont equation to suggest how to improve the hospital’s financial condition. To influence the profit margin, Riverside must increase revenues and/or reduce costs. Thus, the hospital’s marketing staff can study the effects of raising charges, or lowering them to increase volume; moving into new services or markets with higher margins; entering into new contracts with managed care plans; and so on. Furthermore, management accountants can study the expense items and, while working with department heads and clinical staff, can seek ways to reduce costs. More specific ideas regarding actions needed to improve financial condition will be gleaned from an operating indicator analysis, which is discussed in a later section.

Regarding total asset turnover, Riverside’s analysts, while working with both clinical and marketing staffs, can investigate ways of reducing investments in various types of assets. Finally, the hospital’s financial staff can analyze the effects of alternative financing strategies on the equity multiplier, seeking to hold down interest expenses and the risks of debt while still using debt to leverage up ROE.

The Du Pont equation provides a useful comparison between a busi- ness’s performance as measured by ROE and the performance of an average hospital. For example, here is the comparative analysis for 2015:

Riverside: ROE = 7.5% × 0.75 × 1.4

= 5.6% × 1.4 = 8.0%.

Industry average: ROE = 5.0% × 0.97 × 1.7

= 4.8% × 1.7 = 8.4%.

The Du Pont analysis tells managers and creditors that Riverside has a significantly higher profit margin, and thus better control over expenses, than the average hospital has. However, the average hospital has a better total asset turnover, and thus Riverside is getting below-average utilization from its assets. In spite of the average hospital’s advantage in asset utilization, Riverside’s superior expense control outweighs its utilization disadvantage because its ROA of 5.6 percent is higher than the industry average ROA of 4.8 percent. Finally, the average hospital has offset Riverside’s advantage in ROA by using more financial leverage, although Riverside’s lower use of debt financing decreases its risk. The end result is that Riverside gets somewhat less return on its equity capital than the average hospital gets.

One potential problem with Du Pont and ratio analyses applied to not-for-profit organizations, especially hospitals, is that a large portion of their net income may come from nonoperating sources. If the nonoperating rev- enues are highly variable and unpredictable, as they often are, return on equity and the ratios as previously defined may be a poor measure of the hospital’s inherent profitability. All applicable ratios, as well as the Du Pont analysis,

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could be recast to focus on operations by using operating revenue and operat- ing income in lieu of total (all) revenues and net income.

Other Analytical Techniques

Besides ratio and Du Pont analyses, two additional financial statement analysis techniques are commonly used in financial condition analysis. In common size analysis, all income statement items are divided by total revenues and all balance sheet items are divided by total assets. Thus, a common size income statement shows each item as a percentage of total revenues, and a common size balance sheet shows each account as a percentage of total assets. The advantage of common size statements is that they facilitate comparisons of income statements and balance sheets over time and across companies because they remove the influence of the scale (size) of the business.

Another frequently used technique when analyzing financial statements is percentage change analysis. Here, the percentage changes in the balance sheet accounts and income statement items from year to year are calculated and compared. In this format, it is easy to see what accounts and items are growing faster or slower than others and thus to identify which are under control and which are out of control.

The conclusions reached in common size and percentage change analyses generally parallel those derived from ratio analysis. However, occasionally a serious deficiency is highlighted only by one of the three analytical techniques, while the other two techniques fail to bring the deficiency to light. Thus, a thorough financial statement analysis usually consists of a Du Pont analysis to provide an overview and then includes several different techniques such as ratio, common size, and percentage change analyses. For illustrations of com- mon size and percentage change analyses, see the supplement to this chapter.

1. Explain how the Du Pont equation combines several ratios to obtain an overview of a business’s financial condition.

2. Why might a focus on operating revenue and operating income be preferable to a focus on total revenue and net income?

SELF-TEST QUESTIONS

Common size analysis A technique to analyze a business’s financial statements that expresses income statement items and balance sheet accounts as percentages rather than in dollars.

Percentage change analysis A technique to analyze a business’s financial statements that expresses the year-to-year changes in income statement items and balance accounts as percentages.

1. What advantage do common size statements have over regular statements when conducting a financial statement analysis?

2. What is percentage change analysis, and why is it useful? 3. Which analytical techniques should be used in a complete financial

statement analysis?

SELF-TEST QUESTIONS

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Operating Indicator Analysis

Operating indicator analysis goes one step beyond financial statement analy- sis by examining operating variables with the goal of explaining a business’s financial condition. Like the financial ratios, operating indicators are typically grouped into major categories to make interpretation easier. For hospitals, the most commonly used categories are

• profit indicators, • price indicators, • volume (utilization) indicators, • length-of-stay indicators, • intensity-of-service indicators, • efficiency indicators, and • unit cost indicators.

Because of the large number of operating indicators used in a typical analysis, the indicators cannot be discussed in detail here. However, to give you an appreciation for this type of analysis, we discuss seven commonly used hospital operating indicators—one from each category. Note that most of the data needed to calculate operating indicators are not contained in the financial statements. More complete data are required for this type of analysis.

Profit per Discharge Profit per discharge, a profit indicator, provides a measure of the amount of profit on inpatient services earned per discharge. Note that this measure is “raw” in the sense that it is not adjusted for case mix, which we discuss later, or local wage conditions. Often, operating indicators are calculated in both raw and adjusted forms. In 2015, Riverside’s managerial accounting system reported $87,740,000 of inpatient service revenue, $84,865,000 of inpatient costs, and 18,281 patient discharges. Thus, Riverside’s profit per discharge was $157:

= =

= =

=

Profit per discharge Inpatient profit Total discharges

$87,740,000 – $84,865,000 18,281

$2,875,000 18,281

$157.

Industry average $73.

Compared to the industry average, Riverside’s inpatient services are more than twice as profitable. It is not uncommon in today’s tight reimbursement

Operating indicator A ratio that focuses on operating data rather than financial data.

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environment for hospitals to lose money (as measured by accounting profit) on inpatient services. In fact, with an industry average profit per discharge of only $73, half of the hospitals are making less than $73, which indicates that a significant percentage of hospitals are losing money on inpatient services. Most, however, make up the losses with profits from other services or from nonoperating income.

Net Price per Discharge Net price per discharge, which is one of many price indicators, measures the average inpatient revenue collected on each discharge. Based on the data presented in the discussion of the profit-per-discharge indicator, Riverside’s net price per discharge for 2015 was $4,800:

= = =

=

Net price per discharge Net inpatient revenue

Total discharges $87,740,000

18,281 $4,800.

Industry average $5,056.

Riverside collects less per discharge than the average hospital; however, we have already seen that Riverside makes a profit of $157 on each discharge, so its inpatient services cost structure must be proportionally even lower than the industry average. Riverside’s ability to make a profit on each discharge could be attributed to a lower-than-average case mix, which measures the average intensity of services provided, or to an aggressive cost management program.

Occupancy Rate (Percentage) Occupancy rate, one of many volume indicators, measures the utilization of a hospital’s licensed beds and hence fixed assets. Because overhead costs are incurred on all assets whether used or not, higher occupancy spreads fixed costs over more patients and hence increases per patient profitability. Based on 95,061 inpatient days in 2015, Riverside’s occupancy rate was 57.9 percent:

Occupancy rate Inpatient days

(Number of licensed beds 365) 95, 061

450 365 57.9%.

Industry average 45.4%.

= ×

= ×

=

=

Riverside has a higher occupancy rate than the average hospital and hence is using its inpatient fixed assets more productively. Note that this conclusion contradicts the financial statement analysis interpretation of the hospital’s 2015 fixed-asset-turnover ratio. While that ratio is affected by inflation, accounting convention, and the amount of assets devoted to other functions, the occupancy rate is not. Hence, it is a superior measure of pure asset utilization, at least regarding inpatient utilization. On this basis, Riverside’s managers appear to

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be doing a good job, relative to the industry, of using the hospital’s inpatient fixed assets. This measure can also be applied to staffed beds. In Riverside’s case, the two measures of capacity are the same, but some hospitals have fewer staffed beds than licensed beds.

Average Length of Stay Average length of stay (ALOS), or just length of stay (LOS), is the number of days an average inpatient is hospitalized with each admission. ALOS and an alternative version adjusted for case mix are the sole LOS indicators. Riverside’s 2015 LOS was 5.2 days:

= = =

=

LOS Inpatient days

Total discharges 95, 061 18, 281

5.2 days.

Industry average 4.7 days.

On average, Riverside keeps its patients in the hospital slightly longer than the average hospital does. In general, that longer stay is considered to have a negative impact on inpatient profitability because most hospitals have a reimbursement mix heavily weighted toward prospective (episodic) payment. With payment fixed per discharge, lower LOS typically leads to lower costs and hence higher profitability.

All Patient Case-Mix Index The all patient case-mix index is one of several intensity-of-service indicators. The concept of measuring case mix was first applied to Medicare patients; hence, many hospitals calculate both a Medicare case-mix index and an all patient case-mix index. Case mix is based on diagnosis; diagnoses requiring more complex treatments are assigned a higher value. The idea is to be able to differentiate (on average) between hospitals that provide relatively simple, and hence low-cost, services from those that provide highly complex and costly services. Case-mix values assigned to diagnoses are periodically recalibrated, with the intent of forcing the average hospital to have a case-mix index of 1.0. In general, case mix is related to size because large hospitals typically offer a more complex set of services than small hospitals do. Furthermore, case-mix values tend to be high at teaching hospitals (greater than 1.5) because the most complex cases often are transferred to such hospitals.

Riverside’s all patient case-mix index was 1.12 for 2015, which is slightly below the industry average of 1.15. Thus, the patients that Riverside admits to the hospital require about the same intensity of services that patients at the average hospital require, which tells us that inpatient revenues and costs are not influenced by having a patient mix that is either relatively simple to treat or relatively complex.

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Inpatient FTEs per Occupied Bed The number of inpatient full-time equivalents (FTEs) per occupied bed is a measure of workforce productivity and hence is an efficiency indicator. The lower the number, the more productive the workforce. When the focus is on inpatient productivity, inpatient FTEs are used. The measure can also be adapted to outpatient productivity. Needless to say, there are many situations in a hospital setting in which it is difficult to allocate FTEs to the type of service provided. With an inpatient workforce of 1,251 FTEs, Riverside’s inpatient FTEs per occupied bed was 4.8 in 2015:

=

= ×

= =

=

Inpatient FTEs per occupied bed Inpatient FTEs

Average daily census 1, 251

0.579 450 1, 251 260.55

4.8.

Industry average 5.6.

Note that the average daily census—the number of patients hospitalized on an average day—was calculated by multiplying Riverside’s occupancy rate (57.9 percent = 0.579) by the number of licensed beds (450). With higher- than-average labor productivity, coupled with better fixed-asset utilization, it is no surprise that Riverside’s inpatient services are more profitable than those of the average hospital.

Salary per FTE Salary per FTE, one of the unit cost indicators, provides a simple measure of the relative cost of the largest resource item used in the hospital industry—labor. With total salaries of $83,038,613 in 2015 and 2,681 total FTEs, Riverside’s salary per FTE in 2015 was $30,973:

= = =

=

Salary per FTE Total salaries Total FTEs

$83, 038, 613 2, 681

$30, 973.

Industry average $32, 987.

Now, we can see that Riverside’s above-average profitability is enhanced by both worker productivity and control over wages and benefits.

In a full operating indicator analysis, many more indicators would be examined in an attempt to identify the operating strengths and weaknesses that underlie a business’s financial condition. Although operating indicator analysis has been illustrated using the hospital industry, its concepts can be applied to any healthcare business, although the indicators would differ. Also, operating indicators are interpreted in the same way as financial ratios (i.e., by performing comparative and trend analyses).

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Limitations of Financial Ratio and Operating Indicator Analyses

While financial ratio and operating indicator analyses can provide a great deal of useful information regarding a business’s operations and financial condi- tion, such analyses have limitations that necessitate care and judgment. In this section, some of the problem areas are highlighted.

To begin, many large healthcare businesses operate a number of dif- ferent services in quite different lines of business, and in such cases it is dif- ficult to develop meaningful comparative data. This problem tends to make

financial statement and operating indicator analyses somewhat more useful for provid- ers with single service lines than for large, multiservice companies.

Next, generalizing about whether a particular ratio or indicator is good or bad is often difficult. For example, a high current ratio may show a strong liquidity position, which is good, or an excessive amount of current assets, which is bad. Similarly, a high asset turnover ratio may denote either a business that uses its assets efficiently or one that is undercapitalized and simply cannot afford to acquire enough assets. In addition, firms often have some ratios and indicators that look good and others that look bad, which make a firm’s financial position, strong or weak, difficult to determine. For this reason, significant judgment is required when analyzing finan- cial and operating performance.

Another problem is that different accounting practices can distort financial

For Your Consideration Inflation Accounting

Inflation accounting (also called replacement cost accounting or current cost accounting) describes a range of accounting systems designed to correct problems arising from historical cost accounting under inflation. It was widely used in the nineteenth and early twentieth centuries but was mostly replaced by historical cost accounting in the 1930s after asset values were devastated by the Great Depression.

Historical cost accounting leads to two basic problems. First, many of the historical numbers appearing on financial statements are not eco- nomically relevant because prices have changed since they were incurred. Second, the num- bers on financial statements represent dollars expended at different points of time. Thus, add- ing cash of $10,000 held on December 31, 2015, with a $10,000 cost of land acquired in 1965 makes little sense because inflation has caused the two amounts to represent significantly

1. What is the difference between financial and operating indicator analyses?

2. Why is operating indicator analysis important? 3. Describe several metrics commonly used in operating indicator

analysis.

SELF-TEST QUESTIONS

(continued)

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statement ratio comparisons. For example, firms can use different accounting conven- tions to value cost of goods sold and end- ing inventories. During inflationary periods these differences can lead to ratio distor- tions. Other accounting practices, such as those related to leases, can also create prob- lems in ratio interpretation.

Finally, inflation effects can distort balance sheets and income statements. Numerous reporting methods have been proposed to adjust accounting statements for inflation, but no consensus has been reached on how to do this or even on the practical usefulness of the resulting data. Nevertheless, accounting standards encour- age, but do not require, businesses to dis- close supplementary data to reflect the effects of general inflation. Inflation effects tend to make ratio comparisons over time for a given business, and across businesses at any point in time, less reliable than would be the case in the absence of inflation.

Benchmarking

Most techniques for evaluating financial condition require comparisons to make meaningful judgments. In the previous examination of selected financial and operating indicator ratios, Riverside’s ratios were compared to industry aver- age ratios. However, like managers in most businesses, Riverside’s managers go one step further—they compare their ratios not only with industry aver- ages but also with industry leaders and primary competitors. The technique of comparing ratios against selected standards is called benchmarking, while the comparative ratios are called benchmarks. Riverside’s managers benchmark

1. Briefly describe some of the problems encountered when performing financial statement and operating indicator analyses.

2. Explain how inflation effects created problems in the Riverside illustration.

SELF-TEST QUESTIONS

Benchmarking The comparison of performance metrics, such as financial ratios, of one business against those of similar businesses and industry averages. Also called comparative analysis.

different levels of purchasing power. Under infla- tion accounting, the $10,000 cash would be added to the current market value of the land, say, $50,000, which equalizes the purchasing power of the two amounts.

During the past 50 years, accounting stan- dards have encouraged companies to supplement historical cost-based financial statements with price level (inflation)–adjusted statements, but few companies have done so. Additionally, in the 1970s, the Financial Accounting Standards Board reviewed a draft proposal that would man- date price level–adjusted statements. However, because of stringent opposition from companies, the proposal was never adopted.

What do you think? Would it be easy to esti- mate the current values of balance sheet assets? What are the advantages and disadvantages of inflation accounting? Should generally accepted accounting principles be revised to require infla- tion accounting?

(continued from previous page)

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against industry averages; against National/GFB Healthcare and Pennant Healthcare, which are two leading for-profit hospital businesses; and against Woodbridge Memorial Hospital and St. Anthony’s, which are its primary local competitors.

To illustrate the concept, consider how Riverside’s analysts present total margin data to the firm’s board of trustees:

2015 2014 National/GFB 9.8% National/GFB 9.6% Industry top quartile 8.4 Industry top quartile 8.0 St. Anthony’s 8.0 St. Anthony’s 7.9 Riverside 7.5 Pennant Healthcare 5.0 Industry median 5.0 Industry median 4.7 Pennant Healthcare 4.8 Riverside 2.3 Industry lower quartile 1.8 Industry lower quartile 2.1 Woodbridge Memorial 0.5 Woodbridge Memorial (1.3)

Benchmarking permits Riverside’s managers to easily see where the firm stands relative to its competition in any given year and over time. As the data show, Riverside was roughly in the middle of the pack in 2015 with respect to its primary competitors and two large investor-owned hospital chains, although its showing was better than the average hospital’s. Its 2014 performance was significantly worse, so it improved substantially from 2014 to 2015. Although benchmarking is illustrated with one ratio, other ratios can be analyzed similarly. Also, for presentation purposes, bar charts are often used with comparative data that are color coded for ease of recognition and interpretation.

All comparative analyses require comparative data. Such data are avail- able from a number of sources, including commercial suppliers, federal and state governmental agencies, and various industry trade groups. Each of these data suppliers uses a somewhat different set of ratios designed to meet its own needs. Thus, the comparative data source selected dictates, in a very real sense, the ratios that will be used in the analysis. Also, there are minor and sometimes major differences in ratio definitions between data sources—for example, one source may use a 365-day year, while another uses a 360-day year. Or one source might use operating values, as opposed to total values, when constructing ratios. It is very important to know the specific defini- tions used in the comparative data because definitional differences between the ratios being calculated and the comparative ratios can lead to erroneous interpretations and conclusions. Thus, the first task in any ratio analysis is to identify the comparative data set and the ratios to be used. The second task is to make sure the ratio definitions used in the analysis match those from the comparative data set.

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Key Performance Indicators and Dashboards

Financial statement data are usually created on an annual and quarterly basis, while operating indicator data are generated much more often, even daily. Furthermore, financial condition analyses produced from this information may include literally hundreds of metrics (ratios and other measures). Although annual and quarterly financial condition analyses are always performed, man- agers need to monitor financial condition on a more regular basis so that problem areas can be identified and corrective action taken in a timely manner. However, the type of financial condition analyses described in this chapter with, say, weekly data would overload managers, and as a result, important findings could be missed.

To help solve the data overload and timeliness problems, many health- care businesses use key performance indicators (KPIs) and dashboards. KPIs are a limited number of financial and operating indicator metrics that measure performance critical to the success of an organization. In essence, they assess the current state of the business, measure progress toward organizational goals, and facilitate prompt managerial action to correct deficiencies.

The KPIs chosen by any business depend on the line of business and its mission, objectives, and goals. In addition, KPIs usually differ by timing. For example, a hospital might have a daily KPI of number of net admissions (admissions minus discharges), while the corresponding quarterly and annual KPI might be occupancy rate. Clearly, the number of KPIs used must be kept to a minimum to allow managers to focus on the most important aspects of financial and operating performance.

Dashboards are a common way to present an organization’s KPIs. The term stems from an automobile’s dashboard, which presents key information (e.g., speed, engine temperature, oil pressure) about the car’s performance. Often, the KPIs are shown as gauges, which allow managers to quickly inter- pret the indicators. The basic idea here is to allow managers to monitor the business’s most important financial and operating metrics on a regular basis (daily for some metrics) in a form that is easy to read and interpret.

Key performance indicator (KPI) A financial statement ratio or operating indicator that is considered by management to be critical to mission success.

Dashboard A format for presenting a business’s key performance indicators that resembles the dashboard of an automobile.

1. What is a key performance indicator (KPI)? A dashboard? 2. How are KPIs and dashboards used in financial condition

analysis?

SELF-TEST QUESTIONS

1. What is benchmarking? 2. Why is it important to be familiar with the comparative data set?

SELF-TEST QUESTIONS

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Key Concepts The primary purpose of this chapter is to present the techniques used by managers and investors to assess an organization’s financial condition. The main focus is on financial condition as reflected in a business’s financial state- ments, although operating data are also introduced to explain a business’s current financial status. The key concepts of this chapter are as follows:

• Financial statement analysis, which is designed to identify a firm’s financial condition, focuses on the firm’s financial statements. Operating indicator analysis, which uses data typically found outside of the financial statements, provides insights into why a firm is in a given financial condition.

• Financial ratio analysis, which focuses on financial statement data, is designed to reveal the relative financial strengths and weaknesses of a company as compared to other companies in the same industry, and to show whether the business’s financial condition has been improving or deteriorating over time.

• The Du Pont equation indicates how the total margin, the total asset turnover ratio, and the use of debt interact to determine the rate of return on equity. It provides a good overview of a business’s financial condition.

• Liquidity ratios indicate the business’s ability to meet its short-term obligations.

• Asset management ratios measure how effectively managers are using the business’s assets.

• Debt management ratios reveal the extent to which the firm is financed with debt and the extent to which operating cash flows cover debt service and other fixed-charge requirements.

• Profitability ratios show the combined effects of liquidity, asset management, and debt management on operating results.

• Ratios are analyzed using comparative analysis, in which a firm’s ratios are compared with industry averages or those of another firm, and trend analysis, in which a firm’s ratios are examined over time.

• In a common size analysis, a business’s income statement and balance sheet are expressed in percentages. This facilitates comparisons between firms of different sizes and for a single firm over time.

• In percentage change analysis, the differences in income statement items and balance sheet accounts from one year to the next are expressed in percentages. In this way, it is easy to identify those

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Financial condition analysis has its limitations, but if used with care and judgment, it can provide managers with a sound picture of an organization’s financial condition as well as identify those operating factors that contributed to that condition.

Questions

17.1 a. What is the primary difference between financial statement analysis and operating indicator analysis?

b. Why are both types of analyses useful to health services managers and investors?

17.2 Should financial statement and operating indicator analyses be conducted only on historical data? Explain your answer.

17.3 One asset management ratio, the inventory turnover ratio, is defined as sales (i.e., revenues) divided by inventories. Why would this ratio be important for a medical device manufacturer or a hospital management company?

17.4 a. Assume that Kindred Healthcare and Sun Healthcare Group, two operators of nursing homes, have fiscal years that end at different times—say, one in June and one in December. Would this fact cause any problems when comparing ratios between the two companies?

b. Assume that two companies that operate walk-in clinics both had the same December year-end, but one was based in Aspen, Colorado, a winter resort, while the other operated in Cape Cod, Massachusetts, a summer resort. Would their locations lead to problems in a comparative analysis?

items and accounts that are growing appreciably faster or slower than average.

• Benchmarking is the process of comparing the performance of a particular company with a group of benchmark companies, often industry leaders and primary competitors.

• Financial condition analysis is hampered by some serious problems, including development of comparative data, interpretation of results, and inflation effects.

• Key performance indicators (KPIs) are a limited number of metrics that focus on those measures that are most important to an organization’s mission success. Often, KPIs are presented in a format that resembles a dashboard.

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17.5 a. How does inflation distort ratio analysis comparisons, both for one company over time and when different companies are compared?

b. Are only balance sheet accounts or both balance sheet accounts and income statement items affected by inflation?

17.6 a. What is the difference between trend analysis and comparative analysis?

b. Which is more important? 17.7 Assume that a large managed care company has a low return on

equity (ROE). How could Du Pont analysis be used to identify possible actions to help boost ROE?

17.8 Regardless of the specific line of business, should all healthcare businesses use the same set of ratios when conducting a financial statement analysis? Explain your answer.

17.9 What are key performance indicators (KPIs)? What is a dashboard?

Problems

17.1 a. Modern Medical Devices has a current ratio of 0.5. Which of the following actions would improve (i.e., increase) this ratio? • Use cash to pay off current liabilities. • Collect some of the current accounts receivable. • Use cash to pay off some long-term debt. • Purchase additional inventory on credit (i.e., accounts payable). • Sell some of the existing inventory at cost.

b. Assume that the company has a current ratio of 1.2. Now which of the above actions would improve this ratio?

17.2 Southwest Physicians, a medical group practice, is just being formed. It will need $2 million of total assets to generate $3 million in revenues. Furthermore, the group expects to have a profit margin of 5 percent. The group is considering two financing alternatives. First, it can use all-equity financing by requiring each physician to contribute his or her pro rata share. Alternatively, the practice can finance up to 50 percent of its assets with a bank loan. Assuming that the debt alternative has no impact on the expected profit margin, what is the difference between the expected ROE if the group finances with 50 percent debt versus the expected ROE if it finances entirely with equity capital?

17.3 Riverside Memorial’s primary financial statements are presented in exhibits 17.1, 17.2, and 17.3.

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a. Calculate Riverside’s financial ratios for 2014. Assume that Riverside had $1,000,000 in lease payments and $1,400,000 in debt principal repayments in 2014. (Hint: Use the book discussion to identify the applicable ratios.)

b. Interpret the ratios. Use both trend and comparative analyses. For the comparative analysis, assume that the industry average data presented in the book are valid for both 2014 and 2015.

17.4 Consider the following financial statements for BestCare HMO, a not-for-profit managed care plan:

BestCare HMO Statement of Operations and Change in Net Assets, Year Ended June 30, 2015

(in thousands) Revenue: Premiums earned $26,682 Coinsurance 1,689 Interest and other income 242 Total revenues $28,613 Expenses: Salaries and benefits $15,154 Medical supplies and drugs 7,507 Insurance 3,963 Provision for bad debts 19 Depreciation 367 Interest 385 Total expenses $27,395 Net income $ 1,218

Net assets, beginning of year $ 900 Net assets, end of year $ 2,118

BestCare HMO Balance Sheet, June 30, 2015 (in thousands)

Assets: Cash and cash equivalents $2,737 Net premiums receivable 821 Supplies 387 Total current assets $3,945 Net property and equipment $5,924 Total assets $9,869

(continued)

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Liabilities and Net Assets: Accounts payable—medical services $2,145 Accrued expenses 929 Notes payable 141 Current portion of long-term debt 241 Total current liabilities $3,456 Long-term debt $4,295 Total liabilities $7,751 Net assets (equity) $2,118 Total liabilities and net assets $9,869

a. Perform a Du Pont analysis on BestCare. Assume that the industry average ratios are as follows:

Total margin 3.8% Total asset turnover 2.1 Equity multiplier 3.2 Return on equity (ROE) 25.5%

b. Calculate and interpret the following ratios for BestCare:

Industry Average Return on assets (ROA) 8.0% Current ratio 1.3 Days cash on hand 41 days Average collection period 7 days Debt ratio 69% Debt-to-equity ratio 2.2 Times interest earned (TIE) ratio 2.8 Fixed asset turnover ratio 5.2

17.5 Consider the following financial statements for Green Valley Nursing Home, Inc., a for-profit, long-term care facility:

(continued from previous page)

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Green Valley Nursing Home, Inc., Statement of Income and Retained Earnings, Year Ended

December 31, 2015 Revenue: Net patient service revenue $3,163,258 Other revenue 106,146 Total revenues $3,269,404 Expenses: Salaries and benefits $1,515,438 Medical supplies and drugs 966,781 Insurance 296,357 Provision for bad debts 110,000 Depreciation 85,000 Interest 206,780 Total expenses $3,180,356 Operating income $ 89,048 Provision for income taxes 31,167 Net income $ 57,881

Retained earnings, beginning of year $ 199,961 Retained earnings, end of year $ 257,842

Green Valley Nursing Home, Inc., Balance Sheet, December 31, 2015

Assets Current Assets: Cash $ 105,737 Marketable securities 200,000 Net patient accounts receivable 215,600 Supplies 87,655 Total current assets $ 608,992 Property and equipment $2,250,000 Less accumulated depreciation 356,000 Net property and equipment $1,894,000 Total assets $2,502,992

(continued)

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Liabilities and Shareholders’ Equity

Current Liabilities: Accounts payable $ 72,250 Accrued expenses 192,900 Notes payable 100,000 Current portion of long-term debt 80,000 Total current liabilities $ 445,150 Long-term debt $1,700,000 Shareholders’ Equity: Common stock, $10 par value $ 100,000 Retained earnings 257,842 Total shareholders’ equity $ 357,842 Total liabilities and shareholders’

equity $2,502,992

a. Perform a Du Pont analysis on Green Valley. Assume that the industry average ratios are as follows:

Total margin 3.5% Total asset turnover 1.5 Equity multiplier 2.5 Return on equity (ROE) 13.1%

b. Calculate and interpret the following ratios:

Industry Average Return on assets (ROA) 5.2% Current ratio 2.0 Days cash on hand 22 days Average collection period 19 days Debt ratio 71% Debt-to-equity ratio 2.5 Times interest earned (TIE) ratio 2.6 Fixed asset turnover ratio 1.4

c. Assume that there are 10,000 shares of Green Valley’s stock outstanding and that some recently sold for $45 per share.

(continued from previous page)

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• What is the firm’s price/earnings ratio? • What is its market/book ratio?

(Hint: These ratios are discussed in the supplement to this chapter.)

17.6 Examine the industry average ratios given in problems 17.4 and 17.5. Explain why the ratios are different between the managed care and nursing home industries.

17.7 Recent financial statements for The Heart Hospital are provided below:

The Heart Hospital, Balance Sheet, September 30, 2015 (in thousands)

Current assets: Cash $14,202 Accounts receivable, net 5,918 Medical supplies inventory 1,211 Prepaid expenses and other current

assets 1,429 Total current assets $22,760 Property, plant, and equipment, net $33,769 Other assets 901 Total assets $57,430 Current liabilities: Accounts payable $ 1,910 Accrued compensation and benefits 2,543 Other accrued liabilities 1,843 Current portion of long-term debt 2,064 Total current liabilities $ 8,360 Long-term debt 21,640 Total liabilities $30,000 Owners’ equity $27,430 Total liabilities and owners’ equity $57,430

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The Heart Hospital, Statement of Operations, Year Ended September 30, 2015 (in thousands)

Patient service revenue net of discounts and allowances $66,962

Provision for bad debt ( 2,457) Net patient service revenue $64,505

Operating expenses: Personnel expense $21,707 Medical supplies expense 15,047 Other operating expenses 9,721 Depreciation expense 2,625 Total operating expenses $49,100 Income from operations $15,405 Other income (expenses): Interest expense ($ 1,322) Interest and other income, net 159 Total other income (expenses), net ($ 1,163) Net income $14,242

a. Perform a Du Pont analysis on The Heart Hospital. Assume that the industry average ratios are as follows:

Total margin 15.0% Total asset turnover 1.5 Equity multiplier 1.67 Return on equity (ROE) 37.6%

b. Calculate and interpret the following ratios for The Heart Hospital:

Industry Average Return on assets (ROA) 22.5% Current ratio 2.0 Days cash on hand 85 days Average collection period 20 days Debt ratio 40% Debt-to-equity ratio 0.67 Times interest earned (TIE) ratio 5.0 Fixed asset turnover ratio 1.4

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17.8 Refer to the financial statements for The Heart Hospital in Problem 17.7. Prepare a common size balance sheet (where each account is expressed as a percentage of total assets) and a common size income statement (where each account is expressed as a percentage of total revenues). What do the common size balance sheet and income statement reveal about The Heart Hospital?

(Hint: Common size analysis is illustrated in the supplement to this chapter.)

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