Accounting Assgnt Wk Eight

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Chapter 11 provided, if needed

 

Dr. Smith and Brown supplemental included.

 

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Doctors Smith and Brown Statement of Net Income and Balance Sheet

Use the Axia Material: Ratio Analysis Form to complete the following:

#1. Define each of the following ratios:

·

Current ratio

· Quick ratio

· Debt service coverage ratio

· Operating margin

· Return on total assets

#2. Explain the purpose of each ratio.

Compute the following ratios from Drs. Smith & Brown’s financial statements located on the student website:

· Current ratio

· Quick ratio
· Debt service coverage ratio
· Operating margin
· Return on total assets

#3. Explain what these ratios tell you about the status of the organization. Compare to the median hospitals.

See the table in the Material: Ratio Analysis Form.

Cite your references where indicated consistent with APA guidelines.

Post your assignment as an attachment.

Resources: Ch. 11 of Health Care Finance,

Doctors Smith and Brown:
Statement of Net Income

for the Three Months Ended March 31, 2___

Revenue
Net patient service revenue 180,000
Other revenue -0-

Total Operating Revenue 180,000

Expenses
Nursing/PA salaries 16,650
Clerical salaries 10,150
Payroll taxes/employee benefits 4,800
Medical supplies and drugs 15,000
Professional fees 3,000
Dues and publications 2,400
Janitorial service 1,200
Office supplies 1,500
Repairs and maintenance 1,200
Utilities and telephone 6,000
Depreciation 30,000
Interest 3,100
Other 5,000

Total Expenses 100,000

Income from Operations 80,000

Nonoperating Gains (Losses)
Interest Income -0-

Nonoperating Gains, Net -0-

Net Income 80,000

Chapter 10 373

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374 EXAMPLES AND EXERCISES, SUPPLEMENTAL MATERIALS, AND SOLUTIONS

Doctors Smith and Brown
Balance Sheet
March 31, 2___

Assets
Current Assets

Cash and cash equivalents 25,000
Patient accounts receivable 40,000
Inventories—supplies and drugs 5,000

Total Current Assets 70,000

Property, Plant, and Equipment
Buildings and Improvements 500,000
Equipment 800,000

Total 1,300,000
Less Accumulated Depreciation (480,000)
Net Depreciable Assets 820,000
Land 100,000

Property, Plant, and Equipment, Net 920,000

Other Assets 10,000

Total Assets 1,000,000

Liabilities and Capital

Current Liabilities
Current maturities of long-term 10,000

debt
Accounts payable and accrued 20,000

expenses

Total Current Liabilities 30,000

Long-Term Debt 180,000
Less Current Portion of Long-Term Debt (10,000)
Net Long-Term Debt 170,000

Total Liabilities 200,000

Capital 800,000

Total Liabilities and Capital 1,000,000

Doctors Smith and Brown
Statement of Changes in Capital

for the Three Months Ended March 31, 2___

Beginning Balance $720,000
Net Income 80,000
Ending Balance $800,000

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Finance and Business Transcript

1

Finance and Business Transcript

Speakers: Narrator, Host, Paul C. Clendening

NARRATOR: On the subject of banking and finance, we hear Paul C. Clendening, a banker from Kansas City, who is active locally and nationally with Robert Morris Associates, National Association of Bank Loan and Credit Officers.

HOST: What does the term finance mean in reference to a small business person?

PAUL C. CLENDENING: The term finance refers to the dynamic measurement of a company’s health and progress. Business owners are given accounting information that historically report what a company’s sales have been, how its assets and its liabilities are structured, etc. But the dynamic interaction of those assets, liabilities, and income figures really relate to the health of the company itself. The primary way to utilize financial information is to look at a trend analysis and a ratio analysis.

HOST: What about liquidity. What does that mean?

PAUL C. CLENDENING: Liquidity is a very important day-to-day measurement for a business owner and really a key tool to use in the management of that business. As an example, one of the most common ratios of liquidity is the current ratio. The current ratio is defined as the total current assets of the company less the current liabilities. Now what that should show is a margin of short-term assets in excess of the short-term liabilities. The benefit of that to the small business owner of manager is that it provides a working capital cushion that generates cash to meet short-term obligations and therefore gives the company flexibility in meeting its obligations, paying its people, and gives it the opportunity to take advantage of market conditions.

The two other measurements of liquidity are very important to a business manager and/or owner. And one relates to the accounts receivable and the other relates to the inventory. And there is a ratio that relates to the number of days that the receivables – accounts receivable are outstanding. And the reason I mention this is accounts receivable and inventory, for most small businesses, are really the largest concentration of assets of that company and the better they work for that company, the more healthy that company will be.

Days outstanding of accounts receivable is a ratio that is effectively computed by dividing the net sales for the year by 365 days. And that gives an average dollar figure for sales per day of the company. And taking that figure, one divides that into the average accounts receivable outstanding for the year to show as a net figure, what the average number of days those accounts receivable were outstanding. Now, why do I say that? The speed with which the company can collect this accounts receivable relates directly to the recovery of the cash for the sale of a product or service and that cash is then available for payment of its bills and/or investment, and degeneration –

[End of Audio]

From “Finance,” 1986, Films Media Group. Copyright 2012 by Films on Demand. Adapted with permission.

115

Financial and
Operating Ratios as

Performance
Measure s

11
C H A P T E R

THE IMPORTANCE OF RATIOS

Ratios are convenient and uniform measures that are
widely adopted in healthcare financial management.
They are important because they are so widely used, es-
pecially because they are used for credit analysis. But a
ratio is only a number. It has to be considered within the
context of the operation. There is another caveat: ratio
analysis should be conducted as a comparative analysis. In
other words, one ratio standing alone with nothing to
compare it with does not mean very much. When inter-
preting ratios, the differences between periods must be
considered, and the reasons for such differences should
be sought. It is a good practice to compare results with
equivalent computations from outside the organization—
regional figures from similar institutions would be a good
example of such outside sources. Caution and good man-
agerial judgment must always be exercised when working
with ratios.

Financial ratios basically pull together two elements of
the financial statements: one expressed as the numerator
and one as the denominator. To calculate a ratio, divide
the bottom number (the denominator) into the top
number (the numerator). The Case Study in Appendix
25-A entitled “Using Financial Ratios and Benchmark-
ing: A Case Study in Comparative Analysis” uses financial
ratios as indicators of financial position. We highly rec-
ommend that you spend time with this Case Study, as it
will add depth and background to the contents of this
chapter.

In this chapter we examine liquidity, solvency, and
profitability ratios. Exhibit 11-1 sets out eight basic ratios

After completing this chapter,
you should be able to

1. Understand four types of
liquidity ratios.

2. Understand two types of
solvency ratios.

3. Understand two types of
profitability ratios.

4. Successfully compute ratios.

P r o g r e s s N o t e s

116 CHAPTER 11 Financial and Operating Ratios as Performance Measures

Exhibit 11–1 Eight Basic Ratios Used in Health Care

Liquidity Ratios

1.

Current Ratio

Current Assets

Current Liabilities

2.

Quick Ratio

Cash and Cash Equivalents +

Net Receivables

Current Liabilities

3. Days Cash on Hand (DCOH)

Unrestricted Cash and Cash Equivalents

Cash Operation Expenses ÷ No. of Days in Period (365)

4.

Days Receivables

Net Receivables

Net Credit Revenues ÷ No. of Days in Period (365)

Solvency Ratios

5. Debt Service Coverage Ratio (DSCR)

Change in Unrestricted Net Assets (net income)
+ Interest, Depreciation, Amortization

Maximum Annual Debt Service

6. Liabilities to Fund Balance

Total Liabilities

Unrestricted Fund Balances

Profitability Ratios

7. Operating Margin (%)

Operating Income (Loss)

Total Operating Revenues

8. Return on Total Assets (%)

EBIT (Earnings before Interest and Taxes)

Total Assets

Courtesy of Resource Group, Ltd., Dallas, Texas.

that are widely used in healthcare organizations: four liquidity types, two solvency types, and
two profitability types. All are discussed later.

LIQUIDITY RATIOS

Liquidity ratios reflect the ability of the organization to meet its current obligations. Li-
quidity ratios measure short-term sufficiency. As the name implies, they measure the ability
of the organization to “be liquid”: in other words, to have sufficient cash—or assets that can
be converted to cash—on hand.

Current Ratio

The current ratio equals current assets divided by current liabilities. For instance, consider
this example

Current Assets
�

$120,000
� 2 to 1

Current Liabilities $60,000

This ratio is considered to be a measure of short-term debt-paying ability. However, it
must be carefully interpreted. The standard by which the current ratio is measured is 2 to 1,
as computed previously.

Quick Ratio

The quick ratio equals cash plus short-term investments plus net receivables divided by cur-
rent liabilities. In our example

Cash and Cash Eqivalents � Net Receivables
�

$65,000
� 1.08 to 1

Current Liabilities 60,000

The standard by which the quick ratio is measured is generally 1 to 1. This computation,
at 1.08 to 1, is a little better than the standard.

This ratio is considered to be an even more severe test of short-term debt-paying ability
(even more than the current ratio). The quick ratio is also known as the acid-test ratio for
obvious reasons.

Days Cash on Hand

The days cash on hand (DCOH) equals unrestricted cash and investments divided by cash
operating expenses/365. In our example

Unrestricted Cash and Cash Equivalents
�

$330,000
� 30 days

Cash Operating Expenses $11,000
� No. of Days in Period

Liquidity Ratios 117

118 CHAPTER 11 Financial and Operating Ratios as Performance Measures

There is no concrete standard for this computation.
This ratio indicates cash on hand in relation to the amount of daily operating expense.

This example indicates the organization has 30 days worth of operating expenses repre-
sented in the amount of (unrestricted) cash on hand.

Days Receivables

The days receivables computation is represented as net receivables divided by net credit rev-
enues/365. In our example

Net Receivables
�

$720,000
� 60 days

Net Credit Revenue/No. of Days in Period $12,000

This computation represents the number of days in receivables. The older a receivable
is, the more difficult it becomes to collect. Therefore, this computation is a measure of
worth as well as performance.

There is no hard and fast rule for this computation because much depends on the mix of
payers in your organization. This example indicates that the organization has 60 days worth
of credit revenue tied up in net receivables. This computation is a common measure of
billing and collection performance. There are many “days receivables” regional and na-
tional figures to compare with your own organization’s computation.

Figure 11-1 shows how the information for the numerator and the denominator of
each calculation is obtained. It takes the Westside Clinic balance sheet and the statement
of revenue and expense that were discussed in the preceding chapter and illustrates the
source of each figure in the four ratios just discussed. The multiple computations for days
cash on hand and for days receivables are further broken down into a three-step process.
If you study Figure 11-1 and work with the Appendix 25-A Case Study, you will own this
process.

SOLVENCY RATIOS

Solvency ratios reflect the ability of the organization to pay the annual interest and princi-
pal obligations on its long-term debt. As the name implies, they measure the ability of the
organization to “be solvent”: in other words, to have sufficient resources to meet its long-
term obligations.

Debt Service Coverage Ratio

The debt service coverage ratio (DSCR) is represented as change in unrestricted net assets
(net income) plus interest, depreciation, and amortization divided by maximum annual
debt service. In our example

Change in Unrestricted Net Assets (Net Income)
� Interest, Depreciation, and Amortization

�
$250,000

� 2.5
Maximum Annual Debt Service $100,000

This ratio is universally used in credit analysis and figures prominently in the Mini-Case
Study.

Each lending institution has its particular criteria for the DSCR. Lending agreements
often have a provision that requires the DSCR to be maintained at or above a certain figure.

Liabilities to Fund Balance (or Debt to Net Worth)

The liabilities to fund balance or net worth computation is represented as total liabilities di-
vided by unrestricted net assets (i.e., fund balances or net worth) or total debt divided by
tangible net worth. In our example

Solvency Ratios 119

Figure 11–1 Examples of Liquidity Ratio Calculations.
Courtesy of Resource Group, Ltd, Dallas, Texas.

Assets December 31, 20X2
Current Assets

Cash and cash equivalents $190,000
Accounts receivable (net) 250,000
Inventories 25,000
Prepaid Insurance 5,000

Total Current Assets $470,000

Property, Plant, and Equipment
Land $100,000
Buildings (net) 0
Equipment (net) 260,000
Net Property, Plant, and Equipment 360,000

Other Assets
Investments $133,000

133,000
Total Other Assets

Total Assets $963,000

Liabilities and Fund Balance
Current Liabilities

Current maturities of long-term debt $52,000
Accounts payable and accrued expenses 293,000
Total Current Liabilities $345,000

Long-Term Debt $252,000
Less Current Maturities of Long-Term Debt (52,000)
Net Long-Term Debt 200,000

Total Liabilities $545,000

Fund Balances
Unrestricted fund balance $418,000
Restricted fund balance 0
Total Fund Balances 418,000

Total Liabilities and Fund Balance $963,000

For the Year Ending

Revenue December 31, 20X2
Net patient service revenue
$2,000,000

Total operating revenue $2,000,000

Operating Expenses
Medical/surgical services $600,000
Therapy services 860,000
Other professional services 80,000
Support services 220,000
General services 65,000
Depreciation 40,000
Interest 20,000

Total operating expenses $1,885,000

Income from Operations $115,000

Nonoperating Gains (Losses)
Interest Income $5,000

Net nonoperating gains 5,000

Revenue and Gains in Excess of
Expenses and Losses $120,000

Increase in Unrestricted Fund Balance $120,000

470,000
345,000
= 1.362

Current Assets
Current Liabilities

1. Current Ratio

Step 2

1,845,000

365

= 5,055

Step 3

190,000
5,055

= 37.5 days

Step 1

1,885,000
(40,000)

1,845,000

190,000 + 250,000
345,000
= 1.275

Cash and Cash Equivalent + Net Receivables
Current Liabilities

2. Quick Ratio

3. Days Cash on Hand (DCOH)

Unrestricted Cash and Cash Equivalents
Cash Operating Expenses divided by # days in period (365)

Step 2

1,800,000
365

= 4,931

Step 3

250,000
4,931

= 50.7 days

Step 1

2,000,000
× 90%

1,800,000 4. Days Receivables

Net Receivables
Net Credit Revenue divided by # days in period (365)

Percent of Credit Revenues
Information obtained elsewhere

Statement of Revenue and Expenses

Balance Sheet

120 CHAPTER 11 Financial and Operating Ratios as Performance Measures

Total Liabilities
�

$2,000,000
� .80

Unrestricted Fund Balances $2,250,000

This figure is a quick indicator of debt load.
Another indicator that is more severe is long-term debt to net worth (fund balance),

which is computed as long-term debt divided by fund balance. This computation is some-
what equivalent to the quick ratio discussed previously here in its restrictiveness to net
worth computation.

A mirror image of total liabilities to fund balance is total assets to fund balance, which is
computed as total assets divided by fund balance.

Figure 11-2 shows how the information for the numerator and the denominator of each
calculation is obtained. This figure again takes the Westside Clinic balance sheet and state-
ment of revenue and expense that were discussed in the preceding chapter and illustrates
the source of each figure in the two solvency ratios just discussed, along with each figure in
the two profitability ratios still to be discussed. When multiple computations are necessary,
they are further broken down into a two-step process.

PROFITABILITY RATIOS

Profitability ratios reflect the ability of the organization to operate with an excess of oper-
ating revenue over operating expense. Nonprofit organizations may not call this result a
profit, but the measurement ratios are still generally called profitability ratios, whether they
are applied to for-profit or nonprofit organizations.

Operating Margin

The operating margin, which is generally expressed as a percentage, is represented as op-
erating income (loss) divided by total operating revenues. In our example

Operating Income (Loss)
�

$250,000
� 5.0%

Total Operating Revenues $5,000,000

This ratio is used for a number of managerial purposes and also sometimes enters into
credit analysis. It is therefore a multipurpose measure. It is so universal that many outside
sources are available for comparative purposes. The result of the computation must still be
carefully considered because of variables in each period being compared.

Return on Total Assets

The return on total assets is represented as earnings before interest and taxes (EBIT) di-
vided by total assets. In our example

EBIT
�

$400,000
� 10%

Total Assets $4,000,000

This is a broad measure in common use. Note the acronym EBIT, as its use is widespread
in credit analysis circles. (Some analysts use an alternative computation for Return on Total
Assets. They compute this ratio as Net Income divided by Total Assets.)

This concludes the description of solvency and profitability ratios. Again, if you study
Figure 11-2 and work with the Appendix 25-A Case Study, you will own this process too.

Profitability Ratios 121

Figure 11–2 Examples of Solvency and Profitability Ratio Calculations.
Courtesy of Resource Group, Ltd, Dallas, Texas.

Balance Sheet

Assets December 31, 20×2

Current Assets $190,000
Accounts receivable (net) 250,000
Inventories 25,000
Prepaid Insurance 5,000
Total Current Assets $470,000

Property, Plant and Equipment
Land $100,000
Buildings (net) 0
Equipment (net) 260,000
Net Property, Plant and Equipment 360,000

Other Assets
Investments $133,000
133,000
Total Other Assets
Total Assets $963,000
Liabilities and Fund Balance
Current Liabilities
Current maturities of long-term debt $52,000
Accounts payable and accrued expenses 293,000
Total Current Liabilities $345,000

Long-term Debt $252,000
Less current maturities of long-term debt -52,000
Net Long-term Debt 200,000

Total Liabilities $545,000
Fund Balances
Unrestricted fund balance $418,000
Restricted fund balance 0
Total Fund Balances 418,000
Total Liabilities and Fund Balance $963,000
Statement of Revenue and Expenses
For the Year Ending

Revenue December 31, 20×2

Net patient service revenue $2,000,000

Total operating revenue $2,000,000
Operating Expenses
Medical/surgical services $600,000
Therapy services 860,000
Other professional services 80,000
Support services 220,000
General services 65,000
Depreciation 40,000
Interest 20,000

Total operating expenses 1,885,000

Income from Operations $115,000

Nonoperating Gains (Losses)
Interest Income $5,000
Net nonoperating gains 5,000

Revenue and Gains in Excess of
Expenses and Losses $120,000
Increase in Unrestricted Fund Balance $120,000

Step 1 5. Return on Total Assets (%)

120,000
20,000

140,000

Step 2

140,000
963,000

= 14.54%

6. Operating Margin (%)
115,000

2,000,000
5.75%

7. Liabilities to Fund Balance
545,000
418,000
= 1.304

Step 1 8. Debt Service Coverage Ratio (DSCR)

120,000
20,000
40,000

180,000

Step 2

180,000 Maximum Annual Debt Service
72,000 Information derived elsewhere

= 2.5

IT (Earnings Before Interest and Taxes)
Total Assets

Operating Income (Loss)
Total Operating Revenues

Total Liabilities
Unrestricted Fund Balance

Change in Unrestricted Net Assets (net income)
plus Depreciation-Amortization

plus Interest
Maximum Annual Debt Service

122 CHAPTER 11 Financial and Operating Ratios as Performance Measures

INFORMATION CHECKPOINT

What Is Needed? Reports that use ratios as measures.
Where Is It Found? Possibly in your supervisor’s file; in the administrator’s of-

fice; in the chief executive officer’s office.
How Is It Used? Use as a measure against outside benchmarks (as discussed

in this chapter); also use as internal benchmarks for de-
partments/divisions/units; also use as benchmarks at
various points over time.

KEY TERMS

Current Ratio
Days Cash on Hand (DCOH)
Days Receivables
Debt Service Coverage Ratio (DSCR)
Liabilities to Fund Balance
Liquidity Ratios
Operating Margin
Profitability Ratios
Quick Ratio
Return on Total Assets
Solvency Ratios

DISCUSSION QUESTIONS

1. Are there ratios in the reports you receive at your workplace?
2. If so, do you use them? How?
3. If not, do you believe ratios should be on the reports? Which reports?
4. Can you think of good outside sources that could be used to obtain ratios for com-

parative purposes? If the outside information was available, what ratios would you
choose to use? Why?

RatioAnalysis Form

HCA/270 Version 3

1

Associate Level Material

Ratio Analysis Form

Use the table on the next page to complete the Week Eight assignment. In this assignment, you will review the textbook to find the definitions for each ratio. Use the financial statements for Drs. Smith and Brown, located on the student website, to perform the calculations and complete the form.

Review the following example on how to perform the inventory turnover calculation, which shows you how to complete the table.

· Two different methods can determine the inventory turnover ratio.

· Cost of goods sold—operating revenue of a hospital—divided by ending inventory

· Total revenues plus net nonoperating gains divided by ending inventory

This example uses the first method to perform the calculation.

Because a hospital provides a service, we would find the number that reflects services provided. Total operating revenue reflects money that is earned for providing services. Locate the Statement of Net Income on the student website. Find the total operating revenue. This is $180,000. Then, locate the ending inventory number. To find the ending Inventory, use the Balance Sheet on the student website. The ending inventory number is 5000.

Cost of goods sold—operating revenue: 180,000 divided by ending inventory of 5000;

180,000/5000

=

36

· Place this information in the table. You will do the same with the rest of the ratios. Take the result of your calculations and place in the grid, as in the example.

· In addition, you are responsible for stating whether the ratios are solvency, leverage, or profitability ratios. Enter your answers in the appropriate column. Then, explain what these ratios tell us about the physician group practice.

Note.
You will use the financial statements of Drs. Smith & Brown to perform the calculations on the next page. To calculate the debt service coverage ratio, you need the maximum annual debt service, which is $22,200.

The following table shows the median financial ratios for acute care hospitals. You can use this table to gauge the financial viability of the physician group practice.

Ratio	Numbers from Arcadia financial statement	Result	Is it a liquidity, solvency, or profitability ratio?	Define the ratio and explain what the result shown in Column 3 means to the organization. Do not forget to provide your references at the bottom of the form.
Inventory turnover (Example)	180,000/5000	36	N/A	Inventory turnover is calculated to determine how quickly the inventory is used based on the services rendered. If the inventory turnover is high, this means the hospital does not have enough inventories on hand to accommodate the patient load. For this example, the hospital is turning over their inventory 36 times per year, which is about 3 times a month. The opposite is true if the inventory turnover calculation is lower than the median. This could mean that there is a build-up of inventory due to lower than expected patient revenues.
Current ratio
Quick ratio
Debt service coverage ratio	/22,200
Operating margin
Return on total assets

References