Financial Aspect of Health care system assignment. Please read carefully and make sure you understand what needs to be done.

Notes - Chapter 11

Overview

• Understand four types of liquidity ratios

• Understand two types of solvency ratios

• Understand two types of profitability ratios

• Successfully compute ratios

Financial and Operating Ratios as Performance Measures

Ratios are measures that are widely adopted in the healthcare financial management. One of the most important reasons that financial ratios are used is for credit analysis. Banking institutions will use ratios to determine if an organization can borrow money. As an individual, you would be subject to the same performance measures if you were borrowing money to pay a mortgage or some other type of debt.

Ratio analysis should be conducted as a comparative analysis. Just looking at one ratio standing alone does not give any meaning to the ratio. Ratios should be compared to other periods in order to determine business trends and to make informed business decisions. When differences between periods is identified, reasons should be sought for those differences. Financial ratios can be compared period to period or more importantly, amongst other organizations within the same region.

Liquidity, Solvency and Profitability

There are eight basic ratios used in health care.

Liquidity Ratios

• Current Ratio

• Quick Ratio

• Days Cash on Hand

• Days Receivables

Solvency Ratios

• Debt Service Coverage Ratio

• Liabilities to Fund Balance

Profitability Ratios

• Operating Margin

• Return on Total Assets

Liquidity Ratios

Liquidity ratios reflect the ability an organization has to meet its current obligations. LR measure short term sufficiency. They measure the ability an organization has to be liquid or to have sufficient cash.

1. Current Ratio

Current ratio equals current assets divided by current liabilities.

Current Assets / Current Liabilities

$120,000 / $60,000 = 2 to 1

This ratio is a measure of short term debt paying ability. The organization has twice as much cash to pay its debts. As you can see, the result is a ratio , not a dollar amount.

1. Quick Ratio

Quick ratio equals cash plus short term investments plus net receivables divided by current liabilities.

Cash & Cash Equivalents + Net Receivables/Current Liabilities

$65,000 / $60,000 = 1.08 to 1

The standard by which quick ratio is measured is usually 1 to 1 so this ratio is a little better than the standard.

1. Days Cash on Hand

Days Cash on Hand equals unrestricted cash and investments divided by cash operating expenses divided by 365 days. An example is:

Unrestricted Cash & Cash Equivalents / Cash Operating Expenses / Days in Period

$330,000 / $11,000 = 30 days

There is no standard measure to compare this to as all organizations can function differently with their cash on hand. This ratio indicates that in relation to the amount of daily operating expense, the organization has 30 days’ worth of operating expenses in cash on hand.

1. Days Receivables

Days Receivable computation is net receivables divided by net credit revenues / 365.

Net Receivables / Net Credit Revenue /Days in Period

$720,000 /$12,000 = 60 days

This number represents the number of days in receivables. The older a receivable is, the harder it is to collect. This, therefore is a measure of worth and performance. This example indicates that the organization has 60 days’ worth of credit revenue tied up in net receivables. This is a common measure of billing and collection performance. This is an easily comparable measure as there are numerous regional and national figures to compare to.

Solvency Ratios

Reflects the organizations ability to pay the annual interest and principal obligations on its long term debt. Measures the organizations ability to be solvent, to have sufficient resources to meet its long term obligations.

1. Debt Service Coverage Ratio

The change in unrestricted net assets (net income) plus interest, depreciation and amortization divided by maximum annual debt service.

Change in Unrestricted Net Assets(Net Income) + Interest, Depreciation & Amortization

Maximum Annual Debt Service

$250,000 / $100,000 = 2.5

This ratio is used in credit analysis and each lending institution has its own particular criteria for lending agreements.

1. Liabilities to Fund Balance (or Debt to Net Worth)

Represented as total liabilities divided by unrestricted net assets (fund balance or net worth) or total debt divided by tangible net worth.

Total Liabilities / Unrestricted Fund Balances

$2,000,000 / $2,250,000 = .80

This is an indicator of debt load. The higher the number the more debt an organization has.

Profitability Ratios

Reflect the ability of the organization to operate with an excess of operating revenue over operating expense.

1. Operating Margin

The Operating Margin is generally expressed as a percentage, is represented as operating income (loss) divided by total operating revenues.

Operating Income (Loss) / Total Operating Revenues

$250,000 / $5,000,000 = 5.0%

This ratio is used for managerial purposes and also for credit analysis. There are many outside comparisons available. The higher the percentage the better.

1. Return on Total Assets

The return on total assets is represented as earnings before interest and taxes (EBIT) divided by total assets.

EBIT / Total Assets

$400,000 / $4,000,000 – 10%