Healthcare Finance Case Study

CHAPTER 29 Mini-Case Study 1: Proposal to Add a Retail Pharmacy to a Hospital in the Metropolis Health System

Sample General Hospital belongs to the Metropolis Health System. The new chief financial officer (CFO) at Sample Hospital has been attempting to find new sources of badly needed revenue for the facility. Consequently, the CFO is preparing a proposal to add a retail pharmacy within the hospital itself. If the proposal is accepted, this would generate a new revenue stream. The CFO has prepared four exhibits, all of which appear at the end of this case study. Exhibit 29–1 , a three-year retail pharmacy profitability analysis, is the primary document. It is supported by Exhibit 29–2 , the retail pharmacy proposal assumptions. The profitability analysis is further supported by Exhibit 29–3 , a year 1 monthly income statement detail. Finally, Exhibit 29–4 presents the supporting year 1 monthly cash flow detail and assumptions.

When the controller reviewed the exhibits, she asked how the working capital of $49,789 was derived. The CFO explained that it represents 3 months of departmental expense. He also explained that the cost of drugs purchased for the first 60 days was offset by these purchases’ accounts payable cycle, so the net effect was 0. In essence, the vendors were financing the drug purchases. Thus, the working capital reconciled as follows:

Working Capital:
Cost of drugs (2 months)	$303,400
Vendor financing (accounts payable)	($303,400)
Departmental expense (3 months)	$49,789
Total Working Capital Required	$49,789

The controller also noticed on Exhibit 29–4 that the cost of renovations to the building is estimated at $80,000 and equipment purchases are estimated at $50,000 for a total capital expenditure of $130,000. The building renovations are depreciated on a straight-line basis over a useful life of 15 years, whereas the equipment purchases are depreciated on a straight-line basis over a useful life of 5 years. The required capital is proposed to be obtained from hospital sources, and no borrowing would be necessary. In addition, the total capital expenditure is projected to be retrieved through operating cash flows before the end of year 1.

Exhibit 29–1 Sample General Hospital 3-Year Retail Pharmacy Profitability Analysis

		Year 1	Year 2	Year 3
Rx Sales		2,587,613	2,692,152	2,828,375
Cost of Goods Sold		2,047,950	2,088,909	2,151,576
Gross Margin		539,663	603,243	676,799
GM %		20.9%	22.4%	23.9%
EXPENSES
Salaries and Wages		192,000	197,760	203,693
Benefits		38,400	39,552	40,739
Materials and Supplies		12,000	14,400	17,280
Contract Services and Fees		14,400	17,280	20,736
Depreciation and Amortization		15,333	15,333	15,333
Interest		—	—	—
Provision for Bad Debts		25,876	26,922	28,284
Misc. Exp.		3,600	4,320	5,184
Total Expense		301,609	315,567	331,248
Net Income		238,053	287,676	345,550
Operating Margin		9.2%	10.7%	12.2%
	Cash Flow
		Year 1	Year 2	Year 3
Sources
Net Income		238,053	287,676	345,550
Depreciation		15,333	15,333	15,333
Borrowing		—	—	—
Total Sources		253,386	303,010	360,884
Uses
Capital Purchasing		130,000	—	—
Working Capital		49,789	—	—
Total Uses		179,789	—	—
Cash at Beginning of Period		—	73,597	376,607
Net Cash Activities		73,597	303,010	360,884
Cash at Ending of Period		73,597	376,607	737,490
	Volume
		Year 1	Year 2	Year 3
Number of Prescriptions Sold		55,350	56,457	58,151

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

Exhibit 29–2 Sample General Hospital Retail Pharmacy Proposal Assumptions

			Prescriptions
1.	Annual Prescription Estimates—Rate of Growth/Capture		Per Day	Annual
	Year 1		225	55,350
	Year 2	2.0%	230	56,457
	Year 3	3.0%	236	58,151
2.	Average Net Revenue per Prescription—Yearly Increases
	Year 1			$ 46.75
	Year 2	2.0%		$ 47.69
	Year 3	2.0%		$ 48.64
3.	Bad Debt Percentage	1.0%
4.	Average Cost per Prescription—Yearly Increases
	Year 1			$ 37.00
	Year 2	3.0%		$ 38.11
	Year 3	3.0%		$ 39.25
5.	Inflation Rates—Per Year
	Salary and Wages			3.0%
	Other Than Prescriptions			2.0%
	Benefits as a % of Salaries			20.0%
6.	Initial Capital Requirements
	Building			80,000
	Equipment			50,000
	Working Capital			49,789
	Total			179,789
		Year 1	Year 2	Year 3
	Gross Margin	539,663	603,243	676,799
	Net Income before Taxes	238,053	287,676	345,550
		Year 1	Year 2	Year 3
	Beginning Cash Balance	—	73,597	376,607
	Net Cash Activity	73,597	303,010	360,884
	Ending Cash Balance	73,597	376,607	737,490

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

Exhibit 29–3 Sample General Hospital Retail PharmacyProposal Year 1 Monthly Income Statement Detail

Exhibit 29–4 Sample General Hospital Retail Pharmacy Proposal Year 1 Monthly Cash Flow Detail and Assumptions

So how was the proposal received by the hospital’s board of trustees? They first asked for a small market study to test the amount of prescription sales projected within the proposal. When