Medicomp physical therapy stuart va

L O U I S C . G A P E N S K I

F I F T H E D I T I O N

AUPHA

UNDERSTANDING HEALTHCARE

FINANCIAL MANAGEMENT

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UNDERSTANDING HEALTHCARE FINANCIAL MANAGEMENT

Fifth Edition

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AUPHA HAP

Editorial Board

Leonard Friedman, Ph.D., Chair Oregon State University

G. Ross Baker, Ph.D. University of Toronto

Caryl Carpenter, Ph.D. Widener University

Barry Greene, Ph.D. University of Iowa

Richard S. Kurz, Ph.D. Saint Louis University

Sarah B. Laditka, Ph.D. University of South Carolina

Stephen S. Mick, Ph.D., CHE Virginia Commonwealth University

Michael A. Morrisey, Ph.D. University of Alabama-Birmingham

Peter C. Olden, Ph.D. University of Scranton

Janet E. Porter, Ph.D. Dana-Farber Cancer Institute

Sandra Potthoff, Ph.D. University of Minnesota

Lydia M. Reed AUPHA

Sharon B. Schweikhart, Ph.D. The Ohio State University

Nancy H. Shanks, Ph.D. Metropolitan State College of Denver

Dean G. Smith, Ph.D. University of Michigan

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UNDERSTANDING HEALTHCARE

FINANCIAL MANAGEMENT

Fifth Edition

Louis C. Gapenski In Collaboration with George H. Pink

Health Administration Press, Chicago, Illinois AUPHA, Washington, DC

AUPHA HAP

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Your board, staff, or clients may also benefit from this book’s insight. For more information on quantity discounts, contact the Health Administration Press Marketing Manager at (312) 424-9470.

This publication is intended to provide accurate and authoritative information in regard to the subject matter covered. It is sold, or otherwise provided, with the understanding that the publisher is not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional should be sought.

The statements and opinions contained in this book are strictly those of the author(s) and do not represent the official positions of the American College of Healthcare Executives, of the Foundation of the American College of Healthcare Executives, or of the Association of University Programs in Health Administration.

Copyright © 2007 by the Foundation of the American College of Healthcare Executives. Printed in the United States of America. All rights reserved. This book or parts thereof may not be reproduced in any form without written permission of the publisher. Opinions and views expressed in this book are those of the author and do not necessarily reflect those of the Foundation of the American College of Healthcare Executives or the Association of University Programs in Health Administration.

11 10 09 08 07 5 4 3 2 1

The paper used in this publication meets the minimum requirements of American National Standards for Information Sciences—Permanence of Paper for Printed Library Materials, ANSI Z39.48–1984. �� ™

Library of Congress Cataloging-in-Publication Data

Gapenski, Louis C. Understanding healthcare financial management / Louis C. Gapenski. — 5th ed.

p. cm. Includes bibliographical references and index. ISBN-13: 978-1-56793-264-5 ISBN-10: 1-56793-264-9 (alk. paper) 1. Health facilities—Business management. 2. Health facilities—United

States—Business management. 3. Medical care—United States—Finance. 4. Health services administration—Economic aspects—United States. I. Title. RA971.3.G37 2006 362.11068'1—dc21 2006049050

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BRIEF CONTENTS

Preface xiii

PART I The Healthcare Environment

1 Introduction to Healthcare Financial Management . . . . . . . . . . . . . 3

2 The Third-Party-Payer System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

PART II Basic Financial Management Concepts

3 Time Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

4 Financial Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . 115

PART III Capital Acquisition

5 Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

6 Equity Financing and Investment Banking . . . . . . . . . . . . . . . . . . 191

7 Securities Valuation, Market Efficiency, and Debt Refunding . . 221

8 Lease Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

PART IV Cost of Capital and Capital Structure

9 Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293

10 Capital Structure Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

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PART V Capital Allocation

11 The Basics of Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 377

12 Project Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423

PART VI Financial Condition Analysis and Forecasting

13 Financial Condition Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463

14 Financial Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501

PART VII Other Topics

15 Working Capital Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539

16 Business Valuation, Mergers, and Acquisitions . . . . . . . . . . . . . . . 575

17 Capitation, Rate Setting, and Risk Sharing . . . . . . . . . . . . . . . . . . 613

18 Financial Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647

Glossary 679

Index 697

About the Authors 715

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DETAILED CONTENTS

Preface xiii

PART I The Healthcare Environment

1 Introduction to Healthcare Financial Management . . . . . . . . . . . . . 3

The Role of Financial Management in the Health Services Industry, 6; Current Challenges, 8; Alternative Forms of Business Organization, 8; Hybrid Forms of Organization, 11; Alternative Forms of Ownership, 13; Organizational Structures, 17; Organizational Goals, 20; Tax Laws, 24; Depreciation, 32

2 The Third-Party-Payer System . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41

Insurance Concepts, 42; Generic Reimbursement Methods, 49; Major Health Insurers (Third-Party Payers), 56; Other Issues, 69

PART II Basic Financial Management Concepts

3 Time Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 79

Time Lines, 80; Future Value of a Lump Sum (Compounding), 81; Present Value of a Lump Sum (Discounting), 87; Opportunity Costs, 90; Solving for Interest Rate and Time, 92; Annuities, 94; Perpetuities, 99; Uneven Cash Flow Streams, 100; Using Time Value Analysis to Measure ROI, 102; Semiannual and Other Compounding Periods, 105; A Review of Interest Rate Types, 110

4 Financial Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . 115

The Many Faces of Financial Risk, 115; Introduction to Financial Risk, 116; Portfolio Risk and Return, 124; Portfolio Risk of Business

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Investments, 133; Portfolio Risk of Stocks (Entire Businesses), 139; Portfolio Betas, 140; Relevance of the Risk Measures, 141; Interpretation of the Risk Measures, 143; The Relationship Between Risk and Return, 143; Some Thoughts About Beta and the CAPM, 147

PART III Capital Acquisition

5 Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

The Cost of Money, 153; Interest Rate Levels, 155; Long-Term Debt, 156; Term Loans, 157; Bonds, 158; Short-Term Debt, 163; Debt Contracts, 169; Credit Ratings, 171; Credit Enhancement, 174; Interest Rate Components, 175; The Term Structure of Interest Rates, 180; Economic Factors That Influence Interest Rate Levels, 182; Advantages and Disadvantages of Debt Financing, 184

6 Equity Financing and Investment Banking . . . . . . . . . . . . . . . . . . 191

Preferred Stock, 191; Rights and Privileges of Common Stockholders, 194; Classified Stock, 197; Selling New Common Stock, 198; The Decision to Go Public, 203; The Decision to List, 205; Advantages and Disadvantages of Common Stock Financing, 206; Securities Regulation and the Investment Banking Process, 207; Equity in Not-for-Profit Firms, 214

7 Securities Valuation, Market Efficiency, and Debt Refunding . . 221

The General Valuation Model, 222; Debt Valuation, 223; Preferred Stock Valuation, 236; Common Stock Valuation, 237; Security Market Equilibrium, 247; Informational Efficiency, 248; The Risk/Return Trade-off, 251; Debt Refunding, 252

8 Lease Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 261

Lease Parties and Types, 261; Tax Effects, 264; Financial Statement Effects, 266; Evaluation by the Lessee, 269; Evaluation by the Lessor, 277; Lease Analysis Symmetry, 279; Setting the Lease Payment, 280; Leveraged Leases, 280; Motivations for Leasing, 282; Additional Issues, 285

PART IV Cost of Capital and Capital Structure

9 Cost of Capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 293

Overview of the Cost of Capital Estimation Process, 293; Estimating the Cost of Debt, 295; Estimating the Cost of Equity to Large

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Investor-Owned Businesses, 298; Estimating the Cost of Equity to Not-for-Profit Businesses, 311; Estimating the Corporate Cost of Capital, 316; An Economic Interpretation of the Corporate Cost of Capital, 318; Flotation Costs, 321; Divisional Costs of Capital, 322; Warning! Warning! Warning!, 323; Cost of Capital Estimation for Small Businesses, 324; Factors That Influence a Business’s Cost of Capital, 327

10 Capital Structure Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333

Impact of Debt Financing on Risk and Return, 334; Business and Financial Risk, 337; Capital Structure Theory, 341; Criticisms of the MM and Miller Models, 350; Financial Distress Costs, 351; Trade-off Models, 352; Asymmetric Information Model of Capital Structure, 355; A Summary of the Capital Structure Models, 357; Application of Capital Structure Theory to Not-for-Profit Firms, 359; Making the Capital Structure Decision, 361; Capital Structure Decisions for Small Investor-Owned Businesses, 364; The Debt Maturity Decision, 365

PART V Capital Allocation

11 The Basics of Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 377

Project Classifications, 378; The Role of Financial Analysis in Health Services Capital Budgeting, 379; Overview of Capital Budgeting Financial Analysis, 380; Cash Flow Estimation, 381; Cash Flow Estimation Example, 389; Breakeven Analysis, 397; Return on Investment Analysis, 399; Some Final Thoughts on Breakeven and Profitability Analysis, 405; Evaluating Projects with Unequal Lives, 406; Economic Life Versus Physical Life (Abandonment Value), 410; Capital Budgeting in Not-for-Profit Businesses, 412; The Post-Audit, 416; Using Capital Budgeting Techniques in Other Contexts, 416

12 Project Risk Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 423

Types of Project Risk, 424; Relationships Among Stand-Alone, Corporate, and Market Risks, 425; Risk Analysis Illustration, 427; Sensitivity Analysis, 429; Scenario Analysis, 432; Monte Carlo Simulation, 435; Qualitative Risk Assessment, 438; Incorporating Risk into the Decision Process, 439; Final Risk Assessment and Incorporation for the MRI Project, 442; Incorporating Debt Capacity into the Decision Process, 443; Adjusting Cash Outflows for Risk, 444; Real (Managerial) Options, 446; The Real Option of Abandonment, 449; An Overview of the Capital Budgeting Decision Process, 453; Capital Rationing, 455

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PART VI Financial Condition Analysis and Forecasting

13 Financial Condition Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 463

Financial Reporting in the Health Services Industry, 464; Financial Statement Analysis, 470; Ratio Analysis, 470; Tying the Ratios Together: Du Pont Analysis, 481; Common Size Analysis, 483; Percentage Change Analysis, 484; Operating Indicator Analysis, 485; Limitations of Financial Statement and Operating Indicator Analyses, 489; Economic Value Added, 491; Benchmarking, 492; Key Performance Indicators and Dashboards, 494

14 Financial Forecasting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 501

Strategic Planning, 501; Operational Planning, 504; Financial Planning, 504; Revenue Forecasts, 507; Creating Forecasted Financial Statements, 510; Constant Growth Forecasting, 511; Factors That Influence the External Financing Requirement, 517; Problems with the Constant Growth Approach, 520; Real-World Forecasting, 521; Computerized Financial Forecasting Models, 525; Financial Controls, 526; The Cash Budget, 527

PART VII Other Topics

15 Working Capital Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 539

Cash Management, 540; Marketable Securities Management, 544; Long-Term Securities Management, 546; Receivables Management, 547; Credit Policy, 553; Supply Chain Management, 556; The Economic Ordering Quantity Model, 559; Accruals, 563; Accounts Payable (Trade Credit), 564

16 Business Valuation, Mergers, and Acquisitions . . . . . . . . . . . . . . . 575

Level of Merger Activity, 575; Motives for Mergers: The Good, the Bad, and the Ugly, 578; Types of Mergers, 582; Hostile Versus Friendly Takeovers, 583; Merger Regulation, 584; Mergers Involving Not-for-Profit Businesses, 588; Business Valuation, 590; Unique Problems in Valuing Small Businesses, 596; Setting the Bid Price, 598; Structuring the Takeover Bid, 600; Due Diligence Analysis, 602; The Role of Investment Bankers, 602; Who Wins? The Empirical Evidence, 604; Corporate Alliances, 606; Goodwill, 607

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17 Capitation, Rate Setting, and Risk Sharing . . . . . . . . . . . . . . . . . . 613

An Overview of Capitation, 614; Provider Incentives Under Capitation, 615; Financial Risk Under Capitation, 617; Development of Premium Rates, 626; Risk-Sharing Arrangements, 634

18 Financial Risk Management . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 647

Fundamentals of Financial Risk Management, 648; Risk Management of Capitated Contracts, 651; Debt Portfolio Immunization, 657; An Overview of Derivatives, 661; Options, 663; Futures, 668; Swaps, 671; The Use and Misuse of Derivatives, 673

Glossary 679

Index 697

About the Authors 715

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PREFACE

A fter years of teaching corporate finance and writing related textbooks and casebooks, I began teaching the healthcare financial management course in the University of Florida’s Graduate Program in Health and

Hospital Administration. The first thing that struck me was that no textbook was available that truly focused on healthcare financial management. To me, financial management primarily involves analysis and decision making, yet the textbooks available at the time mostly covered accounting and institutional detail, with only a very limited number of pages devoted to financial manage- ment.

Thus, I set about creating a textbook that emphasized (1) financial management rather than accounting and (2) analysis and decision making rather than institutional detail. In creating this textbook, I set out to do two things. First, I adopted a very broad definition of the health services industry that included medical practices, managed care organizations, nursing homes, and home health care providers, in addition to hospitals. Today, more and more health services administration students are electing careers outside the hospital industry, and it is important that a textbook on healthcare financial management presents a broad range of provider settings. Second, I identified the environmental factors that are unique to the health services industry and hence make healthcare financial management different from corporate finance. Then, I made sure that these factors played an important role in the textbook discussions.

Concept of the Textbook My goals in writing the first edition were to create a textbook that provided health services administration students with (1) an operational knowledge of financial management theory and concepts, (2) the opportunity to apply these ideas to real-world healthcare business settings, and (3) the opportunity to use spreadsheet analyses to help make better financial decisions. Additionally, I wanted to create a textbook that could be used as a reference during intern- ships and residencies as well as after graduation. Finally, I wanted a textbook that students would find user friendly, meaning one that they would enjoy xiii

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reading and could learn from on their own. If students don’t find a textbook interesting, understandable, and useful, they won’t read it!

This fifth edition of the textbook continues to meet those goals. It be- gins with basic concepts about both the health services industry and financial management. The textbook then progresses to show how financial manage- ment theory and concepts can be applied to healthcare businesses to help managers make better decisions, where “better” is defined as promoting the financial well-being of the organization.

Intended Market and Use The textbook is targeted for the healthcare financial management course required in graduate programs in health services administration. Students typically have some background in basic business topics such as financial and managerial accounting, probability and statistics, spreadsheet analysis, and perhaps even corporate finance. However, the textbook contains a great deal of background information in these areas, and it can be used in programs where students have not had prior exposure to business topics. The textbook is useful also to healthcare professionals, including both those holding general management positions and those working as members of financial staffs.

Alternative Course Formats There is no single best approach to teaching a healthcare financial manage- ment course. The optimal approach varies with students’ backgrounds, in- structors’ interests, class contact hours, and the role of the course in the overall curriculum. Because these factors change, most instructors vary their approaches over time. Still, it may be useful to adopters to learn how the textbook has been used at the University of Florida.

In the Florida program, students first take an introductory healthcare finance course that covers both accounting and financial management. The healthcare financial management course is the second, and final, finance course in the curriculum unless a student elects to take an advanced independent study course. The second financial management course in any curriculum gen- erally is taught either as a theoretically based lecture course, as a pragmatically based pure case course, or as a blend of theory and practice where lectures are combined with some cases. Over time, I have used all three approaches, but the one that I have found best is a blend of theory and practice, but with a strong bias toward practice. Thus, I lecture occasionally but use a large num- ber of cases to provide insights into the complex financial decisions faced by practicing healthcare managers.

Understanding Healthcare Financial Management provides both the theory and concepts behind financial decision making in the health services industry and the “nuts and bolts” tools required to implement the theory

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and concepts. Students learn the theory and concepts of healthcare financial management from the textbook and periodic lectures and then implement the material by working cases. In the first two editions, the cases were contained in the textbook. However, the editorial and production burden of having both textbook and casebook in a single edition created constraints that became too confining. The publisher and I agreed that the optimal solution to this problem was to separate the cases from the textbook, which we implemented in the third edition. I will have much more to say about this decision later in the preface.

I cover most of the textbook, along with 12 cases (one per week, after some introductory material), in a one-semester course. In addition, I typically include a few accounting-oriented cases from the casebook as a re- fresher. However, the dominant theme is financial management because a well-grounded understanding of financial decision making is more important for most students than a better understanding of accounting. Also, our stu- dents are studying to be general managers, not financial staff specialists, and hence I am willing to sacrifice depth to expose students to a large range of topics. The course runs fast and furious, but this tends to keep students, and instructors, on their toes and in high gear.

Although the textbook is designed for use in the second course in financial management, a great deal of introductory material has been included. In spite of the fact that the Florida students have already had one finance course, I have found that many of them still do not have a good grasp of the basic fundamentals of financial management. Thus, they appreciate the fact that Understanding Healthcare Financial Management reviews basic concepts in addition to presenting new material. After all, repetition is the key to learning.

Because the textbook contains so much introductory material, it is also suitable for use in courses in which students have not had an introductory finance course, including two-course sequences. In this situation, I would tend to go slower to give students more time to digest the material, and the lectures would be more frequent and extensive to ensure that students really know the fundamentals before working the cases, which would be fewer in number. In a two-course sequence, instructors can easily supplement the textbook with outside readings and/or additional cases.

Changes in the Fifth Edition Since the fourth edition of the textbook was published, I have used the text- book several times in courses I have taught and have received many comments from users at other universities. Furthermore, Health Administration Press has solicited and received a number of thoughtful reviews. The reaction of stu- dents, other professors, and the market in general has been overwhelmingly positive—every comment indicates that the basic concept of the textbook is

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sound. Even so, nothing is perfect, and the health services industry is evolving at a dizzying pace. These circumstances have led to a number of changes to the textbook; the most important of which are listed below:

• First and foremost, this edition was written in collaboration with George H. Pink, a well-known healthcare finance professor at the University of North Carolina at Chapel Hill. George brings new insights to the book that, over time, will have a profound and positive impact.

• Time value calculations, particularly in Chapter 3, now focus exclusively on spreadsheets, with pictorials used to illustrate solution techniques. Students overwhelmingly state that because they do not use financial calculators for time value problems, the inclusion of calculator solutions was a distraction. Note, however, that a calculator tutorial is available as an ancillary to the text.

• Many students, as well as instructors, have asked that a glossary be added to the book. This edition has one.

• A new chapter, Chapter 19: Distributions to Owners: Bonuses, Dividends, and Repurchases, has been added as an ancillary. It is available online.

• Short introductions have been added to each part page to introduce the topics contained in the chapters of that part.

• All aspects of the text discussion as well as references have been updated and clarified as needed. Particular care was taken to include the most recent reimbursement changes and to update the real-world examples.

• New sections have been added or existing sections have been expanded for the following topics: municipal bond pools, cost of capital for not-for-profit and small businesses, modified IRR, subjective risk assessment, supply chain management, stop-loss insurance, current challenges for healthcare managers, and health savings accounts.

Ancillary Materials Several ancillary materials have been designed to enhance the learning expe- rience associated with this text.

Materials for Instructors

Two very useful ancillaries are available to instructors who adopt this text:

1. Slideshow. A set of PowerPoint® slides that cover the essential topics contained in each chapter is available. Concepts, graphs, tables, lists, and calculations are presented in about 40 slides per chapter, much as an instructor might do on a blackboard. However, the slides are more crisp, clear, and colorful and can be displayed on a screen almost instantaneously. Furthermore, hard copies of the slides can be provided to students for use as lecture notes, which I have found that students truly appreciate. Many

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instructors will find these slides useful, either as is or as customized to best meet unique course and student requirements.

2. End-of-chapter problem solutions. As indicated below, a set of problems in spreadsheet format is available for most chapters. These problem sets, which focus on key concepts, can be assigned as graded homework or used in any way that the instructor desires. A section at the end of each chapter indicates when problems are available.

Materials for Students and Instructors

Four useful ancillaries are available to students (and instructors) who use this text:

1. Text models. Most of the chapters in the text have accompanying Excel® models that illustrate the text calculations as well as additional calculations that are relevant to the chapter material. The purpose of these spreadsheet models is twofold. First, students can learn the material better because they can more easily visualize how various input factors influence a particular calculation. For example, the spreadsheet model for capital budgeting allows students to change input values, such as volume and average reimbursement, and immediately see the effects on profitability. Second, the spreadsheets permit students to learn the mechanics of spreadsheet analysis in a less challenging context than the cases (discussed below) because these models typically are not part of a graded assignment. Note that sections of the text that have accompanying models are designated by a web icon: . Also, a section at the end of each chapter indicates when text models are available.

2. End-of-chapter problems. A set of problems in spreadsheet format is available for most chapters. The problems may be assigned by the instructor as homework or worked by students on their own to gain an additional understanding of the topics in the chapter. A section at the end of each chapter indicates when problems are available.

3. Calculator tutorial. A short tutorial is available for those students who use financial calculators to solve time value problems.

4. Chapter 19. This chapter, Distributions to Owners: Bonuses, Dividends, and Repurchases, is available online either to instructors for coverage in class or to students for independent learning.

Obtaining the Ancillary Materials

All student ancillary materials can be accessed on this book’s companion web- site: ache.org/UnderstandingFinancialManagement5. Instructor ancillaries, which are contained in a secure area, are available only to adopters of this text. For access information, e-mail hap1@ache.org.

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The Casebook

In addition to the free ancillaries, many adopters pair this textbook with its accompanying casebook, Cases in Healthcare Finance. Of course, the most realistic application of healthcare finance occurs within health services orga- nizations, and there is no substitute for on-the-job experience. The next best thing, and the only real option for the classroom, is to use cases to simulate, to the extent possible, the environment in which finance decisions are actually made. Cases provide students with the opportunity to bridge the gap between learning concepts in a lecture setting and actually applying them on the job. By using cases, students can be better prepared to deal with the multitude of problems that arise in the practice of healthcare financial management.

Cases in Healthcare Finance, 3rd edition, contains 30 cases that focus on the practice of healthcare finance, including accounting, within provider organizations. In general, each case addresses a single financial issue, such as a capital investment decision; but the uncertainty of the input data, along with the presence of relevant nonfinancial factors, makes each case interesting and challenging. The case settings include a wide variety of provider organizations, including integrated delivery systems and managed care organizations. In ad- dition to cases that focus purely on financial decisions, the casebook contains eight mini-cases on ethics. The mini-cases are not quantitative in nature but rather are designed to promote discussion about a finance situation that has potential ethical implications.

In general, cases may be classified as directed or nondirected. Directed cases include a specific set of questions that students must answer to complete the case, while nondirected cases (as I use the term) contain only general guidance to point students in the right direction. Most of the cases in the casebook are nondirected. The primary advantage of nondirected cases is that they closely resemble how real-world managers confront financial decision making because they require students to develop their own solution approach. The disadvantage is that students who stray from the key issues of the case often do not obtain full value from their effort.

I have found that students with more advanced finance skills gain the most from nondirected cases, while students that have had less finance exposure gain most from directed cases. The online Instructor’s Manual for the casebook contains a set of case questions that can be used to convert each nondirected case to a directed case. Thus, instructors have the option of using the nondirected cases in either way, depending on the experience of the students, the objectives of the course, and the extent to which cases will be used.

Spreadsheet analysis has become extremely important in all aspects of healthcare finance. Students must be given the opportunity to develop com- puter skills and be allowed, or required, to use spreadsheet programs to assist in case analyses. If students have not previously learned about spreadsheets,

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they must be exposed to them because functional literacy in any area of man- agement today means at least some knowledge of spreadsheet modeling. Fur- thermore, spreadsheet models can reduce the amount of “busywork” required to perform the required calculations and hence leave students with more time to focus on financial management issues.

Because of these factors, I developed well-structured, user-friendly spreadsheet models for those cases where models would help to create a more efficient analysis. Most of the cases can, of course, be done with a calculator, but the spreadsheet models are far more efficient and hence big time-savers, especially when conducting risk assessment using techniques such as sensitivity and scenario analyses. In addition, spreadsheet models allow students to easily create graphics and other computer outputs that enhance the quality of both the analyses and any required presentations.

The student versions of the case models are complete in the sense that no modeling is required to obtain a base case solution. However, zeros have been entered for all input data, and hence students must identify and then enter the appropriate input values. When this is done, the model automatically calculates the base case solution. However, the models do not contain risk analyses or other extensions such as graphics, so students must modify the models as necessary to make them most useful in completing the cases.

The instructor versions of the case models are similar to the student versions, except that the input values are intact. Thus, instructors can view the base case solution without entering any data. In addition, some instructor version models have additional modeling, such as risk analyses, included. The instructor versions of the case models are distributed with the online Instructor’s Manual to the casebook.

Health Administration Press is keenly aware of the increasing financial burden that students face as course materials escalate in both quantity and price. The casebook is discounted 20 percent when purchased with this text. For more information, call Health Administration Press at (301) 362–6905 or e-mail hap@pmds.com.

Acknowledgments This book reflects the efforts of many people. First, I would like to welcome George Pink as a collaborator. His work on the text and ancillaries has been invaluable. Furthermore, my thanks go to the following individuals, who re- viewed previous editions of the textbook and provided many valuable com- ments and suggestions for improving it:

Doug Conrad of the University of Washington Tom Getzen of Temple University Mike McCue of Virginia Commonwealth University Dean Smith of the University of Michigan Jack Wheeler of the University of Michigan

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Also, special thanks are due to Mike McCue and Jack Wheeler, who coauthored some sections.

Colleagues, students, and staff at the University of Florida provided in- spirational support, as well as more tangible support, during the development and class testing of each edition of the textbook. And last, but certainly not least, I would like to thank the Health Administration Press staff, who were instrumental in ensuring the quality and usefulness of the textbook.

Errors in the Textbook In spite of the significant effort that has been expended on this edition, it is safe to say that some errors exist. In an attempt to create the most error- free and useful textbook possible, we strongly encourage both instructors and students to write me at the address below with comments and suggestions for improving the textbook. We welcome and value your input!

Conclusion Good financial management is vital to the economic well-being of the health services industry. Because of its importance, financial management theory and concepts should be thoroughly understood, but this is easier said than done. We hope that Understanding Healthcare Financial Management will help you better appreciate the financial management problems faced by the health services industry today and that it will provide guidance on how best to solve them.

Louis C. Gapenski, Ph.D.

Submit comments to:

Box 100195 Health Science Center University of Florida Gainesville, FL 32610-0195

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PART

I The Healthcare Environment

Two factors make the provision of health services different from other services. First, many providers are organized as not-for-profit corporations as opposed to investor owned. Second, payment for services typically is made by third parties rather than by patients, who receive the services. By focusing on these differences, Part I of the text provides students with unique background information that creates the framework for financial decision making within healthcare organizations.

Chapter 1 discusses the institutional setting for the delivery of health- care services. Topics covered include the role of financial management, al- ternative forms of organization and ownership, organizational goals, and tax laws. In essence, this chapter creates the organizational background for the provision of health services.

Chapter 2 focuses on insurance concepts and the third-party-payer system. It is essential that healthcare managers understand who the payers are and the payment methods used because these external factors have a profound influence on financial decision making.

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CHAPTER

1 INTRODUCTION TO HEALTHCARE FINANCIAL MANAGEMENT

Learning Objectives

After studying this chapter, readers should be able to:

■ Explain the difference between accounting and financial management. ■ Discuss the role of financial management in health services

organizations. ■ Describe the basic forms of business organization along with their

advantages and disadvantages. ■ Discuss the two basic types of ownership and explain why ownership

type is so important when making financial management decisions. ■ Explain how the goals of investor-owned and not-for-profit businesses

differ. ■ Describe, in general terms, the tax laws that apply both to individuals

and to healthcare businesses.

Introduction The study of healthcare financial management is both fascinating and reward- ing. It is fascinating because so many of the concepts involved have impli- cations for both professional and personal behavior. It is rewarding because, rightly or wrongly, the healthcare environment today, and into the foresee- able future, is forcing managers to place an increasing emphasis on financial implications when making operating decisions.

First and foremost, financial management is a decision science. Whereas accounting provides decision makers with a rational means by which to budget for and measure a business’s financial performance, financial management provides the theory, concepts, and tools necessary to make better decisions. Thus, the primary purpose of this textbook is to help healthcare managers and students become better decision makers. The text is designed primarily for nonfinancial managers, although financial specialists—especially those with accounting rather than finance backgrounds or those who are moving into the health services industry from other industries—will also find the text useful.

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The major difference between this text and corporate finance texts is that this text focuses on factors that are unique to the health services industry. For example, the provision of health services is dominated by not-for-profit organizations (both private and governmental), which are inherently different from investor-owned businesses.1 Also, the majority of payments for services made to healthcare providers are not made by patients—the consumers of the service—but rather by some third-party payer (for example, a commercial insurance company or a government program). Indeed, even the purchase of health insurance is dominated by employers rather than by the individuals who will receive the services. Throughout this text, we emphasize ways in which the unique features of the health services industry affect financial management decisions.

Although this text contains some theory, and a great number of fi- nancial management concepts, its primary emphasis is on how managers can apply the theory and concepts; thus, it does not contain the traditional end-of- chapter questions and problems. (Note, however, that end-of-chapter prob- lems in spreadsheet format are available as ancillary materials.) Rather, the text is designed to be used with the casebook Cases in Healthcare Finance, which contains cases that are based on real-life decisions faced by practicing healthcare managers. The cases are designed to enable students to apply the skills learned in this text’s chapters in a realistic context, where judgment is just as critical to good decision making as numerical analysis. Furthermore, the cases are semidirected, which means that although students receive some guidance, they must formulate their own approach to the analyses, just as real-world decision makers must do.2

Also, personal computers are changing the way managers think about structuring and performing financial analyses. Managers, and students, must recognize that computers are capable of providing answers to questions that were not even asked a few years ago. Thus, both this text and the casebook are oriented toward using spreadsheets to help make better decisions. This text has accompanying spreadsheet models that illustrate the key concepts presented in many of the chapters. The casebook has spreadsheet models that make the quantitative portion of the case analyses both easier to do and more complete.

Note, however, that it is impossible to create a text that includes every- thing that a manager needs to know about healthcare financial management. Indeed, it would be foolish even to try because the industry is so vast and is changing so rapidly that many of the details needed to become completely knowledgeable in the field can only be learned through contemporary expe- rience. Thus, we do not expect readers to fully understand every nuance of every financial management theory and concept that pertains to the industry, nor do we expect readers to become experts in quantitative analysis. Neverthe- less, this text will provide the core competencies required to enable readers to (1) judge the validity of analyses performed by others, usually financial staff

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specialists or consultants, and (2) incorporate sound financial management theory and concepts in their own managerial and personal decision making.

How to Use This Book The overriding goal in creating this text is to provide an easy-to-read, content- filled text on healthcare financial management. The text contains several fea- tures designed to assist in learning the material.

First, pay particular attention to the LEARNING OBJECTIVES listed at the beginning of each chapter. These objectives provide a feel for the most important topics in each chapter and what readers should set as learning goals for that chapter. After each major section, except the Introduction, one or more SELF-TEST QUESTIONS are listed. As you finish reading each major section, try to provide reasonable answers to these questions. Your responses do not have to be perfect, but if you are not satisfied with your answer, it would be best to reread that section before proceeding. Answers to the self- test questions are not provided, so a review of the section is indicated if you are in doubt about the adequacy and correctness of your answer.

Within the book, italics and boldface are use to indicate special terms. Italics are used whenever a key term is introduced; thus, italics alert read- ers that a new and important concept is being presented. Boldface is solely used for emphasis; thus, the meaning of a boldface word or phrase has un- usual significance to the point being discussed. As indicated in the Preface, the book has accompanying spreadsheet models that match, and sometimes expand on, selected calculations within text. The sections of the text that have accompanying models are indicated by a web icon: .

In addition to in-chapter learning aids, materials designed to help read- ers learn healthcare financial management are included at the end of each chapter. First, each chapter ends with a summary section titled KEY CON- CEPTS that very briefly reviews the most important topics covered in the chapter. If the meaning of a key concept is not apparent, you may find it use- ful to review the applicable section. Immediately after the KEY CONCEPT section, a paragraph is included that indicates if spreadsheet models and prob- lems sets are available for that chapter. (See the Preface for more information on these ancillaries.)

Finally, each chapter ends with SELECTED WEBSITES and REFER- ENCES. The websites are designed to just “scratch the surface” of relevant material available on the World Wide Web. The books and articles cited as ref- erences can provide a more in-depth understanding of the material covered in the chapter.

Taken together, the pedagogic structure of the book is designed to make the learning of healthcare financial management as easy and efficient as possible.

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Self-Test Question

1. Briefly describe the key features of the text designed to enhance the learning experience.

The Role of Financial Management in the Health Services Industry Until the 1960s, financial management in all industries was generally viewed as descriptive in nature, with its primary role being to secure the financing needed to meet a business’s operating objectives. A business’s marketing, or planning, department would project demand for the firm’s goods or services; facilities managers would estimate the assets needed to meet the projected de- mand; and the finance department would raise the money needed to purchase the required plant, equipment, and supplies. The study of financial manage- ment concentrated on business securities and the markets in which they are sold and on how businesses could access the financial markets to raise capital. Consequently, financial management textbooks of that era were almost totally descriptive in nature.

Today, financial management plays a much larger role in the overall management of a business. Now, the primary role of financial management is to plan for, acquire, and utilize funds (capital) to maximize the efficiency and value of the enterprise. Because of this role, financial management is known also as capital finance. The specific goals of financial management depend on the nature of the business, so we must postpone that discussion until later. In larger organizations, financial management and accounting are separate functions, although the accounting function typically is carried out under the direction of the organization’s chief financial officer (CFO) and hence falls under the overall category of “finance.”

In general, the financial management function includes the following activities:

• Evaluation and planning. First and foremost, financial management involves evaluating the financial effectiveness of current operations and planning for the future.

• Long-term investment decisions. Although more important to senior management, managers at all levels must be concerned with the capital investment decision process. Such decisions, which focus on the acquisition of new facilities and equipment (fixed assets), are the primary means by which businesses implement strategic plans, and hence they play a key role in a business’s financial future.

• Financing decisions. All organizations must raise funds to buy the assets necessary to support operations. Such decisions involve the choice between internal and external funds, the use of debt versus equity capital, and the use of long-term versus short-term debt. Although senior

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managers typically make financing decisions, these decisions have ramifications for managers at all levels.

• Working capital management. An organization’s current, or short-term, assets, such as cash, marketable securities, receivables, and inventories, must be properly managed both to ensure operational effectiveness and to reduce costs. Generally, managers at all levels are involved, to some extent, in short-term asset management, which is often called working capital management.

• Contract management. In today’s healthcare environment, health services organizations must negotiate, sign, and monitor contracts with managed care organizations and third-party payers. The financial staff typically has primary responsibility for these tasks, but managers at all levels are involved in these activities and must be aware of their effect on operating decisions.

• Financial risk management. Many financial transactions that take place to support the operations of a business can, themselves, increase a business’s risk. Thus, an important financial management activity is to control financial risk.

In times of high profitability and abundant financial resources, the fi- nance function tends to decline in importance. Thus, when most healthcare providers were reimbursed on the basis of costs incurred, the role of finance was minimal. At that time, the most critical finance function was cost account- ing because it was more important to account for costs than it was to control them. Today, however, healthcare providers are facing an increasingly hostile environment, and any business that ignores the finance function runs the risk of financial deterioration, which ultimately can lead to bankruptcy and closure.

In recent years, providers have been redesigning their finance functions to recognize the changes that have been occurring in the health services indus- try. Historically, the practice of finance had been driven by the Medicare pro- gram, which demanded that providers (primarily hospitals) churn out a mul- titude of reports both to comply with regulations and to maximize Medicare revenues. Third-party reimbursement complexities meant that a large amount of time had to be spent on cumbersome accounting, billing, and collection procedures. Thus, instead of focusing on value-adding activities, most finance work focused on bureaucratic functions. Today, to be of maximum value to the enterprise, the finance function must support cost-containment efforts, managed care and other payer contract negotiations, joint venture decisions, and integrated delivery system participation. In essence, finance must help lead organizations into the future, rather than merely record what has happened in the past.

In this text, the emphasis is on financial management, but there are no unimportant functions in health services organizations. Managers must un- derstand a multitude of functions such as marketing, accounting, and human

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resource management in addition to financial management. Still, all business decisions have financial implications, so all managers—whether in operations, marketing, personnel, or facilities—must know enough about financial man- agement to incorporate financial implications in decisions made within their own specialized areas. Thus, all managers must understand the theory and principles of financial management because this knowledge will make them even more effective at their own specialized work.