Finance Assignment - Hospital Analysis

Hospital Performance Assessment Case Study

Eastside Memorial Hospital

Hospitals are accredited by JCAHO (Joint Commission on Accreditation of Healthcare Organizations), which is an independent not-for-profit organization sponsored by a number of professional organizations such as the American Hospital Association (AHA) and the American Medical Association (AMA). (For more information on the Joint Commission, visit their Web site at http://www.jcaho.org .) Although accreditation is optional for hospitals, it is generally required to qualify for governmental (Medicare and Medicaid) reimbursement, and hence the vast majority of hospitals apply for accreditation. Eastside passed its latest Joint Commission accreditation with flying colors, receiving an Accreditation with Full Standards Compliance, the highest of eight accreditation categories.

In recent years, competition among the four hospitals in Eastside's service area has been keen, but friendly. However, a large for-profit chain recently purchased the for-profit hospital, which has resulted in some anxiety among the managers of the other three hospitals because of the chain's reputation for aggressively increasing market share in the markets they serve.

Relevant financial and operating data for Eastside are in Tables 1 through 4, and selected industry data are in Tables 5 and 6. (Note: The industry data given in the case are for illustrative purposes only and do not represent actual data for the years specified. For a better idea of the type of comparative data actually available for hospitals, see the Ingenix Web site at http://www.hospitalbenchmarks.com .) In addition, the following information was extracted from the notes section of Eastside's 2006 Annual Report:

· A significant portion of the hospital's net patient service revenue was generated by patients who are covered either by Medicare, Medicaid, or other government programs as well as by various private plans, including managed care plans, which operate according to hospital contracts that specify discounts from charges. In general, the proportional amount of deductions is similar between inpatients and outpatients. The gross/net revenue breakdown for both inpatient and outpatient services is given below (in millions of dollars):

	2002	2003	2004	2005	2006
Gross patient service revenue
Inpatient	25.16	25.275	26.117	29.148	33.216
Outpatient	4.748	5.969	6.535	9.130	11.912
Gross patient revenue	29.908	31.244	32.652	38.278	45.128
Revenue deductions
Contractual allowances	2.489	2.053	1.729	5.196	7.516
Charity care	1.759	1.955	2.127	2.506	3.030
Total deductions	4.248	4.008	3.856	7.702	10.546
Net patient service revenue	25.661	27.236	28.796	30.576	34.582

· Inventories are stated at the lower of cost, determined on a first-in, first-out basis, or market value.

· The breakdown of operating expenses between inpatient and outpatient activities for 2002 through 2006 is as follows (in millions of dollars):

	2002	2003	2004	2005	2006
Inpatient expenses	18.635	19.221	20.573	22.229	24.771
Outpatient expenses	5.621	6.062	6.831	8.098	9.187
Total operating expenses	23.896	25.283	27.404	30.327	33.958

· Eastside has a contributory money accumulation (defined contribution) pension plan, which substantially covers all its employees. Participants can contribute up to 20 percent of earnings to the pension plan. The hospital matches on a dollar-for-dollar basis employee contributions of up to 2 percent of wages, and it pays 50 cents on the dollar for contributions over 2 percent and up to 4 percent. Because the plan is a defined contribution plan (as opposed to a defined benefit plan), there are no unfunded pension liabilities. Pension expense was approximately $0.543 million in 2005 and $0.588 million in 2006.

· The hospital is a member of the State Hospital Trust Fund under which it purchases professional liability insurance coverage for individual claims up to $1 million (subject to a deductible of $100,000 per claim). Eastside is self-insured for amounts above $1 million, but less than $5 million. Any liability award in excess of $5 million is covered by a commercial liability policy; for example, the policy pays $2 million on a $7 million award. The hospital is currently involved in eight suits involving claims of various amounts that could ultimately be tried before juries. Although it is impossible to determine the exact potential liability in these claims, management does not believe that the settlement of these cases has a material effect on the hospital's financial position.

Assume that you have just joined the staff of Eastside Memorial Hospital as assistant administrator. On your first day on the job, Melissa Randolph, the administrator, assigns you with the task of conducting a thorough financial and operating analysis. Although you also believe that an analysis is a good way to begin, you wonder whether Melissa has ulterior motives. Perhaps the hospital is having problems and she thinks that you can spot them or perhaps she wants to test your analytical skills. Melissa is from the “old school” of hospital management and is looking for someone to bring modern management methods to the hospital. In any event, she has already scheduled a financial performance analysis presentation for the next board of trustees meeting so that you can meet the other board members. To help you structure your presentation, Melissa has suggested the following points:

· Interpret the hospital's statements of cash flows.

· Present an overview of the hospital's financial position using the Du Pont equation as a guide.

· Use ratio analysis to identify the hospital's financial strengths and weaknesses.

· Use operating analysis to identify the operational factors that explain the hospital's current financial condition.

· Summarize your evaluation of the hospital's financial condition. However, don't just rehash numbers; rather, present your views on the potential underlying economic and managerial factors that might have caused any problems that surfaced in the financial and operating analysis.

· Finally, make recommendations that you believe Eastside must follow to ensure future financial soundness.

In preparing for the presentation, several relevant factors come to light. First, in reviewing policy decisions made by Eastside's board of trustees over the past decade, you note that in 2001 the board made the decision to significantly expand the hospital's outpatient services. The rationale is that many procedures historically based on inpatient data, are now conducted in an outpatient setting. If Eastside did not offer such services it stood to lose patients to other providers. Furthermore, according to consensus outpatient services were more profitable than inpatient services.

Second, you discover an AHA publication that identifies six ratios believed to be critical financial indicators. (For more information on the AHA, visit their Web site at http://www.aha.org. Note in particular the studies and statistics that are available, especially those that provide financial benchmark information.) Table 7 provides information on the six critical financial indicators. You must plan to include these indicators in your analysis and presentation.

Finally, the day before you make your presentation, Melissa catches you in the hallway. In addition to asking if you are ready to go, she asks whether or not management should be concerned about the hospital's annual economic value added (EVA) performance. Apparently, she just read an article in Fortune that discusses this measure of managerial performance. (For more information on EVA, as well as market value added (MVA), see the Stern Stewart & Co. Web site at http://www.eva.com/ny/ .) As she is leaving for a meeting, Melissa says, "By the way, our overall (corporate) cost of capital is 10 percent." You aren't quite sure why she passes that information on to you, but you jot it down, just in case.

Table 1: Eastside Memorial Hospital: Statements of Operations (millions of dollars)
	2002	2003	2004	2005	2006
Revenues
Net patient service revenue	25.661	27.236	28.796	30.576	34.582
Other revenue	1.305	1.261	1.237	1.853	1.834
Total revenues	26.966	28.497	30.033	32.429	36.416
Expenses
Salaries and wages	10.829	11.135	12.245	12.468	13.994
Fringe benefits	1.496	1.731	1.830	2.408	2.568
Interest expense	1.341	1.305	1.181	1.598	1.776
Depreciation	1.708	1.977	2.350	2.658	2.778
Provision for bad debts	0.546	0.589	0.622	0.655	0.776
Professional liability	0.102	0.157	0.140	0.201	0.218
Other	7.874	8.389	9.036	10.339	11.848
Total expenses	23.896	25.283	27.404	30.327	33.958
Revenue excess over expenses	3.070	3.214	2.629	2.102	2.458

Table 2: Eastside Memorial Hospital: Balance Sheets (millions of dollars)
	2002	2003	2004	2005	2006
Assets
Cash and investments	3.513	5.799	4.673	5.069	2.795
Accounts receivable (net)	5.195	4.832	4.359	5.674	7.413
Inventories	0.338	0.403	0.432	0.523	0.601
Other current assets	0.693	0.294	0.308	0.703	0.923
Total current assets	10.459	11.328	9.772	11.969	11.732
Gross plant and equipment	37.999	42.005	47.786	55.333	59.552
Accumulated depreciation	8.831	10.092	11.820	14.338	17.009
Net plant and equipment	29.168	31.913	35.966	40.996	42.543
Total assets	39.627	43.241	45.738	52.964	54.275
Liabilities and Net Assets
Accounts payable	1.068	1.273	0.928	1.253	1.760
Accruals	1.085	1.311	1.804	1.823	1.473
Current portion of LT debt	0.136	0.290	0.110	1.341	1.465
Total current liabilities	2.289	2.874	2.842	4.417	4.698
Long-term debt	15.959	15.775	15.673	19.222	17.795
Net assets	21.379	24.592	27.223	29.325	31.782
Total liabilities and net assets	39.627	43.241	45.738	52.964	54.275

Table 3: Eastside Memorial Hospital: Statements of Cash Flows (millions of dollars)
	2003	2004	2005	2006
Cash Flows from Operating Activities
Income from operations	3.214	2.629	2.102	2.458
Non-cash expenses	1.952	2.326	2.633	2.756
Decrease (increase) in net working capital (except cash)	2.026	0.423	0.202	1.733
Net cash flow from operations	7.192	5.378	4.533	3.481
Cash Flows from Investing Activities
Fixed asset acquisitions	4.722	6.402	7.687	4.327
Cash Flows from Financing Activities
Increase (decrease) in long-term debt	0.184	0.102	3.550	1.428
Net increase (decrease) in cash	2.286	1.126	0.396	2.274
Beginning cash and investments	3.513	5.799	4.673	5.069
Ending cash and investments	5.799	4.673	5.069	2.795
Note: The non-cash expenses and fixed assets acquisition data in the statements of cash flows are somewhat different than they would be if calculated directly from the other financial statements because of asset revaluations.

Table 4: Eastside Memorial Hospital: Selected Operating Data
	2002	2003	2004	2005	2006
Medicare discharges	3,008	2,960	2,721	2,860	2,741
Total discharges	9.680	9,311	8,784	8,318	8,576
Outpatient visits	30,754	31,960	32,285	32,878	36,796
Licensed beds	210	210	210	210	210
Staffed beds	192	196	193	197	178
Patient days	45,296	45,983	44,085	42,434	40,062
Case mix index	1.2531	1.2674	1.2869	1.2993	1.3161
Full-time equivalents	604.5	618.1	610.8	625.8	619.3

Table 5: Eastside Memorial Hospital: Selected Industry Financial Data
	2006 Industry Data (200 - 299 beds)
	+Quartile	Median	−Quartile
Profitability Ratios
Deductible ratio*	0.34	0.26	0.18
Profit (total margin)	5.58%	3.48%	0.53%
Return on assets	5.80%	3.10%	0.40%
Return on equity	15.66%	6.01%	0.62%
Liquidity Ratios
Current ratio	2.53	1.99	1.48
Days cash on hand	32.35	15.89	6.24
Debt Management Ratios
Debt ratio	62.90%	48.40%	35.20%
Long – term debt to equity	127.00%	64.70%	26.90%
Times interest earned	4.29	2.23	1.14
Fixed charge coverage	2.18	1.35	1.02
Cash flow coverage	5.32	3.22	1.76
Asset Management Ratios
Inventory turnover	98.68	63.95	43.99
Current asset turnover	3.94	3.38	2.88
Fixed asset turnover	2.20	1.76	1.49
Total asset turnover	1.04	0.89	0.75
Average collection period (days)	87.53	75.67	63.33
Average payment period (days)	71.24	56.52	45.84
Other Ratios
Average age of plant (years)	8.86	7.39	6.14
Profit per discharges	89.04	21.30	120.08
Profit per visit'	6.22	0.66	7.01
Net Price Indicators
Net price per discharge	4,091	3,411	2,815
Net price per visit	201	139	98
Medicare payment percentage	43.47%	36.60%	31.25%
Bad debt/charity percentage	7.89%	4.76%	2.97%
Contractual allowance	25.27%	20.02%	12.12%
Outpatient revenue%	25.26%	21.03%	17.44%
Volume Indicators
Occupancy rate	67.12%	58.10%	47.84%
Average daily census	173.23	144.73	114.39
Length of Stay Indicators
Average length of stay (days)	6.80	6.07	5.41
Adjusted length of stay	6.48	5.36	4.52
Note: * Deductions/Gross patient service revenue The industry data shown here are for illustration purposes only and hence should not be used outside this case. The upper quartile is based on the higher numerical value for the ration and the lower quartile the lower numerical value, regardless of whether a high value is good or bad. The interpretation is left to the analyst.

Table 6: Eastside Memorial Hospital: Selected Industry Operating Data
	2006 Industry Data (200 - 299 beds)
	+Quartile	Median	−Quartile
Intensity of Service Indicators
Cost per discharge	3,937	3,392	2,972
Adjusted cost per discharge	3,417	2,924	2,572
Cost per visit	202.23	141.97	111.53
Case mix index	1.2795	1.1756	1.0259
Efficiency Indicators
FTEs per occupied bed	4.59	4.15	3.77
Outpatient man-hours per visit	4.68	5.84	8.66
Unit Cost Indicators
Salary per FTE	24,447	22,517	20,347
Employee benefits percentage	19.58%	17.04	15.18
Liability costs per discharge	80.94	42.05	18.31

Table 7: Eastside Memorial Hospital: AHA Critical Financial Indicators
	Very Poor	Poor	Good	Excellent
Cash Flow to Net Patient Service Revenue Cash flow is defined as net income plus depreciation /amortization expense.	9.6% or less 30.7%	9.6% to 12.3% 25.3%	12.3% to 15.6% 25.5%	15.6% or more 18.5%
Cash Flow to Total Liabilities Cash flow is defined as net income plus depreciation/amortization expense, and total liabilities represent everything on the right side of the balance sheet except equity.	15.8% or less 31.4%	15.8% to 23.3% 24.0%	23.3% to 32.4% 22.6%	32.4% or more 22.0%
Return to Total Revenue (Total Margin) This ratio is net income divided by total revenues.	3.5% or less 28.6%	3.8% to 6.3% 26.7%	6.0% to 9.0% 26.1%	9.0% or more 18.6%
Return to Patient Service Revenue This ratio is net income divided by net patient service revenue.	3.8% or less 28.6%	3.8% to 6.3% 26.7%	6.3% to 9.2% 26.3%	9.2% or more 18.4%
Case Mix Index This value measures the general level of complexity of services offered. The theory is that a higher case mix index means better use of technology.	1.27 or less 28.7%	1.27 to 1.42 27.5%	1.42 to 1.65 25.9%	1.65 or more 17.9%
Age of Plant and Equipment This measure (in years) is approximated by dividing accumulated depreciation by depreciation expense.	9.5 or more 26.2%	8.1 to 9.5 29.6%	7.1 to 8.1 20.7%	7.1 or less 23.5%
Note: The first line of the comparative data gives the ratio values for four rating categories, while the second line gives the percentage of hospitals that fall into each category.