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Net cash ļ¬‚ow from operations $11,196
2004 (in
thousands) Cash Flows from Investing Activities
Investment in plant and equipment ($ 4,293)

Cash Flows from Financing Activities
Investment in short-term securities ($ 2,000)
Repayment of long-term debt (2,150)
Repayment of notes payable (3,412)
Capital lease principal repayment (323)
Change in current portion of LT debt 150
Net cash ļ¬‚ow from ļ¬nancing ($ 7,735)

Net increase (decrease) in cash ($ 832)

Beginning cash and equivalents $ 5,095

Ending cash and securities $ 4,263
529
Chapter 17: Analyzing Financial Performance


TABLE 17.2
2004 2003
Riverside
Memorial
Cash and equivalents $ 4,263 $ 5,095 Hospital:
Short-term investments 2,000 0
Balance Sheets
Accounts receivable 21,840 20,738
December 31,
Inventories 3,177 2,982
2004 and 2003
Total current assets $ 31,280 $ 28,815
(in thousands)
Gross plant and equipment $ 145,158 $ 140,865
Accumulated depreciation 25,160 21,030
Net plant and equipment $ 119,998 $ 119,835

Total assets $ 151,278 $ 148,650


Accounts payable $ 4,707 $ 5,145
Accrued expenses 5,650 5,421
Notes payable 825 4,237
Current portion of long-term debt 2,150 2,000
Total current liabilities $ 13,332 $ 16,803
Long-term debt $ 28,750 $ 30,900
Capital lease obligations 1,832 2,155
Total long-term liabilities $ 30,582 $ 33,055
Net assets (equity) $ 107,364 $ 98,792

Total liabilities and net assets $ 151,278 $ 148,650




and what impact operating and ļ¬nancing decisions had on the ļ¬rmā€™s cash
position.
Table 17.1 contains Riversideā€™s statement of cash ļ¬‚ows, which fo-
cuses on the overall sources and uses of cash in 2004. The top part shows
cash generated by and used in operations. For Riverside, operations provided
$11,196,000 in net cash ļ¬‚ow. The income statement reported net income
plus depreciation of $8,572,000 + $4,130,000 = $12,702,000, but as part
of its operations Riverside invested $1,297,000 in current assets (receivables
and inventories) and reduced its spontaneous liabilities (payables and accru-
als) balances by $209,000. The end result, net cash ļ¬‚ow from operations, is
$12,702,000 āˆ’ $1,297,000 āˆ’ $209,000 = $11,196,000.
The next section of the statement of cash ļ¬‚ows focuses on investments
in ļ¬xed assets. Riverside spent $4,293,000 on capital expenditures in 2004.
Riversideā€™s ļ¬nancing activities, as shown in the third section, highlight the fact
that the hospital used cash to pay off previously incurred debt and to invest
in marketable securities. The net effect of the hospitalā€™s ļ¬nancing activities is
a net cash outļ¬‚ow from ļ¬nancing of $7,735,000.
530 Healthcare Finance


TABLE 17.3
2004 2003
Riverside
Memorial
Net patient service revenue $108,600 $ 97,393
Hospital: Premium revenue 5,232 4,622
Statements of Other revenue 3,644 6,014
Operations Total revenues $117,476 $108,029
(Income
Expenses:
Statements) Nursing services $ 58,285 $ 56,752
Years Ended Dietary services 5,424 4,718
General services 13,198 11,655
December 31,
Administrative services 11,427 11,585
2004 and 2003
Employee health and welfare 10,250 10,705
(in thousands)
Provision for uncollectibles 3,328 3,469
Provision for malpractice 1,320 1,204
Depreciation 4,130 4,025
Interest expense 1,542 1,521
Total expenses $108,904 $105,634

Net income $ 8,572 $ 2,395




When the three major sections are totaled, Riverside had a $11,196,000
āˆ’ $4,293,000 āˆ’ $7,735,000 = $832,000 net decrease in cash (i.e., net cash
outļ¬‚ow) during 2004. The very bottom of Table 17.1 reconciles the 2004 net
cash ļ¬‚ow with the ending cash balance shown on the balance sheet. Riverside
began 2004 with $5,095,000; experienced a cash outļ¬‚ow of $832,000 during
the year; and ended the year with $5,095,000 āˆ’ $832,000 = $4,263,000 in
its cash and equivalents account, as veriļ¬ed by the value reported on Table
17.2.
Riversideā€™s statement of cash ļ¬‚ows shows nothing unusual or alarming.
It does show that the hospitalā€™s operations are inherently proļ¬table, at least
in 2004. Had the statement showed an operating cash drain, Riversideā€™s
managers would have had something to worry about; if it continued, such
a drain could bleed the hospital to death. The statement of cash ļ¬‚ows also
provides easily interpreted information about Riversideā€™s ļ¬nancing and ļ¬xed
asset investing activities for the year. For example, Riversideā€™s cash ļ¬‚ow from
operations was used primarily to purchase new ļ¬xed assets, to invest in short-
term securities, and to pay off notes payable and long-term debt. Again, such
uses of operating cash ļ¬‚ow do not raise any red ļ¬‚ags regarding the hospitalā€™s
ļ¬nancial actions.
Managers and investors must pay close attention to the statement of
cash ļ¬‚ows. Financial condition is driven by cash ļ¬‚ows, and the statement
gives a good picture of the annual cash ļ¬‚ows generated by the business. An
531
Chapter 17: Analyzing Financial Performance



examination of Table 17.1 (or, better yet, a series of such tables going back the
last ļ¬ve years and projected ļ¬ve years into the future) would give Riversideā€™s
managers and creditors an idea of whether or not the hospitalā€™s operations are
self-sustainingā€”that is, does the business generate the cash ļ¬‚ows necessary to
pay its bills, including those associated with the capital employed? Although
the statement of cash ļ¬‚ows is ļ¬lled with valuable information, the bottom line
tells little about the businessā€™s ļ¬nancial condition because operating losses
can be covered by ļ¬nancing transactions such as borrowing or selling new
common stock (if investor-owned), at least in the short run.


Self-Test
1. What type of ļ¬nancial performance information is provided in the
Questions
statement of cash ļ¬‚ows?
2. What is the difference between net income and cash ļ¬‚ow, and which is
more meaningful to a businessā€™s ļ¬nancial condition?
3. Does the fact that a businessā€™s cash position has improved provide
much insight into the yearā€™s ļ¬nancial results?


Ratio Analysis
Although a ļ¬rmā€™s balance sheet and income statement contain a wealth of ļ¬-
nancial information, it is often difļ¬cult to make meaningful judgments about
ļ¬nancial performance by merely examining the raw data. To illustrate, one
managed care plan may have $5,248,760 in long-term debt and interest
charges of $419,900, while another may have $52,647,980 in debt and inter-
est charges of $3,948,600. The true burden of these debts, and each managed
care planā€™s ability to pay the interest and principal due on them, cannot be eas-
ily assessed without additional comparisons, such as those provided by ratio
analysis. In essence, ratio analysis combines data from the balance sheet and
the income statement to create single numbers that have easily interpreted
ļ¬nancial signiļ¬cance (i.e., numbers that measure various aspects of ļ¬nancial
performance). In the case of debt and interest payments, ratios could be con-
structed that relate each planā€™s debt to its assets and the interest it pays to the
income it has available for payment.
Unfortunately, an almost unlimited number of ļ¬nancial ratios can be
constructed, and the choice of ratios depends in large part on the nature of
the business being analyzed, the purpose of the analysis, and the availability
of comparative data. Generally, ratios are grouped into categories to make
them easier to interpret. In the paragraphs that follow, the data presented in
Tables 17.2 and 17.3 are used to calculate an illustrative sampling of 2004
ļ¬nancial ratios for Riverside Memorial Hospital, which are then compared
with hospital industry average ratios.1 Note that in a real analysis, many more
ratios would be calculated and analyzed. Also, although a hospital is used to
532 Healthcare Finance



illustrate ratio analysis, the speciļ¬c ratios used in any analysis depend on the
type of healthcare provider. Some ratios are more meaningful for hospitals,
some for managed care organizations, some for group practices, and so on.

Proļ¬tability Ratios
Proļ¬tability is the net result of a large number of managerial policies and
decisions, so proļ¬tability ratios provide one measure of the aggregate ļ¬nancial
performance of a business.

Total Margin The total margin, often called the total proļ¬t margin or just proļ¬t margin, is
deļ¬ned as net income divided by total revenues:

Net income $8,572
Total margin = = = 0.073 = 7.3%.
Total revenues $117,476
Industry average = 5.0%.
Riversideā€™s total margin of 7.3 percent shows that the hospital makes 7.3 cents
on every dollar of total revenues. The total margin measures the ability of
the organization to control expenses. With all else the same, the higher the
total margin, the lower the expenses relative to revenues. Riversideā€™s total
margin is above the industry average of 5.0 percent, indicating relatively
good expense control. How good? The industry data source also reports
quartiles; for total margin, the upper quartile was 8.4 percent, meaning that 25
percent of hospitals had total margins higher than 8.4 percent. Thus, although
Riversideā€™s total margin was better than average, it was not as good as the top
25 percent of hospitals.
Although industry average ļ¬gures are discussed in detail later, it should
be noted here that the industry average is not a magic number that all busi-
nesses should strive to achieve. In fact, some very well managed businesses
will be above the average, while other good ļ¬rms will be below it. However,
if a businessā€™s ratios are far removed from the average for the industry, its
managers should be concerned about why this difference occurs.
Riversideā€™s relatively high total margin could mean that the hospitalā€™s
charges are relatively high, its allowances are relatively low, its costs are rel-
atively low, it has relatively high nonoperating (other) revenue, or a combi-
nation of these factors. A thorough operating indicator analysis would help
pinpoint the cause, or causes, of Riversideā€™s high total margin.
When data are available, another useful margin ratio is the operating
margin, deļ¬ned as operating income divided by operating revenues. (Oper-
ating revenues are deļ¬ned here as patient service revenue plus premium rev-
enue.) The advantage of this margin measure is that it focuses on core business
operations and hence removes the inļ¬‚uence of nonoperating gains and losses,
which often are transitory and unrelated to core operations. However, the
format of many healthcare organizationsā€™ ļ¬nancial statements makes this ratio
difļ¬cult to determine without additional information.
533
Chapter 17: Analyzing Financial Performance



With only the data given in the ļ¬nancial statements, Riversideā€™s operat-
ing margin can be estimated as follows. First, Riversideā€™s operating revenue for
2004 was $108,600,000 + $5,232,000 = $113,832,000. If the assumption
is made that all expenses were operating expenses, Riversideā€™s 2004 operating
margin would be ($113,832 āˆ’ $108,904) / $113,832 = $4,928 / $113,832
= 0.043 = 4.3%. Removing nonoperating (other) revenue from the calcula-
tion lowers the proļ¬t margin.

The ratio of net income to total assets measures the return on total assets, often Return on
Assets (ROA)
just called return on assets (ROA):

Net income $8,572
Return on assets = = = 0.057 = 5.7%.
Total assets $151,278
Industry average = 4.8%.
Riversideā€™s 5.7 percent ROA, which means that each dollar of assets generated
5.7 cents in proļ¬t, is well above the 4.8 percent average for the hospital
industry. ROA tells managers how productively, in a ļ¬nancial sense, a business
is using its assets. The higher the ROA, the greater the net income for each
dollar invested in assets and hence the more productive the assets. ROA
measures both a businessā€™s ability to control expenses, as expressed by the
total margin, and its ability to use its assets to generate revenue.

The ratio of net income to total equity (net assets) measures the return on Return on
Equity (ROE)
equity (ROE):

Net income $8,572
Return on equity = = = 0.080 = 8.0%.
Total equity $107,364
Industry average = 8.4%.
Riversideā€™s 8.0 percent ROE is slightly below the 8.4 percent industry average.
The hospital was able to generate 8.0 cents of income for each dollar of
equity investment, while the average hospital produced 8.4 cents. ROE is
especially meaningful for investor-owned businesses. Owners are concerned
with how well the businessā€™s managers are utilizing owner-supplied capital,
and ROE gives one answer to this question. For not-for-proļ¬t businesses
such as Riverside, ROE tells its board of trustees and managers how well,
in ļ¬nancial terms, its community-supplied capital is being utilized.
Riversideā€™s 2004 total margin and return on assets were above the
industry averages, yet the hospitalā€™s ROE is below the average. As we will
explain later in the section on Du Pont analysis, this seeming inconsistency is
a result of the hospitalā€™s relatively low use of debt ļ¬nancing.

Liquidity Ratios
One of the ļ¬rst concerns of most managers, and the major concern of a
ļ¬rmā€™s creditors, is the businessā€™s liquidity. Will the business be able to meet
534 Healthcare Finance



its obligations as they become due? Riverside has debts totaling over $13
million (i.e., its current liabilities) that must be paid off within the coming
year. Will the hospital be able to make these payments? A full liquidity analysis
requires the use of a cash budget, which was discussed in Chapter 8. However,
by relating the amount of cash and other current assets to current obligations,
ratio analysis provides a quick, easy-to-use, rough measure of liquidity.

Current Ratio The current ratio is computed by dividing current assets by current liabilities:

Current assets $31,280
Current ratio = = = 2.3, or 2.3 times.
Current liabilities $13,332
Industry average = 2.0.
The current ratio tells managers that the liquidation of Riversideā€™s current
assets at book value would provide $2.3 of cash for every $1 of current
liabilities. If a business is getting into ļ¬nancial difļ¬culty, it will begin paying its
accounts payable more slowly, building up short-term bank loans (i.e., notes
payable), and so on. If these current liabilities rise faster than current assets,
the current ratio will fall, and this could spell trouble. Because the current
ratio is an indicator of the extent to which short-term claims are covered by
assets that are expected to be converted to cash in the near term, it is one
commonly used measure of liquidity.
Riversideā€™s current ratio is slightly above the average for the hospital
industry. Because current assets should be converted to cash in the near future,
it is highly probable that these assets could be liquidated at close to their stated
values. With a current ratio of 2.3, the hospital could liquidate current assets
at only 43 percent of book value and still pay off current creditors in full.2

Days Cash on The current ratio measures liquidity on the basis of balance sheet accounts,
Hand and hence is a static measure of liquidity. However, the true measure of a
businessā€™s liquidity is whether or not it can meet its payments as they become
due, and so liquidity is more related to cash ļ¬‚ows than it is to assets and
liabilities. The days-cash-on-hand ratio moves closer to those factors that truly
determine liquidity:
Cash + Marketable securities
Days cash on hand =
(Expenses āˆ’ Depreciation āˆ’ Provision for uncollectibles)/365
$4,263 + $2,000 $6,263
= = = 22.5 days.
($108,904 āˆ’ $4,130 āˆ’ $3,328)/365 $277.93
Industry average = 30.6 days.

The denominator of the equation estimates average daily cash expenses by
stripping out noncash expenses from reported total expenses. The numerator
is the cash and securities that are available to make those cash payments.
Because Riversideā€™s days cash on hand is lower than the industry average, its
535
Chapter 17: Analyzing Financial Performance



liquidity position as measured by days cash on hand is worse than that of the
average hospital.
For Riverside, the two measures of liquidity, current ratio and days cash
on hand, give conļ¬‚icting results. Perhaps the average hospital has a greater
proportion of cash and marketable securities in its current assets than does
Riverside. More analysis would be required to make a supportable judgment
concerning Riversideā€™s liquidity position. Remember, though, that the cash
budget is the primary tool used by managers to ensure liquidity.

Debt Management (Capital Structure) Ratios
The degree to which a ļ¬rm uses debt ļ¬nancing, or ļ¬nancial leverage, is
an important measure of ļ¬nancial performance for several reasons. First, by
raising funds through debt, owners of for-proļ¬t ļ¬rms can maintain control
of the ļ¬rm with a limited investment. For not-for-proļ¬t ļ¬rms, debt ļ¬nancing
allows the organization to provide more services than it could if it were solely
ļ¬nanced with contributed and earned capital. Next, creditors look to equity
capital to provide a margin of safety; if the owners (or community) have
provided only a small proportion of total ļ¬nancing, the risks of the enterprise
are borne mainly by its creditors. Finally, if a ļ¬rm earns more on investments
ļ¬nanced with borrowed funds than it pays in interest, its return on equity
capital is magniļ¬ed, or leveraged up.
Two types of ratios are used to assess debt management:

1. Capitalization ratios. These ratios use balance sheet data to determine
the extent to which borrowed funds have been used to ļ¬nance assets.
2. Coverage ratios. Here, income statement data are used to determine the
extent to which ļ¬xed ļ¬nancial charges are covered by reported proļ¬ts.

The two sets of ratios are complementary, so most ļ¬nancial statement analyses
examine both types.

The ratio of total debt to total assets (total liabilities and equity), generally Capitalization
called the debt ratio, measures the percentage of total capital provided by Ratio 1:
Total Debt to
creditors:
Total Assets
(Debt Ratio)
Total debt $43,914
Debt ratio = = = 0.290, or 29.0%.
Total assets $151,278
Industry average = 42.3%.
For our purposes, debt is deļ¬ned as all debt, including current liabilities,
long-term debt, and capital lease obligationsā€”everything but equity. How-
ever, this ratio has many variations, all of which use different deļ¬nitions of
what constitutes debt. For example, the debt-to-capitalization ratio, which is
deļ¬ned as long-term debt divided by long-term capital (long-term debt plus
536 Healthcare Finance



equity), is often used because it focuses on the proportion of debt used for
permanent capital.
Creditors prefer low debt ratios because the lower the ratio, the greater
the cushion against creditorsā€™ losses in the event of bankruptcy and liquidation.
Conversely, owners of for-proļ¬t ļ¬rms may seek high leverage either to leverage
up returns or because selling new stock would mean giving up some degree
of control. In not-for-proļ¬t ļ¬rms, managers may seek high leverage to offer
more services.
Riversideā€™s debt ratio is 29.0 percent. This means that its creditors
have supplied somewhat less than one-third of the businessā€™s total ļ¬nancing.
Put another way, each dollar of assets was ļ¬nanced with 29 cents of debt,
and consequently, 71 cents of equity. (The equity ratio is 1 āˆ’ Debt ratio, so
Riversideā€™s equity ratio is 71 percent.) Because the average debt ratio for the
hospital industry is over 40 percent, Riverside uses signiļ¬cantly less debt than
the average hospital. The low debt ratio indicates that the hospital would ļ¬nd
it relatively easy to borrow additional funds, presumably at favorable rates.

Capitalization Another commonly used capitalization ratio is the debt-to-equity ratio. The
Ratio 2: debt ratio and debt-to-equity ratios are transformations of each other, and
Debt-to-Equity hence provide the same information, but with a slightly different twist:
Ratio
Total debt $43,914
Debt-to-equity ratio = = = 0.409, or 40.9%.
Total equity $107,364
Industry average = 73.3%.
This ratio indicates that Riversideā€™s creditors have contributed 40.9 cents for
each dollar of equity capital, while the industry average is 73.3 cents per dollar.
Both the debt ratio and debt-to-equity ratio increase as a business of a given
size uses a greater proportion of debt ļ¬nancing, but the debt ratio rises linearly
and approaches a limit of 100 percent, while the debt-to-equity ratio rises
exponentially and approaches inļ¬nity.
Lenders, in particular, prefer the debt to equity ratio to the debt ratio.
Their preference is based on the fact that it tells them how much capital
creditors have provided to the business per dollar of equity capital. The
higher this ratio, the riskier the creditorsā€™ position.

Coverage The times interest earned (TIE) ratio is determined by dividing earnings before
Ratio 1: interest and taxes (EBIT) by interest charges. EBIT is used in the numerator
Times Interest because it represents the amount of income that is available to pay interest
Earned Ratio expense. For a not-for-proļ¬t business, which does not pay taxes, EBIT = Net
income + Interest expense. For Riverside:
$8,572 + $1,542
EBIT $10,114
TIE ratio = = = = 6.6 times.
Interest expense $1,542 $1,542
Industry average = 4.0.
537
Chapter 17: Analyzing Financial Performance



The TIE ratio measures the number of dollars of accounting income available
to pay each dollar of interest expense. In essence, it is an indicator of the extent
to which income can decline before it is less than annual interest costs. Failure
to pay interest can bring legal action by the ļ¬rmā€™s creditors, possibly resulting
in bankruptcy.
Riversideā€™s interest is covered 6.6 times, so it has $6.60 of accounting
income to pay each dollar of interest expense. Because the industry average
TIE ratio is four times, the hospital is covering its interest charges by a
relatively high margin of safety. Thus, the TIE ratio reinforces the previous
conclusion based on the debt ratioā€”namely, that the hospital could easily
expand its use of debt ļ¬nancing.
Coverage ratios are often better measures of a ļ¬rmā€™s debt utilization
than capitalization ratios because coverage ratios discriminate between low-
interest rate debt and high-interest rate debt. For example, a group practice
might have $10 million of 4 percent debt on its balance sheet, while another
might have $10 million of 8 percent debt. If both practices have the same
income and assets, both would have the same debt ratio. However, the group
that pays 4 percent interest would have lower interest charges and hence
would be in better ļ¬nancial position than the group that pays 8 percent. Such
improved ļ¬nancial performance is captured by the TIE ratio.

Coverage
Although the TIE ratio is easy to calculate, it has two major deļ¬ciencies. First,
Ratio 2:
leasing has become widespread in recent years, and the TIE ratio ignores lease
Cash Flow
payments. Also, many debt contracts require that principal payments be made
Coverage Ratio
over the life of the loan, rather than only at maturity. Thus, most businesses
must meet ļ¬xed ļ¬nancial charges other than interest payments. Second, the
TIE ratio ignores the fact that accounting income, whether measured by EBIT
or net income, does not indicate the actual cash ļ¬‚ow available to meet ļ¬xed
charge payments. These deļ¬ciencies are corrected in the cash ļ¬‚ow coverage
(CFC) ratio, which shows the margin by which cash ļ¬‚ow covers ļ¬xed ļ¬nancial
requirements:

EBIT + Lease payments + Depreciation expense
CFC ratio =
Interest expense + Lease payments + Debt principal/(1 āˆ’ T)
$10,114 + $1,368 + $4,130 $15,612
= = = 3.2 times.
$1,542 + $1,368 + $2,000/(1 āˆ’ 0) $4,910
Industry average = 2.3.

Although not shown directly on Riversideā€™s ļ¬nancial statements, the hospital
had $1,368,000 of lease payments and $2,000,000 of required debt principal
repayments in 2004.
What is the purpose of the (1 āˆ’ T) term applied to the debt principal?
For investor-owned ļ¬rms, the debt principal repayments, because they are paid
with after-tax dollars, must be grossed up by dividing by 1 āˆ’ T. This gives the
538 Healthcare Finance



amount of pretax dollars, which is what is contained in the numerator, that
are required to cover the required principal repayments.
Like its TIE ratio, Riversideā€™s CFC ratio exceeds industry standard, in-
dicating that Riverside is better at covering total ļ¬xed payments with cash ļ¬‚ow
than is the average hospital. This fact should be reassuring both to creditors
and management, and reinforces the view that Riverside has untapped debt
capacity.

Asset Management (Activity) Ratios
The next group of ratios, the asset management ratios, is designed to measure
how effectively the businessā€™s assets are being utilized. These ratios help to
answer whether or not the amount of each type of asset as reported on the
balance sheet seems reasonable, too high, or too low in view of current (or
projected) operating levels. Riverside and other hospitals must borrow or raise
equity capital to acquire assets. If they have too many assets, then their capital
costs will be too high and their proļ¬ts will be depressed. Conversely, if the
level of assets is too low, then volume may be lost or vital services not offered.

Fixed Asset The ļ¬xed asset turnover ratio, also called the ļ¬xed asset utilization ratio, mea-
Turnover Ratio sures the utilization of plant and equipment, and it is the ratio of total revenues
to net ļ¬xed assets:
Total revenues $117,476
Fixed asset turnover = = = 0.98 times.
Net ļ¬xed assets $119,998
Industry average = 2.2.
Riversideā€™s ratio of 0.98 indicates that each dollar of ļ¬xed assets generated 98
cents in revenue. This value compares poorly with the industry average of 2.2
times, indicating that Riverside is not using its ļ¬xed assets as productively
as the average hospital. (The lower quartile value for the industry is 1.1;
thus, Riverside falls in the bottom 25 percent of all hospitals in its ļ¬xed asset
utilization.)
Before condemning Riversideā€™s management for poor performance,
it should be pointed out that a major problem exists with the use of the
ļ¬xed asset turnover ratio for comparative purposes. Recall that most assets
reļ¬‚ect historical costs rather than current value. Inļ¬‚ation and depreciation
have caused the values of many assets that were purchased in the past to be
seriously understated. Therefore, if an old hospital that had acquired much
of its plant and equipment years ago is compared to a new hospital with the
same physical capacity, the old hospital, because of a much lower book value
of ļ¬xed assets, would report a much higher turnover ratio. This difference in
ļ¬xed asset turnover is more reļ¬‚ective of the inability of ļ¬nancial statements to
deal with inļ¬‚ation than of any inefļ¬ciency on the part of the new hospitalā€™s
managers.
539
Chapter 17: Analyzing Financial Performance



The total asset turnover ratio measures the turnover, or utilization, of all of a Total Asset
Turnover Ratio
businessā€™s assets. It is calculated by dividing total revenues by total assets:

Total revenues $117,476
Total asset turnover = = = 0.78 times.
Total assets $151,278
Industry average = 0.97.

Thus, each dollar of total assets generated 78 cents in total revenue. Riversideā€™s
total asset ratio is below the industry average but not as far below as its ļ¬xed
asset turnover ratio. Thus, the hospital is utilizing its current assets better than
its ļ¬xed assets, relative to the industry. Such judgments could be conļ¬rmed
by examining Riversideā€™s current asset turnover.3

Days in patient accounts receivable is used to measure effectiveness in man- Days in Patient
aging receivables. This measure of ļ¬nancial performance, which is sometimes Accounts
classiļ¬ed as a liquidity ratio rather than an asset management ratio, has many Receivable
names, including average collection period (ACP) and daysā€™ sales outstanding
(DSO). It is computed by dividing net patient accounts receivable by average
daily patient revenue to ļ¬nd the number of days that it takes an organization,
on average, to collect its receivables:4

Net patient accounts receivable
Days in patient accounts receivable =
Net patient service revenue/365
$21,840
= = 73.4 days.
$108,600/365
Industry average = 64.0 days.

In the calculation for Riverside, premium revenue has not been included
because such revenue is collected before services are provided and hence does
not affect receivables.
Riverside is not doing as well as the average hospital in collecting
its receivables. The lower quartile value is 78.7 days, so a relatively large
number of hospitals are doing worse. Still, as was discussed in Chapter 16, it is
important that businesses collect their receivables as soon as possible. Clearly,
Riversideā€™s managers should strive to increase the hospitalā€™s performance in
this key area.

Other Ratios
The ļ¬nal group of ratios examines other facets of a businessā€™s ļ¬nancial condi-
tion.

The average age of plant gives a rough measure of the average age in years of Average Age
of Plant
a businessā€™s ļ¬xed assets:
540 Healthcare Finance



Accumulated depreciation $25,160
Average age of plant = = = 6.1 years.
Depreciation expense $4,130
Industry average = 9.1 years.

Riversideā€™s physical assets are newer than those of the average hospital. Thus,
the hospital is offering more up-to-date facilities than average, and hence it
will probably have fewer capital expenditures in the near future. On the other
hand, Riversideā€™s net ļ¬xed asset valuation will be relatively high, biasing the
hospitalā€™s ļ¬xed asset and total asset turnover ratios downward. This fact raises
serious questions about the interpretation of the turnover ratios calculated
previously.


Price/ Earnings For investor-owned ļ¬rms, at least those with publicly traded stock, some
Ratio ratios can be developed that relate the ļ¬rmā€™s stock price to its earnings and
book value per share. Such market value ratios give managers an indication
of what equity investors think of the companyā€™s past performance and future
prospects.
The price/earnings (P/E) ratio shows how much investors are willing
to pay per dollar of reported proļ¬ts. Suppose that the stock of General Home
Care, an investor-owned home health care company, sells for $28.50, while
the ļ¬rm had 2004 earnings per share (EPS) of $2.20. Then, its P/E ratio
would be 13.0:

Price per share $28.50
P/E ratio = = = 13.0 times.
Earnings per share $2.20
Industry average = 15.2.
P/E ratios are higher for ļ¬rms with high growth prospects, other things held
constant, but they are lower for riskier ļ¬rms. Generalā€™s P/E ratio is slightly
below the average of other investor-owned home health care companies,
which suggests that the company is regarded as being somewhat riskier than
most, as having poorer growth prospects, or both.


Market/Book The ratio of a stockā€™s market price to its book value gives another indication
Ratio of how investors regard the company. Companies with relatively high rates of
return on equity generally sell at higher multiples of book value than those
with low returns. General reported $80 million in total equity on its 2004
balance sheet, and the ļ¬rm had 5 million shares outstanding, so its book value
per share is $80 / 5 = $16.00. Dividing the price per share by the book value
per share gives a market/book (M/B) ratio of 1.8 times:

Price per share $28.50
M/B ratio = = = 1.8 times.
Book value per share $16.00
Industry average = 2.1.
541
Chapter 17: Analyzing Financial Performance



Investors are willing to pay slightly less for each dollar of Generalā€™s book value
than for that of an average home health care company.

Comparative and Trend Analysis
When conducting ratio analysis, the value of a particular ratio, in the absence
of other information, tells almost nothing. For example, if it is known that a
nursing home management company has a current ratio of 2.5, it is virtually
impossible to say whether this is good or bad. Additional data are needed to
help interpret the results of this ratio analysis. In the discussion of Riversideā€™s
ratios, the focus was on comparative analysisā€”that is, the hospitalā€™s ratios were
compared with the average ratios for the industry. Another useful ratio analysis
tool is trend analysis, in which the trend of a single ratio is analyzed over
time. Trend analysis gives clues about whether a businessā€™s ļ¬nancial situation
is improving, holding constant, or deteriorating.
It is easy to combine comparative and trend analyses in a single graph
such as the one shown in Figure 17.1. Here, Riversideā€™s ROE (the solid lines)
and industry average ROE data (the dashed lines) are plotted for the past


FIGURE 17.1
Riverside
ROE (%)
Memorial
Hospital: ROE
15
Analysis,
Upper Quartile 2000ā€“2004

10
Median

5
Lower Quartile


2000 2001 2002 2003 2004



Return on Equity (ROE)
Industry
Year Riverside Lower Quartile Median Upper Quartile

2000 12.5% 2.6% 8.6% 13.3%
2001 10.0 2.5 8.6 13.3
2002 6.7 2.8 7.2 12.0
2003 2.4 4.1 7.2 12.1
2004 8.0 3.8 7.4 12.3
542 Healthcare Finance



ļ¬ve years. The graph shows that the hospitalā€™s ROE has been declining faster
than the industry average from 2000 through 2003, but that it rose above the
industry in 2004. Other ratios can be analyzed in a similar manner.


Self-Test 1. What is the purpose of ratio analysis?
Questions 2. What are two ratios that measure proļ¬tability?
3. What are two ratios that measure liquidity?
4. What are two ratios that measure debt management?
5. What are two ratios that measure asset management?
6. What are two ratios that measure market value?
7. How can comparative and trend analyses be used to help interpret a
ratio?


Tying the Ratios Together: Du Pont Analysis
Ratio analysis provides a detailed picture of a businessā€™s ļ¬nancial condition,
but it does not provide an overview nor does it tie any of the ratios together.
Du Pont analysis provides an overview of a businessā€™s ļ¬nancial condition and
helps managers and investors understand the relationships among several ra-
tios.5 Du Pont analysis, so named because managers at the Du Pont Company
developed it, combines basic ļ¬nancial ratios in a way that provides valuable
insights into a ļ¬rmā€™s ļ¬nancial performance. The analysis decomposes return
on equity (ROE), one of the most important measures of a businessā€™s prof-
itability, into the product of three other ratios, each of which has an important
economic interpretation. The result is the Du Pont equation:

ROE = Total margin Ć— Total asset turnover Ć— Equity multiplier
Net income Net income Total revenue Total assets
= Ć— Ć— .
Total equity Total revenue Total assets Total equity

Riversideā€™s 2004 data is used to illustrate the Du Pont equation:

$8,572 $8,572 $117,476 $151,278
= Ć— Ć—
$107,364 $117,476 $151,278 $107,364
7.98% = Ć— Ć—
7.30% 0.78 1.41
= Ć—
5.69% 1.41.
In the Du Pont equation, the product of the ļ¬rst two terms on the right side is
return on assets (ROA), so the equation can also be written as ROE = ROA
Ć— Equity multiplier. Riversideā€™s 2004 total margin was 7.3 percent, so the
hospital made 7.3 cents proļ¬t on each dollar of total revenue. Furthermore,
assets were turned over (or created revenues) 0.78 times during the year, so
the hospital earned a return of 7.30% Ć— 0.78 = 5.69% on its assets. This value
543
Chapter 17: Analyzing Financial Performance



for ROA, when rounded, is the same as was calculated previously in our ratio
analysis discussion.
If the hospital used only equity ļ¬nancing, its 5.69 percent ROA would
equal its ROE. However, creditors supplied 29 percent of Riversideā€™s capi-
tal, while the equityholders (the community) supplied the rest. Because the
5.69 percent ROA belongs exclusively to the suppliers of equity capital, which
comprises only 29 percent of total capital, Riversideā€™s ROE is higher than its
5.69 percent ROA. Speciļ¬cally, ROA must be multiplied by the equity mul-
tiplier, which shows the total assets working for each dollar of equity capital,
to obtain the ROE of 7.98 percent. This 7.98 percent ROE could be calcu-
lated directly: ROE = Net income / Total equity = $8,572 / $107,364 =
7.98%. However, the Du Pont equation shows how total margin, which mea-
sures expense control; total asset turnover, which measures asset utilization;
and ļ¬nancial leverage, which measures debt utilization, interact to determine
ROE.
Riversideā€™s managers use the Du Pont equation to analyze ways of
improving the hospitalā€™s ļ¬nancial performance. To inļ¬‚uence the proļ¬t margin,
Riverside must increase revenues and/or reduce costs. Thus, the hospitalā€™s
marketing staff can study the effects of raising charges, or lowering them to
increase volume; moving into new services or markets with higher margins;
entering into new contracts with managed care plans; and so on. Furthermore,
management accountants can study the expense items and, while working with
department heads and clinical staff, can seek ways to reduce costs.
Regarding total asset turnover, Riversideā€™s analysts, while working with
both clinical and marketing staffs, can investigate ways of reducing invest-
ments in various types of assets. Finally, the hospitalā€™s ļ¬nancial staff can analyze
the effects of alternative ļ¬nancing strategies on the equity multiplier, seeking
to hold down interest expenses and the risks of debt while still using debt to
leverage up ROE.
The Du Pont equation provides a useful comparison between a busi-
nessā€™s performance as measured by ROE and the performance of an average
hospital. For example, here is the comparative analysis for 2004:

ROE = 7.3% Ć— 0.78 Ć— 1.41
Riverside:
= Ć— 1.41 ā‰ˆ 8.0%.
5.69%
Industry average: ROE = 5.0% Ć— 0.97 Ć— 1.73
4.85% Ć— 1.73 ā‰ˆ 8.4%.
The Du Pont analysis tells managers and creditors that Riverside has a sig-
niļ¬cantly higher proļ¬t margin, and thus better control over expenses, than
does the average hospital. However, the average hospital has a better total
asset turnover, and thus Riverside is getting below-average utilization from its
assets. In spite of the average hospitalā€™s advantage in asset utilization, River-
544 Healthcare Finance



sideā€™s superior expense control outweighs its utilization disadvantage because
its ROA of 5.69 percent is higher than the industry average ROA of 4.85 per-
cent. Finally, the average hospital has offset Riversideā€™s advantage in ROA by
using more ļ¬nancial leverage, although Riversideā€™s lower use of debt ļ¬nancing
decreases its risk. The end result is that Riverside gets somewhat less return
on its equity capital than does the average hospital.
One potential problem with Du Pont and ratio analyses applied to not-
for-proļ¬t organizations, especially hospitals, is that a large portion of their net
income may come from nonoperating sources rather than from operations.
If the nonoperating revenues are highly variable and unpredictable, as they
are often, return on equity and the ratios as previously deļ¬ned may be a poor
measure of the hospitalā€™s inherent proļ¬tability. All applicable ratios, as well as
the Du Pont analysis, could be recast to focus on operations by using operating
revenue in lieu of total revenue.


Self-Test 1. Explain how the Du Pont equation combines several ratios to obtain an
Questions overview of a businessā€™s ļ¬nancial condition.
2. Why may a focus on operating revenue be preferable to a focus on total
revenue?


Other Analytical Techniques
Two additional ļ¬nancial statement analysis techniques are commonly used
in ļ¬nancial statement analysis. In common size analysis, all income statement
items are divided by total revenues and all balance sheet items are divided
by total assets. Thus, a common size income statement shows each item
as a percentage of total revenues, and a common size balance sheet shows
each account as a percentage of total assets. The advantage of common size
statements is that they facilitate comparisons of income statements and balance
sheets over time and across companies because they remove the inļ¬‚uence of
the scale (size) of the business.
Another frequently used technique when analyzing ļ¬nancial statements
is percentage change analysis. Here, the percentage changes in the balance
sheet accounts and income statement items from year to year are calculated
and compared. In this format, it is easy to see what accounts and items are
growing faster or slower than others and thus to identify which are under
control and which are out of control.
The conclusions reached in common size and percentage change analy-
ses generally parallel those derived from ratio analysis. However, occasionally a
serious deļ¬ciency is highlighted only by one of the three analytical techniques,
while the other two techniques fail to bring the deļ¬ciency to light. Thus, a
thorough ļ¬nancial statement analysis usually consists of a Du Pont analysis
545
Chapter 17: Analyzing Financial Performance



to provide an overview and then includes several different techniques such as
ratio, common size, and percentage change analyses.6


Self-Test
1. How are common size statements created?
Questions
2. What advantage do common size statements have over regular
statements when conducting a ļ¬nancial statement analysis?
3. What is percentage change analysis, and why is it useful?
4. Which analytical techniques should be used in a complete ļ¬nancial
statement analysis?


Market Value Added and Economic Value Added
Two ļ¬nancial performance measures that are being used by managers with
increasing frequency focus directly on managementā€™s success or failure in cre-
ating value: they are Market Value Added (MVA) and Economic Value Added
(EVA). These measures are especially useful in investor-owned businesses be-
cause of their direct link with shareholder wealth maximization. However,
EVA can be used with not-for-proļ¬t ļ¬rms, so the EVA discussion to follow is
relevant to both forms of ownership.

Market Value Added (MVA)
A primary ļ¬nancial goal of any investor-owned ļ¬rm is shareholder wealth max-
imization. This goal obviously beneļ¬ts shareholders, and it also ensures that
scarce resources are allocated as efļ¬ciently as possible. However, managerial
zeal to enhance shareholder wealth does not mean that other stakeholders,
including creditors, employees, patients, and so on, should be treated unfairly
because such actions are both unethical and will ultimately be detrimental to
shareholders.
Although the fundamental goal of shareholder wealth maximization is
widely accepted, managers sometimes confuse shareholder wealth maximiza-
tion with maximizing the total market value of the ļ¬rmā€™s stock. A ļ¬rmā€™s total
market valueā€”its stock price multiplied by the number of shares outstanding
ā€”can be increased by raising and investing as much equity capital as possible,
which increases the size and aggregate value of the ļ¬rm, but not necessarily
stock price. Although size-increasing actions often result in higher managerial
salaries and beneļ¬ts, such a strategy may ignore the fact that what is most
relevant to shareholders is not the size of the ļ¬rm but the return that it earns
on shareholder supplied capital.
Individual shareholderā€™s wealth is actually maximized when a ļ¬rmā€™s
managers maximize the difference between the market value of the ļ¬rmā€™s
stock and the amount of capital that equity investors have supplied to the
ļ¬rm. This difference is called Market Value Added (MVA):
546 Healthcare Finance



MVA = Market value of equity āˆ’ Book value of equity.
To illustrate the MVA concept, consider HCA. In early 2004, its total market
value of equity was 490 million shares outstanding Ć— $44 stock price =
$21.6 billion, while its shareholders had supplied about $6.2 billion in equity
capital. Thus, HCAā€™s MVA was $21.6 āˆ’ $6.2 = $15.4 billion. This amount
represents the difference between the funds, including retained earnings, that
HCAā€™s equity investors have put into the corporation since its founding and
the value of the cash they could get by selling the business. In other words,
HCAā€™s managers in the aggregate have created $15.4 billion of wealth for the
companyā€™s shareholders.
Clearly, the MVA concept is applicable only to investor-owned ļ¬rms
because it focuses on how well managers have done in creating value for
shareholders, and hence equity market value is needed for its calculation.
Plus, MVA does not account for the time value of money in the sense that
the timing of shareholder contributions is not considered. However EVA,
which is discussed in the next section, applies to both investor-owned and
not-for-proļ¬t businesses and does not have the time value problem associated
with MVA.

Economic Value Added (EVA)
Whereas MVA measures the combined effect of managerial actions to create
shareholder wealth since the inception of the company, Economic Value Added
(EVA) focuses on managerial effectiveness in a given year. The basic formula
for EVA is:

EVA = After-tax operating proļ¬t āˆ’ (Total capital Ć— Cost of capital).
In the EVA context, after-tax operating proļ¬t is often called net operating
proļ¬t after taxes (NOPAT), and it is calculated as EBIT Ć— (1 āˆ’ T). Unlike
MVA, EVA does not focus directly on market values, and hence it can be
applied to not-for-proļ¬t ļ¬rms.7
To illustrate the EVA concept, consider Birmingham Health Providers,
a medical group practice. The group had $1 million in NOPAT in 2004 gen-
erated from $5 million of investor-supplied debt and equity capital. The ļ¬rmā€™s
corporate cost of capital was 10 percent. With these assumptions, Birmingham
Health Providersā€™ EVA was $500,000:

EVA = $1 āˆ’ ($5 Ć— 0.10) = $1 āˆ’ $0.5 = $0.5 million.
EVA is an estimate of a businessā€™s true economic proļ¬t for the year, and it
differs substantially from accounting proļ¬tability measures such as net income.
EVA represents the residual income that remains after all costs have been
recognized, including the opportunity cost of the employed equity capital.
Conversely, accounting proļ¬t is formulated without imposing a charge for
equity capital. EVA depends on both operating efļ¬ciency and balance sheet
547
Chapter 17: Analyzing Financial Performance



management: without operating efļ¬ciency, proļ¬ts will be low, and without
efļ¬cient balance sheet management, there will be too many assets and hence
too much capital, which results in higher-than-necessary dollar capital costs.
For not-for-proļ¬t businesses, equity capital is a scarce resource that
must be managed well to ensure the ļ¬nancial viability of the organization, and
hence its ability to continue to perform its stated mission. EVA lets managers
know how well they are doing in managing this scarce resource in that the
higher the EVA in any year, the better job that managers are doing in using the
organizationā€™s contributions and earnings to create value for the community.
Of course, EVA measures only economic (ļ¬nancial) value; any social value
created by the equity capital is ignored and therefore must be subjectively
considered.
Although not-for-proļ¬t managers tend not to think in terms of ļ¬nancial
value creation, one could argue that both investor-owned and not-for-proļ¬t
businesses should strive to create ļ¬nancial value. The key difference between
the two forms of ownership is not the creation of ļ¬nancial value, but how that
value is used. In for-proļ¬t businesses, the bulk of the value is distributed to
owners, while in not-for-proļ¬t businesses, the value is used for the good of
the community. The greater the amount of ļ¬nancial value created, the greater
the amount of social value that can be expended.
EVA, but not MVA, can be applied to divisions as well as to entire
companies, and the charge for capital should reļ¬‚ect the riskiness and capital
structure of the business unit, whether it is the whole company or an operating
division. The speciļ¬c calculation of EVA for a company or division is much
more complex than presented here because many accounting issues, such as
inventory valuation, depreciation, amortization of research and development
costs, and the like, must be addressed properly when estimating a ļ¬rmā€™s after-
tax operating proļ¬t.8


Self-Test
1. What is Market Value Added (MVA), and how is it measured?
Questions
2. What is Economic Value Added (EVA), and how is it measured?
3. Can MVA and EVA be applied to not-for-proļ¬t ļ¬rms?
4. Why is EVA a better measure of ļ¬nancial performance than are
accounting measures such as net income or earnings per share?
5. Might ļ¬nancial value creation be an appropriate goal for not-for-proļ¬t
businesses? Explain.


Benchmarking
Ratio analysis, as well as other ļ¬nancial performance evaluation techniques,
requires comparisons to make meaningful judgments. In the previous exam-
ination of selected ratios, Riversideā€™s ratios were compared to industry aver-
age ratios. However, similar to most businesses, Riversideā€™s managers go one
548 Healthcare Finance



step furtherā€”they compare their ratios not only with industry averages but
also with data from industry leaders and primary competitors. The technique
of comparing ratios against selected standards is called benchmarking, while
the comparative ratios are called benchmarks. Riversideā€™s managers benchmark
against industry averages; against National/GFB Healthcare and Pennant
Healthcare, which are two leading for-proļ¬t hospital companies; and against
Woodbridge Memorial Hospital and St. Anthonyā€™s, which are its primary local
competitors.
To illustrate, consider how Riversideā€™s analysts present total margin
data to the ļ¬rmā€™s board of trustees:
2004 2003
National/GFB 9.8% National/GFB 9.6%
Industry top quartile 8.4 Industry top quartile 8.0
St. Anthonyā€™s 8.0 St. Anthonyā€™s 7.9
Pennant Healthcare 5.0
Riverside 7.3
Industry median 5.0 Industry median 4.7
Pennant Healthcare 4.8 Riverside 2.2
Industry lower quartile 1.8 Industry lower quartile 2.1
Woodbridge Memorial 0.5 Woodbridge Memorial (1.3)

Benchmarking permits Riversideā€™s managers to easily see exactly where the
ļ¬rm stands relative to its competition both in any given year and over time.
As the data show, Riverside was roughly in the middle of the pack in 2004
with respect to its primary competitors and two large investor-owned hospital
chains, although its showing was better than the average hospital. Its 2003
performance was signiļ¬cantly worse, so Riverside improved substantially dur-
ing the year. Although benchmarking is illustrated with one ratio, other ratios
could be analyzed similarly. Also, for presentation purposes, comparative data
can be color coded and presented in graphical form for ease of recognition
and interpretation.
All comparative analyses require comparative data. Such data are avail-
able from a number of sources, including commercial suppliers, federal and
state governmental agencies, and various industry trade groups. Each of these
data suppliers uses a somewhat different set of ratios designed to meet its
own needs. Thus, when a comparative data source is selected, in a very real
sense the ratios that will be used in the analysis are being chosen. Also, there
are minor and sometimes major differences in ratio deļ¬nitions between data
sourcesā€”for example, one source may use a 365-day year, while another uses a
360-day year. There are also numerous differences on using operating values
versus total values when constructing ratios. It is very important to know
the speciļ¬c deļ¬nitions used in the comparative data because deļ¬nitional dif-
ferences between the ratios being calculated and comparative ratios can lead
to erroneous interpretations and conclusions. Thus, the ļ¬rst task in a ratio
analysis is to make sure that the deļ¬nitions used to develop the comparative
data are understood.
549
Chapter 17: Analyzing Financial Performance




Self-Test
1. What is benchmarking?
Questions
2. Why is it important to be familiar with the comparative data set?


Operating Indicator Analysis
Operating indicator analysis goes one step beyond ļ¬nancial statement analysis
in that operating indicator analysis examines operating variables with the goal
of explaining a businessā€™s ļ¬nancial performance. Like ratios, operating indica-
tors are typically grouped into major categories to make interpretation easier.
Because of the large number of indicators used in a typical operating
indicator analysis, it cannot be discussed in detail here. However, to give
readers an appreciation for this type of analysis, six commonly used hospital
operating indicators are deļ¬ned and illustrated. Note that most of the data
needed to calculate operating indicators are not contained in a businessā€™s
ļ¬nancial statements. Thus, a larger data set is required for this type of analysis,
and hence it is used more by managers than by outside analysts.

Net Price Per Discharge
Net price per discharge measures the average revenue collected on each inpa-
tient discharge. In 2004, Riverside reported $93,740,000 in inpatient service
revenue and discharged 18,281 patients:

Net inpatient revenue $93,740,000
Net price per discharge = = = $5,128.
Total discharges 18,281
Industry average = $5,510.
Riverside collects less per discharge than the average hospital, ignoring bad
debt losses. However, if Riversideā€™s case mix, which measures the average
intensity of services provided, were lower than average, perhaps its net price
per discharge is appropriate, even though it is below the industry average. In
fact, Riversideā€™s case mix is slightly higher than average. Still, as we explain in
a later section, the net price per discharge cannot be completely interpreted
without knowing Riversideā€™s cost per discharge.

Medicare Payment Percentage
Medicare payment percentage measures the exposure of a hospital to Medi-
care patients and hence to payments set by political, rather than economic,
processes:
Medicare discharges 7,642
Medicare payment percentage = = = 41.8%.
Total discharges 18,281
Industry average = 43.5%.
Riverside has a somewhat lower percentage of Medicare patients than the
average hospital. To the extent that Medicare payments are less than payments
550 Healthcare Finance



from other third-party payers, a higher Medicare payment percentage puts
pressure on operating revenues. Conversely, if Medicare payments are higher
than reimbursements by managed care plans, then, in some situations, a higher
Medicare payment percentage might be good. Similar operating indicators
could be constructed for Medicaid, managed care plan, and bad debt and
charity care patients.

Outpatient Revenue Percentage
The outpatient revenue percentage measures the mix between outpatient and
inpatient revenues:
Net outpatient revenue $20,092,000
Outpatient revenue percentage = = = 17.6%.
Net patient service revenue $113,832,000
Industry average = 34.5%.

Riverside has a much smaller outpatient program, relative to its size, than
the average hospital. During the 1990s, most hospitals signiļ¬cantly expanded
their outpatient programs based on the belief that such services were more
proļ¬table because Medicare paid for outpatient services on a charge basis,
whereas inpatient services were paid for on a prospective basis. However, the
claims of increased proļ¬tability were never proved, and Medicare has since
changed to a prospective payment system for outpatient services.

Occupancy Percentage (Rate)
Occupancy rate measures the extent of utilization of a hospitalā€™s beds and
hence ļ¬xed assets. As discussed in Chapter 5, because overhead costs are
incurred on all assets, whether used or not, higher occupancy spreads ļ¬xed
costs over more patients and hence increases per patient proļ¬tability. Based on
95,061 inpatient days in 2004, Riversideā€™s occupancy rate was 57.9 percent:
Inpatient days 95,061
Occupancy percentage = = = 57.9%.
Number of staffed beds Ć— 365 450 Ć— 365
Industry average = 44.9%.

Riverside has a higher occupancy rate and hence is using its ļ¬xed assets more
productively than the average hospital. It is interesting to note that this con-
clusion is contrary to the ļ¬nancial analysis interpretation of the hospitalā€™s 2004
ļ¬xed asset turnover ratio. While that ratio is affected by inļ¬‚ation and account-
ing convention, the occupancy rate is not. Hence, it is a superior measure of
pure asset utilization, at least regarding inpatient assets. On this basis, it ap-
pears that Riversideā€™s managers are doing a good job, relative to the industry,
of utilizing the hospitalā€™s inpatient ļ¬xed assets.

Average Length of Stay (ALOS)
Average length of stay (ALOS), or just length of stay (LOS), is the number of
days that an average inpatient is hospitalized with each admission.
551
Chapter 17: Analyzing Financial Performance



Inpatient days 95,061
ALOS = = = 5.2 days.
Total discharges 18,281
Industry average = 4.1 days.
On average, Riverside keeps its patients in the hospital longer than the average
hospital does. Riverside has a case-mix index of 1.28 compared with an average
for the industry of 1.14. The case-mix index is a weighted average of DRG
weights, so the higher the index, the more intense the services provided.
Thus, the hospitalā€™s patients, on average, require more intensive treatment
than patients in the average hospital.

Cost Per Discharge
So far, the operating analysis illustration has focused on revenue and volume
measures. Cost per discharge measures the dollar amount of resources, on
average, expended on each discharge. Because Riversideā€™s inpatient operating
expenses for 2004 were $84,865,000, its cost per discharge was $4,642:

Inpatient operating expenses $84,865,000
Cost per discharge = = = $4,642.
Total discharges 18,281
Industry average = $5, 446.

Even though Riversideā€™s price per discharge is below average, its cost per dis-
charge is even more so. Thus, the hospitalā€™s average margin on each discharge
is more than that for the hospital industry.
As is apparent from the six operating indicators presented, operating in-
dicator analysis goes beyond ļ¬nancial analysis in an attempt to identify the op-
erating strengths and weaknesses that underlie a ļ¬rmā€™s ļ¬nancial performance.
Although operating indicator analysis has been illustrated using the hospital
industry, the concepts can be applied to any healthcare business, although the
ratios selected would differ. Also, operating indicators are interpreted in the
same way as ļ¬nancial ratios (i.e., by using comparative and trend analysis).



Self-Test
1. What is the difference between ļ¬nancial and operating indicator
Questions
analyses?
2. Why is operating indicator analysis important?
3. Describe four indicators commonly used in operating indicator analysis.



Limitations of Financial Performance Analysis
While ļ¬nancial performance analysis can provide a great deal of useful infor-
mation regarding a businessā€™s operations and ļ¬nancial condition, such analyses
have limitations that necessitate care and judgment. In this section, some of
the problem areas are highlighted.
552 Healthcare Finance



To begin, many large healthcare businesses operate a number of dif-
ferent divisions in quite different lines of business, and in such cases it is dif-
ļ¬cult to develop meaningful comparative data. This problem tends to make
ļ¬nancial statement and operating indicator analyses somewhat more useful for
providers with single service lines than for large, multiservice companies.
Next, generalizing about whether or not a particular ratio or indicator
is good or bad is often difļ¬cult. For example, a high current ratio may show
a strong liquidity position, which is good, or an excessive amount of current
assets, which is bad. Similarly, a high asset turnover ratio may denote either
a business that uses its assets efļ¬ciently or one that is undercapitalized and
simply cannot afford to buy enough assets. In addition, ļ¬rms often have
some ratios and indicators that look good and others that look bad, which
make the ļ¬rmā€™s ļ¬nancial position, strong or weak, difļ¬cult to determine.
For this reason, signiļ¬cant judgment is required when analyzing ļ¬nancial and
operating performance.
Another problem is that different accounting practices can distort ļ¬-
nancial statement ratio comparisons. For example, ļ¬rms can use different ac-
counting conventions to value cost of goods sold and ending inventories. Dur-
ing inļ¬‚ationary periods these differences can lead to ratio distortions. Other
accounting practices, such as those related to leases, can also create distortions.
Finally, inļ¬‚ation effects can distort both ļ¬rmsā€™ balance sheets and in-
come statements. Numerous reporting methods have been proposed to adjust
accounting statements for inļ¬‚ation, but no consensus has been reached either
on how to do this or even on the practical usefulness of the resulting data.
Nevertheless, accounting standards encourage, but do not require, businesses
to disclose supplementary data to reļ¬‚ect the effects of general inļ¬‚ation. In-
ļ¬‚ation effects tend to make ratio comparisons over time for a given company,
and across companies at any point in time, less reliable than would be the case
in the absence of inļ¬‚ation.



Self-Test 1. Brieļ¬‚y describe some of the problems encountered when performing
Questions ļ¬nancial statement and operating indicator analyses.
2. Explain how inļ¬‚ation effects created problems in the Riverside illustra-
tion.


Key Concepts
The primary purpose of this chapter is to present the techniques used by
managers and investors to assess a businessā€™s ļ¬nancial performance. The
main focus is on ļ¬nancial performance as reļ¬‚ected in a businessā€™s ļ¬nancial
statements, although operating data was also introduced to try to explain
ļ¬nancial performance. In addition, other performance measuresā€”namely,
553
Chapter 17: Analyzing Financial Performance



Market Value Added (MVA) and Economic Value Added (EVA)ā€”were
discussed. The key concepts of this chapter are:
ā€¢ Financial statement analysis, which is designed to identify a ļ¬rmā€™s ļ¬nancial
condition, focuses on the ļ¬rmā€™s ļ¬nancial statements. Operating indicator
analysis, which uses data typically found outside of the ļ¬nancial statements,
provides insights into why a ļ¬rm is in a given ļ¬nancial condition.
ā€¢ Ratio analysis is designed to reveal the relative strengths and weaknesses
of a company as compared to other companies in the same industry, and
to show whether the businessā€™s position has been improving or
deteriorating over time.
ā€¢ The Du Pont equation indicates how the total margin, the total asset turn-
over ratio, and the use of debt interact to determine the rate of return on
equity. It provides a good overview of a businessā€™s ļ¬nancial performance.
ā€¢ Liquidity ratios indicate the businessā€™s ability to meet its short-term
obligations.
ā€¢ Asset management ratios measure how effectively managers are utilizing
the businessā€™s assets.
ā€¢ Debt management ratios reveal the extent to which the ļ¬rm is ļ¬nanced
with debt and the extent to which operating cash ļ¬‚ows cover debt service
and other ļ¬xed charge requirements.
ā€¢ Proļ¬tability ratios show the combined effects of liquidity, asset
management, and debt management on operating results.
ā€¢ Ratios are analyzed using comparative analysis, in which a ļ¬rmā€™s ratios are
compared with industry averages or those of another ļ¬rm, and trend
analysis, in which a ļ¬rmā€™s ratios are examined over time.
ā€¢ In a common size analysis, a businessā€™s income statement and balance sheet
are expressed in percentages. This facilitates comparisons between ļ¬rms of
different sizes and for a single ļ¬rm over time.
ā€¢ In percentage change analysis, the differences in income statement items
and balance sheet accounts from one year to the next are expressed in
percentages. In this way, it is easy to identify those items and accounts that
are growing appreciably faster or slower than average.
ā€¢ Market Value Added (MVA) and Economic Value Added (EVA) are two
measures of business performance that focus directly on managementā€™s
ability to enhance shareholder wealth. Although MVA is not applicable to
not-for-proļ¬t businesses, EVA can be used to assess the performance of
any business, regardless of ownership.
ā€¢ Benchmarking is the process of comparing the performance of a particular
company with a group of benchmark companies, often industry leaders
and primary competitors.
ā€¢ Financial performance analysis is hampered by some serious problems,
including development of comparative data, interpretation of results, and
inļ¬‚ation effects.
554 Healthcare Finance



Financial performance analysis has its limitations, but if used with care and
judgment, it can provide managers with a sound picture of a businessā€™s ļ¬nan-
cial condition as well as identify those operating factors that contributed to
that condition.

Questions
17.1 a. What is the primary difference between ļ¬nancial statement analysis
and operating indicator analysis?
b. Why are both types of analyses useful to health services managers
and investors?
17.2 Should ļ¬nancial statement and operating indicator analyses be
conducted only on historical data? Explain your answer.
17.3 One asset management ratio, the inventory turnover ratio, is deļ¬ned
as sales (i.e., revenues) divided by inventories. Why would this ratio
be more important for a medical device manufacturer or a hospital
management company?
17.4 a. Assume that Beverly Enterprises and Manor Care, two operators of
nursing homes, have ļ¬scal years that end at different timesā€”say, one
in June and one in December. Would this fact cause any problems
when comparing ratios between the two companies?
b. Assume that two companies that operate walk-in clinics both had the
same December year end, but one was based in Aspen, Colorado, a
winter resort, while the other operated in Cape Cod, Massachusetts,
a summer resort. Would this lead to problems in a comparative
analysis?
17.5 a. How does inļ¬‚ation distort ratio analysis comparisons, both for one
company over time and when different companies are compared?
b. Are only balance sheet accounts or both balance sheet accounts and
income statement items affected by inļ¬‚ation?
17.6 a. What is the difference between trend analysis and comparative
analysis?
b. Which one is more important?
17.7 Assume that a large managed care company has a low return on equity
(ROE). How could Du Pont analysis be used to identify possible
actions to help boost ROE?
17.8 Regardless of the speciļ¬c line of business, should all healthcare
businesses use the same set of ratios when conducting a ļ¬nancial
statement analysis? Explain your answer.
17.9 a. What is the difference between MVA and EVA?
b. Are both measures applicable to not-for-proļ¬t businesses? Explain
your answer.

Problems
17.1 a. Modern Medical Devices has a current ratio of 0.5. Which of the
following actions would improve (i.e., increase) this ratio?
555
Chapter 17: Analyzing Financial Performance



ā€¢ Use cash to pay off current liabilities.
ā€¢ Collect some of the current accounts receivable.
ā€¢ Use cash to pay off some long-term debt.
ā€¢ Purchase additional inventory on credit (i.e., accounts payable).
ā€¢ Sell some of the existing inventory at cost.
b. Assume that the company has a current ratio of 1.2. Now, which of
the above actions would improve this ratio?
17.2 Southwest Physicians, a medical group practice, is just being formed. It
will need $2 million of total assets to generate $3 million in revenues.
Furthermore, the group expects to have a proļ¬t margin of 5 percent.
The group is considering two ļ¬nancing alternatives. First, it can use
all-equity ļ¬nancing by requiring each physician to contribute his or her
pro rata share. Alternatively, the practice can ļ¬nance up to 50 percent
of its assets with a bank loan. Assuming that the debt alternative has no
impact on the expected proļ¬t margin, what is the difference between
the expected ROE if the group ļ¬nances with 50 percent debt versus
the expected ROE if it ļ¬nances entirely with equity capital?
17.3 Riverside Memorialā€™s ļ¬nancial statements are presented in Tables 17.1,
17.2, and 17.3.
a. Calculate Riversideā€™s ļ¬nancial ratios for 2003. Assume that Riverside
had $1,000,000 in lease payments and $1,400,000 in debt principal
repayments in 2003. (Hint: Use the book discussion to identify the
applicable ratios.)
b. Interpret the ratios. Use both trend and comparative analysis. For
the comparative analysis, assume that the industry average data
presented in the book is valid for both 2003 and 2004.
17.4 Consider the following ļ¬nancial statements for BestCare HMO, a
not-for-proļ¬t managed care plan:
BestCare HMO
Statement of Operations and Change in Net Assets
Year Ended June 30, 2004
(in thousands)

Revenue:
Premiums earned $26,682
Co-insurance 1,689
Interest and other income 242
Total revenue $28,613
Expenses:
Salaries and beneļ¬ts $15,154
Medical supplies and drugs 7,507
Insurance 3,963
Provision for bad debts 19
Depreciation 367
Interest 385
Total expenses $27,395
556 Healthcare Finance



Net income $ 1,218

Net assets, beginning of year $ 900
Net assets, end of year $ 2,118

BestCare HMO
Balance Sheet
June 30, 2004

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