. 18
( 21)


records of the receipts collected, usually via an electronic data transmission
system in a format that permits online updating of the ¬rm™s receivables
A lockbox system reduces the time required for a business to receive
incoming checks, to deposit them, and to get them cleared through the
banking system, so that the funds are available for use more quickly. This
time reduction occurs because mail time and check collection time are both
reduced if the lockbox is located in the geographic area where the customer
is located. Lockbox services can often increase the availability of funds by one
to four days over the regular system for ¬rms with customers over a large
geographical area.
500 Healthcare Finance

Lockbox systems, although ef¬cient in speeding up collections, result in
the ¬rm™s cash being spread around among many banks. The primary purpose
of concentration banking is to mobilize funds from decentralized receiving lo-
cations, whether they are lockboxes or decentralized company locations, into
one or more central cash pools. In a typical concentration system, the ¬rm™s
collection banks record deposits received each day. Based on disbursement
needs, the funds are then transferred from these collection points to a concen-
tration bank. Concentration accounts allow ¬rms to take maximum advantage
of economies of scale in cash management and investment. Health SouthWest
uses an Oklahoma City bank as its concentration bank. The HMO cash man-
ager then uses this pool for short-term investing or reallocation among its
other banks.
One of the keys to concentration banking is the ability to quickly trans-
fer funds from collecting banks to concentration banks, and electronic systems
make such transfers easy. Automated clearinghouses are communications net-
works that provide a means of sending data from one ¬nancial institution to
another. Instead of using paper checks, computer ¬les are created, and all en-
tries for a particular bank are placed on a single ¬le that is sent to that bank.
Some banks send and receive their data on tapes, while others have direct
computer links to the clearinghouse.

Disbursement Accelerated collections represent one side of using ¬‚oat, and controlling funds
Control out¬‚ows is the ¬‚ip side of the coin. Ef¬cient cash management can only result
if both in¬‚ows and out¬‚ows are effectively managed.
No single action controls disbursements more effectively than payables
centralization. This permits the ¬rm™s managers to evaluate the payments
coming due for the entire ¬rm and to schedule cash transfers to meet these
needs on a companywide basis. Centralized disbursement also permits more
ef¬cient monitoring of payables and ¬‚oat balances. However, centralized dis-
bursement can have a downside”centralized of¬ces may not be able to make
prompt payment for services rendered, which can create ill will with suppliers.
Zero-balance accounts (ZBAs) are special disbursement accounts that
have a zero-dollar balance on which checks are written. Typically, a ¬rm
establishes several ZBAs in the concentration bank and funds them from a
master account. As checks are presented to a ZBA for payment, funds are
automatically transferred from the master account. If the master account goes
negative, it is replenished by borrowing from the bank against a line of credit
or by selling some securities from the ¬rm™s marketable securities portfolio.
Zero-balance accounts simplify the control of disbursements and cash balances
and hence reduce the amount of idle (i.e., noninterest-bearing) cash.
Whereas zero-balance accounts are typically established at concentra-
tion banks, controlled disbursement accounts can be set up at any bank. In fact,
controlled disbursement accounts were initially used only in relatively remote
Chapter 16: Current Asset Management and Financing

banks, so this technique was originally called remote disbursement. The basic
technique is simple: Controlled disbursement accounts are not funded until
the day™s checks are presented against the account. The key to controlled dis-
bursement is the ability of the bank that has the account to report the total
amount of checks received for clearance each morning. This early noti¬ca-
tion gives a ¬rm™s managers suf¬cient time to wire funds to the controlled
disbursement account to cover the checks presented for payment.

Matching the Costs and Bene¬ts of Cash Management
Although a number of techniques have been discussed to reduce cash balance
requirements, implementing these procedures is not a costless operation. How
far should a ¬rm go in making its cash operations more ef¬cient? As a gen-
eral rule, the ¬rm should incur these expenses only so long as the marginal
returns exceed the marginal costs. Larger ¬rms, with larger cash balances, can
better afford to hire the personnel necessary to maintain tight control over
their cash positions. Cash management is one element of business operations
in which economies of scale are present. Banks also have placed considerable
emphasis on developing and marketing cash management services. Because of
scale economies, banks can generally provide these services to smaller com-
panies at lower costs than companies can achieve by operating in-house cash
management systems.

1. What is ¬‚oat?
2. How do ¬rms use ¬‚oat to increase cash management ef¬ciency?
3. What are some methods businesses can use to accelerate receipts?
4. What are some methods businesses can use to control disbursements?
5. How should cash management actions be evaluated?

Marketable Securities Management
Many businesses hold temporary portfolios of securities called marketable
securities. Although cash and marketable securities management are discussed
in separate sections, they cannot be separated in practice because management
of one implies management of the other. There are two primary reasons
for these holdings: (1) they serve as an interest-earning substitute for cash
balances and (2) they are used to hold funds that are being accumulated
to meet a speci¬c near-term obligation, such as a tax payment. In addition
to marketable securities holdings, not-for-pro¬t hospitals tend to hold large
portfolios of long-term securities (as explained in the next section).
In general, the key characteristic sought in marketable securities in-
vestments is safety. Thus, most health services managers are willing to give up
some return to ensure that funds are available, in the amounts expected, when
502 Healthcare Finance

needed. Large businesses, with large amounts of surplus cash, often directly
own securities such as Treasury bills, commercial paper, and negotiable cer-
ti¬cates of deposit. In addition, large taxable ¬rms often hold preferred stock
because of its 70 percent dividend exclusion from federal income taxes.
Conversely, smaller businesses are more likely to invest with a bank or
with a money market or preferred stock mutual fund because a small ¬rm™s
volume of investment simply does not warrant its hiring specialists to manage
a marketable securities portfolio. Small businesses often use a mutual fund
and then literally write checks on the fund to bolster the cash account as the
need arises.3 Interest rates on mutual funds are somewhat lower than rates on
direct investments of equivalent risk because of management fees. However,
for smaller companies, net returns may well be higher on mutual funds because
no in-house management expense is required.

Self-Test 1. Why do ¬rms hold marketable securities portfolios?
Questions 2. What are some securities that are commonly held as marketable
3. Why are these the securities of choice?

Long-Term Securities Management
Not-for-pro¬t providers, and hospitals in particular, often have large portfolios
of long-term security holdings, which is something that is not common in
other businesses. These holdings are listed on the balance sheet as long-
term investments. The reasons that not-for-pro¬t hospitals typically carry large
amounts of long-term securities are as follows:

• Not-for-pro¬t hospitals often set aside funds for future ¬xed asset
replacement rather than obtain the funds at the time the assets are
acquired. Because the funds for this purpose generally stem from
depreciation-generated cash ¬‚ow, as opposed to net income, such a
portfolio usually is called the funded depreciation portfolio.
• Many hospitals self-insure at least part of their professional liability
exposure and hence establish an investment pool to meet actuarial needs.
• Many hospitals have de¬ned bene¬t pension plans, which require a
¬rm-sponsored pension fund.
• Not-for-pro¬t hospitals receive endowment gifts that must be managed
over time. If a separate foundation is not established, such funds must be
carried on the hospital™s balance sheet.

The selection of securities for long-term investment portfolios obvi-
ously is quite different from the selection of those for marketable securities
portfolios. With time now on their side, managers are more willing to take risks
Chapter 16: Current Asset Management and Financing

to gain a return edge. For example, the typical hospital™s funded depreciation
account (portfolio) consists of about 30 percent stocks, 50 percent bonds, and
20 percent cash equivalents. Furthermore, the typical endowment fund con-
sists of 50 percent stocks, 40 percent bonds, and 10 percent cash equivalents.
It is clear that hospital managers, especially those managers at large hospitals
and hospital systems with large amounts of money to invest, are willing to
create riskier portfolios in the search for higher returns. With time on the side
of long-term investment portfolios, a series of years with below-average results
can still be salvaged by just a few years with above-average performance.

1. Why do businesses, mostly not-for-pro¬t hospitals, hold long-term
investment portfolios?
2. Why do the securities held differ from those held in marketable
securities portfolios?

Receivables Management
Generally, businesses would rather sell for cash than on credit, but competitive
pressure forces most ¬rms to offer credit. The problem is most acute in
the health services industry, where the third-party payment system forces
providers to extend credit to most patients. In a credit sale, goods are shipped
or services are provided, inventories are reduced, and an account receivable is
created. Eventually, the customer or third party payer will pay the account, at
which time the business will receive cash and its receivables will decline.

The Accumulation of Receivables
The total amount of accounts receivable outstanding at any given time is deter-
mined by two factors: the volume of credit sales and the average length of time
between sales and collections. For example, suppose Home Infusion provides
an average of 10 home health visits a day at an average net charge of $100 per
visit, for $1,000 in average daily billings (ADB). Assuming 250 workdays a
year, the company™s annual billings total $1,000 — 250 = $250,000. Further-
more, assume that all services are paid by two third-party payers: one pays for
half of the billings 15 days after the service is provided and the second pays
for the other half of billings in 25 days. Home Infusion™s average collection
period (ACP), also called days in patient accounts receivable, is 20 days.

ACP = (0.5 — 15 days) + (0.5 — 25 days) = 20 days.
Assuming a constant uniform rate of services provided, and hence
billings, the accounts receivable balance will at any point in time be equal to
ABD — ACP. Thus, Home Infusion™s receivable balance would be $20,000:

Receivables balance = ADB — ACP = $1,000 — 20 = $20,000.
504 Healthcare Finance

What is the cost implication of carrying $20,000 in receivables? The
$20,000 on the left side of the balance sheet must be ¬nanced by a like amount
on the right side.4 Home Infusion uses a bank loan to ¬nance its receivables,
which has an interest rate of 8 percent. Thus, over a year, the ¬rm must pay
the bank 0.08 — $20,000 = $1,600 in interest to carry its receivables balance.
The cost associated with carrying other current assets can be thought of in a
similar way.

Monitoring the Receivables Position
If a service is provided for cash, the resulting revenue is collected “on the
spot,” but if payment for the service is billed to a third-party payer, the
revenue is not actually received until the account is collected. If the account is
never collected, the revenue is never received. Thus, health services managers
must monitor receivables to ensure that they are being collected in a timely
manner and to uncover any deterioration in the “quality” of receivables. Early
detection can help managers take corrective action before the situation has a
signi¬cant negative impact on the organization™s ¬nancial condition.
The ACP, which is a measure of the average length of time it takes
patients (or third-party payers) to pay their bills, often is compared to the in-
dustry average ACP. For example, if the home health industry average ACP is
22 days versus Home Infusion™s 20-day ACP, then its collections department
is doing a better-than-average job.
Note however, that even though Home Infusion™s payers are, on aver-
age, paying faster than the 22-day industry average, its two payers are paying
in 15 days and 25 days. Thus, the ¬rm™s collections department should take a
hard look to see if the ACP of the 25-day payer can be reduced to the industry
average, or even to the 15 days of the other payer.
Why is it so important to minimize a business™s average collection
period? To illustrate, assume that Home Infusion™s ACP was 25 days, and
hence its receivables balance was $25,000. Assuming an 8 percent cost of
¬nancing (carrying) its receivables, the annual carrying cost to Home Infusion
is 0.08 — $25,000 = $2,000. But, at its actual ACP of 20 days, its carrying
costs are only 0.08 — $20,000 = $1,600. Thus, by reducing its ACP by 5
days, Home Infusion reduced its receivables carrying costs by $400 annually.
“No big deal,” you say. True, but now consider a 500-bed hospital with $100
million in receivables and a 60-day ACP, which implies average daily billings
(ADB) of $100 / 60 = $1.67 million. A reduction of ACP by 5 days would
reduce the receivables balance to $1.67 — 55 = $91.85 million, or by about
$8 million. Assuming the same 8 percent cost of carrying receivables, the
savings amounts to a substantial 0.08 — $8 = $0.64 million = $640,000.
In addition, the hospital would receive a one-time cash ¬‚ow of $8 million as
the receivables balance is reduced. It should be apparent that immediate cash
¬‚ow as well as large savings can be obtained by reducing a business™s ACP,
and hence its receivables balance.
Chapter 16: Current Asset Management and Financing

An aging schedule breaks down a ¬rm™s receivables by age of account. To il- Aging
lustrate, Table 16.2 contains the December 31, 2004, aging schedules of two Schedules
home health companies: Home Infusion and Home Care. Both ¬rms offer the
same services and show the same total receivables balance. However, Home
Infusion™s aging schedule indicates that it is collecting its receivables faster
than does Home Care. Only 50 percent of Home Infusion™s receivables are
more than 10 days old, while Home Care shows 55 percent of its receivables
fall into the over 10 day categories. More importantly, Home Care has re-
ceivables that are over 30 days old, and even some that are over 40 days old.
Based on an industry average ACP of 22 days, Home Care™s managers should
be concerned both about the ef¬ciency of the ¬rm™s collections effort and the
ability of the late payers to actually make the payments due.
Aging schedules cannot be constructed from the type of summary data
that are reported in a ¬rm™s ¬nancial statements; they must be developed
from the ¬rm™s accounts receivable ledger. However, well-run businesses have
computerized accounts receivable records. Thus, it is easy to determine the
age of each invoice, sort electronically by age categories, and thus generate an
aging schedule.

Unique Problems Faced by Healthcare Providers
Although the general principles of receivables management discussed up to
this point are applicable to all businesses, healthcare providers face some
unique problems. The most obvious problem is the complexities in billing
created by the third-party-payer system. For example, rather than have a single
billing system that applies to all customers, providers have to deal with the
rules and regulations of many different governmental and private insurers that
use different payment methodologies. Thus, providers have to maintain large
staffs of specialists that operate under the ¬rm™s patient accounts manager.
To illustrate the problem, consider Table 16.3, which contains the
receivables mix for the hospital industry. There are multiple payers within
many of the categories listed in the table, so the actual number of different
payers can easily run into the hundreds.

TABLE 16.2
Home Infusion Home Care
Aging Schedules
Age of Value of Percentage of Value of Percentage of for Two Firms
Account (Days) Account Total Value Account Total Value

0“10 $10,000 50% $ 9,000 45%
11“20 7,500 38 5,000 25
21“30 2,500 12 3,000 15
31“40 0 0 2,000 10
Over 40 0 0 1,000 5
Total $20,000 100% $20,000 100%
506 Healthcare Finance

TABLE 16.3
Payer Percentage of Total Accounts Receivable
Medicare 30.2%
Receivables Mix Commercial insurers 19.5
Medicaid 14.0
Self-pay 13.4
Blue Cross 8.1

Source: Aspen Publishers, Hospital Accounts Receivable Analysis (HARA). Published quarterly.

Table 16.4 provides information on how long it takes hospitals to col-
lect receivables. Because of the large number of payers, and the complexities
involved with billing and follow-up actions, which lead to high error rates,
hospitals clearly have a great deal of dif¬culty in collecting bills in a timely
manner. On average, collecting a receivable takes 62.1 days. However, this
number has decreased in recent years as hospital managers have become in-
creasingly aware of the costs associated with carrying receivables. In spite of
the positive trend, 24.9 percent of receivables still were over 90 days old.
To help providers collect from managed care plans in a timely fashion,
many states have enacted “prompt payment” laws, which require payers to
pay within a mandated time period or face penalties. For example, New York
State requires that all undisputed claims by providers be paid by managed
care plans within 45 days of receipt. If prompt payment is not made, ¬nes
are assessed. In the ¬rst year of enactment (1999), managed care plans were
assessed $266,000 in ¬nes for late payment.

The Revenue Cycle
One of the current “hot” topics in healthcare ¬nance, especially among hos-
pitals, is the revenue cycle. The concept is not new, but it is gaining increased
emphasis as it becomes harder and harder to maintain pro¬tability in today™s
healthcare environment. Generically, the revenue cycle is de¬ned as the set
of recurring business activities and related information processing associated
with billing and collecting for goods or services provided to customers. More
pragmatically, the revenue cycle at provider organizations should ensure that
patients are properly categorized regarding payment obligation, that correct
billing takes place, and that the correct payment is received, all in a timely
For analysis at individual businesses, revenue cycle activities typically are
broken down into three parts: (1) those that occur before service is provided,
(2) those that are simultaneous with the service, and (3) those that occur
Chapter 16: Current Asset Management and Financing

TABLE 16.4
Aggregate Aging Schedule
Age of Account (Days) Percentage of Total Accounts Receivable Industry™s
0“30 42.5% Collection
31“60 21.4 Performance
61“90 11.2
91“120 7.8
Over 120 17.1
Average Collection Period
(Days in Patient Accounts Receivable)
Percentile Values Average Collection Period (Days)
10th 44.0 days
25th 52.5
Median 62.1
75th 73.0
90th 85.1

Sources : a. Aspen Publishers, Hospital Accounts Receivable Analysis (HARA). Published quarterly.
b. Ingenix, Comprehensive Performance Report, published annually.

afterward. Here are some examples of revenue cycle activities and suggested
time frames:

• Preinsurance veri¬cation. Here, the payer status of the patient is
identi¬ed immediately after the appointment (stay) is scheduled.
• Precerti¬cation of managed care patients. If the veri¬cation
indicates that the payer requires precerti¬cation, it should be done
• Preservice patient ¬nancial counseling. The patient should be
counseled before the service regarding both the payer™s and
patient™s responsibilities regarding payment for services.
• Time of service veri¬cation. The patient™s insurance status should
be checked at time of service to ensure that there have been no
changes. The veri¬cation should be done both with the patient and
with the payer.
• Third-party claim submission. The claim should be ¬led as
quickly as possible after the service is rendered, with a maximum
time of ¬ve days. However, speed should not take precedence over
accuracy because incomplete and inaccurate billing accounts for a
large proportion of late payments.
• Third-party follow-up. If payment is not received within 30 days,
a follow-up should be sent.
• Payment receipt and posting. This activity ends the revenue cycle.
508 Healthcare Finance

Once the revenue cycle activities are identi¬ed and timing goals are set for
each activity, the patient accounts manager then must implement a system to
ensure that these goals are being met.

Electronic Claims Processing
One development of note in provider billing and collections is the movement
toward electronic claims processing. In such a system, claims and reimburse-
ment information is electronically transmitted in a standard format that can
be processed without human intervention. Although the electronic data in-
terchange (EDI) of payer information has been around for many years, its im-
plementation has tended to be fragmented and payer unique. However, one
portion of the Health Insurance Portability and Accountability Act (HIPAA)
of 1996 requires that all providers and insurers adhere to speci¬c electronic
data transaction standards. Hopefully, this initiative will provide the impetus
to fully automate all billing and collections data exchange, which would help
ensure the shortest possible revenue cycle.

Self-Test 1. Explain how a ¬rm™s receivables balance is built up over time and why
Questions there are costs associated with carrying receivables.
2. Brie¬‚y discuss two means by which a ¬rm can monitor its receivables
3. What are some of the unique problems faced by healthcare providers in
managing receivables?
4. What is the revenue cycle and how does electronic data interchange
(EDI) ¬t in?

Supply Chain Management
Supply chain management involves the requisitioning, ordering, receipt, and
payment for supplies. Historically, supply chain management was called in-
ventory management. Inventories are an essential part of virtually all business
operations. As is the case with accounts receivable, inventory levels depend
heavily on volume. However, whereas receivables build up after services have
been provided, inventories must be acquired ahead of time. This is a critical
difference, and the necessity of forecasting volume before establishing target
inventory levels makes inventory management a dif¬cult task. Also, because
errors in the establishment of inventory levels quickly lead either to service
problems or to excessive carrying costs, inventory management is as impor-
tant as it is dif¬cult. In the health services industry, inventory management
is especially critical because an inventory shortage could lead to catastrophic
consequences for patients.
Proper supply chain management requires close coordination among
the marketing, purchasing, patient services, and ¬nance departments. The
Chapter 16: Current Asset Management and Financing

marketing department is generally the ¬rst to spot changes in demand. These
changes must be worked into the company™s purchasing and operating sched-
ules, and the ¬nancial manager must arrange any ¬nancing that will be needed
to support inventory buildups. Improper communication among depart-
ments, poor volume forecasts, or both can lead to disaster.
Larger businesses employ computerized inventory control systems. The
computer starts with an inventory count in memory. As withdrawals are made,
they are recorded in the computer, and the inventory balance is revised. When
the order point is reached, the computer automatically places an order, and
when the order is received, the recorded balance is increased.5
A good inventory control system must be dynamic. A large provider
may stock thousands of different items. The usage of these various items can
rise or fall quite separately from rising or falling aggregate utilization. As the
usage rate for an individual item begins to rise or fall, the inventory manager
must adjust its balance to avoid running short or ending up with obsolete
items. If the change in the usage rate appears to be permanent, then the base
inventory level should be recomputed, the safety stock should be reconsidered,
and the computer model used in the control process should be reprogrammed.
A relatively new approach to inventory control called just-in-time (JIT)
is gaining popularity in all industries, including health services. To illustrate
the use of just-in-time systems among providers, consider Bayside Memorial
Hospital, which consumes large quantities of medical supplies each year. A
few years ago, the hospital maintained a 25,000 square foot warehouse to
hold its medical supplies. However, as cost pressures mounted, the hospital
closed its warehouse and sold the inventory to a major hospital supplier. Now,
the supplier is a full-time partner of Bayside in ordering and delivering the
products of some 400 hospital supply companies.
The inventory streamlining process began with daily deliveries to the
hospital™s loading dock, but soon expanded to a JIT system called stockless in-
ventory. Now, the supplier ¬lls orders in exact, sometimes small, quantities and
delivers them directly to departments inside the hospital, including the oper-
ating rooms and nursing ¬‚oors. Bayside™s managers estimate that the stockless
system has saved the hospital about $1.5 million a year since it was instituted,
including $350,000 from staff reductions and $650,000 from inventory re-
ductions. Additionally, the hospital has converted space that was previously
used as storerooms to patient care and other cash-generating uses. The distrib-
utors that offer stockless inventory systems typically add 3 to 5 percent service
fees, but many hospitals still can realize savings on total inventory costs.
However, the stockless inventory concept has its own set of problems.
The major concern is that a stock-out, which occurs when a needed inventory
item is not available, will cause a serious problem. In addition, some hospital
managers are concerned that such systems create too much dependence on a
single supplier, and eventually the cost savings will disappear as prices increase
because of the sole-supplier relationship.
510 Healthcare Finance

As stockless inventory systems become more prevalent in hospitals,
more and more hospitals are decreasing their in-house supply chain manage-
ment, or materials management as it is sometimes called, in favor of outside
contractors who assume both inventory management and supplier roles. In
effect, hospitals are beginning to outsource inventory management. For ex-
ample, some hospitals are experimenting with an inventory management pro-
gram known as point-of-service distribution, which is one generation ahead
of stockless systems. Under point-of-service programs, the supplier delivers
supplies, intravenous solutions, medical forms, and so on to the supply rooms.
The supplier owns the products in the supply rooms until used by the hospital,
at which time the hospital pays for the items.
In addition to reducing inventories, outside inventory managers are
often better at ferreting out waste than are their in-house counterparts. For
example, an inventory management company recently found that one hospital
was spending $600 for products used in open heart surgery, while another was
spending only $420. Because there was no meaningful difference in the pro-
cedure or outcomes, the higher-cost hospital was able to change the medical
devices used in the surgery and pocket the difference.
In an even more advanced form of inventory management, some hos-
pitals are just beginning to negotiate with suppliers to furnish materials on
the basis of how much medical care is delivered, rather than the type and
number of products used. In such agreements, providers pay suppliers a set
fee for each unit of patient service provided”for example, $125 for each case-
mix-adjusted patient day. Under this type of system, a hospital ties its supplies
expenditures to its revenues, which, at least for now, are for the most part
tied to the number of units of patient service. The end of the evolution of
inventory management techniques for healthcare providers is expected to be
some form of capitated payment, whereby providers will pay suppliers a pre-
viously agreed-upon fee, regardless of actual future patient volume and hence
regardless of the amount of materials actually consumed.

Self-Test 1. Why is good supply chain management important to a ¬rm™s success?
Questions 2. Describe some recent trends in inventory management by healthcare

Short-Term Financing
Chapters 11, 12, and 13 focused on long-term ¬nancing decisions. However,
as pointed out in the introduction to Chapter 11, healthcare providers use 5
percent short-term debt in their total ¬nancing mix, typically to fund short-
term (current) assets. This section provides some of the details associated with
short-term ¬nancing.
Chapter 16: Current Asset Management and Financing

Advantages and Disadvantages of Short-Term Debt
Short-term debt has three primary advantages over long-term debt. First, a
short-term loan can be obtained much faster than long-term credit. Lenders
will insist on a more thorough ¬nancial examination before extending long-
term credit, and the loan agreement (or bond indenture) will have to be
spelled out in considerable detail because a lot can happen during the life
of a 10- or 20-year loan (or bond). Thus, if a business requires funds in a
hurry, it should look to the short-term credit markets.
Second, if needs for funds are seasonal or cyclical, a ¬rm may not want
to commit itself to long-term debt for three reasons:
1. Administrative costs are generally high when raising long-term debt
but trivial for short-term debt. Although long-term debt can be repaid
early, provided the loan agreement includes a prepayment provision,
prepayment penalties can be expensive. Accordingly, if a ¬rm thinks
its need for funds may diminish in the near future, it should choose
short-term debt for the ¬‚exibility it provides.
2. Long-term loan agreements always contain restrictive covenants that
constrain the ¬rm™s future actions. Short-term debt agreements are
generally much less onerous in this regard.
3. The interest rate on short-term debt generally is lower than the rate on
long-term debt because the yield curve normally is upward sloping. Thus,
when coupled with lower administrative costs, short-term debt can have a
signi¬cant total cost advantage over long-term debt.
In spite of these advantages, short-term debt has one serious disad-
vantage: it subjects the ¬rm to more risk than does long-term ¬nancing. The
increased risk occurs for two reasons. First, if a ¬rm borrows on a long-term
basis, its interest costs will be relatively stable over time, but if it uses short-
term debt, its interest expense can ¬‚uctuate widely, at times possibly going
quite high. For example, the short-term rate that banks charge large corpo-
rations (the prime rate) more than tripled over a two-year period in the early
1980s, rising from 6.25 to 21 percent.6 Many ¬rms that had borrowed heavily
on a short-term basis simply could not meet their rising interest costs, and as
a result, bankruptcies hit record levels during that period.
Second, the principal amount on short-term debt comes due on a regu-
lar basis. If the ¬nancial condition of a business temporarily deteriorates, it may
¬nd itself unable to repay this debt when it matures. Furthermore, the business
may be in such a weak ¬nancial position that the lender will not extend the
loan. Such a scenario can result in severe problems for the borrower, which,
like unexpectedly high interest rates, could force the business into bankruptcy.

Sources of Short-Term Financing
Statements about the ¬‚exibility, cost, and riskiness of short-term versus long-
term debt depend to a large extent on the type of short-term ¬nancing that is
512 Healthcare Finance

actually used. Three major types of short-term ¬nancing”accruals, accounts
payable, and bank loans”are discussed in the following sections.7

Accruals Firms generally pay employees on a weekly, biweekly, or monthly basis, so the
balance sheet will typically show some accrued wages. Similarly, the ¬rm™s own
estimated income taxes (if applicable), the social security and income taxes
withheld from employee payrolls, and the sales taxes collected are generally
paid on a weekly, monthly, or quarterly basis. Thus, as discussed in Chapter
4, the balance sheet accruals account typically includes both taxes and wages.
Accruals increase automatically, or spontaneously, as a ¬rm™s operations
expand. Furthermore, this type of short-term debt is free in the sense that no
explicit interest is paid on funds raised through accruals. However, a ¬rm can-
not ordinarily control its accruals because the timing of wage payments is set
by economic forces and industry custom, while tax payment dates are estab-
lished by law. Thus, businesses should use all the accruals they can because
they represent free ¬nancing, but managers have little control over the levels
of such accounts.

Accounts Firms often make purchases from other ¬rms on credit. Such debt is recorded
Payable (Trade on the balance sheet as an account payable. Accounts payable, or trade credit,
Credit) is the largest single category of short-term debt for many businesses. Because
very small companies often do not qualify for ¬nancing from other sources,
they rely especially heavily on trade credit.8
Trade credit is another spontaneous source of ¬nancing in the sense
that it arises from ordinary business transactions. For example, suppose that a
hospital purchases an average of $2,000 a day of supplies on terms of net 30”
meaning that it must pay for goods 30 days after the invoice date. On average,
the hospital will owe 30 times $2,000, or $60,000, to its suppliers, assuming
that the hospital™s managers act rationally and do not pay before the credit is
due. If the hospital™s volume, and consequently its purchases, were to double,
its accounts payable would also double to $120,000. Simply by growing,
the hospital would have spontaneously generated an additional $60,000 of
¬nancing. Similarly, if the terms under which it bought supplies were extended
from 30 to 40 days, the hospital™s accounts payable would expand from
$60,000 to $80,000. Thus, a supplier lengthening the credit period, as well
as expanding volume, and hence purchases, generates additional ¬nancing for
a business.
Firms that sell on credit have a credit policy that includes certain terms
of credit. For example, Midwestern Medical Supply Company sells on terms of
2/10, net 30”meaning that a 2 percent discount is given if payment is made
within ten days of the invoice date, with the full invoice amount being due
and payable within 30 days if the discount is not taken. Suppose that Chicago
Health System buys an average of $12 million of medical and surgical supplies
from Midwestern each year, less a 2 percent discount, for net purchases of
Chapter 16: Current Asset Management and Financing

$11,760,000 / 360 = $32,666.67 per day. For the sake of simplicity, suppose
that Midwestern is Chicago Health System™s only supplier. If Chicago Health
System takes the discount, paying at the end of the tenth day, its payables will
average 10 — $32,666.67 = $326,667, so Chicago Health System will, on
average, be receiving $326,667 of credit from its only supplier, Midwestern
Medical Supply Company.
Suppose now that the system™s managers decide not to take the dis-
count. What effect will this decision have on the system™s ¬nancial condition?
First, Chicago Health System will begin paying invoices after 30 days, so its
accounts payable will increase to 30 — $32,666.67 = $980,000.9 Midwestern
will now be supplying Chicago Health System with $980,000 ’ $326,667 =
$653,333 of additional trade credit. The health system could use this addi-
tional credit to pay off bank loans, to expand inventories, to increase ¬xed
assets, to build up its cash account, or even to increase its own accounts
Chicago Health System™s additional credit from Midwestern has a cost
”it is foregoing a 2 percent discount on its $12 million of purchases, so its
costs will rise by $240,000 per year. Dividing this $240,000 dollar cost by the
amount of additional credit provides the implicit approximate percentage cost
of the added trade credit:

Approximate % cost = = 36.7%.

Assuming that Chicago Health System can borrow from its bank or from
other sources at an interest rate less than 36.7 percent, it should not expand
its payables by foregoing discounts.
The following equation can be used to calculate the approximate per-
centage cost, on an annual basis, of not taking discounts:

Discount percent
Approximate % cost =
100 ’ Discount percent
— .
Days credit received ’ Discount period

The numerator of the ¬rst term, Discount percent, is the cost per dollar of
credit, while the denominator in this term, 100 ’ Discount percent, repre-
sents the funds made available by not taking the discount. Thus, the ¬rst term
is the periodic cost rate of the trade credit”in this example, Chicago Health
System must spend $2 to gain $98 of credit, for a cost rate of 2 / 98 = 0.0204
= 2.04%. The second term shows how many times each year this cost is in-
curred; in this example, 360 / (30 ’ 10) = 360 / 20 = 18 times. Putting the
two terms together, the approximate cost of not taking the discount when the
terms are 2/10, net 30, is computed as follows:10
514 Healthcare Finance

2 360
Approximate % cost = — = 0.0204 — 18
98 20
= 0.367 = 36.7%.
The cost of trade credit can be reduced by paying late”that is, by
paying beyond the date that the credit terms allow. Such a strategy is called
stretching. If Chicago Health System could get away with paying Midwestern
in 60 days rather than in the speci¬ed 30, the effective credit period would
become 60 ’ 10 = 50 days, and the approximate cost would drop from 36.7
percent to (2 / 98) — (360 / 50) = 14.7%. In recessionary periods, businesses
may be able to get away with late payments to suppliers, but they will also
suffer a variety of problems associated with stretching accounts payable and
being branded as a slow payer.
On the basis of the preceding discussion, it is clear that trade credit
usually consists of two distinct components:

1. Free trade credit. This credit consists of the free credit received during
the discount period. For Chicago Health System, the free trade credit
amounts to ten days™ net purchases, or $326,667.
2. Costly trade credit. The costly trade credit is that in excess of the
free credit, and whose cost is an implicit one based on the foregone
discount. For Chicago Health System, the amount of costly trade credit is

From a ¬nance perspective, managers should view trade credit in this
way. First, the actual price of supplies is the discounted price”that is, the
price that would be paid on a cash purchase. Any credit that can be taken
without an increase in price is free credit that should be taken. Second, if the
discounted price is the actual price, then the added amount that must be paid
if the discount is not taken is, in reality, a ¬nance charge for granting additional
credit. A business should take the additional credit only if the ¬nance charge
is less than the cost of alternative credit sources.
In the example, Chicago Health System should take the $326,667 of
free credit offered by Midwestern Medical Supply Company. Free credit is
good credit. However, the cost rate of the additional $653,333 of costly trade
credit is approximately 37 percent. The system has access to bank loans at a
9.5 percent rate, so it does not take the additional credit. Under the terms of
trade found in most industries, the costly component will involve a relatively
high percentage cost, so stronger ¬rms will avoid using it.

Bank Loans Commercial banks, whose short-term loans generally appear on ¬rms™ balance
sheets as notes payable, are another important source of short-term ¬nanc-
ing.11 The banks™ in¬‚uence is actually greater than it appears from the dollar
amounts they lend because banks provide nonspontaneous funds. As a busi-
ness™s ¬nancing needs increase, it requests its bank to provide the additional
Chapter 16: Current Asset Management and Financing

funds. If the request is denied, the ¬rm may be forced to abandon attractive
growth opportunities.
Although banks make longer-term loans, the bulk of their lending is
on a short-term basis (about two-thirds of all bank loans mature in a year or
less). Bank loans to businesses are frequently written as 90-day notes, so the
loan must be repaid or renewed at the end of 90 days. When a bank loan is
approved, the agreement is executed by signing a promissory note, which is
similar to a bond indenture or loan agreement but much less detailed. When
the note is signed, the bank credits the borrower™s checking account with
the amount of the loan, while both cash and notes payable increase on the
borrower™s balance sheet.
Banks sometimes require borrowers to maintain a checking account
balance equal to 10 to 20 percent of the face amount of the loan. This
requirement is called a compensating balance, and such balances raise the
effective interest rate on the loan. For example, suppose that Pine Garden
nursing home needs an $80,000 bank loan to pay off maturing obligations. If
the loan requires a 20 percent compensating balance, then the nursing home
must borrow $100,000 to obtain a usable $80,000, assuming that the business
does not have an “extra” $20,000 around to use as a compensating balance.
If the stated interest rate is 8 percent, the effective cost rate is actually 10
percent: 0.08 — $100,000 = $8,000 in interest expense divided by $80,000
of usable funds equals 10 percent.
A line of credit, sometimes called a revolving credit agreement or just
revolver, is a formal understanding between the bank and the borrower, which
indicates the maximum credit the bank will extend to the borrower over some
speci¬ed period of time. For example, on December 31 a bank loan of¬cer
might indicate to Pine Garden™s manager that the bank regards the nursing
home as being good for up to $80,000 during the forthcoming year. If on
January 10, Pine Garden borrows $15,000 against the line, this would be
called taking down $15,000 of the credit line. This take down would be
credited to the nursing home™s checking account at the bank, and before
repayment of the $15,000, Pine Garden could borrow additional amounts
up to a total of $80,000 outstanding at any one time. Lines of credit are
generally for one year or less, and borrowers typically have to pay an up-front
commitment fee of about 0.5 to 1 percent of the total amount of the line.
Interest is paid only on the amount of the credit line that is actually used. As a
general rule, the rate of interest on credit lines is pegged to the prime rate, so
the cost of the loan can vary over time if interest rates change. Pine Garden™s
rate was set at prime plus 0.5 percentage points.

Secured Short-Term Debt
Thus far, the question of whether or not short-term debt is secured has not
been addressed. Given a choice, it is ordinarily better to borrow on an un-
secured basis because the administrative costs associated with secured loans
516 Healthcare Finance

are often high. However, weak businesses may ¬nd that they can borrow only
if they put up some form of security to protect the lender or that by using
security they can borrow at a much lower rate.
Several kinds of collateral, or security, can be employed, including mar-
ketable securities, land or buildings, equipment, inventory, and accounts re-
ceivable. Marketable securities make excellent collateral, but generally, busi-
nesses that need short-term credit do not hold large marketable securities
portfolios. Both real property (i.e., land and buildings) and equipment are
good forms of collateral. However, because of maturity matching, such assets
are generally used as security for long-term loans rather than for short-term
credit. Therefore, most secured short-term business borrowing involves the
use of accounts receivable or inventories as collateral.12
Accounts receivable ¬nancing involves either the pledging of receivables
or the selling of receivables. The pledging of accounts receivable is character-
ized by the fact that the lender not only has a claim against the dollar amount
of the receivables but also has recourse against the pledging ¬rm. This means
that if the person or ¬rm that owes the receivable does not pay, the business
that borrows against the receivable must take the loss. Therefore, the risk of
default on the accounts receivable pledged remains with the borrowing ¬rm.
When receivables are pledged, the payer is not ordinarily noti¬ed about the
pledging, and payments are made on the receivables in the same way as when
receivables are not used as loan security.
The second form of receivables ¬nancing is factoring, or selling accounts
receivable. In this type of secured ¬nancing, the receivables account is actually
“purchased” by the capital supplier, generally without recourse to the selling
business. In a typical factoring transaction, the buyer of the receivables pays
the seller about 90 to 95 percent of the face value of the receivables. When
receivables are factored, the person or business that owes the receivable is often
noti¬ed of the transfer and is asked to make payment directly to the company
that bought the receivables. Because the factoring ¬rm assumes the risk of
default on bad accounts, it must perform a credit check on the receivables prior
to the purchase. Accordingly, factors, which are the ¬rms that buy receivables,
can provide not only money but also a credit department for the borrower.
Incidentally, the same ¬nancial institutions that make loans against pledged
receivables also serve as factors. Thus, depending on the circumstances and
the wishes of the borrower, a ¬nancial institution will provide either form of
receivables ¬nancing.
Because healthcare providers tend to carry relatively large amounts of
receivables, such businesses are prime candidates for receivables ¬nancing. For
example, hospitals alone have accounts receivables that total nearly $15 bil-
lion. The selling of these receivables, especially by hospitals that are experi-
encing liquidity problems, represents one way to reduce carrying costs and
stimulate cash ¬‚ow.13
To illustrate receivables ¬nancing for hospitals, consider the program
Chapter 16: Current Asset Management and Financing

recently instituted between Chase Manhattan Bank and City Hospital, a large
urban hospital. This program provides $15 million in advance funding of
receivables over a three-year period. The hospital sells its accounts receivable
to Chase for cash. The payers of the receivables technically make payments
directly to Chase, although Chase actually pays the hospital a fee to service
the receivables accounts. Chase charges an up-front fee for the program and
then charges an interest rate of about 1 to 1.5 percent above the prime rate
on the amount advanced.
Although receivables ¬nancing is a way to reduce current assets, and
hence ¬nancing costs, critics contend that such programs are too expensive.
Because of costs involved, most receivables ¬nancing programs are used by
providers that have serious liquidity problems, although programs are being
developed that can provide bene¬ts even to well-run businesses that are not
facing a liquidity crunch.
Receivables ¬nancing dominates healthcare providers™ use of secured
¬nancing, but other healthcare businesses, such as equipment manufacturers
and pharmaceutical ¬rms, are more likely to obtain credit secured by business
inventories. If a ¬rm is a relatively good credit risk, the mere existence of the
inventory may be suf¬cient to obtain an unsecured loan. However, if the ¬rm
is a relatively poor risk, the lending institution may insist on security, which
can take the form of a blanket lien against all inventory or a trust receipt against
speci¬c inventory items.

1. What are accruals and what is their role in short-term ¬nancing?
2. What is the difference between free and costly trade credit?
3. How might a hospital that expects to have a cash shortage sometime
during the coming year make sure that needed funds will be available?
4. What are some types of current assets that might be pledged as security
for short-term loans?

Key Concepts
This chapter examined current asset management and ¬nancing. The key
concepts of this chapter are:
• The goal of current asset management and ¬nancing is to support the
business™s operations at the lowest possible cost without taking undue risks.
• Under a high current asset investment policy, a ¬rm holds relatively large
amounts of each type of current asset. A low policy entails holding minimal
amounts of these items, whereas a moderate policy falls between the two
• Permanent assets are those assets that businesses hold even during slack
times, whereas temporary assets are the additional assets, usually current
assets, that are needed to meet seasonal or cyclical peaks. The method
518 Healthcare Finance

used to ¬nance permanent and temporary assets de¬nes the ¬rm™s current
asset ¬nancing policy.
• A moderate approach to current asset ¬nancing involves matching the
maturities of assets and liabilities so that temporary current assets are
¬nanced with temporary ¬nancing and permanent assets are ¬nanced with
permanent ¬nancing. Under an aggressive approach, some permanent
current assets and perhaps some ¬xed assets are ¬nanced with short-term
debt. A conservative approach would be to use long-term capital to
¬nance all permanent assets and some temporary current assets.
• The primary goal of cash management is to reduce the amount of cash
held to the minimum necessary to conduct business.
• Float management techniques include accelerating collections and
controlling disbursements.
• Lockboxes are used to accelerate collections. A concentration banking system
consolidates the collections into a centralized pool that can be managed
more ef¬ciently than a large number of individual accounts.
• Three techniques for controlling disbursements are payables
centralization, zero-balance accounts, and controlled disbursement accounts.
• The implementation of a sophisticated cash management system is costly,
and all cash management actions must be evaluated to ensure that the
bene¬ts exceed the costs.
• Businesses can reduce their cash balances by holding marketable securities.
Marketable securities serve both as a substitute for cash and as a temporary
investment for funds that will be needed in the near future. Safety is the
primary consideration when selecting marketable securities.
• When a business sells goods to a customer on credit, an account receivable
is created.
• Businesses can use an aging schedule and the average collection period
(ACP) to help keep track of their receivables position and to help avoid
the buildup of possible bad debts.
• The revenue cycle includes all activities associated with billings and
collections for services provided.
• Proper supply chain (inventory) management requires close coordination
among the marketing, purchasing, patient services, and ¬nance
departments. Because the cost of holding inventory can be high and
stockouts can be disastrous, inventory management is very important.
• Just-in-time (JIT) systems are used to minimize inventory costs and,
simultaneously, to improve operations.
• The advantages of short-term debt are the speed with which short-term
loans can be arranged, increased ¬‚exibility, and the fact that short-term
interest rates are generally lower than long-term rates. The principal
disadvantage of short-term credit is the extra risk that borrowers must
bear because lenders can demand payment on short notice, and the cost of
the loan will increase if interest rates rise.
Chapter 16: Current Asset Management and Financing

• Accruals, which are continually recurring short-term liabilities, represent
free spontaneous credit.
• Accounts payable, or trade credit, arises spontaneously as a result of
purchases on credit. Businesses should use all the free trade credit they can
obtain, but they should use costly trade credit only if it is less expensive
than alternative sources of short-term debt.
• Bank loans are an important source of short-term credit. When a bank
loan is approved, a promissory note is signed.
• Banks sometimes require borrowers to maintain compensating balances,
which are deposit requirements set at between 10 and 20 percent of the
loan amount. Compensating balances raise the effective rate of interest on
bank loans.
• Lines of credit, or revolving credit agreements, are formal understandings
between the bank and the borrower in which the bank agrees to extend
some maximum amount of credit to the borrower over some speci¬ed
• Sometimes a borrower will ¬nd that it is necessary to borrow on a secured
basis, in which case the borrower uses assets such as real estate, securities,
equipment, inventories, or accounts receivable as collateral for the loan.

This chapter has focused on short-term ¬nancial management rather than the
long-term topics that were covered in earlier chapters. In Chapter 17 we will
cover ¬nancial performance analysis, while in Chapter 18 we will discuss two
unrelated, but interesting, ¬nancial management topics: leasing and business

16.1 Describe three alternative current asset investment policies. Explain
each policy™s risk and return characteristics.
16.2 a. What is the difference between permanent assets and temporary
b. If a ¬rm uses the maturity matching approach to current asset
¬nancing, how will its temporary assets be ¬nanced?
c. Describe three alternative current asset ¬nancing policies. Explain
each policy™s risk and return characteristics.
16.3 a. What is the goal of cash management?
b. Brie¬‚y describe ¬‚oat and the following associated cash management
• Receipt acceleration
• Disbursement control
16.4 a. Give two reasons why businesses hold marketable securities.
b. Which types of securities are most suitable for holding as marketable
520 Healthcare Finance

c. Suppose Southwest Regional Medical Center has just raised $6
million in new capital that it plans to use to build three freestanding
clinics, one each year over the next three years. (For the sake of
simplicity, assume that equal payments have to be made at the end of
each of the next three years.) What securities should be bought for
the ¬rm™s marketable securities portfolio, assuming that the ¬rm has
no other excess cash? (Hint: Consider both the type and maturity of
the securities.)
d. Now, consider the situation faced by the Huntsville Physical Therapy
Group. It has accumulated $20,000 in cash above its target cash
balance, and it has no immediate needs for this excess cash. However,
the ¬rm may at any time need some part or all of the $20,000 to
meet unforeseen cash needs. What securities should be bought for
the ¬rm™s marketable securities portfolio?
16.5 a. De¬ne average collection period.
b. How is it used to monitor a ¬rm™s accounts receivable?
c. What is an aging schedule?
d. How is it used to monitor a ¬rm™s accounts receivable?
16.6 a. What is a just-in-time (JIT) inventory system?
b. What are the advantages and disadvantages of JIT systems?
c. Can JIT inventory systems be used by healthcare providers? Explain
your answer.
16.7 Describe the three major sources of short-term ¬nancing.
16.8 a. What is the difference between free trade credit and costly trade
b. Should businesses use all the free trade credit that they can get?
Explain your answer.
c. Should businesses use all the costly trade credit they can get? Explain
your answer.
16.9 Explain brie¬‚y how businesses can obtain secured short-term ¬nancing.

16.1 On a typical day, Park Place Clinic writes $1,000 in checks. It generally
takes four days for those checks to clear. Each day the clinic typically
receives $1,000 in checks that take three days to clear. What is the
clinic™s average net ¬‚oat?
16.2 Drugs ™R Us operates a mail order pharmaceutical business on the West
Coast. The ¬rm receives an average of $325,000 in payments per day.
On average, it takes four days for the ¬rm to receive payment, from
the time customers mail their checks to the time the ¬rm receives and
processes them. A lockbox system that consists of ten local depository
banks and a concentration bank in San Francisco would cost $6,500
per month. Under this system, customers™ checks would be received
at the lockbox locations one day after they are mailed, and the daily
Chapter 16: Current Asset Management and Financing

total would be wired to the concentration bank at a cost of $9.75 each.
Assume that the ¬rm could earn 10 percent on marketable securities
and that there are 260 working days and hence 260 transfers from each
lockbox location per year.
a. What is the total annual cost of operating the lockbox system?
b. What is the dollar bene¬t of the system to Drugs ™R Us?
c. Should the ¬rm initiate the lockbox system?
16.3 Suppose one of the suppliers to Seattle Health System offers terms of
3/20, net 60.
a. When does the system have to pay its bills from this supplier?
b. What is the approximate cost of the costly trade credit offered by
this supplier? (Assume 360 days per year.)
16.4 Langley Clinics, Inc., buys $400,000 in medical supplies a year (at
gross prices) from its major supplier, Consolidated Services, which
offers Langley terms of 2.5/10, net 45. Currently, Langley is paying
the supplier the full amount due on Day 45, but it is considering taking
the discount, paying on Day 10, and replacing the trade credit with a
bank loan that has a 10 percent annual cost.
a. What is the amount of free trade credit that Langley obtains from
Consolidated Services? (Assume 360 days per year throughout this
b. What is the amount of costly trade credit?
c. What is the approximate annual cost of the costly trade credit?
d. Should Langley replace its trade credit with the bank loan? Explain
your answer.
e. If the bank loan is used, how much of the trade credit should be
16.5 Milwaukee Surgical Supplies, Inc., sells on terms of 3/10, net 30.
Gross sales for the year are $1,200,000 and the collections department
estimates that 30 percent of the customers pay on the tenth day and
take discounts, 40 percent pay on the thirtieth day, and the remaining
30 percent pay, on average, 40 days after the purchase. (Assume 360
days per year.)
a. What is the ¬rm™s average collection period?
b. What is the ¬rm™s current receivables balance?
c. What would be the ¬rm™s new receivables balance if Milwaukee
Surgical toughened up on its collection policy, with the result that
all nondiscount customers paid on the 30th day?
d. Suppose that the ¬rm™s cost of carrying receivables was 8 percent
annually. How much would the toughened credit policy save the
¬rm in annual receivables carrying expense? (Assume that the entire
amount of receivables had to be ¬nanced.)
16.6 Fargo Memorial Hospital has annual net patient service revenues
of $14,400,000. It has two major third-party payers, plus some of
its patients are self-payers. The hospital™s patient accounts manager
522 Healthcare Finance

estimates that 10 percent of the hospital™s paying patients (its self-
payers) pay on Day 30, 60 percent pay on Day 60 (Payer A), and 30
percent pay on Day 90 (Payer B). (Five percent of total billings end up
as bad debt losses, but that is not relevant for this problem.)
a. What is Fargo™s average collection period? (Assume 360 days per
year throughout this problem.)
b. What is the ¬rm™s current receivables balance?
c. What would be the ¬rm™s new receivables balance if a newly
proposed electronic claims system resulted in collecting from
third-party payers in 45 and 75 days, instead of in 60 and 90 days?
d. Suppose the ¬rm™s annual cost of carrying receivables was 10
percent. If the electronic claims system costs $30,000 a year to
lease and operate, should it be adopted? (Assume that the entire
receivables balance has to be ¬nanced.)

1. At the limit, a business could attempt to match exactly the maturity structure
of its assets and liabilities. Inventory expected to be sold in 30 days could be
¬nanced with a 30-day bank loan, a machine expected to last for ¬ve years could
be ¬nanced by a ¬ve-year loan, a 20-year building could be ¬nanced by a 20-year
mortgage bond, and so forth. Actually, three factors make this exact maturity
matching strategy both unpractical and wrong: (1) there is uncertainty about the
lives of assets; (2) some common equity (or fund capital) must be used, and this
capital has no maturity; and (3) to develop a meaningful current asset ¬nancing
policy it is necessary to consider whether an asset is permanent or temporary.
2. This discussion of cash management is necessarily brief. For a much more
detailed discussion of cash management within the health services industry, see
A. G. Seidner and W. O. Cleverley, Cash and Investment Management for the
Health Care Industry (Rockville, MD: Aspen, 1990).
3. Mutual funds cannot be used as a replacement for commercial checking accounts
because the number of checks that can be written against such accounts is
normally limited to a few per month.
4. To be precise, the full amount of the receivables account does not require
¬nancing. The cash costs associated with producing the $20,000 in revenues do
need to be ¬nanced, but the pro¬t component does not. For example, assume
that Home Infusion has cash costs of $800 to support each day™s sales of $1,000.
Then, 20 days of receivables would actually require ¬nancing of 20 — $800 =
$16,000. The remaining $4,000 in the receivables account would be offset on
the balance sheet by $4,000 pro¬t placed in the equity account.
5. It is estimated that average cost for hospitals to process a purchase order manually
is $75, while the same order handled electronically would cost only $20.
6. The prime rate is the interest rate charged to a bank™s very best customers. Each
bank sets its own prime rate, but, because of competition, most banks™ prime
rates are identical. Furthermore, most banks follow the lead of the large New
York City banks.
Chapter 16: Current Asset Management and Financing

7. The fourth major type of short-term ¬nancing is commercial paper, which is a
type of unsecured business debt sold primarily to other businesses, insurance
companies, pension funds, and money market mutual funds. Commercial paper
is issued with maturities less than 270 days and generally carries an interest rate
below the prime rate but above the rate on short-term Treasury securities. The
catch is that commercial paper can be issued only by very large companies with
excellent credit standing, so most healthcare providers cannot use this source of
8. In a credit sale, the seller records the transaction as a receivable, while the buyer
records it as a payable. If a ¬rm™s payables exceed its receivables, it is said to
be receiving net trade credit, whereas if its receivables exceed its payables, it is
extending net trade credit. Smaller ¬rms frequently receive net credit, while larger
¬rms generally extend it.
9. A question arises here as to whether accounts payable should re¬‚ect gross
purchases or purchases net of discounts. Although the GAAP permit either
treatment on the grounds that the difference is not material, most accountants
prefer to record payables net of discounts, and then to report the higher
payments that result if the discounts are not taken as an additional expense,
called “discounts lost.”
10. This cost has purposely been labeled as the approximate percentage cost. The
true effective cost, which recognizes intra-year compounding, is 43.8 percent,
found as follows:

(1 + 0.0204)18 ’ 1.0 = (1.0204)18 ’ 1.0 = 0.438 = 43.8%.

11. Although commercial banks remain the primary source of short-term loans,
other sources are available. For example, GE Capital Corporation has over $2
billion in commercial loans outstanding. Firms such as GE Capital, which was
initially established to ¬nance consumers™ purchases of GE™s appliances, often
¬nd business loans to be more pro¬table than consumer loans.
12. In addition to business assets, owners of small businesses, such as medical
practices, often are required to pledge personal assets as collateral (make personal
guarantees) for bank business loans.
13. For more information on the use of receivables ¬nancing by healthcare providers,
see T. J. Kincaid, “Selling Accounts Receivable to Fund Working Capital,”
Healthcare Financial Management (May 1993): 27“32.

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524 Healthcare Finance

Calvello, A. A. 2003. “Investment Management: Eight Steps to Improve Perfor-
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Healthcare Financial Management (September): 74“78.
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Chapter 16: Current Asset Management and Financing

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526 Healthcare Finance

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Learning Objectives
After studying this chapter, readers will be able to:

• Explain the purposes of ¬nancial statement and operating analyses.
• Describe the primary techniques used in ¬nancial statement and
operating analyses.
• Conduct basic ¬nancial statement and operating analyses to assess
the ¬nancial condition of a business.
• Describe the problems associated with ¬nancial statement and
operating indicator analyses.
• Explain the meaning and use of Market Value Added (MVA) and
Economic Value Added (EVA) performance measures.

One of the most important characteristics of a business is its ¬nancial per-
formance. Financial performance has many dimensions, but to health services
managers the most relevant feature of performance is the business™s ¬nancial
condition: Does the business have the ¬nancial capacity to perform its mission?
Often, judgments about ¬nancial condition are made of the basis of ¬nancial
statement analysis, which focuses on the data contained in a business™s ¬nan-
cial statements. Financial statement analysis is applied both to historical data,
which re¬‚ect the results of past managerial decisions, and to forecasted data,
which comprise the roadmap for the business™s future. Therefore, managers
use ¬nancial statement analysis both to assess current condition and to plan
for the future.
Although ¬nancial statement analysis provides a great deal of impor-
tant information regarding ¬nancial condition, it often fails to provide much
insight into the operational causes of that condition. Thus, ¬nancial state-
ment analysis is often supplemented by operating indicator analysis, which
uses operating data not usually found in a business™s ¬nancial statements,
such as occupancy, patient mix, length of stay, and productivity measures, to
help identify those factors that contributed to the assessed ¬nancial condition.
Through operating indicator analysis, managers are better able to identify and
implement strategies that ensure a sound ¬nancial condition in the future.
528 Healthcare Finance

Financial statement and operating indicator analyses involve a num-
ber of techniques that extract information contained in a business™s ¬nancial
statements and elsewhere and combine it in a form that facilitates making
judgments about the business™s ¬nancial condition and operations. Often, the
end result of such analyses is a list of corporate strengths and weaknesses.
In this chapter, several analytical techniques used in ¬nancial statement and
operating indicator analyses, some related topics, and the problems inherent
in such analyses are discussed.
In much of the chapter, Riverside Memorial Hospital, a 450-bed, not-
for-pro¬t facility, is used to illustrate ¬nancial performance analysis. Although
a hospital is being used to illustrate the techniques, they can be applied to
any health services setting. Simpli¬ed versions of Riverside™s primary ¬nancial
statements are contained in Tables 17.1, 17.2, and 17.3.

The Statement of Cash Flows
The statement of cash ¬‚ows was ¬rst described in Chapter 4. Speci¬cally, this
statement tells such things as whether or not the ¬rm™s core operations are
pro¬table, how much capital the ¬rm raised and how this capital was used,

TABLE 17.1
Cash Flows from Operating Activities
Change in net assets (net income) $ 8,572
Memorial Adjustments:
Depreciation 4,130
Increase in accounts receivable (1,102)
Statement of
Increase in inventories (195)
Cash Flows
Decrease in accounts payable (438)
Year Ended
Increase in accrued expenses 229
December 31,


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