ANSWERS TO END-OF-CHAPTER QUESTIONS

Transcription

1 ANSWERS TO END-OF-CHAPTER QUESTIONS 8/6/ a. Financial statement analysis, which focuses on the data contained in a business s financial statements, is designed to assess the financial condition of the business. Operational analysis, which focuses on operating (as opposed to financial) variables, attempts to identify the underlying operating parameters that contributed to the assessed financial condition. b. Of course, it is extremely important to understand a business s financial condition because any future plans must be supported financially. However, it is equally important, especially for managers, to understand what operational actions are required to ensure that the business has the future financial capability to accomplish its mission Analyses that examine historical data provide managers and investors with an appreciation of the business s current condition, which is important. However, the future is more important than the past, and the most important use of a historical analysis is as a springboard for preparing for the future. When plans are being made, pro forma (forecasted) financial statements are prepared and analyzed so that managers can gain insights regarding the impact of alternative strategies on the business s financial and operating condition The inventory turnover ratio indicates how well a business is utilizing its inventories. It tells managers how many dollars of sales (revenues) are generated by each dollar of inventories. Inventories are a primary input into the medical device production process, whereas inventories (although important) are not as critical to the inpatient healthcare business. Thus, the inventory turnover ratio is a more important financial performance measure for a medical device company than for a hospital management company a. Nursing homes experience virtually no seasonality, so the fact that different nursing homes have different fiscal years would have little impact on a comparative ratio analysis. b. Unlike nursing homes, the volume at walk-in clinics is directly related to temporary changes in population. December would be the busy season for a clinic in Aspen but the slow season for a clinic in Cape Cod. Thus, the two balance sheets could look quite different even if the clinics were similar in all other respects a. For a single company, inflation causes fixed assets that are added now to cost much more than comparable assets added in the past. Thus, the dollars that appear on the balance sheet have different values in regard to the amount of assets purchased. For cross comparisons, inflation can create improper interpretations. For example, consider two hospitals that are alike in all respects except that one hospital was built 20 years ago (and kept current) and the other was built last year. Even though both hospitals have identical physical assets, the new hospital will show a much higher value for fixed assets than will the old hospital. Thus, the total asset turnover and fixed asset turnover ratios will be higher for the old (low asset value) hospital than for the new (high asset value) hospital. Such differences would indicate that management at the old hospital is doing a better job at managing the organization s assets when in fact there is no difference. Copyright 2012 Health Administration Press 13-1

2 b. The balance sheet is affected most by inflation, but inflation also affects the income statement through depreciation and inventory valuation. For example, consider the two hospitals described in Part a. The new (high asset value) hospital would have a higher depreciation expense than the old (low asset value) hospital, and hence the old hospital would report higher net income and all ratios associated with net income would look better for the old hospital. Yet, the actual cash flow generated would be the same if they were not-for-profit hospitals. If they were investor-owned hospitals, the new hospital (with the lower net income) would actually have the greater cash flow because the higher depreciation expense would lead to lower taxes a. Trend analysis examines the ratios of a given organization over time and hence gives managers insights into how an organization s financial and operating condition has changed over time. Comparative analysis compares the ratios of a given organization with other entities, which could be individual businesses or industry averages. Comparative analysis is often called benchmarking. b. Neither method is more important than the other one. A thorough analysis will include both trend and comparative analyses The Du Pont equation decomposes return on equity (ROE), one of the most important measures of a business s profitability, into the product of three other ratios, each of which has an important economic interpretation: ROE = Total margin Total asset turnover Equity multiplier or Net income Net income Total revenue Total assets =. Total equity Total revenue Total assets Total equity The total margin measures expense control, the total asset turnover ratio measures asset utilization, and the equity multiplier measures debt utilization. By comparing the company s Du Pont equation to those for other managed care firms or the industry average, managers would learn which of the three areas contributed most to the low ROE. Then, they could conduct further analysis into the deficient areas to try to pinpoint the precise problem areas as a starting point for corrective action No. Different lines of business have different critical measures of performance. For example, a critical measure for hospitals is fixed asset utilization, because hospitals require a large fixed asset base. On the other hand, managed care and home health care businesses do not require a large asset base, so this measure is more or less meaningless for such organizations. However, other ratios, such as the medical loss ratio (the proportion of premiums spent on medical care) for managed care organizations, are not meaningful for hospitals. The key here is that the ratios used must contain information that has economic value to the organization being analyzed. Thus, different lines of business lead to different sets of ratios. Copyright 2012 Health Administration Press 13-2

3 ANSWERS TO END-OF-CHAPTER PROBLEMS 13.1 a. The key to this problem is to recognize that the current ratio is defined as current assets divided by current liabilities. With a ratio of 0.5, assume that current assets = $5 and current liabilities = $10, so the current ratio = $5 $10 = 0.5. Then, ask this question: Do the actions given affect either current assets or current liabilities and, if they do, in what way? 1. Cash is used to pay off current liabilities. If $1 of cash is used to pay off $1 of current liabilities, then the current ratio = $4 $9 = 0.44, so the current ratio falls. 2. Some of the current receivables are collected. In this case, funds are transferred from one current asset account to another, so the current ratio does not change. 3. Cash is used to pay off long-term debt. Here, current assets are lowered but current liabilities are unaffected, so the current ratio falls. 4. Inventory is purchased on credit. If $1 of payables is used to buy $1 of inventory, then the current ratio = $6 $11 = 0.55, so the current ratio rises. 5. Inventory is sold at cost. Again, funds are transferred from one current asset account to another, so there is no change in the current ratio. Note that if the inventory were sold at a profit, the cash (or receivables) account would increase more than the inventory account decreases, so the current ratio would increase. Only one action, that discussed in Point 4, increases the current ratio when it starts out at less than 1.0. b. Now, with a current ratio of 1.2, assume that current assets = $12 and current liabilities = $ Cash is used to pay off current liabilities. If $1 of cash is used to pay off $1 of current liabilities, then the current ratio = $11 $9 = 1.22, so the current ratio rises. 2. Some of the current receivables are collected. In this case, funds are transferred from one current asset account to another, so the current ratio does not change. 3. Cash is used to pay off long-term debt. Here, current assets are lowered but current liabilities are unaffected, so the current ratio falls. 4. Inventory is purchased on credit. If $1 of payables is used to buy $1 of inventory, then the current ratio = $13 $11 = 1.18, so the current ratio falls. 5. Inventory is sold at cost. Again, funds are transferred from one current asset account to another, so there is no change in the current ratio. Note that if the inventory was sold at a profit, the cash (or receivables) account would increase more than the inventory account decreases, so the current ratio would increase. Only one action, that discussed in Point 1, increases the current ratio when it starts out at greater than 1.0. Note that the results in Part b differ from the results in Part a. The difference occurs because the results are affected by whether the current ratio begins at less than or greater than 1.0. Copyright 2012 Health Administration Press 13-3

4 13.2 If the group uses all-equity financing, it will require $2 million in equity. Its net income will equal Total margin Revenues = 0.05 $3,000,000 = $150,000. Thus, ROE = Net income Total equity = $150,000 $2,000,000 = = 7.5%. If the group uses 50 percent debt, it would require only $1 million in equity. If we assume that the debt has no impact on the profit margin, the net income remains at $150,000, so ROE = $150,000 $1,000,000 = 0.15 = 15.0% a. The data used in the ratio calculations, as well as the 2012 values and industry data, were taken from the text discussion. Profitability Ratios: Net income (Excess of Revenues) $99 Total margin = = = = 3.6%. Total revenues $2, value = 4.0%. Industry average = 6.8%. Operating income $71 Operating margin = = = = 2.6%. Operating revenues $2, value = 3.4%. Industry average = 5.5%. Net income $99 Return on assets = = = = 11.6%. Total assets $ value = 13.8%. Industry average = 9.5%. Net income $99 Return on equity = = = = 31.4%. Total equity $ value = 34.1%. Industry average = 26.3%. Copyright 2012 Health Administration Press 13-4

5 Liquidity Ratios: Current assets $676 Current ratio = = = 1.8, or 1.8 times. Current liabilities $ value = 1.8. Industry average = 2.0. Cash + Short-term investments Days cash on hand = (Expenses Depreciation Provision for uncollectibles) / 365 $41 + $137 $178 = = = 24.9 days. ($2,648 $15 $21) / 365 $ value = 20.9 days. Industry average = 22.6 days. Debt Management Ratios: Total debt $538 Debt ratio = = = 0.631, or 63.1%. Total assets $ value = 59.5%. Industry average = 63.0%. Long-term debt $167 Debt to capitalization ratio = = = 0.346, or 34.6%. Long-term debt + Equity $ value = 24.4%. Industry average = 28.6%. EBIT $99 + $19 $118 TIE ratio = = = = 6.2 times. Interest expense $19 $ value = Industry average = 5.9. EBIT + Lease payments + Depreciation expense CFC ratio = Interest expense + Lease payments + Debt principal / (1 T ) $99 + $18 + $15 $132 = = = 2.8 times. $16 + $18 + $13 $ value = 4.6. Industry average = 2.8. Copyright 2012 Health Administration Press 13-5

6 Asset Management Ratios: Total revenues $2,747 Fixed asset turnover = = = 35.3 times. Net fixed assets $ value = Industry average = Total revenues $2,747 Total asset turnover = = = 3.2 times. Total assets $ value = 3.5. Industry average = 1.4. Net patient accounts receivable $476 Days in pat. accounts receivable = = Net patient service revenue / 365 $2,687 / 365 = 64.7 days value = Industry average = b. Park Ridge Homecare s profitability is a mixed bag. Although all measures have increased substantially from 2011 to 2012, margins (which measure expense control) remain below the industry average, while ROA and ROE are well above the industry. Thus, the company needs to review its expense structure, but it appears to be doing a good job of translating assets into profits. The current ratio has remained stable but is slightly below the industry average. The days cash on hand has fallen from 2011 to 2012 and also is somewhat below the industry average. Thus, Park Ridge Homecare s liquidity must be monitored to ensure that it does not deteriorate further. The debt management ratios indicate that the business has reduced its debt utilization and is currently below the industry average. This indicates that Park Ridge Homecare could probably obtain additional debt financing at reasonable terms. Regarding asset management, the company has improved its asset utilization (the ability of its assets to generate revenues). However, its receivables management needs to be examined to determine why it is taking ten days longer than the industry average to collect its receivables. Copyright 2012 Health Administration Press 13-6

7 13.4 a. Here is BestCare s Du Pont analysis: ROE = Total margin Total asset turnover Equity multiplier Net income Net income Total revenue Total assets = Total equity Total revenue Total assets Total equity $1,218 $1,218 $28,613 $9,869 = $2,118 $28,613 $9,869 $2, % = 4.26% = 12.35% Here is the industry Du Pont equation: 25.5% = 3.8% = 7.98% 3.2. BestCare is besting the industry on all fronts. That is, its expense control is better, its asset utilization is better, and it is taking more advantage of financial leverage. The end result is an ROE that is substantially higher than the industry average. Of course, by using so much financial leverage, BestCare is assuming more financial risk. b. Net income $1,218 Return on assets = = = = 12.3%. Total assets $9,869 Industry average = 8.0%. As noted in the Du Pont analysis, BestCare is doing appreciably better than the industry average regarding asset profitability. Current assets $3,945 Current ratio = = = 1.1, or 1.1 times. Current liabilities $3,456 Industry average = 1.3. The industry average HMO is slightly more liquid than BestCare. Copyright 2012 Health Administration Press 13-7

8 Cash + Short-term investments Days cash on hand = (Expenses Depreciation Provision for uncollectibles) / 365 $2,737 $2,737 = = = 37.0 days. ($27,395 $367 $19) / 365 $74.00 Industry average = 41 days. The days cash on hand ratio confirms the liquidity assessment based on the current ratio. That is, the average HMO has slightly greater liquidity than does BestCare. Net premiums receivable $821 Average collection period = = = 11.2 days. Premiums earned / 365 $26,682 / 365 Industry average = 7 days. BestCare is collecting its receivables somewhat slower than the average HMO. Total debt $7,751 Debt ratio = = = 0.785, or 78.5%. Total assets $9,869 Industry average = 69%. This value, along with the ratio below, confirms the Du Pont analysis finding that BestCare uses more debt than the average HMO does. Total debt $7,751 Debt to equity ratio = = = 3.7. Total equity $2,118 Industry average = 2.2. EBIT $1,218 + $385 $1,603 TIE ratio = = = = 4.2 times. Interest expense $385 $385 Industry average = 2.8. Interestingly, the debt BestCare uses is greater than the industry average, yet its interest coverage is better. This indicates that BestCare has access to lower interest rate debt financing. Copyright 2012 Health Administration Press 13-8

9 Total revenue $28,613 Fixed asset turnover = = = 4.8 times. Net fixed assets $5,924 Industry average = 5.2. BestCare s fixed asset turnover is slightly below the industry average. However, the Du Pont analysis indicated that BestCare s total asset turnover was better than average. Thus, BestCare must be doing a better job of managing its current assets a. Here is Green Valley s Du Pont analysis: ROE = Total margin Total asset turnover Equity multiplier Net income Net income Total revenue Total assets = Total equity Total revenue Total assets Total equity $57,881 $57,881 $3,269,404 $2,502,992 = $357,842 $3,269,404 $2,502,992 $357, % = 1.77% = 2.32% Here is the industry Du Pont equation: 13.1% = 3.5% = 5.25% 2.5. Green Valley is not doing as well as the average nursing home in both expense control and asset utilization, as reflected by its ROA of 2.32 percent versus 5.25 percent for the industry. Nevertheless, it is using very high (perhaps dangerously so) financial leverage, which produces an equity multiplier, and hence ROE, that is well above the industry average. Copyright 2012 Health Administration Press 13-9

10 b. Net income $57,881 Return on assets = = = = 2.3%. Total assets $2,502,992 Industry average = 5.2%. As noted in the Du Pont analysis, Green Valley is not doing as well as the industry average regarding asset profitability. Current assets $608,992 Current ratio = = = 1.4, or 1.4 times. Current liabilities $445,150 Industry average = 2.0. Green Valley s liquidity, as measured by the current ratio, is below that of the average nursing home. Cash + Marketable securities Days cash on hand = (Expenses Depreciation Provision for uncollectibles) / 365 $105,737 + $200,000 $305,737 = = = 37.4 days. ($3,180,356 $85,000 $110,000) / 365 $8, Industry average = 22 days. The days cash on hand ratio conflicts with the liquidity assessment based on the current ratio. Perhaps Green Valley s current liabilities are higher than average, or perhaps its receivables and supplies are lower than average, which could mean that Green Valley is doing a better job at current asset management than is the average nursing home. Net patient receivables $215,600 Average collection period = = = 24.9 days. Patient revenue / 365 $3,163,258 / 365 Industry average = 19 days. Green Valley is not doing as good a job of collecting its receivables as does the average nursing home. Total debt $2,145,150 Debt ratio = = = 0.857, or 85.7%. Total assets $2,502,992 Industry average = 71%. This value, along with the ratio below, confirms the Du Pont analysis finding that Green Valley uses more debt than the industry average. This very high debt ratio suggests that further analysis is needed. Copyright 2012 Health Administration Press 13-10

11 Total debt $2,145,150 Debt to equity ratio = = = 6.0. Total equity $357,842 Industry average = 2.5. EBIT $57,881 + $206,780 + $31,167 $295,828 TIE ratio = = = = 1.4 times. Interest expense $206,780 $206,780 Industry average = 2.6. The TIE ratio confirms the effects of Green Valley s high debt utilization. Note that as an investor-owned business, Green Valley has to add its taxes (along with interest expense) back to net income to calculate EBIT. Total revenue $3,269,404 Fixed asset turnover = = = 1.7 times. Net fixed assets $1,894,000 Industry average = 1.4. Green Valley s fixed asset turnover is slightly above the industry average. Note that the Du Pont analysis indicated that Green Valley s total asset turnover was somewhat worse than average. Thus, Green Valley must not be doing a good job of managing its current assets. Copyright 2012 Health Administration Press 13-11

12 13.6 To gain a better appreciation for the differences, we first list the industry average ratios: Ratio Managed Care Nursing Homes Total margin 3.8% 3.5% Return on assets (ROA) 8.0% 5.2% Return on equity (ROE) 25.5% 13.1% Current ratio Days cash on hand 41 days 22 days Average collection period 7 days 19 days Debt ratio 69% 71% Times-interest-earned (TIE) ratio Fixed asset turnover ratio Total asset turnover ratio The two major underlying differences are (1) the amount of fixed assets required to run the business and (2) the payment pattern of revenues. A lower fixed asset requirement for managed care organizations means relatively lower fixed (and total) assets and hence better reported asset utilization. The fact that nursing homes are paid later means that the mix of cash and receivables differs, which leads to liquidity differences. The differences in profitability probably do not mean much in any given year because the profitability of both industries is highly variable. Although both industries use a large amount of debt, it is for different reasons. The nursing home industry has high debt capacity because it uses a large amount of fixed assets that are suitable as collateral. It is unclear why the managed care industry shows so much debt in this illustration. Perhaps years of losses in the past have created a need for significant debt usage, or perhaps there is an error in the data. A more complete analysis could provide a great deal more information. However, for purposes here, a simple look at the differences is sufficient. Copyright 2012 Health Administration Press 13-12