Current Asset Management Chapter 16 Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Introduction Investment and financing policies Manage cash and marketable securities Manage receivables and inventory Short-term financing Cartwright Fin Mng HSCI 703

Short Term Financial Management Current Assets and Liabilities Found in Financial Statements Support operational requirements Goal is to minimize financial costs Maintain liquidity Manage fluctuations in business environment Receive payment Pay bills Have services ready to meet demand Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Uncertainty If flows were certain, easy job to plan for known fluctuations in business. If flows uncertain, unexpected needs require additional cash and inventories to meet needs of business. A low policy provides for minimum cash and inventories stocks. Minimizes cost A high policy provides the converse. Opportunity cost is profit penalty. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Policy Choices Aggressive – highest return and risk Use higher proportion short-term debt and credit Conservative – lowest return and risk Use higher proportion of marketable securities and cash, long term debt and equity capital Moderate – falls in the middle somewhere. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Financing Policies Conservative- use no to very little short-term financing Moderate- use some short-term financing Aggressive – use much more short-term financing (highest risk and return) Long-term debt and equity are adjusted up and down depending on strategy selected. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Policy Choices If a firm has low business risk, may choose to follow a higher risk financial strategy. Higher debt ratio in target capital structure More aggressive short-term financing If a firm has high business risk, may choose to follow a low risk financial strategy Lower debt ratio More conservative short term financing. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Cash Management The goal of cash management is to hold the minimum amount necessary to meet liquidity requirements. Opportunity costs? The primary cash management technique is float management: Acceleration of receipts Disbursement control The cost of cash management initiatives must be balanced by corresponding benefits. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Cash Management Liquidity Ratios – financial analysis Cash Budget Calculation of alternative financing arrangements Managing receivables Managing payments negotiating with vendors Negotiating bank loans and lines of credit. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Using Float Net float is the difference between the cash amount on the firm’s books and the amount on the bank’s books. Suppose Colonial Healthcare writes $2,000 in checks daily. It takes 6 days for these to be received and clear the banking system, so its disbursement float is $12,000. Colonial receives $3,000 in checks daily which are cleared in 3 days. Thus, its collections float is $9,000. Its net float is $12,000 - $9,000 = $3,000. Cartwright Fin Mng HSCI 703

Accelerating Receipts Net float is maximized by accelerating receipts and slowing disbursements. Deposit checks received daily Lockboxes (perhaps multiple banks and locations) Concentration banking (single bank) Automated clearinghouses (electronic banking) Federal Reserve wire system Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Disbursement Control Disbursement control for outflows Payables centralization Prompt payment? Master and zero-balance accounts Controlled (remote) disbursement Cartwright Fin Mng HSCI 703

Economic Decision Making Efficiency in Cash Operations Make the policy decision on the criteria The marginal benefit of policy should exceed the marginal benefit In finance, one can often calculate the benefit and costs in dollar terms Cartwright Fin Mng HSCI 703

Marketable Securities Two primary reasons to hold: As an interest earning substitute for cash. Opportunity costs of cash balances is foregone interest As a temporary repository for cash being accumulated to meet a specific need. Cash management of obligations Managers do cash and marketable securities management simultaneously. Cartwright Fin Mng HSCI 703

Marketable Securities Examples are short-term treasury securities, money market funds, In general, marketable securities are chosen on the basis of safety. Protection of principal is primary Amount of return is secondary Specific securities used depend on the: Expected holding period Size of the business Cartwright Fin Mng HSCI 703

Receivables management If a service is provided for cash, the revenue is immediately received. If the service is provided on credit, the revenue is not received until the receivable is collected. Receivables management is fundamental to healthcare providers. Cartwright Fin Mng HSCI 703

Accumulation of Receivables Suppose Colonial contracts with an insurer whose patients use $2,000 in services daily and who pays in 20 days. Average daily billings ADB of $2,000 Average collection period ACP of 20 days The clinic will accumulate receivables at a rate of $2,000 per day. However, after 20 days, the receivables balance will stabilize at $40,000: Receivables balance = ADB x ACP $2,000 x 20 = $40,000 Cartwright Fin Mng HSCI 703

Receivables Financing Suppose Colonial uses bank financing that has an interest rate of 10% to finance its receivables. The annual cost of carrying the receivables is $4,000: $40,000 x 0.10 = $4,000. Cartwright Fin Mng HSCI 703

Monitoring Receivables Healthcare managers must continuously monitor the firm’s receivables. Monitoring methods include: Average collection period (ACP), often called days in patient accounts receivable (DPAR) Aging schedules Receivables are monitored both in the aggregate and by specific payer. Cartwright Fin Mng HSCI 703

Supply Chain Management Supply chain management is clinically important for healthcare providers, but not as financially motivated as it is for manufacturers, wholesalers, or retailers. Inventories consist of base stocks plus safety stocks. The goal of inventory management is to meet operational needs at the lowest cost. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Inventory Management Management techniques used are: Just-in-time (or stockless) systems Point of distribution systems In addition, some providers have contracts with suppliers that are priced on the basis of the amount of medical services provided or amount may be even capitated. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Revenue Cycle Those recurrent activities associated with billing and collecting for services. For example: Preinsurance verification Patient precertification Preservice patient financial counseling Time of service recertification Third-party claim submission Claim follow-up Payment receipt and posting Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Revenue Cycle In revenue cycle management, each of the identified activities is closely monitored to ensure that: The correct amount of reimbursement is collected on each patient. Reimbursements are collected as quickly as possible. The costs associated with the revenue cycle are minimized consistent with rapid and correct collections. An important key to good revenue cycle management is electronic claims processing. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Short-term Financing Three primary advantages over long-term. Lower issuance costs Fewer restrictive covenants Generally lower interest rate Major sources for providers Accruals Accounts payable (trade credit) Bank loans (notes payable) Cartwright Fin Mng HSCI 703

ST Financing Disadvantage Interest expense can fluctuate much more than LT debt Recently short term rates rather low because of the Federal Reserve Policy ST comes due on a regular basis. If deterioration in business, may have difficulty meeting payments Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Accruals Accruals consist primarily of wages owed to employees and taxes owed to governments. Even not-for-profits have accrued taxes Accruals are free in the sense that no explicit interest is charged. However, managers have little control over the level of accruals, which is influenced more by industry custom and tax laws. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Accounts Payable Trade credit is credit furnished by a business’s suppliers. Trade credit often is the largest source of short-term credit, especially for small businesses. Both accruals and trade credit are spontaneous liabilities in the sense that their levels change spontaneously as patient volume rises and falls. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Colonial Healthcare buys $3,000,000 (invoice price) of medical supplies from one of its vendors on terms of 2/10, net 30. How much trade credit is available from this vendor and how much does it cost? Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Gross/Net Breakdown Colonial buys supplies worth $3,000,000 x 0.98 = $2,940,000 because that is the net, or cash, (true) price. If Northwest does not take the discount, it must pay $3,000,000 for the supplies. This is the gross, or invoice, price. The difference, $60,000, is a financing cost similar to the dollar amount of interest paid on a loan. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Net Daily Purchases (NDP) NDP = ($3,000,000 x 0.98) /360 = $8,167 Payables level with discount Payables = $8,167 x 10 = $81,670 Payables level without discount Payables = $8,167 x 30 = $245,010 Credit breakdown Total trade Credit = $245,010 Free Trade Credit = 81,670 Costly Trade Credit = $163,340 Cartwright Fin Mng HSCI 703

Approximate Cost Rate of Costly Trade Credit Colonial Health Care must pay $60,000 (.02 x $3 mil) to obtain $163,340 in extra trade credit Cost Rate = $60,000/$163,340 = 0.367 = 36.7% The $60,000 in financing charges is paid through the year rather than at year end, so the Expected Annual Rate (EAR) is higher Cartwright Fin Mng HSCI 703

Approximate Cost Formula Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Effective Annual Rate Periodic rate = 2 / 98 = 0.0204 Periods / year = 360 / (30-10) = 18 EAR = (1+ Periodic rate)M - 1.0 = (1.0204)18 -1.0 = 0.438 = 43.8% Higher than the nominal cost previously calculated. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Decision Colonial should take $81,670 in free trade credit Costly trade credit should not be taken if it can be beaten by a less costly alternative If one can obtain a bank loan in the 8 to 12% range, no need to take the $163,340 in costly trade credit. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Bank Loans Commercial banks provide short-term credit to healthcare providers. Where do these appear on the balance sheet? Notes payable Bank loan features Promissory note Compensating balances kept in bank Line of credit Cartwright Fin Mng HSCI 703

Secured Short-term Loans Borrower pledges an asset as collateral. Receivables and inventories are commonly pledged as assets Also possible to pledge marketable securities. Use fixed assets for long term matching Cartwright Fin Mng HSCI 703

Receivables Financing Receivables may be pledged, gives the lender recourse. Receivables may also be factored. This is selling the accounts receivables. There is no recourse to the selling business. The lender has purchased the receivables. Purchaser needs to check credit of receivables. Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Inventory Financing Not really used by healthcare providers Equipment/devices firms and Pharmaceuticals may use it. Inventory secured by Blanket lean Trust receipt against specific items Warehouse receipt Cartwright Fin Mng HSCI 703

Cartwright Fin Mng HSCI 703 Final Comments Borrowing on an unsecured basis is generally cheaper and simpler than a secured loan Businesses must often provide collateral in order to borrow. In some cases, security will lower the interest rate. Accounts receivables may be used as collateral. Cartwright Fin Mng HSCI 703