Question

Unit 5 Discussion Financial Ratios and Analyses Respond to the following: What is the key difference between financial statement analysis and operating indicator analysis? How are these types of analyses useful to healthcare managers and investors? Consider a healthcare organization with which you are familiar and discuss what are some of the problems or challenges inherent in financial statement analysis? Start a New Thread Filter by: All Threads

Answer 1

Financial statement analysis is the process of analyzing a company's financial statements for decision-making purposes. External stakeholders use it to understand the overall health of an organization as well as to evaluate financial performance and business value. Internal constituents use it as a monitoring tool for managing the finances.

The financial statements of a company record important financial data on every aspect of a business’s activities. As such they can be evaluated on the basis of past, current, and projected performance.

In general, financial statements are centered around generally accepted accounting principles (GAAP) in the U.S. These principles require a company to create and maintain three main financial statements: the balance sheet, the income statement, and the cash flow statement. Public companies have stricter standards for financial statement reporting. Public companies must follow GAAP standards which requires accrual accounting.1 Private companies have greater flexibility in their financial statement preparation and also have the option to use either accrual or cash accounting.2

Several techniques are commonly used as part of financial statement analysis. Three of the most important techniques include horizontal analysis, vertical analysis, and ratio analysis. Horizontal analysis compares data horizontally, by analyzing values of line items across two or more years. Vertical analysis looks at the vertical affects line items have on other parts of the business and also the business’s proportions. Ratio analysis uses important ratio metrics to calculate statistical relationships.

Financial Statements

As mentioned, there are three main financial statements that every company creates and monitors: the balance sheet, income statement, and cash flow statement. Companies use these financial statements to manage the operations of their business and also to provide reporting transparency to their stakeholders. All three statements are interconnected and create different views of a company’s activities and performance.

Balance Sheet

The balance sheet is a report of a company's financial worth in terms of book value. It is broken into three parts to include a company’s assets, liabilities, and shareholders' equity. Short-term assets such as cash and accounts receivable can tell a lot about a company’s operational efficiency. Liabilities include its expense arrangements and the debt capital it is paying off. Shareholder’s equity includes details on equity capital investments and retained earnings from periodic net income. The balance sheet must balance with assets minus liabilities equaling shareholder’s equity. The resulting shareholder’s equity is considered a company’s book value. This value is an important performance metric that increases or decreases with the financial activities of a company.

Income Statement

The income statement breaks down the revenue a company earns against the expenses involved in its business to provide a bottom line, net income profit or loss. The income statement is broken into three parts which help to analyze business efficiency at three different points. It begins with revenue and the direct costs associated with revenue to identify gross profit. It then moves to operating profit which subtracts indirect expenses such as marketing costs, general costs, and depreciation. Finally it ends with net profit which deducts interest and taxes.

Basic analysis of the income statement usually involves the calculation of gross profit margin, operating profit margin, and net profit margin which each divide profit by revenue. Profit margin helps to show where company costs are low or high at different points of the operations.

Cash Flow Statement

The cash flow statement provides an overview of the company's cash flows from operating activities, investing activities, and financing activities. Net income is carried over to the cash flow statement where it is included as the top line item for operating activities. Like its title, investing activities include cash flows involved with firmwide investments. The financing activities section includes cash flow from both debt and equity financing. The bottom line shows how much cash a company has available.

Free Cash Flow and Other Valuation Statements

Companies and analysts also use free cash flow statements and other valuation statements to analyze the value of a company. Free cash flow statements arrive at a net present value by discounting the free cash flow a company is estimated to generate over time. Private companies may keep a valuation statement as they progress toward potentially going public.

Riverview Community Hospital operates as a not for profit facility with 210 inpatient beds. The financial ratio and operating indicator analysis of Riverview Community Hospital will attempt to determine their performance within their market. The further assessment of the cash flows, Du Pont equation, and economic value added (EVA) will offer insight to their financial performance.

The assessment of the hospitals cash flows will allow the evaluator to determine if the company’s core operations were profitable, how capital was raised, and how the institution’s financial strategies effected their cash position. The ending cash and investments for 2009 were reduced by almost forty-five percent from the previous year.

This downward trend may become an area of concern, because it could create an inability for the hospital to pay its daily operating commitments. The fixed asset acquisitions have continued to exceed the depreciation indicating a possible area of investigation for budget development to control costs. This was a decrease of forty-six percent from the previous year and may require further financial strategies to justify their expenditure. The most significant factor affecting the change in the cash flow was the payment of long term debt ($1.4 million) as compared to the previous year when more than $3.5 million was incurred to cover for their capital purchases.

The Du Pont analysis offers the management an overall understanding of the profitability of the institution. Riverview’s total margin of 6.75% falls within the upper quartile of the industry data for hospitals with 200-299 beds (Table 2). This higher profit margin indicates that Riverview has attained better control over its total expenses than the majority of similar size hospitals. The asset turnover of 0.67 falls within the lowest quartile of comparable hospitals. This asset utilization indicates that the hospital is not very efficient in generating revenues for every dollar of asset. The equity multiplier of 1.69 falls below the median data group. This indicates that the institution possesses lower debt financing and lower risk than the average hospital but this results in reducing its financial leverage. Riverview’s return on equity (ROE) falls just above the median of similar size hospitals at 7.66% which translates to 7.6 cents profit for every dollar of revenue. This is significantly lower than the top quartile of comparable facilities that had more than double Riverview’s ROE.

The analysis of the income statement and the balance sheet requires the calculations of financial ratios to obtain meaningful data that can be compared to industry values. There are numerous ratios that can be utilized to assess the financial status of a business. The profitability ratios of Riverview fall within the median range, except their total profit margin of 6.75% (Table 3). This level places it within the upper quartile of comparable hospitals. This would indicate that Riverview manages to control expenses well. Riverview’s current ratio and days cash on hand fall within the top twenty-five percent of the industry data. These liquidity ratios indicate that Riverview’s current assets would provide $2.67 for every dollar of current liabilities, and they have 32.72 days of cash on hand. These ratios indicate to their creditors that they are in position to meet their financial obligations. The debt management ratios all fall within the median range. The asset management ratios fall within the median range except the fixed and total asset turnover. Riverview’s utilization of assets falls within the lowest quartile. The fixed asset turnover of 0.86 times may be an indication of their inability to offer specific services. The total asset turnover of 0.67 times is not as low as its fixed asset indicating they are utilizing current assets better than fixed assets. Inflation or age of the hospital may adversely affect these ratios; however, Riverview has an estimated fixed asset age of 6.12 years. Riverview falls within lower quartile to indicate that their hospital offers more recently purchased acquisitions.

The operating indicator analysis examines internal data to determine the factors that contribute to the financial status of the company. These indicators are used by managers to identify and guide financial strategies for the future. Riverview’s profit indicators are within the median range of the industry; however, the significant downward trend for profit per inpatient discharge should be followed closely (Table 4). The profit per outpatient visit has improved but is still negative. The net price per visit and revenue percent of outpatient services are both within the upper quartile. The outpatient services are still not producing a profit with the increased price per visit. Riverview’s occupancy rate is within the median range, but their average daily census is within the lower quartile. This would further indicate their need to utilize fixed assets more effectively. The hospital’s adjusted length of stay is within the lowest quartile indicating a good management of discharging patients. The intensity of service indicators show that the cost per discharge and visit are within the lowest quartile but their case mix is in the upper quartile. They are providing more intense service to their patients at a lower cost. The outpatient labor hours per visit are within the upper quartile at 9.24 hours. The outpatient service would require further investigation of these higher labor hours to increase efficiency.

The economic value added (EVA) measures the management’s ability to create or destroy wealth for their company. Stern Stewart & Co. (Stern, 2010) developed this metric to offer a more effective evaluation of management’s ability to provide stockholders value. The EVA analysis of profitability takes into account all costs including: capital, equity, and its financing. The higher the EVA measure, the more effective management is at creating value for their shareholders. The EVA measurement for Riverview has trended negatively over the two previous years but has improved twenty-five percent this past last year to -1.2 million (Figure 1). The factors contributing to this negative change were shrinking profits and an increasing accumulation of capital. The EVA dollar amount in 2009 improved due to decreased capital purchases and reduction in long term debt. The limitation of the EVA calculation; does not offer an allowance for the social value provided to the community by the not-for-profit facility.

The assessment of the financial performance of Riverview Community Hospital reveals several areas of concern. The further analysis of fixed asset acquisitions should be justified by the hospitals financial strategies. These capital purchases significantly outpace the yearly depreciation allowance. Riverview’s REO analysis reveals a significant decrease in total margin that remains in the upper quartile of their industry. The hospital should assess the viability of improving both total asset turnover and equity multiplier to bring their ROE in line with their level of total margin performance. They should determine if improved fixed asset utilization will better leverage them within the market. The profit of their outpatient services is an area that should be targeted for effective cost reduction strategies.

The financial ratio and operating indicator analysis may have several limitations that need to be addressed. The income from non-operating revenue for not-for-profit hospitals can be unpredictable and inconsistent. This outside source of revenue can be a significant portion of their income. This could distort the calculations based on that highly unreliable income. The many financial ratios may not fully account for the not-for-profit status of the hospital and may need further analysis to determine their validity. The unaccounted equity provided to the community is not factored into the equations. The additional healthcare benefits provided to the shareholders of the community may out weight the decrease in effective asset utilization by the facility.