Accounting Worksheet

115

Financial and Operating Ratios as

Performance Measure s

11 C H A P T E R

THE IMPORTANCE OF RATIOS

Ratios are convenient and uniform measures that are widely adopted in healthcare financial management. They are important because they are so widely used, es- pecially because they are used for credit analysis. But a ratio is only a number. It has to be considered within the context of the operation. There is another caveat: ratio analysis should be conducted as a comparative analysis. In other words, one ratio standing alone with nothing to compare it with does not mean very much. When inter- preting ratios, the differences between periods must be considered, and the reasons for such differences should be sought. It is a good practice to compare results with equivalent computations from outside the organization— regional figures from similar institutions would be a good example of such outside sources. Caution and good man- agerial judgment must always be exercised when working with ratios.

Financial ratios basically pull together two elements of the financial statements: one expressed as the numerator and one as the denominator. To calculate a ratio, divide the bottom number (the denominator) into the top number (the numerator). The Case Study in Appendix 25-A entitled “Using Financial Ratios and Benchmark- ing: A Case Study in Comparative Analysis” uses financial ratios as indicators of financial position. We highly rec- ommend that you spend time with this Case Study, as it will add depth and background to the contents of this chapter.

In this chapter we examine liquidity, solvency, and profitability ratios. Exhibit 11-1 sets out eight basic ratios

After completing this chapter, you should be able to

1. Understand four types of liquidity ratios.

2. Understand two types of solvency ratios.

3. Understand two types of profitability ratios.

4. Successfully compute ratios.

P r o g r e s s N o t e s

116 CHAPTER 11 Financial and Operating Ratios as Performance Measures

Exhibit 11–1 Eight Basic Ratios Used in Health Care

Liquidity Ratios

1. Current Ratio

Current Assets

Current Liabilities

2. Quick Ratio

Cash and Cash Equivalents + Net Receivables

Current Liabilities

3. Days Cash on Hand (DCOH)

Unrestricted Cash and Cash Equivalents

Cash Operation Expenses ÷ No. of Days in Period (365)

4. Days Receivables

Net Receivables

Net Credit Revenues ÷ No. of Days in Period (365)

Solvency Ratios

5. Debt Service Coverage Ratio (DSCR)

Change in Unrestricted Net Assets (net income) + Interest, Depreciation, Amortization

Maximum Annual Debt Service

6. Liabilities to Fund Balance

Total Liabilities

Unrestricted Fund Balances

Profitability Ratios

7. Operating Margin (%)

Operating Income (Loss)

Total Operating Revenues

8. Return on Total Assets (%)

EBIT (Earnings before Interest and Taxes)

Total Assets

Courtesy of Resource Group, Ltd., Dallas, Texas.

that are widely used in healthcare organizations: four liquidity types, two solvency types, and two profitability types. All are discussed later.

LIQUIDITY RATIOS

Liquidity ratios reflect the ability of the organization to meet its current obligations. Li- quidity ratios measure short-term sufficiency. As the name implies, they measure the ability of the organization to “be liquid”: in other words, to have sufficient cash—or assets that can be converted to cash—on hand.

Current Ratio

The current ratio equals current assets divided by current liabilities. For instance, consider this example

Current Assets �

$120,000 � 2 to 1

Current Liabilities $60,000

This ratio is considered to be a measure of short-term debt-paying ability. However, it must be carefully interpreted. The standard by which the current ratio is measured is 2 to 1, as computed previously.

Quick Ratio

The quick ratio equals cash plus short-term investments plus net receivables divided by cur- rent liabilities. In our example

Cash and Cash Eqivalents � Net Receivables �

$65,000 � 1.08 to 1

Current Liabilities 60,000

The standard by which the quick ratio is measured is generally 1 to 1. This computation, at 1.08 to 1, is a little better than the standard.

This ratio is considered to be an even more severe test of short-term debt-paying ability (even more than the current ratio). The quick ratio is also known as the acid-test ratio for obvious reasons.

Days Cash on Hand

The days cash on hand (DCOH) equals unrestricted cash and investments divided by cash operating expenses/365. In our example

Unrestricted Cash and Cash Equivalents �

$330,000 � 30 days

Cash Operating Expenses $11,000 � No. of Days in Period

Liquidity Ratios 117

118 CHAPTER 11 Financial and Operating Ratios as Performance Measures

There is no concrete standard for this computation. This ratio indicates cash on hand in relation to the amount of daily operating expense.

This example indicates the organization has 30 days worth of operating expenses repre- sented in the amount of (unrestricted) cash on hand.

Days Receivables

The days receivables computation is represented as net receivables divided by net credit rev- enues/365. In our example

Net Receivables �

$720,000 � 60 days

Net Credit Revenue/No. of Days in Period $12,000

This computation represents the number of days in receivables. The older a receivable is, the more difficult it becomes to collect. Therefore, this computation is a measure of worth as well as performance.

There is no hard and fast rule for this computation because much depends on the mix of payers in your organization. This example indicates that the organization has 60 days worth of credit revenue tied up in net receivables. This computation is a common measure of billing and collection performance. There are many “days receivables” regional and na- tional figures to compare with your own organization’s computation.

Figure 11-1 shows how the information for the numerator and the denominator of each calculation is obtained. It takes the Westside Clinic balance sheet and the statement of revenue and expense that were discussed in the preceding chapter and illustrates the source of each figure in the four ratios just discussed. The multiple computations for days cash on hand and for days receivables are further broken down into a three-step process. If you study Figure 11-1 and work with the Appendix 25-A Case Study, you will own this process.

SOLVENCY RATIOS

Solvency ratios reflect the ability of the organization to pay the annual interest and princi- pal obligations on its long-term debt. As the name implies, they measure the ability of the organization to “be solvent”: in other words, to have sufficient resources to meet its long- term obligations.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) is represented as change in unrestricted net assets (net income) plus interest, depreciation, and amortization divided by maximum annual debt service. In our example

Change in Unrestricted Net Assets (Net Income) � Interest, Depreciation, and Amortization

� $250,000

� 2.5 Maximum Annual Debt Service $100,000

This ratio is universally used in credit analysis and figures prominently in the Mini-Case Study.

Each lending institution has its particular criteria for the DSCR. Lending agreements often have a provision that requires the DSCR to be maintained at or above a certain figure.

Liabilities to Fund Balance (or Debt to Net Worth)

The liabilities to fund balance or net worth computation is represented as total liabilities di- vided by unrestricted net assets (i.e., fund balances or net worth) or total debt divided by tangible net worth. In our example

Solvency Ratios 119

Figure 11–1 Examples of Liquidity Ratio Calculations. Courtesy of Resource Group, Ltd, Dallas, Texas.

Assets December 31, 20X2 Current Assets

Cash and cash equivalents $190,000 Accounts receivable (net) 250,000 Inventories 25,000 Prepaid Insurance 5,000

Total Current Assets $470,000

Property, Plant, and Equipment Land $100,000 Buildings (net) 0 Equipment (net) 260,000 Net Property, Plant, and Equipment 360,000

Other Assets Investments $133,000

133,000 Total Other Assets

Total Assets $963,000

Liabilities and Fund Balance Current Liabilities

Current maturities of long-term debt $52,000 Accounts payable and accrued expenses 293,000 Total Current Liabilities $345,000

Long-Term Debt $252,000 Less Current Maturities of Long-Term Debt (52,000) Net Long-Term Debt 200,000

Total Liabilities $545,000

Fund Balances Unrestricted fund balance $418,000 Restricted fund balance 0 Total Fund Balances 418,000

Total Liabilities and Fund Balance $963,000

For the Year Ending Revenue December 31, 20X2 Net patient service revenue $2,000,000

Total operating revenue $2,000,000

Operating Expenses Medical/surgical services $600,000 Therapy services 860,000 Other professional services 80,000 Support services 220,000 General services 65,000 Depreciation 40,000 Interest 20,000 Total operating expenses $1,885,000

Income from Operations $115,000

Nonoperating Gains (Losses) Interest Income $5,000

Net nonoperating gains 5,000

Revenue and Gains in Excess of Expenses and Losses $120,000

Increase in Unrestricted Fund Balance $120,000

470,000 345,000 = 1.362

Current Assets Current Liabilities

1. Current Ratio

Step 2

1,845,000 365

= 5,055

Step 3

190,000 5,055

= 37.5 days

Step 1

1,885,000 (40,000)

1,845,000

190,000 + 250,000 345,000 = 1.275

Cash and Cash Equivalent + Net Receivables Current Liabilities

2. Quick Ratio

3. Days Cash on Hand (DCOH)

Unrestricted Cash and Cash Equivalents Cash Operating Expenses divided by # days in period (365)

Step 2

1,800,000 365

= 4,931

Step 3

250,000 4,931

= 50.7 days

Step 1

2,000,000 × 90%

1,800,000 4. Days Receivables

Net Receivables Net Credit Revenue divided by # days in period (365)

Percent of Credit Revenues Information obtained elsewhere

Statement of Revenue and Expenses

Balance Sheet

120 CHAPTER 11 Financial and Operating Ratios as Performance Measures

Total Liabilities �

$2,000,000 � .80

Unrestricted Fund Balances $2,250,000

This figure is a quick indicator of debt load. Another indicator that is more severe is long-term debt to net worth (fund balance),

which is computed as long-term debt divided by fund balance. This computation is some- what equivalent to the quick ratio discussed previously here in its restrictiveness to net worth computation.

A mirror image of total liabilities to fund balance is total assets to fund balance, which is computed as total assets divided by fund balance.

Figure 11-2 shows how the information for the numerator and the denominator of each calculation is obtained. This figure again takes the Westside Clinic balance sheet and state- ment of revenue and expense that were discussed in the preceding chapter and illustrates the source of each figure in the two solvency ratios just discussed, along with each figure in the two profitability ratios still to be discussed. When multiple computations are necessary, they are further broken down into a two-step process.

PROFITABILITY RATIOS

Profitability ratios reflect the ability of the organization to operate with an excess of oper- ating revenue over operating expense. Nonprofit organizations may not call this result a profit, but the measurement ratios are still generally called profitability ratios, whether they are applied to for-profit or nonprofit organizations.

Operating Margin

The operating margin, which is generally expressed as a percentage, is represented as op- erating income (loss) divided by total operating revenues. In our example

Operating Income (Loss) �

$250,000 � 5.0%

Total Operating Revenues $5,000,000

This ratio is used for a number of managerial purposes and also sometimes enters into credit analysis. It is therefore a multipurpose measure. It is so universal that many outside sources are available for comparative purposes. The result of the computation must still be carefully considered because of variables in each period being compared.

Return on Total Assets

The return on total assets is represented as earnings before interest and taxes (EBIT) di- vided by total assets. In our example

EBIT �

$400,000 � 10%

Total Assets $4,000,000

This is a broad measure in common use. Note the acronym EBIT, as its use is widespread in credit analysis circles. (Some analysts use an alternative computation for Return on Total Assets. They compute this ratio as Net Income divided by Total Assets.)

This concludes the description of solvency and profitability ratios. Again, if you study Figure 11-2 and work with the Appendix 25-A Case Study, you will own this process too.

Profitability Ratios 121

Figure 11–2 Examples of Solvency and Profitability Ratio Calculations. Courtesy of Resource Group, Ltd, Dallas, Texas.

Balance Sheet

Assets December 31, 20x2

Current Assets $190,000 Accounts receivable (net) 250,000 Inventories 25,000 Prepaid Insurance 5,000 Total Current Assets $470,000

Property, Plant and Equipment Land $100,000 Buildings (net) 0 Equipment (net) 260,000 Net Property, Plant and Equipment 360,000

Other Assets Investments $133,000

133,000 Total Other Assets

Total Assets $963,000

Liabilities and Fund Balance Current Liabilities

Current maturities of long-term debt $52,000 Accounts payable and accrued expenses 293,000 Total Current Liabilities $345,000

Long-term Debt $252,000 Less current maturities of long-term debt -52,000 Net Long-term Debt 200,000

Total Liabilities $545,000

Fund Balances Unrestricted fund balance $418,000 Restricted fund balance 0 Total Fund Balances 418,000

Total Liabilities and Fund Balance $963,000

Statement of Revenue and Expenses

For the Year Ending

Revenue December 31, 20x2

Net patient service revenue $2,000,000

Total operating revenue $2,000,000

Operating Expenses Medical/surgical services $600,000 Therapy services 860,000 Other professional services 80,000 Support services 220,000 General services 65,000 Depreciation 40,000 Interest 20,000

Total operating expenses 1,885,000

Income from Operations $115,000

Nonoperating Gains (Losses) Interest Income $5,000 Net nonoperating gains 5,000

Revenue and Gains in Excess of Expenses and Losses $120,000

Increase in Unrestricted Fund Balance $120,000

Step 1 5. Return on Total Assets (%)

120,000 20,000

140,000

Step 2

140,000 963,000

= 14.54%

6. Operating Margin (%) 115,000

2,000,000 5.75%

7. Liabilities to Fund Balance 545,000 418,000 = 1.304

Step 1 8. Debt Service Coverage Ratio (DSCR)

120,000 20,000 40,000

180,000

Step 2

180,000 Maximum Annual Debt Service 72,000 Information derived elsewhere

= 2.5

IT (Earnings Before Interest and Taxes) Total Assets

Operating Income (Loss) Total Operating Revenues

Total Liabilities Unrestricted Fund Balance

Change in Unrestricted Net Assets (net income) plus Depreciation-Amortization

plus Interest Maximum Annual Debt Service

122 CHAPTER 11 Financial and Operating Ratios as Performance Measures

INFORMATION CHECKPOINT

What Is Needed? Reports that use ratios as measures. Where Is It Found? Possibly in your supervisor’s file; in the administrator’s of-

fice; in the chief executive officer’s office. How Is It Used? Use as a measure against outside benchmarks (as discussed

in this chapter); also use as internal benchmarks for de- partments/divisions/units; also use as benchmarks at various points over time.

KEY TERMS

Current Ratio Days Cash on Hand (DCOH) Days Receivables Debt Service Coverage Ratio (DSCR) Liabilities to Fund Balance Liquidity Ratios Operating Margin Profitability Ratios Quick Ratio Return on Total Assets Solvency Ratios

DISCUSSION QUESTIONS

1. Are there ratios in the reports you receive at your workplace? 2. If so, do you use them? How? 3. If not, do you believe ratios should be on the reports? Which reports? 4. Can you think of good outside sources that could be used to obtain ratios for com-

parative purposes? If the outside information was available, what ratios would you choose to use? Why?