Patton-Fuller Ratio Computation

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, especially

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 interpreting

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 managerial

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 Benchmarking:

A Case Study in Comparative Analysis” uses financial

ratios as indicators of financial position. We highly recommend

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

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. Liquidity

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 current

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

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 represented

in the amount of (unrestricted) cash on hand.

Days Receivables

The days receivables computation is represented as net receivables divided by net credit revenues/

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 national

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 principal

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 longterm

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 divided

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.

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 divided

by unrestricted net assets (i.e., fund balances or net worth) or total debt divided by tangible net worth.

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 somewhat

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 statement

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 operating

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 operating

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) divided

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.