Evaluation of Financial Performance 3 .Eric Hood/iStock/Thinkstock Learning Outcomes By the end of this chapter, you will be able to: • Identify the steps necessary to evaluate financial performance • Describe and calculate profitability measures • Explain and calculate liquidity measures • Identify and calculate leverage measures • Recall and calculate measures to better understand general positions and operational efficiency • Describe the purpose of trend analysis • Discuss the limitations of financial and operating ratios smi81240_03_c03_059-094.indd 59 3/7/14 9:31 AM Section 3.1 Financial Performance Evaluations Introduction Middaugh United Hospital is a 218-bed hospital that has recently become part of a multihospital system. Management is concerned about their financial performance in general, as well as how it compares to the other hospitals in the system. Even though they are regarded as a well-managed community hospital, Middaugh has lost nearly $9 million on operations in the last two years. At the same time, Middaugh has earned nearly $20 million on financial investments and earned $14 million in positive cash flows. Will the system view Middaugh as profitable? On a more personal note, Brian Craig, the president of Middaugh, and other senior managers are concerned whether they will be able to keep their positions if profits remain at unacceptable levels, and what other measures of financial performance will be important to the system. Monitoring and evaluating financial performance is an essential role for management and governance of an organization. To be effective in this role, it is important to understand how financial performance might be monitored, what decisions must be made in the evaluation process, and how to assess the outcomes. In this chapter, the steps in the financial evaluation process are presented, along with a host of available measures. 3.1 Financial Performance Evaluations Preparation of financial statements that accurately depict the financial status of an organization at a point in time and how its status has changed over the most recent accounting period is the end result of the financial accounting process. Having the financial statements in hand is then the start of the process of evaluating financial performance. Is the organization profitable? Is it able to pay its bills? How efficiently does the organization use its assets? These are all questions that managers and interested parties want to have answered about healthcare organizations. Analysis of financial statements can provide answers to these types of questions and facilitate an informed evaluation of the organization. Any evaluation process takes at least three steps: selecting performance measures, setting standards, and calculating and interpreting results. Selecting performance measures provides a clear indication of what is being evaluated and how. A clear indication of performance measures will leave little doubt as to what is viewed as important in the management of an organization. Standards indicate the values that performance measures are expected to achieve. Calculation involves the use of financial statements and other sources of data to determine values of the performance measures for comparison against chosen standards. Step One: Selecting Performance Measures With regards to a financial evaluation, one must select the aspects of performance that will be evaluated and the values or indicators of those aspects of performance. The four aspects of financial performance that are routinely selected are profitability, liquidity, leverage, and activity, each of which is presented in this chapter. Financial statements can provide specific values of selected measures of each aspect of performance. In the case of profitability, financial statements provide values for operating income, net income, and net cash flows. There are also limitations to the information contained in financial statements. Financial statements can only provide indicators of financial performance for some measures. For example, in the 60 smi81240_03_c03_059-094.indd 60 3/7/14 9:31 AM Section 3.1 Financial Performance Evaluations case of liquidity, financial statements provide values for current assets and current liabilities. The comparison of available assets during the year, with liabilities that must be paid within the year provides a general indication of whether the organization will have sufficient resources. It does not indicate whether the organization will actually have cash available on the day a specific debt must be paid. Step Two: Setting Standards The second step in evaluation is setting standards. Once a value or indicator of financial performance has been selected, how do we determine whether the result is good or bad? The development of standards can arise from internal and external sources. Internal sources often begin by comparing current performance with past performance. If the level of current assets is higher this year than last year, it is a positive sign. If the level of current assets, as compared to the level of current liabilities, is higher this year than last year, it would be an even better sign of performance. Still, if the level of current assets was evaluated as being too low last year and therefore bad, what increase would be required to result in an evaluation of being good? Comparing current performance with past performance provides important information about relative performance (better or worse), but it does not provide information on absolute performance (good or bad). Another internal source would be target levels of financial performance established in the budgeting process. As will be discussed in depth in later chapters, a budget is a plan and forecast of future financial performance. Establishing internal standards for the definition of good performance during the budget process, and then comparing actual results to budgeted results, is a sound financial management practice. Achieving the financial performance presented in the budget is usually considered to be at least an acceptable result for an organization. Comparing current measures of financial performance against last year’s measures, as well as the forecast of these measures presented in the budget, is a good use of internal standards for evaluating financial performance. There are also external sources of standards for evaluating financial performance. The financial performance of similar types of healthcare organizations is a commonly used external source. Comparing the financial performance of one hospital against the average performance of others allows for consideration of factors that affect all hospitals, like changes in Medicare payment policy (affecting patient services revenues) and changes in the stock market (affecting investment earnings). Beyond using the average financial performance of similar types of healthcare organizations, one could develop standards based on the financial performance of a specific set of healthcare organizations. Making comparisons against a specific set of healthcare organizations is called benchmarking. Benchmarking is often accomplished by obtaining the financial statement of another healthcare organization. Many commercial firms collect financial statements from firms in the healthcare industry for the purposes of benchmarking. American Hospital Data collects Medicare Cost Reports for all hospitals and makes them available on a subscription basis (http://www.AHD.com). Benchmarking is often used to develop internal standards for financial performance. Sources of information on the financial performance of other healthcare organizations include the annual assessments by rating agencies. Rating agencies, including Moody’s, Standard & Poor’s, and Fitch, perform financial evaluation of organizations and provide grades on their credit worthiness. Individuals, banks, and companies that may loan money to organizations will use these grades. In annual assessments, rating agencies provide statistics on the average levels 61 smi81240_03_c03_059-094.indd 61 3/7/14 9:31 AM Section 3.1 Financial Performance Evaluations From the Front Lines We are a regional system, residing within a larger system. Our goal is to have enough cash associated with the local entity so that it is not necessary for us to use system cash. The system’s target cash on hand is currently 200 days and will be 220 days by the end of 2014. Source: Health system chief executive officer. of financial performance achieved by organizations in an industry, as well as performance levels achieved by grade level. Using statistics on financial performance at a specific grade level is one type of benchmarking. In addition to the information on financial performance prepared by rating agencies, many states require reporting of financial performance and make these data available to consumers. California’s Office of Statewide Health Planning & Development, Massachusetts’s Center for Health Information and Analysis, and the State of Washington’s Department of Health are three such sources. Step Three: Calculating and Interpreting Results The third step in evaluation is the calculation of selected measures, the comparison against standards, and the interpretation of results. For organizations that choose internal standards, the calculations and comparisons can occur immediately after the financial statements are prepared and are available for use internally. For comparisons against external standards, organizations often have to wait until other organizations have also prepared their financial statements and made them available for use by others. The interpretations of results and the decision making that follows are the key contributions of persons involved with financial performance evaluation. In most cases, indicating whether performance has improved or gotten worse is straightforward. Making an indication of whether performance is good or in need of improvement is highly dependent upon the selection of appropriate standards. If the board of directors or senior management selects standards that are too low, the organization may not be sufficiently challenged to improve. If the standards are too high, an appearance of failure may be inevitable. Further, many measures of financial performance are only indicators of an issue that requires further analysis. The interpretations of financial performance evaluations often involve raising new questions requiring deeper analysis before sound decisions can be made. This chapter focuses on evaluating financial performance through financial statement analysis. The financial statements are an excellent source of information for measures and indicators of profitability, liquidity, leverage, and operational efficiency. Some cautions about the use of financial measures are also offered, along with new ways in which measures are being employed by healthcare organizations. For Review: 1. Why do organizations evaluate financial performance? Organizations evaluate financial performance to gain a clear understanding of their financial position at a point in time and of their change in financial position over the accounting period. Organizations can make better decisions if they understand if their performance is good or bad, and getting better or worse. 62 smi81240_03_c03_059-094.indd 62 3/7/14 9:31 AM Section 3.2 Profitability 3.2 Profitability Evaluation of the financial performance of healthcare organizations starts with information presented on formal financial statements. Although evaluations may need to go further, financial statements present information that has known properties, like following generally accepted accounting principles that make analyses comparable across organizations and consistent over time. For the purposes of providing clear examples of measures of financial performance, the three main financial statements of Middaugh United Hospital are presented as Exhibits 3.1–3.3. Exhibit 3.1 Balance sheet, Middaugh United Hospital 2012 2011 Assets Cash and cash equivalents Patient accounts receivable (net of allowance for Doubtful Accounts of $7,858,408 in 2012 and $8,027,386 in 2011) Inventories Other current assets Total current assets 15,429,906 3,325,377 7,654,268 $123,317,688 17,659,500 3,580,350 2,436,606 $113,395,220 Property, plant, and equipment (Accumulated depreciation) Net property, plant, and equipment Other long-term assets Total long-term assets Total assets $264,441,622 (169,807,310) 94,634,312 13,576,660 $108,210,972 $243,019,946 $257,605,927 (158,447,786) 99,158,141 14,858,818 $114,016,959 $237,774,962 $16,216,745 5,877,895 1,469,474 $23,564,114 $15,318,329 5,082,771 12,715,004 $33,116,104 Assets limited as to use Liabilities Accounts payable Accrued payroll-related liabilities Other accrued liabilities Total current liabilities Long-term debt Total liabilities Net assets Total liabilities and net assets Source: Author’s calculations. $96,908,137 $11,491,286 $89,718,764 $10,362,783 $69,097,240 $92,661,354 $63,342,742 $96,458,846 $150,358,592 $243,019,946 $141,316,116 $237,774,962 63 smi81240_03_c03_059-094.indd 63 3/7/14 9:31 AM Section 3.2 Profitability Exhibit 3.2 Income statement, Middaugh United Hospital Revenues Inpatient revenue Outpatient revenue Total patient revenue (Less bad debts) Total operating revenues Expenses Salaries and wages Fringe benefits Contract labor Depreciation expense Interest expense Other operating expenses Total operating expenses Net operating income (loss) Net nonoperating revenues Net income Source: Author’s calculations. 2012 2011 $92,267,833 113,153,751 205,421,584 (9,487,421) $195,934,163 $88,728,102 110,805,931 199,534,033 (9,927,548) $189,606,485 $68,764,520 17,191,130 12,658,204 4,823,520 2,441,896 96,006,040 $201,885,310 ($5,951,147) 14,231,564 $8,280,417 $67,775,556 16,266,133 10,321,085 4,882,967 2,521,819 90,731,330 $192,498,890 ($2,892,405) 16,955,528 $13,877,200 Exhibit 3.3 Statement of cash flows, Middaugh United Hospital Net income Change in: Depreciation Accounts receivable Inventories Other current assets Accounts payable Accrued payroll/related liabilities Other accrued liabilities Net cash provided (used) by operations Cash flows from investing Purchase of depreciable assets Equipment Other fixed assets Net cash provided (used) by investing Cash flows from financing Long-term debt Net cash provided (used) by financing Net increase (decrease) in cash Cash at beginning of period Cash at end of period 2011 $14,063,123 $1,898,181 (1,282,158) $616,023 ($5,423,657) (5,238,752) ($10,662,409) 4,823,520 2,229,594 254,973 (5,217,662) 898,416 795,124 (11,245,530) $818,852 Source: Author’s calculations. smi81240_03_c03_059-094.indd 64 2012 $8,280,417 64 $5,754,498 $5,754,498 $7,189,373 $89,718,764 $96,908,137 4,882,967 687,543 (89,546) (4,216,584) (875,662) 895,643 (657,832) $14,689,652 $3,265,489 $3,265,489 $7,292,732 $82,426,032 $89,718,764 3/7/14 9:31 AM Section 3.2 Profitability Profitability is almost always the starting point for financial performance analysis. Even for a not-for-profit organization, it is important to know if their revenues sufficiently exceed their expenses to remain in business. The key questions in profitability analysis are: How much money is the organization making and is it enough? The indication of how much is enough is a standard established by the board of directors or the shareholders of the company. Among the many possible measures of profitability, four are commonly used for analysis of healthcare organizations. Operating Margin The first measure of profitability is the operating margin, the amount of money the organization has earned through the provision of healthcare services, as defined by the following equation: Operating margin 5 Operating income 3 100% Operating revenues The operating margin starts with the operating income earned, which is operating revenues minus operating expenses. Operating income is then divided by operating revenues. For ease of interpretation of operating margin and many other ratios, the result is multiplied by 100% to yield a percentage value. For Middaugh United Hospital, ($5,951,147) in operating income (in this case an operating loss) is divided by $195,934,163 in operating revenues and multiplied by 100% to yield an operating margin of (3.0%) in 2012, as compared to its operating margin of (1.5%) in 2011. Operating margin 5 1 $5,951,147 2 3 100% $195,934,163 Operating margin 5 1 3.0% 2 The operating margin (loss) at Middaugh was twice as large in 2012 as compared to 2011. Is this result bad? In a relative sense, losing twice as much is almost certainly a worse result. In an absolute sense, an assessment of this result requires knowledge of (a) the anticipated budget for 2012 as an operating margin, (b) the internal goals for the operating margin, (c) the benchmarks Middaugh uses to compare results, and (d) what similar hospitals might have experienced in 2012. In most cases, information on budgets, goals, and benchmarks would only be available to insiders at Middaugh. Outside analysts would have the data on other organizations for comparison purposes. As presented in Figure 3.1, the median operating margin for stand-alone hospitals (hospitals that are not part of multihospital systems) reviewed by Standard & Poor’s (2013a) was 2.6%. The median operating margin for multi-hospital systems reviewed by Standard & Poor’s (2013b) was 2.9%. Since rating agencies include different hospitals in their analyses, median values will vary slightly. The median operating margins reported by Fitch (2013) and Moody’s (2013) for stand-alone hospitals in 2012 were 2.7% and 2.5%, respectively. Middaugh’s performance on the basis of the operating margin alone was lower than the median in national samples. If the internal goal for Middaugh was the median performance of hospitals nationally, then Middaugh fell short of this goal. 65 smi81240_03_c03_059-094.indd 65 3/7/14 9:31 AM Section 3.2 Profitability Figure 3.1: Median operating margin for stand-alone hospitals 3.0% 2.5% Percentage 2.0% 1.5% 1.0% 0.5% 0.0% 2007 2008 2009 2010 2011 2012 Year Source: Author’s calculations based on Standard & Poor’s (2013a). Figure 3.2 presents the operating margins for hospitals in Massachusetts in 2012, sorted by profitability. Operating margins for these 64 hospitals ranged from 211.7% to 13.4%, with a median of 2.2%. Note that only seven of the hospitals in Massachusetts experienced operating margins of less than 23.0%. With regards to Middaugh, a favorable conclusion about its profitability would not be reached if it were compared against hospitals in Massachusetts. 66 smi81240_03_c03_059-094.indd 66 3/7/14 9:31 AM Section 3.2 Profitability Figure 3.2: Operating margin for Massachusetts hospitals, 2012 (each dot represents the value for one hospital) 15% 12% 9% 6% 3% 0% –3% –6% Hospitals with operating margins of –3.0% or less –9% –12% –15% Source: Author’s calculations based on Massachusetts’ Center for Health Information and Analysis (2013). Average values of operating margins, and most other financial ratios, will vary by industry. Average operating margins for nursing facilities over the past four years have been less than 1% (CliftonLarsonAllen, 2012). Average operating margins for ambulance providers have been 2% over the past two years (U.S. Government Accountability Office, 2012). And, average operating margins for investor-owned managed care organizations have been in excess of 5% over the past four years (American Hospital Association, 2013c). When assessing profitability, the comparison needs to be more narrowly defined than simply looking at healthcare as a whole. Total Profit Margin A second measure of profitability is the total profit margin, which represents the total money the organization has earned from all sources, as a percentage of revenues. It is defined by the following equation: Total profit margin 5 Net income 3 100% Total revenues 67 smi81240_03_c03_059-094.indd 67 3/7/14 9:31 AM Section 3.2 Profitability The total profit margin starts with the total profit earned by the organization (total revenues minus total expenses), also called net income, and is the bottom line on the income statement. Net income is divided by total revenues, which, in the case of many not-for-profit organizations, requires the addition of total operating revenues and total nonoperating revenues. Many organizations list only net nonoperating revenues, rather than the separate value of total nonoperating revenues and total nonoperating expenses. However, since nonoperating revenues are largely investment returns, nonoperating expenses are usually very small, making the use of net nonoperating revenues a reasonable value. For not-for-profit healthcare organizations that refer to the income statement as the statement of revenue and expenses, the total profit margin is often referred to as the excess margin, reflecting that it represents the excess of revenues over expenses. For Middaugh United Hospital, $8,280,417 in net income divided by $210,165,727 in total revenues ($195,934,163 in total operating revenues plus $14,231,564 in net nonoperating revenues) multiplied by 100% yields a total profit margin of 3.9% in 2012, as compared to its total profit margin of 6.8% in 2011. The Standard & Poor’s medians were 4.5% in 2012 and 4.7% in 2011. Total profit margin 5 Total profit margin 5 $8,280,417 3 100% $195,934,163 1 $14,231,564 $8,280,417 3 100% $210,165,727 Total profit margin 5 3.9% While the total profit margin for Middaugh decreased by nearly half in 2012, like the operating margin, the level of the total profit margin is much more favorable. The difference between the total profit margin and the operating margin for healthcare organizations is nonoperating activities, which is primarily comprised of investment returns. On average, positive investment returns are a contribution to the overall profitability of not-for-profit hospitals. However, a bad year for the stock market can also mean a bad year for hospitals’ total profit margin (Song, Smith, & Wheeler, 2008). Analyze This How important were net nonoperating revenues to Middaugh United Hospital in 2012 and 2011? Return on Assets A third measure of profitability is the return on assets, which represents the total money the organization has earned from all sources, as a percentage of assets. It is defined by the following equation: Return on assets 5 Net income 3 100% Total assets 68 smi81240_03_c03_059-094.indd 68 3/7/14 9:31 AM Section 3.2 Profitability The return on assets starts with the total profit earned by the organization, just like the total profit margin. Net income is then divided by total assets, which is a measure of the resources available to the organization with which to provide services. For Middaugh United Hospital, $8,280,417 in net income divided by $243,019,946 in total assets multiplied by 100% yields a return on assets of 3.4% in 2012, as compared to its return on assets of 5.9% in 2011. Return on assets 5 $8,280,417 3 100% $243,019,946 Return on assets 5 3.4% When the book value of assets is similar to total revenues for the year, as is common in hospitals, the return on assets and total profit margin ratios will be similar. For Middaugh, the decrease on the return on assets by nearly half, just the total margin, is a worry for the hospital. Cash Flow Margin One final measure of profitability is the cash flow margin, which represents the total money the organization has in cash terms rather than accrual accounting terms, as a percentage of revenues. It is defined by the following equation: Cash flow margin 5 Cash flow from operations 3 100% Total revenues The cash flow margin starts with the cash flow from operations, rather than the net income of the organization. By using cash flow from operations, the cash flow margin isolates the operational activities and ignores the investment and financing activities. Cash flow from operations is divided by total revenues. For Middaugh United Hospital, cash flow from operations of $818,852 divided by $210,165,727 in total revenues multiplied by 100% yields a cash flow margin of 0.4% in 2012, as compared to its cash flow margin of 7.1% in 2011. Cash flow margin 5 $818,852 3 100% $210,165,727 Cash flow margin 5 0.4% Due to the differences between using cash and accrual accounting, the cash flow margin can differ substantially from the operating margin or total profit margin. The cash flow margin has decreased more substantially than either the operating margin or the total profit margin. This is a negative sign for Middaugh. 69 smi81240_03_c03_059-094.indd 69 3/7/14 9:31 AM Section 3.2 Profitability Questions of Profitability These calculations consider the first question of profitability: How much money is the organization making? The second question also deserves consideration: Is the organization making enough money? With regard to this second question, there is a long-standing debate concerning how much profit is enough for not-for-profit hospitals, with no consensus (Bartlett, Delucia, Goheen, McPherson, O’Brien, & Wedig, 2005). For an organization to remain in business, earning at least zero profit is required. Too many years of losses will deplete the available cash and creditworthiness of an organization and it will become bankrupt. Earning exactly zero profits may still permit some positive cash flow, owing to the difference between cash accounting and accrual accounting. Organizations operating at zero profits could replace plant and equipment at the rate of depreciation expenses. This would only permit replacement of assets at the historical level of cost. For organizations to keep current with increasing costs of plant and equipment, to say nothing of the increasing costs associated with advancing medical technology, some level of profit above zero is required. From the Front Lines Our hospital’s target operating margin is 2% and our target total margin is 6%. We have calculated that we need a total margin of 3–4% to count on year in and year out. Anything less than that and we would be unable to keep up with advancing technology, which would be detrimental to our long-run strategy of being a hospital of choice. Source: Hospital chief operating officer. Beyond replacement and expansion of assets, some level of profitability is also required to provide assurances to creditors that the organization will not soon become bankrupt. Hospitals that were recognized as having high credit ratings and therefore provided access to debt at lower interest rates were those that earned a median total profit margin of 6.9% in 2012. Hospitals with much lower credit ratings were those that earned a median total profit margin of 3.6% in 2012. Other factors influence credit ratings, including market position, balance sheet and capital plan, governance and management, debt structure, and legal covenants, but profitability is important (Standard & Poor’s, 2013a). The profit question can also be asked the other way around: How much profit is too much? A healthcare organization that has high profits may be doing so as a result of not providing community benefits or as a result of high prices, which also affect the community. For not-forprofit organizations, there may be limits on how much profit is acceptable to the community. On the other hand, for investor-owned organizations (for-profit companies), earning high profits is consistent with the reasons for being in business. Altogether, the four measures of profitability provide a range of views on the profits of the organization. It is possible to calculate additional ratios to present even more views, and many analysts will select their own methods of examining the profitability of healthcare organizations. It is common practice to calculate two or more measures of profitability when preparing a comprehensive evaluation of financial performance. Further, it is common to ask the question of whether the profits are sufficient and appropriate for the organization. Analyze This Overall, how would you characterize Middaugh United Hospital’s profitability in 2012 and 2011? Explain your reasoning. 70 smi81240_03_c03_059-094.indd 70 3/7/14 9:31 AM Section 3.3 Liquidity For Review: 1. What are good measures of profitability? The operating margin is a good measure of the profitability of the key activities of the healthcare organization. Total profit margin, return on assets, and cash flow margin are additional measures that provide indications of profitability. 2. Is it possible for a not-for-profit organization to earn too much profit? A not-for-profit organization that solely seeks to maximize profits may not offer services that would benefit the community or may charge high prices, leading to a level of assets or net assets that differs from what the community wants. It is not easy to define what level of profits would be too much. 3.3 Liquidity Liquidity is another important aspect of financial performance, particularly to individuals or companies that provide loans to healthcare organizations. The key question in liquidity is: Does the organization have the money to pay its bills? Among the many possible measures of liquidity, there are four commonly used measures for analysis of healthcare organizations. Like the various measures of profitability, each measure of liquidity looks at a different aspect of the issue, and it may be worthwhile for healthcare organizations to evaluate performance for each measure, rather than to try to select just one. Current Ratio The first measure of liquidity is the current ratio, which measures available funds to pay bills. It is defined by the following equation: Current ratio 5 Current assets Current liabilities The current ratio starts with current assets, which are those assets that are held as cash or cash equivalents or are expected to become cash within the year. Current assets are then divided by current liabilities, those debts that must be paid within the year. For Middaugh United Hospital, current assets of $123,317,688 are divided by current liabilities of $23,564,114 to yield a current ratio of 5.2 in 2012, as compared to its current ratio of 3.4 in 2011. Current ratio 5 $123,317,688 $23,564,114 Current ratio 5 5.2 A current ratio in excess of 1.0 is desired and Middaugh’s ratio is in excess of 1.0 and increasing, both good signs of liquidity. 71 smi81240_03_c03_059-094.indd 71 3/7/14 9:31 AM Section 3.3 Liquidity Days Cash on Hand A second measure of liquidity is days cash on hand, which goes more directly into available funds for paying the routine expenses of the organization. It is defined by the following equation: Days cash on hand 5 Cash and cash equivalents and marketable securities 1 Operating expenses 2 depreciation 2 / 365 days Days cash on hand starts with cash and cash equivalents from the balance sheet. Different results for this ratio are possible depending on which marketable securities are included (Rivenson, Reiter, Wheeler, & Smith, 2011). A narrow definition of days cash on hand would include only cash and cash equivalents and additional marketable securities that are held as current assets. A broad definition of days cash on hand would add long-term marketable securities, typically contained in the amount presented on the balance sheet as assets limited as to use. Even though some of the items included in assets limited as to use may be investments in related healthcare organizations or foundations that are not easily marketable, these assets are typically financial investments. Available cash is divided by the expected use of cash on a daily basis. An approximation for the use of cash is operating expenses less the noncash expense of depreciation. The annual amount presented on the income statement is converted to a daily amount by dividing by 365 (days per year). For Middaugh United Hospital, $96,908,137 in cash and cash equivalents is divided by $197,061,790 ($201,885,310 in operating expenses less $4,823,520 in depreciation), which is first divided by 365 days, and yields 179 days cash on hand in 2012, as compared to 175 days cash on hand in 2011. Days cash on hand 5 Days cash on hand 5 From the Front Lines $96,908,137 $197,061,790 / 365 Days cash on hand 5 179 We invest over $30 million in capital expenditures annually, and our days cash on hand is currently around 206 days, which is not enough, especially because this number may be reduced to 150–160 days within the next 3–4 months due to the irregularity of patient payments. This is stressful, because we must have greater than 140 days at all times, in order to remain in good graces with the bond rating agencies. Source: Hospital chief executive officer. $96,908,137 1 $201,885,310 2 $4,823,520 2 / 365 The Standard & Poor’s medians were 192 days in 2012 and 187 days in 2011. Adding the assets limited as to use as another marketable security increases the days cash on hand at Middaugh to 201 days in 2012 and 195 days in 2011. The narrow and broad measures of days cash on hand improved in 2012 by four days and six days, respectively. Increasing available cash is a good sign for Middaugh. How many days cash on hand is enough? Cash and cash equivalents are held for transactions purposes (paying bills), precautionary purposes (protection from bankruptcy), and speculative purposes (investing) (Rivenson & Smith, 2013). For purely transactions purposes, holding 7–10 days cash on hand may suffice. Investorowned healthcare organizations do not generally hold 72 smi81240_03_c03_059-094.indd 72 3/7/14 9:31 AM Section 3.3 Liquidity marketable securities and other financial securities for purposes other than transactions. In its annual report to the Securities and Exchange Commission (called a 10-K report), HCA Holdings, Inc., the nation’s largest investor-owned hospital company, reported having only 9.0 days cash on hand at the end of 2012 and 5.5 days cash on hand at the end of 2011 (HCA Holdings, Inc., 2013). For precautionary purposes, not-for-profit healthcare organizations often aspire to hold 90 days cash on hand or more. A slowdown of payments from a large insurance company or managed care organization can quickly result in shortages of available cash. The more uncertain the cash flows are from third-party payers, the more precautionary days cash on hand must be held by the organization. Further, precautionary cash balances serve as a reassurance to companies that have loaned money to the organization that there is an intention to pay all bills that come due. The reassurance of lenders associated with having precautionary cash balances can lower the interest rates that must be paid on loans. Hospitals that were recognized as having high credit ratings and access to debt at lower interest rates were those that held a median days cash on hand of 387 days in 2012 (Standard & Poor’s, 2013a). That’s more than one year’s worth of cash on hand. Hospitals with much lower credit ratings were those that held a median days cash on hand of 131 days in 2012 (Standard & Poor’s, 2013a). Speculative holdings are typically designated as being in marketable securities or assets limited as to use. Investments in marketable securities and other assets serve two purposes. First, speculative holdings add to the reassurances provided by precautionary holdings. In practice it is not possible to separate investments into those held for precautionary and speculative purposes. Second, speculative holdings can provide nonoperating income to the organization to augment (make up for) net income (losses) on From the Front Lines operations. As a government health center, our As with profitability, the liquidity question can also be asked the other way around: How much cash is too much? A healthcare organization that has a high number of days cash on hand may be doing so as a result of not investing enough in property, plant, and equipment. Investing in real assets would permit the organization to provide more services to the community. Building a new clinic provides to the community more services than does buying more shares of stock in a company. Given the precautionary motivation for holding cash and marketable securities and all of the uncertainty associated with the healthcare system, it is not easy to determine which marketable securities should be sold to enable the purchase of more equipment. Still, for not-for-profit organizations, there may be limits on how many days cash on hand is acceptable to the community. Having more than one year’s worth of days cash on hand may be more than an organization would need to satisfy all of its needs for cash. approach to days cash on hand is challenging, and it becomes a difficult indication of financial viability. Our days cash on hand is currently less than 30 days, which, in comparison to other health systems and typical evaluations, appears quite poor. However, we are partially supported by tax revenues, so holding higher cash reserves becomes a political issue, as the government would begin to doubt that a subsidy is needed and would question our adherence to our mission, and taxpayers would question why they are paying a property tax subsidy if we have so much cash. Source: Governmental health system chief operating officer. 73 smi81240_03_c03_059-094.indd 73 3/7/14 9:31 AM Section 3.3 Liquidity Days Accounts Receivable A third measure of liquidity is days accounts receivable, a measure of how quickly bills are paid by insurance companies and patients. It is defined by the following equation: Days accounts receivable 5 Net accounts receivable Net patient revenues / 365 days The calculation of days accounts receivable (abbreviated as days A/R) starts with net accounts receivable from the balance sheet. Net accounts receivable is divided by the expected addition to patient accounts on a daily basis. An approximation for the addition to patient accounts is net patient revenues. The annual amount presented on the income statement is converted to a daily amount by dividing by 365 days. For Middaugh United Hospital, $15,429,906 net accounts receivable, which already excludes the allowances for uncollectible accounts, is divided by $195,934,163, which is first divided by 365 days, which yields 29 days A/R in 2012, as compared to 34 days A/R in 2011. The Standard & Poor’s (2013a) medians were 50 days in 2012 and 48 days in 2011. Days accounts receivable 5 $15,429,906 $195,934,163 / 365 Days accounts receivable 5 29 Days A/R is a product of both the patient mix and the efficiency of accounts receivable management practices. Having a lower days A/R is partly a matter of having patients and payers who generally pay faster. Having a lower days A/R is also associated with management practices that assure timely payment, irrespective of the payer, which is helpful to an organization (Rauscher & Wheeler, 2012). Middaugh did a good job and improved its speed of collections of accounts receivable by 5 days in 2012. It is important to note that an organization’s total days A/R is the weighted average of the days A/R from each of its payers. In this light, the days A/R calculation for Middaugh United Hospital is presented in Exhibit 3.4. Medicare is by far the largest single payer at Middaugh and pays patient bills, on average, in 22 days. Medicaid, Blue Cross Blue Shield, other private insurance, and other managed care organizations pay somewhat slower, and likely within the payment periods specified by individual contracts with Middaugh. Workers’ compensation, other government programs, self-pay patients (uninsured patients and the copayment amounts from insured patients), and other sources of payment are less likely to have contractual arrangements with Middaugh and are associated with slower payments. 74 smi81240_03_c03_059-094.indd 74 3/7/14 9:31 AM Section 3.3 Liquidity Exhibit 3.4 Payer revenue share and days accounts receivable, 2012, Middaugh United Hospital Payer Medicare Medicaid Blue Cross Blue Shield, other private insurance Other managed care companies Workers’ compensation, other government Self-pay and other Total Total Revenue Share 42% 16% Weighted Average Days A/R 22 26 3% 7% 100% 54 45 29 18% 14% Source: Author’s calculations. 31 38 Analyze This Medicare and Medicaid pay lower amounts for hospital services than do other payers with patients at Middaugh United Hospital. Should Middaugh attempt to encourage larger Medicare and Medicaid revenue shares to reduce their number of days accounts receivable? Explain your reasoning. Average Payment Period A fourth measure of liquidity is the average payment period, which indicates how long it takes an organization to pay its own bills to other companies. It is defined by the following equation: Average payment period 5 Current liabilities 1 Total operating expenses 2 depreciation 2 / 365 days The calculation of the average payment period starts with current liabilities from the balance sheet. Current liabilities are divided by the expected liabilities that are generated on a daily basis. An approximation for the liabilities that are generated (the expected use of cash from the days cash ratio) is total operating expenses less the noncash expense of depreciation. The annual amount presented on the income statement is converted to a daily amount by dividing by 365. For Middaugh United Hospital, $23,564,114 in current liabilities is divided by $197,061,790 ($201,885,310 in operating expenses less $4,823,520 in depreciation), which is first divided by 365 days, yields an average payment period of 44 days in 2012, as compared to 64 days in 2011. Average payment period 5 Average payment period 5 $23,564,114 1 $201,885,310 2 $4,823,520 2 / 365 $23,564,114 $197,061,790 / 365 Average payment period 5 44 75 smi81240_03_c03_059-094.indd 75 3/7/14 9:31 AM Section 3.4 Leverage Lenders and suppliers of organizations prefer to be paid faster, just as healthcare organizations prefer to be paid faster by third-party payers. Lenders and suppliers may even provide more favorable terms (lower interest rates and discounts) to organizations that pay faster. The average payment period is a product of both the liability mix and the efficiency of payment management practices. Having a shorter average payment period is partly a matter of having liabilities for payroll and supplies that must be paid faster. It is possible that the majority of current liabilities could have payment dates close to the one-year limit to be considered current liabilities, and therefore an average payment period of nearly one year. Having a shorter average payment period is also associated with management practices that assure timely payment, irrespective of the obligation. The substantial reduction in other current liabilities at Middaugh (mostly a pension plan obligation) resulted in the substantial reduction in this ratio. Analyze This Overall, how would you characterize Middaugh United Hospital’s liquidity in 2012 and 2011? Explain your reasoning. For Review: 1. What are good measures of liquidity? The current ratio and days cash on hand are good measures of an organization’s ability to pay its bills in the short run. Days accounts receivable and average payment period also reflect upon liquidity, as well as the efficiency of collection and payment practices. 2. How would an organization establish a target level of days cash on hand? A target level of days cash on hand may be established through an internal assessment of the amount of cash that would be appropriate to pay its bills, perhaps as presented in the budget. Organizations may also establish a target by benchmarking against other organizations and assessing the levels of other organizations presented by rating agencies. 3.4 Leverage Leverage refers to the use of debt to enable the acquisition of assets by an organization. For a given level of net assets, arranging for additional debt permits an organization to have more assets in place to provide services to patients or to invest. The concept of leverage applies equally well to individuals as to organizations. For a given amount of money that you might have in savings, arranging for a mortgage permits you to buy a larger house than you could buy using only your savings. 76 smi81240_03_c03_059-094.indd 76 3/7/14 9:31 AM Section 3.4 Leverage Leverage has an added consideration for organizations in terms of the magnification of profits. Borrowing money to purchase assets enables the provision of more services, which results in higher total revenues. For the same total profit margin, having more assets and revenues means a higher level of net income. However, if the profit margin is negative, more assets and more revenues will mean a larger net loss. Leverage is not without risk; it magnifies both profits and losses. The key question in leverage is: How much of the organization’s assets does it own? Among the many possible measures of leverage, there are two commonly used measures for analysis of healthcare organizations. Each measure provides a slightly different look at leverage, and often calculating only one measure is sufficient for evaluation of organizational performance. Debt Ratio The first measure of leverage is the debt ratio, which is merely the percentage of assets financed by debt. It is defined by the following equation: Debt ratio 5 Total liabilities 3 100% Total assets The debt ratio, which is sometimes called the debt-to-assets ratio, starts with total liabilities, which are divided by total assets and multiplied by 100%. All assets possessed by an organization must be supported by using either funds owned by the organization or borrowed funds. This ratio is the percentage of assets that are supported by funds that were borrowed. The inverse of this ratio is the net assets ratio. For Middaugh United Hospital, total liabilities of $92,661,354 are divided by total assets of $243,019,946 and multiplied by 100% to yield a debt ratio of 38% in 2012, as compared to its debt ratio of 41% in 2011. Debt ratio 5 $92,661,354 3 100% $243,019,946 Debt ratio 5 38% The net assets ratios were therefore 62% in 2012 and 59% in 2011. Long-Term Debt to Capitalization One difficulty with the debt ratio is that it includes all forms of liabilities, both current and long-term liabilities like accounts payable and long-term debt. To focus on what one might call the permanent financing of an organization, a second leverage ratio is the long-term debt to capitalization ratio, which is like the debt ratio, except that it excludes the current liabilities. It is defined by the following equation: Long-term debt to capitalization 5 Long-term liabilities 3 100% Long-term liabilities 1 net assets 77 smi81240_03_c03_059-094.indd 77 3/7/14 9:31 AM Section 3.4 Leverage The long-term debt to capitalization ratio starts with long-term liabilities, which are divided by the sum of long-term liabilities and net assets, which is also called capitalization, and then multiplied by 100%. For Middaugh United Hospital, long-term liabilities of $69,097,240 are divided by $219,455,832 (long-term liabilities of $69,097,240 plus net assets of $150,358,592) and multiplied by 100% to yield a long-term debt to net assets ratio of 31% in both 2012 and 2011. Long-term debt to capitalization 5 Long-term debt to capitalization 5 $69,097,240 3 100% $69,097,240 1 $150,358,592 $69,097,240 3 100% $219,455,832 Long-term debt to capitalization 5 31% Unlike many of the other ratios, there is not a simple answer to the question, what is a good leverage ratio? Having little debt may be associated with having little tolerance for the risk associated with debt, or it may be associated with having adequate net assets to support the desired level of assets of the organization. Some people do not take out loans to buy cars and only buy the cars they can afford with their savings. However, some organizations may be forgoing opportunities to provide needed services in a community. If you had a good job and a good income, would you live in a pup tent your entire life rather than getting a mortgage to buy a home? Likewise, having substantial debt may be associated with having a high tolerance for the risk associated with debt or it may be associated with having inadequate net assets to support the desired level of assets of the organization. Some people take out loans to buy cars even when they have savings in the bank, preserving those savings as precautionary balances to assure they can make the loan payments or as speculative balances if they can earn a higher rate of return on investments than the interest rate they pay on the loan. However, some organizations and some individuals borrow more than they can reasonably afford. As presented in Figure 3.3, most hospitals in Massachusetts and Washington had long-term debt to net assets ratios that were less than 50% in 2012. Some hospitals had ratios that were 51–100%, and some even had ratios that were more than 100% or negative. A much larger percentage of hospitals in Massachusetts had very high debt to capitalization ratios, as compared to hospitals in Washington. Hospitals can have ratios of more than 100% if they have more long-term liabilities than net assets. Hospitals that accumulate losses to the point where net assets become zero or negative may be technically bankrupt, though they may have positive cash flow and continue to operate. 78 smi81240_03_c03_059-094.indd 78 3/7/14 9:31 AM Section 3.4 Leverage Figure 3.3: Long-term debt to capitalization for Massachusetts and state of Washington hospitals, 2012 50% Washington Massachusetts Percentage of hospitals 40% 30% 20% 10% 0% 0–25% 26–50% 51–75% 76–100% Debt to net asset ratios More than 100% Source: Author’s calculations based on Massachusetts’ Center for Health Information and Analysis (2013) and State of Washington’s Department of Health (http://www.doh.wa.gov/DataandStatisticalReports/HealthcareinWashington/ HospitalandPatientData/HospitalFinancialData.aspx). Analyze This Overall, how would you characterize Middaugh United Hospital’s leverage position in 2012 and 2011? Explain your reasoning. For Review: 1. What are good measures of leverage? The debt ratio provides a good measure of overall leverage. The long-term debt to capitalization ratio provides a measure more focused on long-term financing. 2. Why would an organization be concerned with a debt ratio of 90%? A debt ratio of 90% means that only 10% of the assets are owned by the organization. In the event of a financial loss, the organization may risk becoming bankrupt. Further, at a debt ratio of 90%, it is possible that the interest expenses on the debt would be large amounts that may be difficult to afford. 79 smi81240_03_c03_059-094.indd 79 3/7/14 9:31 AM Section 3.5 Position and Operational Efficiency 3.5 Position and Operational Efficiency In addition to the purely financial measures previously presented, a number of measures can be calculated from information on the financial statements and related documents that enable a greater understanding of the general positions and operational efficiency of healthcare organizations. Position Measures Among the most common position measures calculated for healthcare organizations are those related to product mix and payer mix. To understand the services provided by a healthcare organization, one position measure is the outpatient revenue percentage, that is, the percentage of total patient revenues that are the result of outpatient cases: Outpatient revenue percentage 5 Net outpatient revenues 3 100% Total patient revenues The outpatient revenue percentage starts with net outpatient revenues, which are divided by total patient revenues, and then multiplied by 100%. Ideally, this ratio would be calculated with information on the level of doubtful accounts associated with outpatient and inpatient revenues separately. Such information is not always available on financial statements. When total doubtful accounts are presented as a separate line item, the ratio may be calculated using outpatient revenues divided by the sum of outpatient and inpatient revenues. For Middaugh United Hospital, outpatient revenues of $113,153,751 are divided by $205,421,584 (outpatient revenues of $113,153,751 plus inpatient revenues of $92,267,833) and multiplied by 100% to yield an outpatient revenue percentage of 44.9% in 2012 and 44.5% in 2011. Outpatient revenue percentage 5 $113,153,751 3 100% $205,421,584 Outpatient revenue percentage 5 55.1% For many position measures, there is a not a simple answer to the question, what is a good value? Having a low outpatient revenue percentage may be associated with having few patients whose medical needs can be addressed with outpatient services, or it may be associated with having inadequate outpatient resources to support the desired level of outpatient care. Given the technological advances in medicine and financial incentives facing healthcare organizations, many have altered resources to provide more care on an outpatient basis. A second position measure is the Medicare payment percentage: Medicare payment percentage 5 Net medicare revenues 3 100% Total patient revenues The Medicare payment percentage starts with net Medicare revenues, which are divided by total patient revenues, and then multiplied by 100%. Ideally, this ratio would be calculated 80 smi81240_03_c03_059-094.indd 80 3/7/14 9:31 AM Section 3.5 Position and Operational Efficiency with information on the level of doubtful accounts associated with Medicare and other payer revenues separately. Such information is not always available on financial statements. In fact, the footnotes to a healthcare organization’s financial statements don’t always present a detailed analysis of revenues by payer. It is quite common to present a table with an analysis of the number of patients by payer, which may serve as a reasonable alternative. For Middaugh United Hospital, Medicare payment percentage was provided as 42% in Exhibit 3.4 for 2012 and came from the footnotes of their financial statements. The Medicare payment percentage was 41% in 2011. There is a not a simple answer to the question, what is a good value? Having a low Medicare payment percentage may be associated with having few Medicare patients living in the local market and using a healthcare organization, or it may be associated with having inadequate resources to support the services required by the Medicare population. Given the general aging of the U.S. population, many healthcare organizations are providing an increasing percentage of their services to the Medicare population. Ratios similar to the Medicare payment percentage can be calculated for each payer type. With the implementation of the Affordable Care Act, an increasing number of patients who would have otherwise been self-pay patients or qualified as charity care patients will be Medicaid patients or covered by some other source of insurance. Healthcare organizations will be paying close attention to the changes in the payer mix of their patient populations. Measures of Utilization Moving from consideration of position to operational efficiency, healthcare organizations have developed a number of measures and indicators of efficiency. Two important measures of utilization are the occupancy rate, the average percentage of beds that are filled, and average length of stay. The occupancy rate is defined by the following equation: Occupancy rate 5 Inpatient days 3 100% Average staffed beds 3 365 days The occupancy rate starts with the number of inpatient days of care provided during the year. Inpatient days are divided by the available capacity of inpatient days per year, which is measured as the average number of staffed beds multiplied by 365 days, and then multiplied by 100%. The number of beds in a healthcare organization is not always a simple number. Many states have regulations on the number of inpatient beds a healthcare organization is licensed to own. The number of physical beds available will often be a number equal to or less than the number of licensed beds. Middaugh is licensed to own 230 beds and has patient rooms with a total of 218 beds. On any given day, depending on the number of patients and available staff, there may be some beds that are not available for patients because staff (nurses and others) are not assigned to those beds. Healthcare organizations regularly report the average number of staffed beds available during the year, although this information is not always available on financial statements. For Middaugh United Hospital, 24,769 inpatient days divided by 76,650 bed days available (210 staffed beds multiplied by 365 days) and multiplied by 100% yields an occupancy rate of 32.3% in 2012, as compared to its 25,520 inpatient days and occupancy rate of 33.3% in 2011. 81 smi81240_03_c03_059-094.indd 81 3/7/14 9:31 AM Section 3.5 Position and Operational Efficiency Occupancy rate 5 24,769 3 100% 210 3 365 Occupancy rate 5 32.3% In general, a higher occupancy rate is better than a lower occupancy rate. It is worth noting that given the outpatient care being provided at Middaugh, 55.1% in 2012, the occupancy rate is not a perfect measure of the operational efficiency of the organization. Patients who receive services on an outpatient basis may require pharmacy services or laboratory services, even operating room services. The outpatient cases use a portion of the capacity of services available to all patients. Therefore, an organization may be fully utilized at an occupancy rate of less than 100%. Another operational measure related to the occupancy rate is the average length of stay. The average length of stay is defined by the following equation: Average length of stay 5 Inpatient days Inpatient discharges The average length of stay is just that, the average number of days in the healthcare organization for patients who are discharged. Healthcare organizations can use the number of patients admitted (entering) during the year or the number of patients discharged (leaving) during the year; the only difference is the number of patients who happen to be in the organization on New Year’s Day at the beginning and ending of the year. By convention, analysts use the number of discharges. For Middaugh United Hospital, 24,769 inpatient days divided by 5,270 discharged patients yields an average length of stay of 4.7 days in 2012, as compared to its average length of stay of 4.5 days in 2011. Average length of stay 5 24,769 5,270 Average length of stay 5 4.7 There is a not a simple answer to the question, what is a good value for average length of stay? Having a low average length of stay may be associated with having patients with medical needs that can be fully met with a short stay in the organization, or it may be associated with having efficient provision of services and good patterns of discharge to the patients’ homes or skilled nursing facilities. Under payment systems that provide a set amount for the inpatient stay, independent of the number of days of care (see Chapter 4), many healthcare organizations attempt to minimize the average length of stay of their patients. It is important to note that an organization’s average length of stay is the weighted average of the average length of stay for a patient covered by each payer. In this light, the average length of stay calculation for Middaugh United Hospital is presented in Exhibit 3.5. Medicare is by far the largest single payer at Middaugh, and Medicare patients stay, on average, 5.6 days. Medicaid, Blue Cross Blue Shield, other private insurance, and other HMOs or PPOs include younger populations that have shorter lengths of stay. 82 smi81240_03_c03_059-094.indd 82 3/7/14 9:31 AM Section 3.5 Position and Operational Efficiency Exhibit 3.5 Payer revenue share and average length of stay, 2012, Middaugh United Hospital Payer Total Revenue Share Weighted Average Days A/R Medicare 42% 5.6 Medicaid 16% 4.3 Blue Cross Blue Shield, other private insurance 18% 3.8 Other HMO or PPO 14% 3.9 Workers compensation, other government 3% 5.2 Self-pay and other 7% 4.0 Total 100% 4.7 Source: Author’s calculations. Analyze This Blue Cross Blue Shield, other private insurance companies, and other HMOs or PPOs pay higher amounts for hospital services than do Medicare and Medicaid patients at Middaugh United Hospital. Should Middaugh attempt to encourage larger Blue Cross Blue Shield and other commercial revenue shares to reduce their average length of stay? Explain your reasoning. Salaries and Fringe Benefits Salaries and associated fringe benefits, such as health insurance, life insurance, and contributions toward retirement, are the largest component of expenses. Therefore, operational efficiency of healthcare organizations is keenly dependent on effective use of personnel. One common measure of efficiency is the salaries to revenues ratio, which is how much of each dollar earned by an organization goes toward paying salaries to staff. It is defined by the following equation: Salaries to revenues 5 Salary expense 1 benefits expense 3 100% Net patient revenue The salaries to revenues ratio starts with the sum of salary and benefits expenses. These expenses are divided by net patient revenue and then multiplied by 100%. As an alternative, some organizations divide salary and benefits expenses by total operating expenses, which yields a similar percentage. The motivation for division by net patient revenue is to highlight how much of the revenue dollar is associated with personnel expenses, thereby showing how much of the revenue dollar is available for other expenses and net income. For Middaugh United Hospital, salary expenses of $68,764,520, contract labor expenses (another form of income paid to workers) of $12,658,204, and fringe benefits expense of $17,191,130 total $98,613,854. Dividing the total by $195,934,163 in net patient revenues, multiplied by 100% yields a salaries to revenue ratio of 50.3% in 2012, as compared to 49.8% in 2011. 83 smi81240_03_c03_059-094.indd 83 3/7/14 9:31 AM Section 3.5 Position and Operational Efficiency Salaries to revenues 5 Salaries to revenues 5 $68,764,520 1 $12,658,204 1 $17,191,130 3 100% $195,934,163 $98,613,854 3 100% $195,934,163 Salaries to revenues 5 50.3% At Middaugh, salaries and related expenses increased by 4.5% between 2012 and 2011 while revenues increased by only 3.3%. The Standard & Poor’s (2013a) medians were 55.7% in 2012 and 55.0% in 2011. Middaugh experienced an increase in this ratio similar to the national average and maintained a level lower than the national average. Either because of their efficiency, or lower levels of salaries or fringe benefits, Middaugh has a larger portion of each dollar earned available for other expenses. Adequacy of Physical Assets Two additional operational efficiency measures are concerned with the adequacy of the physical assets of a healthcare organization. Average age of plant and capital expenditures to depreciation are indicators of the aging and replacements, respectively, of facilities used in patient care. The average age of plant is defined by the following equation: Average age of plant 5 Accumulated depreciation Depreciation expense The average age of plant uses accounting measures based on depreciation expenses to estimate the average number of years that buildings and equipment have been in place. Accumulated depreciation from the balance sheet is divided by the annual depreciation expense from the income statement. This equation provides a good measure of the average age for long-term assets that have been put into place in recent years, based upon the application of the straight-line depreciation method discussed in Chapter 2. For a piece of equipment that has a useful life of eight years, its first year depreciation expense will be one eighth of its initial cost, which will be the total value of accumulated depreciation, leading to a ratio of one year. In the second year of the use of a piece of equipment, its depreciation expense will again be one eighth of its initial cost and the total value of accumulated depreciation will be two eighths, leading to a ratio of two years. During the useful life of equipment, average age of plant is a good measure. Beyond the useful life of equipment, average age of plant is difficult to interpret. If the piece of equipment is used a ninth year, accumulated depreciation will be the full cost and the depreciation expense will be zero, leading to a calculation of an infinite value for average age of plant. For Middaugh United Hospital, $169,807,310 in accumulated depreciation divided by $4,823,520 in depreciation expense yields an average age of plant of 35 years in 2012, as compared to its average age of plant of 32 years in 2011. Average age of plant 5 $169,807,310 $4,823,520 Average age of plant 5 35 84 smi81240_03_c03_059-094.indd 84 3/7/14 9:31 AM Section 3.5 Position and Operational Efficiency Clearly these are not accurate measures of the actual average age across all of the plant and equipment at this hospital. Still, it likely indicates that the average age is beyond the typical useful life of much of its equipment and likely older than the national average. The Standard & Poor’s (2013a) medians were 10.5 years in 2012 and 10.4 years in 2011. How old is too old? There are many complexities to this question, relating both to the calculations involved in this indicator as well as the physical wearing out and technological obsolescence of medical equipment. Observations of average age of plant beyond 15 years generally find institutions in need of major rehabilitation or equipment upgrading. Closely related to the concept of average age of plant is the ratio of capital expenditures to depreciation, or purchases of property, plant, and equipment divided by the annual depreciation expense. Average age of plant is a point in time indicator of the likely condition of plant and equipment. Capital expenditures indicate what the organization is doing to replace or update plant and equipment. The ratio of capital expenditures to depreciation is defined by the following equation: Capital expenditures to depreciation 5 Purchases of property, plant, and equipment 3 100% Depreciation expense Purchases of property, plant, and equipment can be found on the statement of cash flows and from the balance sheet as the difference between current and prior year values, unless there have been sales of fixed assets. When there are sales of fixed assets, the financial statements, particularly the statement of cash flows, may not provide sufficient information to calculate this ratio. Purchases are divided by depreciation expense from the income statement and then multiplied by 100%. The relationship of purchases to depreciation is designed to indicate if new plant and equipment are being acquired at least at the rate at which older plant and equipment are reaching their useful life. For Middaugh United Hospital, $6,835,695 is the purchases of property, plant, and equipment, which, if divided by $4,823,520 in depreciation expense and then multiplied by 100%, yields capital expenditures to depreciation of 142% in 2012, as compared to its capital expenditures to depreciation of 135% years in 2011. Capital expenditures to depreciation 5 $6,835,695 3 100% $4,823,520 Capital expenditures to depreciation 5 142% Since the capital equipment and other fixed asset investments on the statement of cash flows are lower numbers, Middaugh must have sold assets in 2012 and 2011. The ratio calculated is therefore an underestimate of the true value of purchases of property, plant, and equipment. The Standard & Poor’s (2013a) medians were 121% in 2012 and 116% in 2011. Middaugh is investing in new property, plant, and equipment at a larger rate compared to its depreciation expenses than the national average. Given the unusually large average age of plant, this is a positive sign for the hospital. All of these measures are calculated from information on the financial statements and related documents and enable a greater understanding of the general positions and operational efficiency of healthcare organizations. Still, these measures are focused on financial matters 85 smi81240_03_c03_059-094.indd 85 3/7/14 9:31 AM Section 3.6 Trend Analysis and in many cases may ask more questions than they answer. Raising questions is exactly the point behind presentation of measures of general positions and operational efficiency of healthcare organizations. Financial statements are limited to financial information. Having an understanding of the desired position of an organization relative to the medical needs of its population requires more information than what is presented on financial statements. Further, how an organization makes staffing decisions and buys and sells long-term assets requires operational and technological information beyond the financial statements. Calculation of common measures can assist financial managers in bringing up issues for discussion with operational managers. Analyze This Overall, how would you characterize Middaugh United Hospital’s position and operational efficiency in 2012 and 2011? Explain your reasoning. For Review: 1. Why would an organization be concerned with an outpatient percentage of 10%? An outpatient percentage of 10% may reflect that few investments have been made in the ability to provide services on an outpatient basis. If competing organizations have made larger investments, the organization may not be profitable in the future. 2. Why would a healthcare organization be concerned with an average age of plant of 35 years? An average age of plant often reflects a very old building or very old equipment. The level of care provided to patients may suffer with very old buildings and equipment. 3. If an organization has a stable occupancy rate of 75% and suddenly drops to 65%, should it be concerned? How quickly should it respond? Any large change in occupancy is cause for concern. The reason for the change could be investigated immediately. If the change was budgeted by the organization and is associated with a shift toward outpatient care, there is no serious concern. If the change was not budgeted, the organization should seek to identify the reason and respond to it. It is important to separate short-term reasons that will not last from long-term reasons that require more attention. 3.6 Trend Analysis In analyzing the financial performance of an organization, it is useful to look at the trends in measures, as well as current values. For most values on financial statements, only two years of information is available, which limits opportunities for identifying trends. A good trend analysis would take advantage of information provided over a longer period of time, enabling additional insights. For summary measures like the operating margin, information for even longer periods of time is often available, as presented in Figure 3.4. 86 smi81240_03_c03_059-094.indd 86 3/7/14 9:31 AM Section 3.6 Trend Analysis Figure 3.4: Operating margin trend analysis, Middaugh United Hospital and state-wide average, 2001–2012 8% State-wide Middaugh 6% Operating margin 4% 2% 0% 2001 2002 2003 2004 2005 Year 2006 2007 2008 2009 2010 2011 2012 –2% –4% –6% Source: Author’s calculations. In the case of Middaugh United Hospital, having a 12-year trend indicates that even though performance declined from 2011 to 2012, performance in 2012 is not very different from performance seven years ago. Not since 2004 has Middaugh kept pace with the state-wide average in terms of its operating margin. This trend analysis raises the question, what happened at Middaugh in 2005–2007? It also raises the question, what would Middaugh have to do operationally to achieve the operating margins of the average hospital in the state? These are not questions that can be answered by financial analysts using these data. These are questions that financial analysts need to be asking when preparing an assessment of the organization’s financial performance. In addition to trends that involve multiple years of data, trend analysis can often be conducted using more frequent observations than the year. Within an organization, information may be readily available on a monthly or quarterly basis, permitting the observation of trends within the year for evaluation, planning, and control. For example, the outpatient revenue percentage for Middaugh is presented in Figure 3.5. Between any two quarters there may be a 2.5% change in the outpatient revenue percentage, an observation that might be missed looking only at the annual data. 87 smi81240_03_c03_059-094.indd 87 3/7/14 9:31 AM Section 3.6 Trend Analysis Figure 3.5: Outpatient revenue percentage trend analysis, Middaugh United Hospital, 2009–2012 60 Percentage 58 56 54 52 50 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 1Q 2Q 3Q 4Q 2009 2009 2009 2009 2010 2010 2010 2010 2011 2011 2011 2011 2012 2012 2012 2012 Quarter of year Source: Author’s calculations. Examination of trends in data can help to focus analysis of financial performance on particular time periods, highlight unusual data points, and even permit understanding of expected values for the future. For many organizations, having an unusual value for a measure of performance in one month might not raise a concern. Having unusual values—particularly negative values—for more than two or three months might lead to further investigation. Analyze This Monthly occupancy rates of Chamberlin Skilled Nursing for 2012 are presented here. Are there any obvious trends in these data that management should monitor or months that merit attention? Explain your reasoning. January 94.4% July 92.8% April 93.9% October 99.3% February March May June 88.3% August 95.6% September 90.8% November 91.5% December Average for 2012 88.2% 98.3% 96.9% 95.3% 93.8% 88 smi81240_03_c03_059-094.indd 88 3/7/14 9:31 AM Section 3.7 Limitations of Financial and Operating Ratios For Review: 1. How many time periods are required for a good trend analysis? There is no magic number of time periods for a good trend analysis. Having more time periods can enable a better sense of trends than just two years. For data that vary seasonally, having data over multiple seasons can be helpful. 3.7 Limitations of Financial and Operating Ratios Developing a plan for evaluating financial performance and executing the plan is a sound financial management practice. However, it should be noted that there are many limitations to the use of financial statements as the basis for evaluation and limitations to the meaning and interpretation of any particular financial or operating ratio included in the evaluation. Financial statements should not be relied upon completely (Beaver, 1991). These statements provide recent historical information, sometimes missing longer-term trends, and do not provide information on what will happen next. Financial statements also provide information in a manner that is appropriate for reporting, but not necessarily evaluating or predicting results. Most healthcare organizations conduct regular financial performance evaluations. Exceptions are some governmental agencies, particularly public health departments (Suarez, Lesneski, & Denison, 2011). Governmental agencies follow different accounting practices and are subject to political processes that make management different from community-based not-for-profit or investor-owned organizations. Still, there is a case to be made for being attentive to good financial management of every organization, perhaps even more attentive to those owned by the government. Hospitals, nursing homes, and other large healthcare organizations have readily available reports from which to obtain data. Specialty organizations and organizations that are not routinely evaluated may be challenged to find standards for assessment and comparisons. Each measure or indicator of performance described in this chapter has strengths and weaknesses. Each profitability measure lends insight into an aspect of profitability but says nothing about liquidity or leverage. There have been many attempts to create composite measures of performance, yet there are no widely accepted approaches. There is no easy way to avoid the need to examine several measures, capturing various dimensions of performance and crafting a full interpretation. Good information technology may enable the programming of systems to produce reports of several measures on a regular basis, thereby reducing the need to actually perform the calculations. Finally, financial statements focus on financial results, not other results that may be of concern to decision makers. Many healthcare organizations have implemented balanced scorecards as a way to include a broad set of information relevant to decision makers (Inamdar & Kaplan, 2002). Financial performance is included in most all balanced scorecards, which often include customer views, staff views, and measures of innovation and growth. Financial statement information is important, yet not all encompassing. Analyze This Overall, how would you characterize the financial performance of Middaugh United Hospital in 2012 and 2011? Explain your reasoning. 89 smi81240_03_c03_059-094.indd 89 3/7/14 9:31 AM Summary & Resources For Review: 1. Besides financial performance, what other factors matter in the overall evaluation of a healthcare organization? An overall evaluation of a healthcare organization would consider the mission of the organization and measures of achieving the mission. The quality of care and the accessibility of the care are commonly considered items for the missions of healthcare organizations. Summary & Resources Chapter Summary This chapter has presented a framework and a set of common measures for conducting a financial performance evaluation of a healthcare organization. A financial performance evaluation requires selecting performance measures, setting standards, and calculating and interpreting results. For each aspect of financial performance, profitability, liquidity, leverage, and operational efficiency, there are several measures and indicators from which to choose. Selecting at least one measure of each aspect of financial performance can help to develop a broad picture of a healthcare organization. Comparisons of current performance with past performance provide important information about relative performance (better or worse), but they do not provide information on absolute performance (good or bad). Establishing internal targets or using external sources of information are required for evaluations of absolute performance. Ideally, a sound budget process would employ internal views and benchmarking of competitive organizations to create standards for performance. Financial statements provide a central data source for many measures of financial performance. Profitability, liquidity, and leverage measures can be created from standard financial statements. Some measures and indicators of position and operational efficiency can be derived from data on financial statements or in the footnotes. Other measures must be derived from information related to financial results that may not be consistently included in the financial statements. Measures of nonfinancial performance, such as access to care or quality of care, lie outside financial performance evaluations, though they may be combined with financial measures in broader scorecards. Discussion Questions 1. Many healthcare organizations evaluate financial performance, in part, to recognize the work efforts of senior managers. If senior managers were paid bonuses based upon profitability, which measure should be used? 2. Financial managers may work alongside general services managers to address certain measures of liquidity. How might a financial manager and the department administrator for pediatrics work together to reduce days in accounts receivable? 3. If a healthcare organization has a stable occupancy rate of 75%, and it suddenly drops to 65%, should management be concerned? How quickly should they respond? What can finance do to support a change in occupancy rates? 90 smi81240_03_c03_059-094.indd 90 3/7/14 9:31 AM Summary & Resources Exercises 1. Using Exhibit 3.6, data for Butler Hospital: • Calculate the italicized ratio for 2012 and 2011. • Comment on whether the performance of the organization has gotten better or worse based on the ratio. • Provide a direct answer to the question associated with each ratio. a. Based upon the operating margin and total (profit) margin, is Butler a profitable hospital? b. Using the days cash on hand ratio, do you think that Butler has enough cash to pay its bills? c. Are the recent changes in days in accounts receivable consistent with an organization attempting to approve efficiency? d. To support paying higher salaries next year, management is concerned that they would have to defer other expenses, particularly those like equipment purchases that can be deferred for a short period of time, but not indefinitely. Using the average age of plant, does it appear that Butler has been deferring equipment purchases or has the flexibility to do so now? Exhibit 3.6 Butler Hospital’s balance sheet and income statement Butler Hospital, balance sheet 2012 2011 Assets Cash and marketable securities Patient accounts receivable Less: Allowances for uncollectible accounts Net patient accounts receivable Inventory Other current assets Current assets $5,822,390 14,043,370 (4,844,059) 9,199,311 941,177 946,443 $16,909,321 $5,170,555 12,171,419 (3,975,219) 8,196,200 973,257 894,447 $15,234,459 Property, plant, and equipment Less: Accumulated depreciation Net fixed assets Total assets $41,893,652 (21,593,214) 20,300,438 $41,511,587 $35,210,322 (18,902,203) 16,308,119 $38,556,896 $24,229,888 $32,832,179 $57,062,067 $24,490,749 $32,048,968 $56,539,717 Assets limited as to use $4,301,828 Liabilities and fund balances Current liabilities Long-term liabilities Total liabilities Total fund balances Total liabilities and fund balances ($15,550,480) $41,511,587 $7,014,318 ($17,982,821) $38,556,896 (continued) 91 smi81240_03_c03_059-094.indd 91 3/7/14 9:31 AM Summary & Resources Exhibit 3.6 Butler Hospital’s balance sheet (continued) Butler Hospital, income statement Revenues Inpatient revenue Outpatient revenue Net patient revenues 2012 Expenses Salary expense Contract labor (temporary workers) expense Fringe benefits expense Administrative and general expenses Pharmacy expense Maintenance and utilities cost Depreciation expense Lease cost Interest expense Other expenses Total operating expense Operating income Income from investments Miscellaneous nonpatient revenue Total nonpatient revenue Net income or (loss) $53,269,263 60,691,737 $113,961,000 $53,620,947 56,496,599 $110,117,546 $57,424,694 3,709,089 13,935,382 12,193,704 8,486,386 4,253,944 2,560,733 1,488,222 708,387 9,035,888 $113,796,429 $164,571 $59,386,625 2,827,350 13,090,851 12,193,704 7,422,108 4,327,693 2,585,964 1,655,530 645,048 10,665,797 $114,800,670 ($4,683,124) $134,301 $4,856,719 $4,991,020 $5,155,591 Available beds Total acute days Discharges 2011 165 33,710 6,084 $217,417 $5,800,359 $6,017,776 $1,334,652 165 34,912 6,166 2. Using the data for Chamberlin Skilled Nursing (Exhibit 2.2 and 2.3): • Calculate the listed ratios for 2012 and 2011. • Comment on whether the performance of the organization has gotten better or worse based on the ratio. • Chamberlin Skilled Nursing benchmarks their financial performance against the 75th percentile nationally (being among the best 25% of facilities). Comment on whether the performance meets the benchmark standards. a. b. c. d. e. f. g. Operating margin (benchmark 4.3%) Total margin (benchmark 5.9%) Current ratio (benchmark 3.4) Days cash on hand (benchmark 65) Days accounts receivable (benchmark 33) Average age of plant (benchmark 6.2) Occupancy rate (benchmark 94.5%) 92 smi81240_03_c03_059-094.indd 92 3/7/14 9:31 AM Summary & Resources Key Terms average age of plant A measure of efficiency that reflects the number of years that assets have been in place when the straightline depreciation method is employed, calculated as accumulated depreciation divided by the annual depreciation expense. current ratio A measure of liquidity reflecting the ability to pay bills that may need to be paid quickly, calculated as current assets divided by current liabilities. days accounts receivable (days A/R) A measure of liquidity reflecting timeliness of collections, calculated as net accounts receivable divided by net revenues divided by 365 days. average length of stay A measure of efficiency reflecting how quickly inpatients are treated and released, calculated as the total number of days of patient care provided divided by the number of patients discharged. days cash on hand A measure of liquidity reflecting the number of days of continuing operations with available resources, calculated as cash and cash equivalents and marketable securities divided by operating expenses less depreciation divided by 365 days. A narrow definition would include only cash and cash equivalents and marketable securities that are held as current assets. A broader definition would add marketable securities held as assets limited as to use. average payment period A measure of liquidity reflecting the timeliness of bill payments, calculated as current liabilities divided by total operating expenses less depreciation divided by 365 days. benchmarking The process of making comparisons of performance measures against a specific set of healthcare organizations, often those organizations with aspirational levels of performance. debt ratio A measure of leverage reflecting overall obligations, calculated as total liabilities divided by total assets and then multiplied by 100%. budget An advance statement of the income statement of an organization; often including presentation of much greater detail than would be found in an income statement. leverage The category of performance measures that indicates the level of debt an organization has undertaken. capital expenditures to depreciation A measure of efficiency reflecting an organization’s efforts to keep facilities up to date, calculated as purchases of property, plant, and equipment divided by the annual depreciation expense and then multiplied by 100%. liquidity The category of performance measures that indicates the ability of an organization to pay its bill. long-term debt to capitalization A measure of leverage reflecting the permanent financing of an organization, calculated as long-term liabilities divided by the sum of long-term liabilities and net assets and then multiplied by 100%. cash flow margin A measure of profitability for the organization as a whole on a cash basis, calculated as cash flow from operations divided by total revenues and then multiplied by 100%. 93 smi81240_03_c03_059-094.indd 93 3/7/14 9:31 AM Summary & Resources Medicare payment percentage A measure of position indicating the share of revenues associated with Medicare patients, calculated as net Medicare revenues divided by total patient revenues and then multiplied by 100%. return on assets A measure of profitability for the organization as a whole on the basis of available assets, calculated as total profit (net income) divided by total assets and then multiplied by 100%. salaries to revenues ratio An efficiency measure reflecting expenses associated with employees, calculated as the sum of salary and benefits expenses divided by net patient revenue and then multiplied by 100%. occupancy rate A measure of efficiency reflecting use of inpatient bed capacity, calculated as the number of inpatient days of care divided by the average number of staffed beds multiplied by 365 days, and then multiplied by 100%. total profit margin A measure of profitability for the organization as a whole on the basis of revenues earned, calculated as total profit (net income) divided by total revenues and then multiplied by 100%. operating margin A measure of profitability from operations (patient services), calculated as operating income divided by operating revenues and then multiplied by 100%. trend analysis The process of examining measures of financial performance over more than one or two periods of time. Examining multiple years of data or many months of data, patterns may emerge that provide a better understanding of performance. outpatient revenue percentage A measure of position indicating the share of services provided on an outpatient basis, calculated as net outpatient revenues divided by total patient revenues and then multiplied by 100%. profitability The category of performance measures that indicates the earnings of an organization as a percentage of revenues, assets, or another value. Suggested Websites • • • • For financial statements of California hospitals, California’s Office of Statewide Health Planning & Development, see http://www.oshpd.ca.gov/HID/DataFlow/HospFinancial.html For financial statements of Massachusetts hospitals, Massachusetts’ Center for Health Information and Analysis, see http://www.mass.gov/chia/researcher/hcf-data-resources/hospital-financial -performance/ For information on rating agencies and data on financial ratios, see Fitch (http://www.fitch.com), Moody’s (http://www.moodys.com), and Standard & Poor’s (http://www.standardandpoors.com) For financial statements of Washington hospitals, State of Washington’s Department of Health, see http://www.doh.wa.gov/DataandStatisticalReports/HealthcareinWashington /HospitalandPatientData/HospitalFinancialData.aspx 94 smi81240_03_c03_059-094.indd 94 3/7/14 9:31 AM 8 Time Value of Money Fuse/Thinkstock Learning Outcomes By the end of this chapter, you will be able to: • Explain the role of corporate finance in a healthcare organization • Explain the time value of money in terms of opportunity cost • Calculate the future value of single and multiple cash amounts, as well as with compounding interest • Calculate the present value of single and multiple cash amounts, as well as perpetuities and annuities • Calculate payments and investment amounts smi81240_08_c08_195-220.indd 195 3/10/14 2:20 PM Section 8.1 Introduction to Corporate Finance Introduction In order to remain profitable in the face of declining numbers of inpatient admissions and patient days, Bixby Hospital is evaluating a number of possible services that would better meet the needs of patients requiring higher levels of medical technology than are currently available. One possible area of interest is a sleep lab. Diagnosis of sleep apnea and other sleep disorders will require some renovations to clinic space for which Bixby might use current resources, solicit donations, save money for the investment, or borrow from a bank. The decision by itself may not be difficult, but a sleep lab is only one of a number of areas of interest that have been raised by the medical staff and managers. The medical needs of the community will be an important part of the investment decision. The financial impact on the organization over several years will also be important. In this chapter, the focus will be on tools to enable analyses of financial impact over time. Knowing the future value of funds that are invested now and the present value of amounts that will be received in the future is the foundation for analyses in corporate finance. 8.1 Introduction to Corporate Finance The field of healthcare finance has three main components: financial accounting, managerial accounting, and corporate finance. Corporate finance involves decision making about asset acquisition and other long-term investment decisions. In addition to decisions about which assets to invest in, finance is also concerned with the determination of methods to pay for investments, through the use of debt and equity. The capital expenditure budget and the planned balance sheet are important products of corporate finance. Financial management involves many trade-offs. As discussed in Chapter 7, many components of the budgeting process involve trade-offs between planning and control. Decision making for the short-term operating budget also involves making trade-offs among organizational goals, especially among profitability, viability, and service missions. Profitability of the healthcare organization itself involves trade-offs between risk and return. Quite simply, to earn higher expected profits, organizations must take more risks. The risk-return trade-off will be the focus of Chapter 9. Viability also involves a trade-off between liquidity and investments in plant and equipment. In the short run, it is safe to invest funds in marketable securities where the organization can gain access to cash quickly if needed. In the long run, it is necessary to invest funds in plant and equipment. Decision making among alternative investments in plant and equipment to provide healthcare services will be the focus of Chapter 10. The current chapter develops the tools required for corporate finance and long-term financial decision making. Information provided on current financial statements and budgets is usually adequate for short-run decisions. Calculating the number of patient visits required for a clinic to break even only requires information on the fixed cost, average variable cost, and price of patient visits. Determining whether it is appropriate to take the risk of building a new clinic that will serve patient needs over the next 20 years requires substantially more information and more tools for analysis. Tools for analyzing flows of funds that occur over the long-term planning are presented here. 196 smi81240_08_c08_195-220.indd 196 3/10/14 2:20 PM Section 8.2 Time Value of Money For Review: 1. How is corporate finance different from accounting? Corporate finance is a process of analysis and decision making, focused on long-term asset acquisition and how to pay for it. Managerial accounting is a process of analysis and decision making, focused on short-term operations of an organization. Financial accounting is a process of recordkeeping and reporting, not decision making. 8.2 Time Value of Money The concepts of inflation and interest are common in everyday life. Almost every year, goods and services cost more the next year than the previous year due to inflation. Workers seek higher wages because the value of what they can buy with the same amount of money decreases with inflation. As displayed in Figure 8.1, prices paid by consumers for all items have increased in all recent years, except during the worst part of the recession in 2009 (United States Department of Labor, n.d.). For a consumer to purchase the same set of items in 2012 as they did in 2004, they would need to have had wage increases averaging 2.5% per year. The consumer cost for medical services has also increased in recent years and has usually increased by more than the average of all items. Figure 8.1: Consumer price index (inflation) and interest rates, 200422012 8% 6% 4% 2% 0% 2004 2005 2006 2007 2008 Year 2009 2010 2011 2012 –2% Consumer Price Index–All Items Consumer Price Index–Medical Care Services Interest Rate–20 Year Baa Bond Source: Bureau of Labor Statistics (http://www.BLS.gov), Consumer Price Index—All Urban Consumers—All items, Series ID: CUUR0000SA0; Consumer Price Index—All Urban Consumers—Medical Care Services, Series ID: CUUR0000SAM2; Federal Reserve (http://www.federalreserve.gov/), Moody’s Yield on Seasoned Corporate Bonds, All Industries, Baa, Unique Identifier: H15/H15/ RIMLPBAAR_N.A. 197 smi81240_08_c08_195-220.indd 197 3/10/14 2:20 PM Section 8.2 Time Value of Money Data on interest rates tell a similar story over time. Interest is the price for borrowing money. To obtain a loan to purchase buildings or equipment, healthcare organizations are charged interest on the amount borrowed. As presented in Figure 8.1, the rate of interest per year on 20-year loans has been between 4.9% and 7.4% in recent years. Consumers, organizations, and banks all have the same concerns about prices over time, all recognizing the time value of money. The time value of money refers to the recognition that, due to inflation and interest, holding a dollar today is different from receiving a dollar one year from now. For a consumer, as well as for a healthcare organization, receiving a dollar one year from now is worth less than a dollar in hand today, due to inflation. For banks, healthcare organizations, and consumers who have funds available for investing, receiving a dollar one year from now is worth less than a dollar in hand today due to the opportunity cost of investing. The opportunity cost of investing is the next best alternative use of dollars. The cost of investing, and its relationship to risk and return, is a core concept in finance that is elaborated upon in Chapter 9. With a time value to money, recognizing the value of dollar amounts requires precise accounting for when dollar amounts are spent and received. For ease of presentation and explanation, it is common in finance to display dollar amounts on timelines. A timeline is simply a visual representation of cash flows for an organization. The first timeline shows that $1,000 is held right now, at Time 0. Time 0 Time 1 Time 2 Time 3 $1,000 The second timeline shows that $1,000 will be received at Time 1. Time 0 Time 1 Time 2 Time 3 $1,000 The third timeline shows that $1,000 will be received at Time 1 and another $1,000 will be received at Time 2. Time 0 Time 1 Time 2 $1,000 $1,000 Time 3 Unless it is stated otherwise, the convention in financial calculations is to assume that dollar amounts spent and received are done so at the end of a time period. If our example timelines referred to years, then Time 0 might be December 31, 2013, Time 1 might refer to December 31, 2014, and so forth. When dollar amounts are spent and received at the beginning of the 198 smi81240_08_c08_195-220.indd 198 3/10/14 2:20 PM Section 8.3 Future Value time period, this difference can be highlighted. The fourth timeline shows that $1,000 will be received at Time 1 at the end of the period, and Time 2 at the beginning of the period. Time 0 Time 1 Time 2 Time 3 $1,000 $1,000 For loans and payments of bills, the exact date of the payment is important as there may be fees or penalties associated with late payments. For financial analyses conducted for planning purposes, receipts on December 31 and January 1 are close enough to be thought of as happening at the same time. For Review: 1. Create a timeline for cash amounts of $600 available for investing at Time 0 (December 31, 2014) and Time 1 (December 31, 2015). Time 0 Time 1 $600 $600 Time...
Purchase answer to see full attachment