Financial condition analysis

Financial condition analysis

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Financial condition analysis

Introduction

One of the most important characteristics of a healthcare organization is its financial condition: Does the business have the financial capacity to perform its mission? Many judgments about financial condition are made on the basis of financial statement analysis, which focuses on the data contained in a busi- ness’s financial statements. Financial statement analysis is applied to historical data, which reflect the results of past managerial decisions, and to forecasted data, which constitute the road map for the business’s future. Thus, managers use financial statement analysis both to assess current condition and to plan for the future.

Although financial statement analysis provides a great deal of important information regarding financial condition, it fails to provide much insight into the operational causes of that condition. Thus, financial statement analysis is often supplemented by operating indicator analysis, which uses operat- ing data not usually found in an organization’s financial statements—such as occupancy, patient mix, length of stay, and productivity measures—to help identify factors that contributed to the assessed financial condition. Through operating indicator analysis, managers are better able to identify and implement strategies that ensure a sound financial condition in the future.

Financial statement analysis The process of using data contained in financial statements to make judgments about a business’s financial condition.

Operating indicator analysis The process of using operating indicators to help explain a business’s financial condition.

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

• Explain the purposes of financial statement and operating indicator analyses.
• Describe the primary techniques used in financial statement and operating indicator analyses.
• Conduct basic financial statement and operating indicator analyses to assess the financial condition of a business.
• Describe the problems associated with financial statement and operating indicator analyses.
• Describe how key performance indicators (KPIs) and dashboards can be used to monitor financial condition.

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Financial condition analysis involves a number of techniques that extract information contained in a business’s financial statements and elsewhere and combine it in a form that facilitates making judgments about the organization’s financial condition and operations. Often the end result is a list of organizational strengths and weaknesses. In this chapter, several analytical techniques used in financial condition analyses, some related topics, and the problems inherent in such analyses are discussed. Along the way, you will discover that financial condition analysis generates a great deal of data. A significant problem in assessing financial condition is separating the important from the unimportant and presenting the results in a simple, easy-to-understand, easy-to-monitor format. Thus, we close the chapter with some ideas about data presentation. In addition to the chapter content, the Chapter 17 Supplement discusses four topics: market value ratios, common size analysis, percentage change analysis, and economic value added (EVA).

Financial Statement Analysis

As you learned in chapters 3 and 4, generally accepted accounting standards require businesses to prepare four financial statements: (1) the income state- ment, (2) the statement of changes in equity, (3) the balance sheet, and (4) the statement of cash flows. Taken together, these statements give an accounting picture of an organization’s operations and financial position. Because financial statement data are well organized and easily understood, such statements pro- vide a logical starting place for analyzing an organization’s financial condition.

In much of this chapter, Riverside Memorial Hospital, a 450-bed not- for-profit facility, is used to illustrate financial condition analysis. Although a hospital is being used to illustrate the techniques, they can be applied to any health services setting. Simplified versions of Riverside’s three primary financial statements are contained in exhibits 17.1, 17.2, and 17.3. Riverside’s income statements and balance sheets (exhibits 17.2 and 17.3) will be examined in later sections when we discuss ratio analysis and other tools that are used to help interpret the data. For now, our focus is on the statement of cash flows, which can be interpreted without the aid of additional data or tools.

The statement of cash flows (Exhibit 17.1), first described in Chapter 4, provides such information as whether the firm’s core operations are prof- itable, how much capital the firm raised and how this capital was used, and what impact operating and financing decisions had on the firm’s cash position.

The top part shows cash generated by and used in operations during 2015. For Riverside, operations provided $9,098,000 in net cash flow. The income statement reported $6,474,000 in operating income and $4,130,000 in depreciation, for $10,604,000 in operating cash flow. But as part of its operations, Riverside invested $1,297,000 in current assets (receivables and

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inventories) and reduced its spontaneous liabilities (payables and accruals) bal- ance by $209,000. The end result, net cash flow from operations, is $10,604,000 − $1,297,000 − $209,000 = $9,098,000.

The next section of the statement of cash flows focuses on investments in fixed assets and securities. Riverside spent $4,293,000 on capital expenditures in 2015. Is that a large or small amount? The top part of the statement of cash flows reports a depreciation expense for 2015 of $4,130,000, so the hospital spent only slightly more than its depreciation expense on new fixed assets. Thus, it is likely that the capital expenditures were more to replace worn-out and obsolete assets than to add a significant amount of new property and equip- ment. In addition to fixed-asset investments, Riverside invested $2,000,000 in short-term securities, for a total cash outflow from investing of $6,293,000.

Riverside’s financing activities, as shown in the third section, high- light the fact that the hospital received $2,098,000 in nonoperating income (unrestricted contributions and investment income) and used $2,150,000 + $3,262,000 + $323,000 = $5,735,000 in cash to pay off previously incurred long-term debt, short-term debt, and capital lease obligations.

EXHIBIT 17.1 Riverside Memorial Hospital: Statement of Cash Flows, Year Ended December 31, 2015 (in thousands)

Cash flows from operating activities: Operating income $ 6,474 Adjustments: Depreciation 4,130 Increase in accounts receivable (1,102) Increase in inventories (195) Decrease in accounts payable (438) Increase in accrued expenses 229 Net cash flow from operations $ 9,098

Cash flows from investing activities: Investment in property and equipment ($ 4,293) Investment in short-term securities ( 2,000) Net cash flow from investing ($ 6,293)

Cash flows from financing activities: Nonoperating income $ 2,098 Repayment of long-term debt (2,150) Repayment of notes payable (3,262) Capital lease principal repayment (323) Net cash flow from financing ($ 3,637)

Net increase (decrease) in cash and equivalents ($ 832)

Beginning cash and equivalents 3,095

Ending cash and equivalents $ 2,263

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When the three major sections are totaled, Riverside had a $9,098,000 − $6,293,000 − $3,637,000 = $832,000 net decrease in cash (i.e., net cash outflow) during 2015. The bottom of Exhibit 17.1 reconciles the 2015 net cash flow with the ending cash balance shown on the balance sheet. Riverside began 2015 with $3,095,000; experienced a cash outflow of $832,000 dur- ing the year; and ended the year with $3,095,000 − $832,000 = $2,263,000 in its cash and equivalents account, as verified by the value reported on the balance sheet (Exhibit 17.3).

Riverside’s statement of cash flows shows nothing unusual or alarm- ing. It does show that the hospital’s operations were inherently profitable, at least in 2015. Had the statement showed an operating cash drain, Riverside’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 flows also provides easily interpreted information about Riverside’s financing and fixed- asset investing activities for the year. For example, Riverside’s cash flow from operations was used primarily to purchase replacement fixed assets, to invest in short-term securities, and to pay off notes payable and long-term debt. Again, such uses of operating cash flow do not raise any red flags regarding the hospital’s financial actions.

Managers and investors must pay close attention to the statement of cash flows. Financial condition is driven by cash flows, and the statement gives a good picture of the annual cash flows generated by the organization. An examination of Exhibit 17.1 (or better yet, a series of such exhibits going back the last five years and projected five years into the future) would give River- side’s managers and creditors an idea of whether or not the hospital’s opera- tions are self-sustaining—that is, whether the business generates the cash flows necessary to pay its bills, including those associated with the capital employed. Although the statement of cash flows is filled with valuable information, the bottom line tells little about the business’s financial condition because operat- ing losses can be covered by financing transactions such as borrowing or selling new common stock (if investor owned), at least in the short run.

1. What are the four required financial statements? 2. What type of financial performance information is provided in the

statement of cash flows? 3. What is the difference between net income and cash flow, and

which is more meaningful to a business’s financial condition? 4. Does the fact that a business’s cash position has improved provide

much insight into the year’s financial results?

SELF-TEST QUESTIONS

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Financial Ratio Analysis

The next step in most financial condition analyses is to examine the business’s other financial statements. We analyzed Riverside’s statement of cash flows first because this statement is formatted in a way that facilitates interpretation without further data manipulation. Now we examine the income statement and balance sheet. Although these statements contain a wealth of financial information, it is difficult to make meaningful judgments about financial condi- tion by merely examining the statements’ raw data. To illustrate, one medical group practice 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 interest charges of $3,948,600. The true burden of these debts, and each practice’s ability to pay the interest and principal due on them, cannot be easily assessed without additional data analyses, such as those provided by ratio analysis.

Ratio analysis combines data to create single numbers that have eas- ily interpreted significance (for our purposes, numbers that measure various aspects of financial condition). Financial ratio analysis is ratio analysis applied to the data contained in a business’s financial statements (income statement and balance sheet). In the case of the debt and interest payments described above, ratios could be constructed that relate each practice’s debt to its assets and the interest it pays to the income it has available for payment.

Unfortunately, an almost unlimited number of financial 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 exhibits 17.2 and 17.3 are used to calculate an illustrative sampling of 2015 financial ratios for Riverside Memorial Hospital, which are then compared with hospital industry average ratios.

Industry average ratios are available from many sources. For example, Optum360 publishes an annual almanac that provides hospital industry data on 76 financial and operating indicator ratios. The ratios are reported in several groupings, such as by hospital size and geographic location. (For information about the 2016 edition, visit www.optumcoding.com/Product/43409/.) The industry average ratios presented in this chapter are for illustrative use only and hence should not be used for making real-world comparisons.

Note that in a real analysis, many more ratios would be calculated and analyzed. Also, although a hospital is used to illustrate ratio analysis, the specific 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 medical practices, and so on.

Ratio analysis The process of creating and analyzing ratios from financial statement and other data to help assess a business’s financial condition.

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Profitability Ratios Profitability is the net result of a large number of managerial policies and deci- sions, so profitability ratios provide one measure of the aggregate financial performance of a business.

Total Margin The total margin, often called the total profit margin or just profit margin, is net income divided by all revenues, including both operating revenues and nonoperating income:

Total margin = Net income

Total revenues =

$8,572 $114,148

= 0.075 = 7.5%.

Industry average = 5.0%.

Note that total revenues are defined as net operating revenues plus nonoperating income, so Total revenues = $112,050 + $2,098 = $114,148. Riverside’s total margin of 7.5 percent shows that the hospital makes 7.5 cents on each dollar of revenue. The total margin measures the ability of the

Profitability ratios A group of ratios that measure different dimensions of a business’s profitability.

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