Operating Ratios asPerformanceMeasure s 11C H A P T E RTHE.docx
- 1. 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, especially 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 interpreting 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 managerial 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 Benchmarking: A Case Study in Comparative Analysis” uses financial ratios as indicators of financial position. We highly recommend 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
- 2. 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 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 (%)
- 3. 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. Liquidity 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 current liabilities. In our example
- 4. 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 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 represented in the amount of (unrestricted) cash on hand. Days Receivables The days receivables computation is represented as net receivables divided by net credit revenues/ 365. In our example
- 5. 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 national 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 principal obligations on its long-term debt. As the name implies, they
- 6. measure the ability of the organization to “be solvent”: in other words, to have sufficient resources to meet its longterm 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 divided 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. This ratio is universally used in credit analysis and figures prominently in the Mini-Case Study.
- 7. 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 divided by unrestricted net assets (i.e., fund balances or net worth) or total debt divided by tangible net worth. 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 somewhat 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 statement 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 operating revenue over operating expense. Nonprofit organizations may not call this result a
- 8. 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 operating 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) divided 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.)
- 9. 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.