1. Chapter 22 Working Capital and Cash Management

2. Learning Objectives Explain why cash management is especially crucial in most sectors of the health industry Explain what working capital is and why it is needed Describe the activities covered in the cash budget that affect working capital Describe the tools that an organization manager can use to manage receivables List the external resources available to an organization for its short-term financing needs List and explain the criteria that should be used when investing an organization’s cash in the short term

3. Cash and Investment Management in Health Care Hospitals, compared with firms of similar size in other industries, have large sums of investment eligible funds 2007: 30% of total net income was derived from non-operating sources (e.g. donations and investment income). Investment income is the predominant source of non-operating revenue.

4. Why do Hospitals Hold Investments? Not-for-profit (NFP) firms need to set aside funds for plant and equipment replacement –Investor-owned (IO) firms rely on issuance of new stockholders’ equity to finance replacement needs Firms self-insure all or portion 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

5. Figure 22-1: Cash Conversion Cycle Main objective: To minimize the collection period and maximize payment period

6. Cash Budget Primary tool in cash planning Major purpose – to prepare accurate estimate of future cash flows for short-term financing or investment decisions Cash balances are effected by changes in working capital

7. Working Capital Working capital is the difference between current assets and current liabilities Current assets: –cash and investments, accounts receivable, inventories, other current assets Current liabilities: –accounts payable, accrued salaries and wages, accrued expenses, notes payable, current position of long-term debt

8. Cash Budget, cont. The Cash Budget focuses on four major activities: –Purchasing of resources –Production/sale of service –Billing –Collection These activities represent intervals in the cash conversion cycle

9. Cash Budget Activities Purchasing – relates to acquisition of supplies and labor Production and sale –in the health care industry, there’s little distinction between production and sale, i.e. there is no inventory of products or services Billing – interval between the release /discharge of patient and generation of a bill Collection – interval between generation of a bill and actual collection of the cash from the patient or third- party

10. Steps in the 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 in needed 5.Invest cash surplus to maximize expected yield

12. Working Capital Management Working capital management is related to short-term bank financing and investment of cash surpluses. Consider two major categories (receivables and accounts payable/accrued salaries) on the balance sheet and how they relate to working capital management

13. Accounts Receivable (A/R) Recall A/R represents revenue for services that have been performed but have yet to be paid. Usually represent 40-50% of a hospital’s total current assets Management of accounts receivable focuses on: –Minimizing lost charges –Minimizing write-offs for uncollectable accounts –Minimizing the accounts receivable collection cycle

14. Figure 22–2 Accounts Receivable Collection Cycle in Days

15. Admission to Discharge On average ~ 5 days Shortening this interval is not the main objective from an A/R viewpoint. However, with fixed prices per case, a reduced length of stay (LOS) is desirable from cost management point To expedite later collection: –Determine if interim billings are possible –Use advance deposits for non-emergent admissions –Obtain insurance and eligibility information before admission for non- emergencies –Arrange for deductible portion of coverage for patients with Health Savings Account (HAS)

16. Discharge to Bill Completion Usually 10 days, but should be reduced Acceleration of billing process can create a 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

17. Bill Completion to Receipt by Payer Usually 2 days, but may be shorter where electronic claim submission is used To shorten the interval: –Consider electronic invoicing for large payers when possible (decreases mail time to zero) –Try to settle all outpatient accounts at the point of discharge of departure –Submit a bill for any deductible and copayments for inpatients at the point of discharge

18. Receipt by Payer to Mailing of Payment Usually 35 days, but varies by type of payer To shorten the interval: –Sell some accounts receivable (e.g. Medicare accounts) –Use discounts for prompt payments (e.g. 5%) –Create a system of fast response to third-party requests for additional data –Claim all bad debt of the Medicare deductible and copayment portion of hospital bills –Make frequent follow-up calls to patients to detect problems with bills

19. Payment Mailed to Receipt by Hospital Usually 2 days due to mail time Courier service could be used for government or large insurance payers Wire transfers between payer and the health care provider’s bank are also used (used by Medicare and Medicaid)

20. Receipt by Hospital to Deposit in Bank 1 or more days To shorten the interval, use lockbox arrangements – payments go directly to a post office box that is cleared at least once a day by bank employees Since there is usually a cost for the service, the hospital must determine whether improvement in the cash flow is worth the fee

21. Accounts Payable and Accrued Salaries and Wages Not usually negotiated and vary directly with the level of operations Usually represent a sizable portion of a hospital’s financing Most firms prefer to slow these payments Consider ABC Medical Center Balance sheet: –$2,297,672 in accounts payable trade –$1,366,777 in accrued salaries and wages

23. Accounts Payable Approaches to slow accounts payable (AP): –Delay payment until the actual due date –Stretch AP – delay payment until some time after the due date –Change the frequency of payroll (e.g. from weekly to biweekly) –Use banks in distant cities to pay vendors and employees – delays check clearing and creates “float” (difference between bank balance and check-book balance) –Schedule deposits to checking accounts to match expected disbursements on a daily basis

24. Short-Term Financing Sources Commercial banks – predominant sources Other sources: –Single-payment loan –Line of credit –Revolving credit agreements –Term loans –Letters of credit

25. Single-Payment Loan Usually given for a specific purpose (e.g. purchase of inventory) Main types: –Discount arrangement – interest is computed and deducted from the face value of the 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

26. Line of Credit An agreement that permits a firm to borrow up to a specified limit during a defined loan period (e.g. $ 2 M to a hospital during one year) 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 on the part of the bank

27. Revolving Credit Agreements Similar to a line of credit, but issued for 2-3 years Most are renegotiated before maturity If renegotiation occurs >1 year before maturity, the loan may be stated as a long-term debt and it never appears as a current liability on the balance sheet Interest rates are usually variable

28. Term Loans Made for a specific period: 2-7 years Require periodic installment payments of the principal Frequently used to finance tangible assets that will produce income in the future (e.g. tomography scanner) The asset acquired may be pledged as collateral for the loan

29. 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

30. Investment of Cash Surpluses Cash surplus – money exceeding a minimum balance required to meet immediate operating expenses and minor contingencies of a firm Consider surplus on ABC Medical Center Balance sheet: –$1,216,980 in cash balance –$4,042,407 in short-term investments

31. Money Market Investments A portion of firm’s investment funds Market for short-term securities (e.g. U.S. Treasury bills, negotiable certificates of deposit) Maturity ranges from 1 day to 1 year Investment serves two roles: –Liquidity reserve that can be used if the firm experiences a need for these funds –Temporary investment of surplus funds that can result in return

32. Short-Term Investments Main investment criteria: Price stability Safety of principal Marketability Maturity Yield

33. Price Stability Very important factor for money market investments Most money market investments can be sold at a guaranteed price U.S. Treasury bills – most credit-worthy investments, followed by other treasury obligations and federal agency issues

34. 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 (e.g. negotiable certificates of deposit) and corporate obligations (e.g. commercial paper) may incur a loss of principal through default Bank creditworthiness can be reviewed at Moody’s Bank and Financial Manual

35. 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 (e.g. of industrial firms) may be difficult to redeem before maturity

36. Maturity A date when a note, bill, bond, etc. becomes due for repayment Relationship with the yield of a security can be summarized in a yield curve Yield curve – relationship between the interest rate and the time to maturity of debt Some firms use “riding the yield curve” strategy – investments are made in longer-term securities that are sold before maturity

38. Yield Measure of the 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 taxes