Final Exam Flashcards
Ch. 11, 14, 15, 16, 18, 19, 20, 21, 22, 23
Dashboard/Balanced Scorecard
Tools that help in the collection and communication of financial and operating information
-Balanced scorecards developed by Robert Kaplan and David Norton, Hardvard Business Press
Four Key Elements of a Dashboard
1) What is Most Important to the firm’s success?
2) What are the critical drivers that influence performance attainment?
3) What are the most relevant measures that reflect critical driver relationships?
4) What relevant benchmarking data are available to assess performance?
Four Key Elements of a Dashboard: What is most important to the firm’s success?
Sustainable growth is the key principle
- In the long term, no business can grow assets faster than equity.
- Why? No lender will continue to bear the full risk of a business by financing 100% of its assets.
- Also, interest rates increase as risk does, adding more burdens for the company to pay for.
Operating Margin
=Operating income/revenues
Sustainable Growth via Equity Growth
Formulaic Display of Growth Rate in Equity
Change in equity = Net Income x Change in Equity
_____________ ________ _____________
Equity Equity Net Income
Return on Equity
The primary financial criterion that should be used to evaluate and target financial performance.
Four Key Elements of a Dashboard: Critical Drivers of Performance?
Objectives of ROE:
- Improve operating margins
- Improve non-operating margins
- Increase total asset turnover
- Increase debt financing
Four Key Elements of a Dashboard: Most Relevant Metrics?
Performance areas in a dashboard should tie back to the Key Performance Map that will help improve ROE and build business value.
-Key measures should be externally valid and benchmarked.
Example of 13 Key Metrics
- Market Factors
- Pricing
- Coding
- Contract negotiation
- Overall Cost
- Labor Cost
- Departmental cost
- Supply and Drug Cost
- Service Intensity
- Non-operating income
- Investment efficiency
- Plant obsolescence
- Capital Position
Four Key Elements of a Dashboard: What benchmark data should be used?
-Public data from governmental services such as Medicare.
Ex.
- Medicare cost reports
- Standard analytical outpatient file
- MedPar file
Cost Information
Produced by the firm’s financial accounting system
- Can be used by department managers, 3rd party payers, and planning agencies.
- Cost objects: Products (outputs/services) and responsibility centers (departments).
Cost Classifications
Costs can be classified according to the decision maker’s specific need.
Major classifications include:
- Traceability to the object being costed
- Management responsibility for control.
- Relation of costs to budget.
- Relation of costs to time.
- Behavior of cost to output or activity.
Traceability
Classification of cost by traceability depends on the cost object.
Major cost categories:
- Direct
- Indirect
Cost object
An item for which a separate cost measurement is required.
Example:
- Product
- Process
- Department
- Activity
Direct Cost
Can be specifically linked to a given product or service.
Example:
- Direct labor (Salaries)
- Supplies
- Rent expenses
Indirect Cost
Not easily traceable to a product or service but support production of a product/service.
Example:
- Administrative overheard
- Depreciation
- Employee Benefits
Cost Behavior
Describes the cost variability in relation to output or activity.
-Measurement of cost behavior is influenced by department’s classification of cost (direct v. indirect)
Five Major Categories of Cost (classified by behavior)
- Variable Costs
- Fixed Costs
- Mix Costs
- Semifixed
- Semivariable
- Curvilinear
Variable Costs
Change proportionally as output, volume, or activity level changes
An activity is a measure of whatever causes the incurrence of variable cost.
-Ex: Direct labor hours, discharges, patient visits
Fixed Costs
Do not change or vary in response to changes in activity.
-Fixed costs are a function of time, not output.
Semifixed (Step Fixed) Costs
Cost changes with changes in output but not proportionally.
-Can be considered variable or fixed, depending on the size of steps relative to the range of volume.
Semivariable Costs
Include elements of fixed and variable.
- There is some fixed requirement per unit of time, regardless of volume.
- Also, a direct proportional relationship between volume and costs.
Ex: Utility Costs.
Curvilinear Costs
Variable costs do not always behave in a strictly linear fashion.
But, within a relevant range, costs can be approximated with a straight line.
Relevant range is the range of activity within which the assumptions about the cost behavior are valid.
Controllable Costs
Can be influenced by designated responsibility center with a defined time period.
Main approaches include:
- May be identified as total costs charged to the department
- May be limited to direct costs
- May be costs that are both direct and variable.
-Should be applied consistently throughout departments
Other Relevant Costs: Avoidable
Can be eliminated or saved if an activity is discontinued; they will only remain so long as the activity does.
- Variable costs are usually a subset of avoidable.
- Some fixed costs may be avoidable when large changes in volume are considered.
Other Relevant Costs: Sunk
Retrospective costs that have already been incurred.
Unaffected by the decision under consideration.
-Typically, a subset of fixed costs.
Other Relevant Costs: Incremental
Represent the change in cost that results from a specific management action/decision.
Similar to marginal, or the cost to provide an additional unit of service or product.
-Incremental costs refer to the change in costs due to management decision or increased volume.
Other Relevant Costs: Opportunity
The values forgone by using a resource in a particular way instead of next best alternative.
Budgeted Costs
The amount that has been “planned” or authorized to be spent in a specific category for a specified purpose.
Actual Costs
The amount which is spent in a specific category or for a specific purpose.
Cost Allocation
Process of assigning pooled indirect costs to a specific cost object.
Uses allocation base that represents a major business function.
Allocation Base (Cost Driver)
An item that is used to allocate costs, based on its relationship to why costs occurred.
Importance of Cost Allocation
The cost of indirect, non-revenue departments, need to be allocated to direct revenue departments for decision-making purposes.
Equity is critical in allocating indirect department costs to direct departments.
Cost Allocation should:
- Reflect the actual indirect cost incurred by the direct department.
- Motivate managers of direct departments to reduce costs.
Methods of Cost Allocation
To allocate indirect costs, two decisions must be made:
1)Selection of cost driver or basis of allocation
2) Method of cost apportionment.
- Step-down
- Double-Distribution
- Simultaneous-equations
Methods of Cost Allocation: Step-Down
Indirect department that receives the least amount of service from other indirect departments AND provides the most service to all other departments allocates its costs first.
-Most widely used by health care facilities.
- Order of allocation is important
- Allocation base can create differences in cost allocation.
Break-Even Analysis (Cost-Volume-Profit [CVP])
Quantifies the relationship between profit and various factors, such as:
- Rates/Prices
- Volume
- Variable Cost
- Fixed Cost
- Payer mix
- Bad Debts
Three Questions of Health Care Cost Accounting
What are we trying to cost?
What time period is relevant?
How can we use existing cost systems?
Cost Objects of Health Care
Health care firms produce a large volume or products, many of which are bundled into an encounter of care.
Encounter of Care
Includes all products and services during a specific treatment or episode of care.
What Time Period is Relevant?
Either historical or future.
- Historical, by itself, is of little use.
- Future costs are more relevant but often rely on historical cost data.
Planning and Product Issues
Products v. Product Lines
Ex: A treated patient is a product
Strategic Business Units (SBU)
Ex: Clinical Specialty areas
Budgeting and Resource Expectations
Budgeting translates product decisions into resource expectations.
Two major objectives:
- Assure plan’s financial viability
- Establish a basis for management control
-Primary output of a budget is a set of departmental budgets outlining expected costs.
Control and Corrective Action
Deviations and variances from budgets are identified.
Corrective action may be utilized to correct variances in future time periods.
Sometimes, variances may reflect changes in budget assumptions.
Valuation Areas
Basis? Generally, historical cost.
However, assigning cost to a time period can be an issue in two areas:
- Long-lived assets such as buildings/equipment.
- Normal accruals where costs are recognized prior to expenditure.
Production Phases: Stage 1
Departments/activity centers acquire resources and product products, or Service Units (SU’s).
-Some SU’s are traceable to patients, others are not.
Production Phases: Stage 2
Consumption of SU’s in treatment process.
-Often directed by physicians.
Required Systems for Costing Encounters of Care: Standard Cost Profiles
Tells how much it did or will cost to produce specific service units such as lab tests or surgical procedures.
Required Systems for Costing Encounters of Care: Standard Treatment Protocols (STP)
Tells us how many units of a SU either were required or will be required to produce a specific encounter of care.
Management Control
Process by which managers ensure that resources are obtained and used efficiently and effectively while accomplishing an organization’s objectives.
Efficiency: Inputs to outputs
Effectively: Outputs to goals
-More subjective
Managers exercise control through responsibility centers or departments.
Management Control Programming(Planning)
Determining nature and size of programs to be undertaken.
-Programming distinguishes between new and existing programs.
Management Control - Budgeting
Quantitative expression of a plan of action, usually stated in monetary terms for a one year period.
- Follows Programming phase
- Translates program decisions into responsibility center action plans.
Management Control - Accounting
Reports actual operations in terms of revenues and expenses to budgeted values.
-Follows Budgeting phase
Management Control - Analysis and Reporting
Find phase of management control
- Compares budgeted values with actual values and explains deviations.
- Primary tool is variance analysis.
Budgeting - Participants
- Governing Board
- CEO
- Controller
- Responsibility Center Managers
- Budget Committee
Statistics Budget: Purpose
To estimate the amount of service we are going to offer:
- By type of service
- By payor
- By intensity (relative value units)
To determine:
- Resources needed
- Costs
- Revenues
Statistics Budget: Location of Estimates
Where?
- Self
- History
- Competitors
- Consultants
- Literature
- Internet
- Other
Labor Budget: Purpose
To answer: “How much and what type of personnel are required to provide the amount of service we are planning?”
- Determines Salaries, wages, and benefits.
- By position
- By Employee type (FT, PT, PD)
Two Types:
- Fixed Labor
- Variable Labor
Revenue Budgets
Prices set to cover the following:
- Required profit
- Budgeted expenses
- Loss on fixed price contracts
- Discounts to billed charge patients
-Must follow Expense budgets.
Cash Budget
Primary indicator of short-term solvency.
-Used to arrange necessary short-term financing.
Traditional Budgeting
- Based on modest increase or decrease from year-to-year.
- Tends to maintain existing programs.
- More difficult to start new programs/services.
- Relatively easy to implement.
Zero-Based Budgeting
- Based on justification of importance of the program.
- Does not use last year’s funding as a base for present year.
- Facilities getting rid of old programs to make room for new ones.
- Requires considerable resources.
Importance of Benchmarking
- Relies on assessment of productivity.
- Often used to help set labor budgets.
- Grouped into three categories:
- Internal/Historical
- Engineered values
- Comparative group values.
Investment and Financing
- Investment decisions involve expending funds today while expecting returns in the future.
- Financing involve the receipt of funds today for a promise to make payments in the future.
Time Value of Money
Payment that is made/received in the first year has greater value than an identical payment in the tenth year.
-The idea that the value of money changes over time is absolutely critical to investments and financing.
Present Value
If interest rate is 10% then a dollar received one year from now is only worth $0.9091 in today’s dollar.
-Reciprocal of Future value.
Future Value
If interest rate is 10% then $0.9091 today will be worth exactly $1 in one year’s time.
-Reciprocal of Present value.
Simple Interest
Only calculated on the principal
Compound Interest
Calculated on the principal AND the interest.
-The basis for calculating future values over multiple time periods.
Annuities
More than one payment or receipt, constant per time period.
Capital Project Analysis
Primarily concerned with new projects that require a substantial investment outlay and a long project life (greater than 2 years).
- Occurs during the Programming Phase of the management control process.
- Also, a yearly estimate of resources that will be expended for new programs in the coming year.
External Participants: Financing Sources
- Collectively, may influence the amount of money that can be borrowed and the terms of borrowing
- i.e. Investment bankers, Bond-rating agencies, bankers, feasibility consultants
External Participants: Rate-setting and Rate-controlling agencies:
-Can limit the amount of money available for financing capital projects by reducing the amount of profits that may be retained.
Internal Participants: Board of Trustees
Responsible for the capital expenditure and capital financing program of the health care firm.
- Clearly establish defined goals and objectives, which is the prerequisite to programming phase of capital expenditure analysis.
- Approves preliminary five-year capital expenditure program, which is linked to strategic financial plan
Internal Participants: Planning Committee
Define, analyze, and propose programs to help the organization attain its goals and objectives.
Internal Participants: Finance Committee
Involved with translating programs into financial requirements; ensures adequate financing to meet program requirements.
Internal Participants: Chief Executive Officer (CEO)
Responsible on a day-to-day basis for implementing approved capital expenditure programs and developing related financial plans.
-Much of the authority is delegated by the Board of Trustees.
Internal Participants: Department Managers
Make most of the internal requests for capital expenditure approval.
Internal Participants: Medical Staff
Place demands for capital expenditures due to their influence on firm’s utilization.
-Mostly not employees of the health care firm.
Internal Participants: Controller
Facilities approval of capital expenditure.
-Assists administrator with allocating budget to competing departments.
Internal Participants: Treasurer
Obtains funds for short-term and long-term programs
Capital Expenditure Classification
A commitment of resources that is expected to provide benefits during a reasonably long period, at least 2+ years.
Classified by:
- Period during which investment occurs
- Types of resources invested
- Dollar amounts of capital expenditures
- Types of benefits received.
Period of Investment
Determining the amount of resources committed to a capital project depends heavily on the definition of the period.
Types of Resources Invested: Capital Assets
Tangible, fixed assets.
Types of Resources Invested: Lease
Many health care facilities lease a significant percentage of their fixed assets.
Types of Resources Invested: Operating Costs
Associated with beginning and continuing capital projects.
- Lifecycle Costing: Method for estimating the cost of a capital project that reflects total costs, both operating and capital, over the project’s estimated useful life.
- Should be considered for all programs; doing so may affect selection of alternative projects.
Amount of Expenditures
Control over capital expenditure should be conditioned by the total amount involved, such as:
- Approval require for all expenditures.
- Approval required for all expenditures above a specified threshold
- No approval required for all expenditures under a minimum threshold.
Types of Benefit
Determine what systems of management control and evaluation to be used.
In health care, benefits differ from those considered in other industries and may include benefits that are more important than cost reduction or increased profits.
Types of Benefits: Operational Continuance
Produces benefits that permit continued operations of the facility along present lines
Answer the following:
- Are continued operating in the present form desirable?
- Which alternatives can achieve continued operation in the most desirable way?
Types of Benefits: Financial
Reduced costs or increased profits.
-If major benefits are primarily financial then traditional capital budgeting may be most appropriate.
Types of Benefits: Other
Investments range from projects that activate major new medical areas to projects that improve employee working conditions.
Capital Decision-Making Process: Generation of Project Information
Information is gathered that can be analyzed and later evaluated.
Main categories of info needed for expenditure proposal evaluation:
- Alternatives available
- Resources available
- Incremental Cost data
- Incremental Benefit data
- Prior Performance
- Risk projection
Project Information Types: Alternatives Available
Must be considered to evaluate capital expenditures.
Ex: Different manufacturers, different methods of finance.
Project Information Types: Resources Available
Must be allocated among numerous investment opportunities.
-May force department managers to submit only projects that are in the dept’s best interest.
Project Information Types: Cost Data
Lifecycle costs of a project should be presented.
-Limiting cost information to capital costs can be counter-productive
Project Information Types: Benefit Data
Quantitative (financial) and Qualitative (unquantifiable benefit).
Project Information Types: Prior Performance
Comparison of prior actual results with forecast results gives a decision maker some idea of the reliability of the forecast.
Project Information Types: Risk Projection
“What If?” Questions
-Programs with extremely high proportions of fixed or sunk costs are much more sensitive to changes in volume and thus more risky.
Project Evaluation
Based on solvency and cost.
Project Evaluation: Solvency
Ability to show positive rate of return in the long run.
-Operation of an insolvent program can eventually threaten the solvency of an entire organization
Project Evaluation: Cost
Organization needs to select projects that contribute most to the attainment of its objectives, given resource constraints.
Cost-Effectiveness Analysis
Projects that are eventually selected should cost the least to provide the service.
Project Implementation and Reporting
Expenditure control systems should be focused on whether the projected benefits are actually being realized as forecast.
Benefits of Capital Expenditure Review Program
Highlights differences between planned v. actual performance that may permit corrective action.
- May result in more accurate estimates.
- Forecasts by individuals with a continuous record of biased forecasts can be adjusted to reflect that bias.
Justification of Capital Expenditures
Initiated by a department or responsibility-center manager through the completion of a capital expenditure form.
- Approval provides a detailed summary of:
- Amount and type of expenditure
- Attainment of key decision criteria
- Detailed financial analysis
-Small capital expenditures (>$2000) not subjected to justification process.
Justification of Capital Expenditures: Replacement Items
May not be reviewed under $20,000
- Higher limit due to necessity of equipment for continuation of operations.
- Not evaluated as extensively as new equipment.
Justification of Capital Expenditures: Cont.
Process should focus on best alternatives.
Overall criteria of selection process:
- Need (Management/Hospital goals)
- Economic feasibility
- Acceptability (physicians, employees, community)
-Non-financial criterion also important.
- Key aspect of the process is the financial or economic feasibility of the project measured by summary statistic:
- Discounted cash-flow method
- Non-discounted cash-flow method
Discounted Cash-Flow Method
Based on time-value concept of money.
Main methods and area of application:
- Net Present Value - capital financing alternative
- Profitability index - cap expenditures with financial benefits
- Equivalent annual costs - cap expenditures with non-financial benefits.
Net Present Value
Discounted cash inflows less discounted cash outflows and initial investment outlay.
NPV presents the ROI expressed in dollar values.
Only incremental cash flows should be considered.
-Additional cash flows and outflows that accrue as a result of taking on the capital project
NOT INCLUDED: Sunk and financing costs.
-Financing costs are represented by discount rate.
Highest NPV should always be selected.
Cost Reimbursement
The facility would be entitled to reimbursement for depreciation if the asset was purchased
OR
The facility would be entitled to rent payment if the asset was leased.
Effects are declining in the era of prospective payment and capitation, except for critical access hospitals and other groups under Medicare.
Profitability index
Compare rates of return of competing projects
- Useful when the benefits of the projects are mostly financial.
- When funding is limited, projects with the highest rate of return per dollar of capital investment are best candidate for selection.
Profitability Index cont
Profitability indices > 0 imply that a project is earning at a greater rate than the discount rate.
With no funding constraints, all projects with profitability indices > 0 should be funded.
In most situations, funding constraints do exist, and only a portion of those projects with positive profitability indices are actually accepted
Equivalent Annual Cost
The expected average cost, considering both capital and operating cost, over the life of the project.
Primarily important when choosing capital projects for which alternatives exist.
Discount Rate
Important, but not critical in health care as decisions are not based entirely on financial factors.
Change in relative rankings for projects is much more likely to result from accurate forecast of cash flows than from relative discount rates.
However, the choice of discount rate may affect desirability of alternative projects so it is important to consider.
Primary methods for defining the cost of capital for use in DCF analysis:
- Cost of specific financing source
- Yield achievable on other investments
- Weighted cost of capital
Discount Rate Selection: Specific Financing Source
Sometimes used as the discount rate. (Firm borrows money at 8% rate)
Discount Rate Selection: Yield Rate
The investment yield possible in the firm’s security profile. (Firm earns 10% on security investments)
Discount Rate Selection: Weighted Average Cost of Capital
Represents the marginal cost of capital to the firm, recognizing capital consists of both debt and equity.
Major challenge:
-Defining cost of equity for NFP firms.
Solution?
-Use the cost of equity for a similar IO firm.
Valuation
More hospitals are buying or acquiring related health care businesses.
What is the value of acquired businesses?
Acquired Business - Cap Expenditure that needs to be evaluated
3 Ways to Generate New Equity Financing
Profit Retention: Using net income to increase equity.
Contributions: Using philanthropic gifts to increase equity.
Sale of Equity Interests: Using the issuance of new ownership interest to increase equity.
Contributions/Philanthropy: Keys to Success
1) Case Statement: Define why you need money
2) Designated Development Officer: Incentives based on giving expectations.
3) Trustee and Medial Staff Involvement: People giving to people, not organizations.
4) Prospects List: Know who in the community is most likely to donate.
5) Programs for Giving: Variety of methods and means to encourage giving
6) Goals: Define realistic targets.
Issuance of Equity
Taxable firms have heavily relied on equity issuance to raise capital.
Interest in not-for-profit firms has been generated by raising capital through using restructured organizations and taxable entities to raise capital.
Characteristics of Long-Term Debt Financing: Cost
INTEREST RATES are the most important characteristic that affects the cost of alternative debt financing.
Issuance Costs are simply those expenditures that are essential to consummate the financing.
Characteristics of Long-Term Debt Financing: Control
Investors often will specify some conditions or restrictions that they would like included in the bond contract (aka covenants).
- Financial Performance Indicators (i.e. current ratio)
- Future Financing (Conditions before firm can issue additional debt)
Indenture: “Debt Contract” between the parties
Characteristics of Long-Term Debt Financing: Risk
From the issuer’s perspective, flexibility of repayment terms is highly desirable.
From the investor’s perspective, guarantee that the principal will be repaid in accordance with some pre-established plan.
Prepayment Provision: Specifies the point in time at which the debt can be retired, and the penalty that will be imposed for early retirement.
Call Premium: Some percentage of the par or face value of bonds.
Characteristics of Long-Term Debt Financing: Risk cont
Debt Principal Amortization Pattern:
Level-debt service: The amount of interest and principal that is repaid each year remains fairly consistent (i.e. home mortgages)
Level-Debt Principal: Equal amount of debt principal is repaid each year. In this pattern of debt retirement, the total debt service payment decreases over time.
Characteristics of Long-Term Debt Financing: Availability
Once a health care firm decides that it needs debt financing, it usually wants to obtain the funds as quickly as possible.
HOWEVER
The difference in interest rates may more than offset the costs of delay.
Characteristics of Long-Term Debt Financing: Adequacy
Key requirement is that the financing covers all the associated costs.
Key areas of adequacy is refinancing costs.
Sources of Long-Term Debt Financing: Tax-Exempt Revenue Bonds
Permit the interest earned on them to be exempt from federal income taxation.
The primary security for such loans is usually a pledge of the revenues of the facility seeking a loan, plus a first mortgage on the facility’s assets.
If the tax revenue of a government entity is also pledged then the bonds are referred to as “general obligation bonds”.
Most of these bonds are issued by state or local authorities, entering a lease between the health care firm and those parties.
Authority maintains the title to the assets until repayment is made in full.
Sources of Long-Term Debt Financing: Federal Housing Administration (FHA)-Insure Mortgages
Sponsored by FHA but initially processed in the Department of Health and Human Services.
Gov’t provides mortgage insurance for both proprietary and non-proprietary hospitals. This guarantee reduces the risk of a loan to investors and thus lowers the interest rate that must be paid.
Sources of Long-Term Debt Financing: Public Taxable Bonds
Issued similarly to Tax-Exempt revenue bonds but without an issuing authority and no interest income tax exemption.
An investment banking firm usually underwrites the loan and markets the issue to individual investors.
Interest rates are higher than on tax-exempt revenue bonds
Sources of Long-Term Debt Financing: Conventional Mortgage Financing
Privately places with a bank, pension fund, savings and loan institution, life insurance company, or real estate investment trust.
Can be arranged quickly but does not provide as large a percentage of the total financing requirements for large projects. Thus, greater amounts of equity must be contributed.
Early Retirement of Long-Term Debt
WHY?
1) Permits the issuer to take advantage of a reduction in interest rates.
2) Avoid onerous covenants in the existing indenture.
3) Take advantage of changes in bond ratings.
4) Take advantage of changes in policy regarding tax-exempt financing
Early Retirement of Long-Term Debt: Refinancing
The issuer buys back the outstanding bonds from the investors by:
A: Option of an early call
B: Buy back in open-market transactions or offer to buy from existing shareholders at a determined rate.
Early Retirement of Long-Term Debt: Refunding
Outstanding bonds are not acquired by the issuer, and present bondholders maintain their investment.
Bonds are not retired but can be expunged from financial statements
Also, covenants are broken through a process called defeasance.
Basic Ways to Acquire a Firm: Merger (Consolidation)
Combination of two or more companies, with one continuing as the legal entity while the others dissolve individuality.
Basic Ways to Acquire a Firm: Acquisition of Stock
Majority of a firm’s stocks are bought out on the open market.
Basic Ways to Acquire a Firm: Acquisition of Assets
Acquiring company gains control of all of a firm’s assets.
May or may not have control of liabilities.
Reasons to Merge
1) Efficiency Theory: Increased size = Decreased costs (economies of scale)
2) Information Theory: New Information = New values for firms.
3) Agency Problem: No employee ownership = decreased performance incentives.
4) Market Power: Increased size = increased pricing leverages
5) Tax Considerations: Tax benefits to buying another organization.
Valuation Methods: Income/Cash Flow: Direct Capitalization Approach
A projected value for cash flow is determined. That number is then divided by some discount rate.
The discount rate ideally represents the acquiring firm’s cost of capital, but is adjusted up or down to reflect risk of the business being acquired.
Valuation Methods: Income/Cash Flow: Price Earnings Approach
Similar to Direct Capitalization except that it uses earnings, rather than cash flow, to discount.
Uses multiplication rather than division.
Valuation Methods: Income/Cash Flow: Discounted Cash Flow Approach
Estimates cash flows for each of the next five years. These are then discounted to reflect the present value of the firm. Then estimate the value of the firm at Year 5.
-Most commonly used in health care valuations.
Five Steps in DCF Approach: Calculate Cost of Capital
Minimum acceptable rate of return on new investments based on the rate investors can expect to earn by investing in alternative, identically risky securities.
Using the acquired company’s target capital structure, Weighted Average Cost of Capital is calculated.
Five Steps in DCF Approach: Determine Free Cash Flows
Cash flows available to stakeholders after considerations for taxes, capital expenditures, and working capital needs.
Cash flow should be considered as the cash flow contribution the target is expected to make to the acquiring company.
Five Steps in DCF Approach: Calculate present value of cash flows
Based on determined cost of capital.
Five Steps in DCF Approach: Add Present Value of Terminal Value
The terminal value is the present value of the resulting cash flow perpetuity beginning one year after the forecast period.
Most common method is to calculate the discounted cash flow assuming constant growth of cash flows.
Five Steps in DCF Approach: Subtract Debt and other Obligations Assumed
When valuing equity in a firm, it must be recognized that the shareholders have an obligation to pay any debtholders.
Repayments of these obligations must be subtracted from the present value of the firm’s cash flows.
Valuation Methods: Asset-Based
Three Different Approaches, include:
1) Tangible book value of acquired firm’s assets
2) Replacement costs of acquired firm’s assets
3) Liquidation of acquired firm’s assets
Valuation Methods: Comparable Sales
Appraisers look at similar properties sold in the same location within a given time period.
- Widely used in real estate
- Typically only used as benchmarks in health care.
Valuation Methods: Breakup Value
Book value of the assets of the target company is added to the value of any hidden assets such as real estate, brand name, copyrights.
Market value is set for each piece, as if sold separately.
Cash Investment and Management in Health Care
Hospitals have large sums of investment eligible funds, compared to similarly sized companies in other industries.
Investment income is the predominant course of non-operating revenue.
Why do Hospitals Hold Investments?
Not-for-Profit firms need to set aside funds for plant and equipment replacement.
- Firms self-insure all or part of their professional liability risk.
- Many firms receive gifts and endowments that can provide sources of investment.
- Many firms have funding requirements for pension plans and debt service associated with bond issuance
Cash Budget
To prepare accurate estimate of cash flows for short-term financing or investment decisions.
- Cash balances are affected by changes in working capital.
- Primary tool in cash planning
Focuses on four major activities, each representing an interval in the cash conversion cycle.
Working Capital
The different between current assets and current liabilities.
Current Assets: cash and investments, accounts receivables, inventories, etc
Current Liabilities: accounts payable, accrued salaries and wages, accrued expenses, notes payable. current position of long-term debt
Cash Budget Activities: Purchasing
Acquisition of supplies and labor
Cash Budget Activities: Production and Sale
Little distinction in health care.
Cash Budget Activities: Billing
Interval between the release/discharge of a patient and the generation of a bill
Cash Budget Activities: Collection
Interval between generation of a bill and actual collection of the cash from the patient or third party.
Steps in Cash Management Process
1) Understand and Manage cash conversion cycle
2) Develop cash budget that accurately projects cash inflows and outflows
3) Establish firm’s minimal cash balance
4) Establish working capital loans when short-term financing is needed.
5) Invest cash surplus to maximized expected yields.
Working Capital Management
Related to short-term bank financing and investment of cash surpluses.
Two major categories:
- Receivables
- Accounts Payable/Accrued Salaries
Working Capital Management: Accounts Receivable (A/R)
Represents revenue for services that have been performed but not paid for.
Usually represents 40-50% of a hospital’s total current assets
Management of Receivables focuses on:
- Minimizing lost charges
- Minimizing write-offs for uncollectable accounts
- Minimizing the accounts receivable collection cycle
Admission to Discharge
-On average, ~5 days
Shortening this interval is not the main objective of A/R.
However, with fixed prices per case, a reduced length of stay (LOS) is desirable from cost management perspective.
Means of expediting:
- Determine is interim billings are possible
- Use advance deposits for non-emergent admissions
- Obtain insurance and eligibility information before admission for on-emergencies
- Arrange for deductible portion of coverage for patients with Health Savings Accounts
Discharge to Bill Completion
-On average, ~10 Days
Acceleration of billing process can create reduction in final payments.
To execute billing:
- Implement timely billing to avoid bottlenecks
- Develop educational programs to show the effects of late completion of medical charts by physicians.
Bill Completion to Receipt by Payer
On average, ~2 days (shorter with electronic submission)
To shorten interval:
- Consider electronic invoicing for large payers, when possible.
- Try to settle all outpatient accounts at the point of discharge of departure.
- Submit a bill for any deductible or copayment for inpatients at discharge.
Receipt by Payer to Mailing of Payment
-On Average, ~35 days
To shorten interval:
- Sell some accounts receivable
- Use discounts for prompt payers
- Create a system of fast response to third-party requests for additional information
- Claim all bad debt of the Medicare deductible and copayment portion of hospital bills.
- make frequent follow-up calls to patients to detect billing problems.
Payment Mailed to Receipt by Hospital
-On average, ~2 Days (mail time)
Courier service could be used for government or large insurance payers
Wire transfers between payer and health care providers’ bank
Receipt by Hospital to Deposit in Bank
On average, ~1 Day(s)
To shorten interval:
-Use lockboxes at local post office that are checked daily by bank employees, if financially beneficial.
Accounts Payable and Accrued Salaries/Wages
Not usually negotiated and vary directly with the level of operations.
Usually represent a sizable portion of a hospital’s financing
Accounts Payable
Approaches to slow AP:
- Delay payment until actual due date
- Stretch AP- delay payment until some time after the due date
- Change the frequency of payroll
- Use banks in distant cities to pay vendors and employees
- Schedule deposits to checking accounts to match expected disbursements on a daily basis
Short-Term Financing Sources: Commercial Banks
Predominant source for health care.
Short-Term Financing Sources: Single-Payment Loans
Usually given for a specific purpose
Main types:
-Discount arrangement: interest is computed and deducted from the face value of a note
-Add-on Note: interest is added to the final payment of the loan; borrower receives full value of the loan when the loan is originated.
Short-Term Financing Sources: Line of Credit
An arrangement that permits a firm to borrow up to a specified limit during a defined loan period.
Main types:
Committed- has written agreement with terms and conditions; a fee is charged by the bank to cover the costs and risks
Uncommitted- No formal agreement with bank
Short-Term Financing Sources: Revolving Credit Agreements
Similar to line of credit but good for 2-3 years
Most are renegotiated at maturity
If renegotiation occurs >1 year before maturity, the loan may be stated as long-term debt and will not hit as a current liability on financial statements.
Variable interest rates
Short-Term Financing Sources: Term Loans
Made for a specific period (2-7 years)
Require periodic installment of payments of the principal
Frequently used to finance tangible assets that will produce income in the future
The asset acquired may be pledged as collateral for the loan
Short-Term Financing Sources: Letter of Credit
A letter from a bank stating that a loan will be made if certain conditions are met.
Used by some hospitals as a method of bond insurance
Guarantees payment of the loan if the hospital defaults
Short-Term Investments: Price Stability
Very important factor for money market investments
Most money market investments can be sold at a guaranteed price
U.S. Treasury Bills are the most credit-worth investments
Short-Term Investments: Safety of Principal
It is expected that the principal of an investment is not at risk.
Treasury and federal agency obligations are low risk.
Bank securities and corporate obligations may incur a loss of principal through default.
Bank creditworthiness can be reviewed at Moody’s Bank and Financial Manual
Short-Term Investments: Marketability
Ability to sell a security quickly with little price concession before maturity.
To ensure its existence, an active secondary trading market must exist.
Some commercial paper may be difficult to redeem before maturity.
Short-Term Investments: Maturity
A date when a note, bill, bond becomes due for repayment
Relationship with the yield of a security can be summarized in a Yield Curve
Some firms use “riding the yield curve” strategy: investments are made in longer-term securities that are sold before maturity
Yield
Measure of an investment’s return
Usually affected by maturity, expected default risk of principal, marketability, and price stability
Taxability issue: NFP firms have no incentives to invest in securities that are exempt from federal income tax.
Cash Budget
Key source of information to determine the firm’s short-term needs for cash.
Allows management to manage liquidity position through:
- Increasing levels of cash and investment reserves
- Restructuring maturity of existing debt
- Arranging a line of credit with a bank
Motivations for Holding Cash: Short-Term Working Capital Needs
Capital replacement and contingencies funds require higher cash needs
-Average hospital held 20-30 days cash on hand. (20 days is generally adequate)
Motivations for Holding Cash: Capital Investment Needs
NFP must routinely set aside cash for replacement and renovation of existing assets, due to lack of access to equity capital markets.
Amount to reserve dependent on:
- Percentage of debt financing to be used
- Projected future levels of capital expenditures
Debt Financing
If limited, larger sums should be set aside for replacement and expansion.
Absence of debt reduces future financial risk
Board establishes levels of debt financing based on trade-offs between the risk and firm’s need for capital
Access to debt usually related to historical and projected financial performance and credit ratings
-NFPs with high levels of cash have greater access to debt financing at lower interest rates through higher credit ratings
Projection of Capital Expenditure
Main Factors:
- Routine replacement needs
- Strategic planning of the firm
Common method: based on allowances for depreciation
Motivations for Holding Cash: Contingencies
Unexpected demands for cash flow
Amount reserved reflects tolerance for risk and estimates of unexpected cash demands upon the firm
Motivations for Holding Cash: Supplement Operating Earnings
Provide dependable flow of investment earnings that can be used to supplement expected weaknesses in operating earnings. (aka operating endowments)
May be adopted when significant deterioration in operating earning is expected
Cash Budgets cont
Volatility of cash flows determines length of Cash Budget
Routinely revised due to inaccuracy of original budget assumptions
The greater the degree of possible variation between the actual and forecasted cash flow, the higher the liquidity need of the firm.
Cash Budget Preparation
Revenue forecast - MOST IMPORTANT
Determined by:
- Volumes by product line
- Expected prices by payer category
Volume Estimation:
- Subjective Forecasts
- Statistical Forecasts
Subjective Forecast
Not favorable, “seat of the pants” method
Wisdom and understanding of the forecaster are crucial
May be most reliable when future volumes are likely to deviate from historical patterns
Statistical Forecast
Future prices can be predicted based on some mathematical model extrapolated from the past
Challenging for health care firms as they rely on other entities to determine prices
Due to large volumes of Medicare/Medicaid business, even small changes in price can severely impact the forecast, affecting cash flow.
Projecting Cash Flow
One common method: Decay Curves
Decay Curves: Relate future collections to past billings
Cash Disbursements
After forecasting cash receipts, a schedule of cash disbursements is necessary to complete a cash budget.
Labor - Comprises ~60% of total expenses
-Payroll expenses are monthly but disbursement is typically bi-weekly
Supplies - Not equal to actual supplies disbursement
Cash Budget Completion
Desired levels of cash balances must be defined.
Finally, cash receipts and disbursements are combined to produce a cash budget.
