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Answer & Explanation:Referencing the
chapters in the text, and using evidence from at least one scholarly source for
support answer the following questions. Text attached here: 03CH_Smith_Healthcare.pdf
If you were
considering a capital investment, how would you utilize the information
reported on your balance sheet, statement of revenue and expense, and statement
of cash flows?
What determinations
or decisions can be made with the information reported?
Students, attached is Hartford Hospital annual report. This annual
report contains the organization’s financial reports. Are there any large
discrepancies in Hartford’s financial reports? Would you consider Hartford
financially stable? This will help you further understand financial
reports.
Hartford report attached here: HH_Annual_Report_2014.pdfPlease discuss your
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to support your 250-300 word post
03ch_smith_healthcare.pdf
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Evaluation of Financial
Performance
3
.Eric Hood/iStock/Thinkstock
Learning Outcomes
By the end of this chapter, you will be able to:
• Identify the steps necessary to evaluate financial performance
• Describe and calculate profitability measures
• Explain and calculate liquidity measures
• Identify and calculate leverage measures
• Recall and calculate measures to better understand general positions and operational
efficiency
• Describe the purpose of trend analysis
• Discuss the limitations of financial and operating ratios
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Section 3.1
Financial Performance Evaluations
Introduction
Middaugh United Hospital is a 218-bed hospital that has recently become part of a multihospital system. Management is concerned about their financial performance in general, as
well as how it compares to the other hospitals in the system. Even though they are regarded
as a well-managed community hospital, Middaugh has lost nearly $9 million on operations
in the last two years. At the same time, Middaugh has earned nearly $20 million on financial
investments and earned $14 million in positive cash flows. Will the system view Middaugh as
profitable? On a more personal note, Brian Craig, the president of Middaugh, and other senior
managers are concerned whether they will be able to keep their positions if profits remain at
unacceptable levels, and what other measures of financial performance will be important to
the system.
Monitoring and evaluating financial performance is an essential role for management and
governance of an organization. To be effective in this role, it is important to understand how
financial performance might be monitored, what decisions must be made in the evaluation
process, and how to assess the outcomes. In this chapter, the steps in the financial evaluation
process are presented, along with a host of available measures.
3.1 Financial Performance Evaluations
Preparation of financial statements that accurately depict the financial status of an organization at a point in time and how its status has changed over the most recent accounting period
is the end result of the financial accounting process. Having the financial statements in hand
is then the start of the process of evaluating financial performance. Is the organization profitable? Is it able to pay its bills? How efficiently does the organization use its assets? These are
all questions that managers and interested parties want to have answered about healthcare
organizations. Analysis of financial statements can provide answers to these types of questions and facilitate an informed evaluation of the organization.
Any evaluation process takes at least three steps: selecting performance measures, setting
standards, and calculating and interpreting results. Selecting performance measures provides
a clear indication of what is being evaluated and how. A clear indication of performance measures will leave little doubt as to what is viewed as important in the management of an organization. Standards indicate the values that performance measures are expected to achieve.
Calculation involves the use of financial statements and other sources of data to determine
values of the performance measures for comparison against chosen standards.
Step One: Selecting Performance Measures
With regards to a financial evaluation, one must select the aspects of performance that will
be evaluated and the values or indicators of those aspects of performance. The four aspects
of financial performance that are routinely selected are profitability, liquidity, leverage, and
activity, each of which is presented in this chapter. Financial statements can provide specific
values of selected measures of each aspect of performance. In the case of profitability, financial statements provide values for operating income, net income, and net cash flows. There
are also limitations to the information contained in financial statements. Financial statements
can only provide indicators of financial performance for some measures. For example, in the
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Section 3.1
Financial Performance Evaluations
case of liquidity, financial statements provide values for current assets and current liabilities. The comparison of available assets during the year, with liabilities that must be paid
within the year provides a general indication of whether the organization will have sufficient
resources. It does not indicate whether the organization will actually have cash available on
the day a specific debt must be paid.
Step Two: Setting Standards
The second step in evaluation is setting standards. Once a value or indicator of financial performance has been selected, how do we determine whether the result is good or bad? The
development of standards can arise from internal and external sources. Internal sources
often begin by comparing current performance with past performance. If the level of current
assets is higher this year than last year, it is a positive sign. If the level of current assets, as
compared to the level of current liabilities, is higher this year than last year, it would be an
even better sign of performance. Still, if the level of current assets was evaluated as being too
low last year and therefore bad, what increase would be required to result in an evaluation
of being good? Comparing current performance with past performance provides important
information about relative performance (better or worse), but it does not provide information on absolute performance (good or bad).
Another internal source would be target levels of financial performance established in the
budgeting process. As will be discussed in depth in later chapters, a budget is a plan and
forecast of future financial performance. Establishing internal standards for the definition
of good performance during the budget process, and then comparing actual results to budgeted results, is a sound financial management practice. Achieving the financial performance
presented in the budget is usually considered to be at least an acceptable result for an organization. Comparing current measures of financial performance against last year’s measures,
as well as the forecast of these measures presented in the budget, is a good use of internal
standards for evaluating financial performance.
There are also external sources of standards for evaluating financial performance. The financial performance of similar types of healthcare organizations is a commonly used external
source. Comparing the financial performance of one hospital against the average performance
of others allows for consideration of factors that affect all hospitals, like changes in Medicare
payment policy (affecting patient services revenues) and changes in the stock market (affecting investment earnings). Beyond using the average financial performance of similar types of
healthcare organizations, one could develop standards based on the financial performance
of a specific set of healthcare organizations. Making comparisons against a specific set of
healthcare organizations is called benchmarking. Benchmarking is often accomplished by
obtaining the financial statement of another healthcare organization. Many commercial firms
collect financial statements from firms in the healthcare industry for the purposes of benchmarking. American Hospital Data collects Medicare Cost Reports for all hospitals and makes
them available on a subscription basis (http://www.AHD.com). Benchmarking is often used
to develop internal standards for financial performance.
Sources of information on the financial performance of other healthcare organizations include
the annual assessments by rating agencies. Rating agencies, including Moody’s, Standard &
Poor’s, and Fitch, perform financial evaluation of organizations and provide grades on their
credit worthiness. Individuals, banks, and companies that may loan money to organizations will
use these grades. In annual assessments, rating agencies provide statistics on the average levels
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Section 3.1
Financial Performance Evaluations
From the Front Lines
We are a regional system, residing within
a larger system. Our goal is to have
enough cash associated with the local
entity so that it is not necessary for us to
use system cash. The system’s target cash
on hand is currently 200 days and will be
220 days by the end of 2014.
Source: Health system chief executive officer.
of financial performance achieved by organizations in
an industry, as well as performance levels achieved by
grade level. Using statistics on financial performance at
a specific grade level is one type of benchmarking.
In addition to the information on financial performance
prepared by rating agencies, many states require
reporting of financial performance and make these
data available to consumers. California’s Office of Statewide Health Planning & Development, Massachusetts’s
Center for Health Information and Analysis, and the
State of Washington’s Department of Health are three
such sources.
Step Three: Calculating and Interpreting Results
The third step in evaluation is the calculation of selected measures, the comparison against
standards, and the interpretation of results. For organizations that choose internal standards,
the calculations and comparisons can occur immediately after the financial statements are
prepared and are available for use internally. For comparisons against external standards,
organizations often have to wait until other organizations have also prepared their financial
statements and made them available for use by others.
The interpretations of results and the decision making that follows are the key contributions of persons involved with financial performance evaluation. In most cases, indicating
whether performance has improved or gotten worse is straightforward. Making an indication
of whether performance is good or in need of improvement is highly dependent upon the
selection of appropriate standards. If the board of directors or senior management selects
standards that are too low, the organization may not be sufficiently challenged to improve. If
the standards are too high, an appearance of failure may be inevitable. Further, many measures of financial performance are only indicators of an issue that requires further analysis.
The interpretations of financial performance evaluations often involve raising new questions
requiring deeper analysis before sound decisions can be made.
This chapter focuses on evaluating financial performance through financial statement analysis. The financial statements are an excellent source of information for measures and indicators of profitability, liquidity, leverage, and operational efficiency. Some cautions about the
use of financial measures are also offered, along with new ways in which measures are being
employed by healthcare organizations.
For Review:
1. Why do organizations evaluate financial performance?
Organizations evaluate financial performance to gain a clear understanding of their
financial position at a point in time and of their change in financial position over the
accounting period. Organizations can make better decisions if they understand if
their performance is good or bad, and getting better or worse.
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Section 3.2
Profitability
3.2 Profitability
Evaluation of the financial performance of healthcare organizations starts with information presented on formal financial statements. Although evaluations may need to go further,
financial statements present information that has known properties, like following generally accepted accounting principles that make analyses comparable across organizations and
consistent over time. For the purposes of providing clear examples of measures of financial
performance, the three main financial statements of Middaugh United Hospital are presented
as Exhibits 3.1–3.3.
Exhibit 3.1 Balance sheet, Middaugh United Hospital
2012
2011
Assets
Cash and cash equivalents
Patient accounts receivable (net of allowance for Doubtful
Accounts of $7,858,408 in 2012 and $8,027,386 in 2011)
Inventories
Other current assets
Total current assets
15,429,906
3,325,377
7,654,268
$123,317,688
17,659,500
3,580,350
2,436,606
$113,395,220
Property, plant, and equipment
(Accumulated depreciation)
Net property, plant, and equipment
Other long-term assets
Total long-term assets
Total assets
$264,441,622
(169,807,310)
94,634,312
13,576,660
$108,210,972
$243,019,946
$257,605,927
(158,447,786)
99,158,141
14,858,818
$114,016,959
$237,774,962
$16,216,745
5,877,895
1,469,474
$23,564,114
$15,318,329
5,082,771
12,715,004
$33,116,104
Assets limited as to use
Liabilities
Accounts payable
Accrued payroll-related liabilities
Other accrued liabilities
Total current liabilities
Long-term debt
Total liabilities
Net assets
Total liabilities and net assets
Source: Author’s calculations.
$96,908,137
$11,491,286
$89,718,764
$10,362,783
$69,097,240
$92,661,354
$63,342,742
$96,458,846
$150,358,592
$243,019,946
$141,316,116
$237,774,962
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Section 3.2
Profitability
Exhibit 3.2 Income statement, Middaugh United Hospital
Revenues
Inpatient revenue
Outpatient revenue
Total patient revenue
(Less bad debts)
Total operating revenues
Expenses
Salaries and wages
Fringe benefits
Contract labor
Depreciation expense
Interest expense
Other operating expenses
Total operating expenses
Net operating income (loss)
Net nonoperating revenues
Net income
Source: Author’s calculations.
2012
2011
$92,267,833
113,153,751
205,421,584
(9,487,421)
$195,934,163
$88,728,102
110,805,931
199,534,033
(9,927,548)
$189,606,485
$68,764,520
17,191,130
12,658,204
4,823,520
2,441,896
96,006,040
$201,885,310
($5,951,147)
14,231,564
$8,280,417
$67,775,556
16,266,133
10,321,085
4,882,967
2,521,819
90,731,330
$192,498,890
($2,892,405)
16,955,528
$13,877,200
Exhibit 3.3 Statement of cash flows, Middaugh United Hospital
Net income
Change in:
Depreciation
Accounts receivable
Inventories
Other current assets
Accounts payable
Accrued payroll/related liabilities
Other accrued liabilities
Net cash provided (used) by operations
Cash flows from investing
Purchase of depreciable assets
Equipment
Other fixed assets
Net cash provided (used) by investing
Cash flows from financing
Long-term debt
Net cash provided (used) by financing
Net increase (decrease) in cash
Cash at beginning of period
Cash at end of period
2011
$14,063,123
$1,898,181
(1,282,158)
$616,023
($5,423,657)
(5,238,752)
($10,662,409)
4,823,520
2,229,594
254,973
(5,217,662)
898,416
795,124
(11,245,530)
$818,852
Source: Author’s calculations.
smi81240_03_c03_059-094.indd 64
2012
$8,280,417
64
$5,754,498
$5,754,498
$7,189,373
$89,718,764
$96,908,137
4,882,967
687,543
(89,546)
(4,216,584)
(875,662)
895,643
(657,832)
$14,689,652
$3,265,489
$3,265,489
$7,292,732
$82,426,032
$89,718,764
3/7/14 9:31 AM
Section 3.2
Profitability
Profitability is almost always the starting point for financial performance analysis. Even for a
not-for-profit organization, it is important to know if their revenues sufficiently exceed their
expenses to remain in business. The key questions in profitability analysis are: How much
money is the organization making and is it enough? The indication of how much is enough is
a standard established by the board of directors or the shareholders of the company. Among
the many possible measures of profitability, four are commonly used for analysis of healthcare organizations.
Operating Margin
The first measure of profitability is the operating margin, the amount of money the organization has earned through the provision of healthcare services, as defined by the following
equation:
Operating margin 5
Operating income
3 100%
Operating revenues
The operating margin starts with the operating income earned, which is operating revenues
minus operating expenses. Operating income is then divided by operating revenues. For ease
of interpretation of operating margin and many other ratios, the result is multiplied by 100%
to yield a percentage value.
For Middaugh United Hospital, ($5,951,147) in operating income (in this case an operating
loss) is divided by $195,934,163 in operating revenues and multiplied by 100% to yield an
operating margin of (3.0%) in 2012, as compared to its operating margin of (1.5%) in 2011.
Operating margin 5
1 $5,951,147 2
3 100%
$195,934,163
Operating margin 5 1 3.0% 2
The operating margin (loss) at Middaugh was twice as large in 2012 as compared to 2011.
Is this result bad? In a relative sense, losing twice as much is almost certainly a worse result.
In an absolute sense, an assessment of this result requires knowledge of (a) the anticipated
budget for 2012 as an operating margin, (b) the internal goals for the operating margin,
(c) the benchmarks Middaugh uses to compare results, and (d) what similar hospitals might
have experienced in 2012. In most cases, information on budgets, goals, and benchmarks would
only be available to insiders at Middaugh. Outside analysts would have the data on other organizations for comparison purposes. As presented in Figure 3.1, the median operating margin
for stand-alone hospitals (hospitals that are not part of multihospital systems) reviewed by
Standard & Poor’s (2013a) was 2.6%. The median operating margin for multi-hospital systems reviewed by Standard & Poor’s (2013b) was 2.9%. Since rating agencies include different hospitals in their analyses, median values will vary slightly. The median operating margins
reported by Fitch (2013) and Moody’s (2013) for stand-alone hospitals in 2012 were 2.7%
and 2.5%, respectively. Middaugh’s performance on the basis of the operating margin alone
was lower than the median in national samples. If the internal goal for Middaugh was the
median performance of hospitals nationally, then Middaugh fell short of this goal.
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Section 3.2
Profitability
Figure 3.1: Median operating margin for stand-alone hospitals
3.0%
2.5%
Percentage
2.0%
1.5%
1.0%
0.5%
0.0%
2007
2008
2009
2010
2011
2012
Year
Source: Author’s calculations based on Standard & Poor’s (2013a).
Figure 3.2 presents the operating margins for hospitals in Massachusetts in 2012, sorted by
profitability. Operating margins for these 64 hospitals ranged from 211.7% to 13.4%, with a
median of 2.2%. Note that only seven of the hospitals in Massachusetts experienced operating margins of less than 23.0%. With regards to Middaugh, a favorable conclusion about its
profitability would not be reached if it were compared against hospitals in Massachusetts.
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Section 3.2
Profitability
Figure 3.2: Operating margin for Massachusetts hospitals, 2012 (each dot
represents the value for one hospital)
15%
12%
9%
6%
3%
0%
–3%
–6%
Hospitals with operating margins of –3.0% or less
–9%
–12%
–15%
Source: Author’s calculations based on Massachusetts’ Center for Health Information and Analysis (2013).
Average values of operating margins, and most other financial ratios, will vary by industry.
Average operating margins for nursing facilities over the past four years have been less than
1% (CliftonLarsonAllen, 2012). Average operating margins for ambulance providers have
been 2% over the past two years (U.S. Government Accountability Office, 2012). And, average
operating margins for investor-owned managed care organizations have been in excess of
5% over the past four years (American Hospital Association, 2013c). When assessing profitability, the comparison needs to be more narrowly defined than simply looking at healthcare
as a whole.
Total Profit Margin
A second measu …
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