Copyright © 1999 by the Foundation of the American College of Healthcare Executives Financial Statement Application: Analyzing Financial Performance Purpose of performance analysis Types of analysis Financial statement analysis Operating analysis MVA and EVA analysis Problems with performance analysis

Copyright © 1999 by the Foundation of the American College of Healthcare Executives One of the most important character- istics of a business is its financial performance. Financial performance analysis assesses a business’ financial condition: Does it have the financial capacity to meet its mission. Results sometimes focus on financial strengths and weaknesses. Overview

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Several techniques are used: Financial statement analysis focuses on the information in a business’ financial statements with the goal of assessing financial condition. Operating analysis focuses on operating data with the goal of explaining financial performance. MVA and EVA analysis focuses on assessing managerial performance. Overview (Cont.)

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Ratio analysis is a technique used in financial statement analysis (and in other analyses). It combines values from the financial statements to create single numbers that: Have easily interpretable economic significance. Facilitate comparisons. Ratio Analysis

Copyright © 1999 by the Foundation of the American College of Healthcare Executives A single ratio value has little meaning. For example, a total margin of 7.3%. Therefore, two techniques are used to help interpret “the numbers”: Trend (time series) analysis Comparative (cross-sectional) analysis Both techniques will be illustrated in the in the examples to follow. Interpreting Ratios

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Profitability: Is the business generating sufficient profits? Liquidity: Can the business meet its cash obligations? Debt management: Right mix of debt and equity? Asset management: Right amount of assets for its utilization level? Ratio Analysis Categories

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Profitability Ratios What do they measure? Total margin - net income/revenue divided by total revenue Operating margin - net income/revenue less non-operating sources of revenue divided total operating revenue Return on assets (ROA) - net income or revenue divided by total assets. Return on equity (ROE) - net income divided by total equity

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Profitability Ratios (continued) Version of net income/revenues to use? (FP vs. NFP) Interpretation of ratios? ROA vs. ROE as a measure of org. profitability? Relationship between ROA and ROE: DuPont analysis

Copyright © 1999 by the Foundation of the American College of Healthcare Executives DuPont Analysis Allows for more specific determination of profitability ROE as a function of ROA and the equity multiplier Interpretation of DuPont results - identification of highly leveraged organizations

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Liquidity Ratios What do they measure? Current ratio (CR): current assets divided by current liabilities Quick ratio (Acid test): current assets less inventory and prepaids divided by current liabilities Days of cash on hand: cash plus securities - average expenses/day

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Liquidity Ratios (continued) Need for analysis of cash flow statements to identify source(s) of liquidity/lack thereof.

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Debt Management Ratios What do they measure? Use of debt in FP/NFP organizations Is there such a thing as too much leverage? Leverage and the risk of default Capitalization ratios Coverage ratios

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Debt Management Ratios (continued) Capitalization ratios Total debt to total assets (FP/NFP) Total debt to total equity (FP) Coverage ratios Times interest earned (TIE) ratio - net income/revenue divided by total interest expense Cash flow coverage (CFC) ratio - net income/revenue (cash) divided by debt service expenses (pre-tax)

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Asset Management Ratios What do they measure? Fixed asset turnover ratio - total revenue divided by NET fixed assets Total asset turnover ratio - total revenue divided by total assets Current asset turnover ratio - total revenue divided by current assets

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Asset Management Ratios (continued) Net days in accounts receivable (NDAR) - net A/R divided by average net daily patient service revenue Other analytical methods Common size analysis - rationale Trend analysis - rationale % change analysis - rationale MVA and EVA analysis

Copyright © 1999 by the Foundation of the American College of Healthcare Executives MVA/EVA Analysis Rationale for use Market value added (MVA) analysis What does it measure? Difference between market value and book value of shareholder equity stake How to estimate?

Copyright © 1999 by the Foundation of the American College of Healthcare Executives MVA/EVA Analysis (continued) Economic value added (EVA) analysis What does it measure? Difference between net income/revenue less interest expense (why?) and total organizational cost of capital How to estimate?

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Operating Analysis Rationale for use - adjunct to financial statement analysis (root cause analysis) Examples of operational indicators Net price per discharge Payer/service discharge % Occupancy rate Average length of stay (ALOS) Cost per discharge

Copyright © 1999 by the Foundation of the American College of Healthcare Executives How about an example?? Refer to Gapenski (Ch.17) Income statement (p.510) Balance sheet (p. 511) Cash flow statement (p.512)

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Operations provided $11.2 million in net cash flow in Riverside invested $4.3 million in new fixed assets. Riverside paid off $5.6 million in debt and invested $2.0 million in marketable securities. Statement of Cash Flows Analysis

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Profitability Ratios (1998) Total margin = Net income Total revenue = = = 7.3%. $8,572 $117,476 ROA= = = = 5.7%. $8,572 $151,278 Net income Total assets

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Ind. TM 7.3%2.2%5.0% ROA 5.7%1.6%4.8% ROE8.0%2.4%8.4% ROE= = = = 8.0%. $8,572 $107,364 Net income Total equity

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Liquidity Ratios (1998) CR = = = 2.3 times. DCOH = = = 22.5 days. CA CL $31,280 $13,332 $4,263 + $2,000 $ Cash + Marketable securities Cash expenses / 365

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Ind. CR 2.3x1.7x2.0x DCOH

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Debt Management Ratios (1998) Debt ratio = Total debt Total assets = = = 29.0%. $43,814 $151,278 TIE ratio= = = 6.6 times. $10,114 $1,542 EBIT Interest expense

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Ind. DR 29.0% 33.5%43.3% TIE 6.6x 2.6x4.0x

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Asset Management Ratios (1998) FA turnover = Total revenue Net fixed assets = = 0.98 times. $117,476 $119,998 TA turnover = Total revenue Total assets = = 0.78 times. $117,476 $151,278

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Ind. FATO TATO ACP ACP= = = 73.4 days. $21,840 $108,600 / 365 Net patient accounts rec. Net patient service rev. / 365

Copyright © 1999 by the Foundation of the American College of Healthcare Executives x x = ROE Total margin TA turnover Equity multiplier NI Rev TA TE 1997:2.22% x 0.73 x 1.50 = 2.43%. 1998:7.30% x 0.78 x 1.41 = 7.98%. Ind:5.00% x 0.97 x 1.73 = 8.39%. x x = ROE.

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Market Value Added (MVA) MVA = MV of equity - BV of equity. Assume on November 1, 1998 that Columbia/ HCA had an equity book value of $7.5 billion, that its stock price was $25, and that it had 643 million shares outstanding. MVA = ($25 x 643 million) - $7.5 billion = $ $7.5 = $8.6 billion.  What does this MVA value mean?  Does the MVA concept apply to NFP firms?

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Economic Value Added (EVA) EVA= - = AT op. income - Dollar capital costs = (EBIT x [1 - T]) - (Total assets x CCC). Here, CCC = corporate cost of capital. Funds available to investors Dollar cost of capital employed

Copyright © 1999 by the Foundation of the American College of Healthcare Executives AT operating income = ($8,572 + $1,542) x ( ) = $10,114. Dollar capital costs = $151,278 x 0.10 = $15,128. EVA = $10,114 - $15,128 = -$5,014. EVA Example ($000s) Here is Riverside’s 1998 EVA:

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Benchmarking The process of comparing a business’ ratios to selected standards is called benchmarking. Here are Riverside’s total margin benchmarks: National/GFB 9.8% National/GFB 9.6% Ind. top quartile 8.4 Ind. top quartile 8.0 St. Anthony's 8.0 St. Anthony’s 7.9 Riverside 7.3 Pennant Healthcare 5.0 Industry median 5.0 Industry median 4.7 Pennant Healthcare 4.8 Riverside 2.2 Ind. lower quartile 1.8 Ind. lower quartile 2.1 Woodbridge Memorial 0.5 Woodbridge Memorial (1.3)

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Net Price Per Discharge (1998) NPPD = Net inpatient revenue Total discharges = = $5,128. $93,740,000 18,281 Industry average = $5,510.

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Occupancy Percentage (Rate) (1998) OR = Inpatient days Number of staffed beds x 365 = = = 57.9%. 95, x 365 Industry average = 44.9%.

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Limitations of Financial Performance Analysis? Comparison with industry averages is difficult if the business operates many different divisions. “Average” performance not necessarily good performance. Seasonal factors can distort ratios. Inflation effects can distort financial statement data.

Copyright © 1999 by the Foundation of the American College of Healthcare Executives Different operating and accounting practices can distort comparisons. Sometimes, it is hard to tell if a ratio is “good” or “bad.” It is often difficult to tell whether company is, on balance, in a strong or weak position: Multiple discriminant analysis Financial flexibility index Limitations (Cont.)