What should be a firm's primary long term financial objective

Equity Equity calculations are not discussed in any detail here. It is enough for our purposes to recognize that equity is a derived figure. Equity must equal total assets less liabilities. In our Williams Convalescent Center example, this generates values of $2,562 for the constant dollar method and $2,867 for the current cost method.

SUMMARY Financial reporting suffers from its current reliance on the HC valuation concept. Inflation has made many of the reported values in current financial reports meaningless to decision makers. The example used in this chapter illustrates this point. The total asset investment of Williams Convalescent Center is approximately 100% larger when adjusted for inflation under the current cost or constant dollar method. Net income, however, decreased. The result is a dramatic deterioration in return on investment––the single most important test of business success. Table 10–11 summarizes (Cleverley 227-237) Cleverley, William O. Essentials of Health Care Finance, 7th Edition. Jones & Bartlett Learning, 20101022. VitalBook file..

Chapter 11 Analyzing Financial Position LEARNING OBJECTIVES After studying this chapter, you should be able to do the following:

• 1.Describe the balanced scorecard and dashboard reporting.

• 2.Describe the four key elements of dashboard reporting.

Increase in specific prices over general price level ($3,783 less $3,791)

($8)

• 3.Explain what is most important in long-term financial success.

• 4.Explain the primary financial objective of a healthcare firm.

• 5.Describe the critical drivers of financial performance. • 6.Discuss the importance and types of performance

measures. • 7.Introduce the hospital cost index measure.

REAL-WORLD SCENARIO Michael Dean has been recently appointed to the board of Kenyon Medical Center, a 300-bed, not-for-profit community hospital. Mike is an attorney who specializes in labor law and is the firm’s primary litigation expert in this area. He is reviewing the financial information that was sent to him this morning in preparation for his first board meeting this evening. His total financial package includes 28 pages of financial information consisting of current monthly income statements, a balance sheet, and other monthly actual-to-budget comparisons of performance with some selected financial ratios. Tonight’s meeting is critical because the board’s major item for discussion is related to a proposed bond issue to finance major hospital renovation. Mike recognizes that he has a fiduciary responsibility to protect the assets of the hospital and to ensure its continued financial viability, but he does not know how to determine whether the hospital can afford to take on this additional debt. There is so much information and no apparent pattern as to what really is important. He is also concerned about assessing how the proposed financing would impact the hospital’s financial performance and thus its ability to repay both interest and principal on the debt. He recently read a report on “dashboard reporting” and wonders if some structure like this would help him and other board members to get a better appreciation for the financial performance of the hospital.

The major purpose of this chapter is to introduce some analytical tools for evaluating the financial condition of healthcare entities. Think for a moment how confusing and difficult it would be without a key to reach

any conclusions about financial position from any of the financial statements presented in Chapter 9. Unless your training is in business or finance, the statements may look like a mass of endless numbers with little meaning. In short, there may be too much information in most financial statements to be digested easily by a general-purpose user. During the last 30 years there has been an explosion in the adoption and integration of information technology to financial reporting. Financial data are collected, analyzed, and distributed to decision makers in a more accurate and timely manner and in greater quantity than ever before. However, many people believe the technology has not had a positive impact on performance. Although we have made important strides in the technology of information collection and distribution, we have failed to realize significant improvements in the decision-making value of that information. What accounts for the failure to take advantage of information technology advances? We believe the answer is very clear and is one that most executives would readily acknowledge. We have been using the technology to deliver data, and more of it, to decision makers more rapidly, but we have ignored the issue of information relevance. As a result we have in many cases simply used technology to deliver irrelevant or inappropriate data more quickly. Bad data delivered more quickly are not likely to improve performance in either the short run or the long run. LEARNING OBJECTIVE 1 Describe the balanced scorecard and dashboard reporting. To improve the collection and communication of financial and operating information, “balanced scorecards” and “dashboards” were created. Essentially, these tools are neatly formatted reports that provide information on the organization’s performance in a limited number of areas. The reports help focus attention to key performance indicators (also referred to as key metrics or measures) that are typically defined by senior leadership. The concept of balanced scorecards developed by Robert Kaplan and David Norton represents an attempt to enhance the value of

information and exploit the capability of information technology to deliver true value to decision makers. Balanced scorecards, in their stripped-down version, simply state that reporting should be available on those key attributes affecting performance. More data are of little value if they do not provide information to a decision maker that can be used to improve the performance of the firm. Dashboard reporting is a natural subset of balanced scorecards and is increasingly used in almost all sectors of the economy to keep managers focused on critical areas that affect overall firm performance. In 1988, a major company won a Vision Award issued by Business Finance for its dashboard reporting system. The company’s present dashboard system is intranet based and replaced the company’s monthly 200-page binder system that was sent to managers. The mix of 16 financial, operating, and human resource measures is available online in a drill-down format into which managers can dig deeper if they desire. The system is extremely easy to use and focuses on critical performance drivers. DEVELOPING AN EFFECTIVE FINANCIAL REPORTING SYSTEM LEARNING OBJECTIVE 2 Describe the four key elements of dashboard reporting. Assuming that many healthcare providers are interested in developing a dashboard reporting system for key executives and board members, what needs to be done? In general, four critical questions must be answered:

• 1.What is most important to the firm’s success? • 2.What are the critical drivers that influence performance

attainment? • 3.What are the most relevant measures that reflect critical

driver relationships? • 4.What relevant benchmarking data are available to assess

performance?

In the remainder of this chapter we answer these four questions with respect to financial performance. We then examine a specific hospital example to illustrate the definition and utilization of financial indicators to assess financial performance and to identify critical opportunities for management intervention. Question One: What is Most Important for Success? Understanding financial performance in any business requires some global or summary measure of financial success. For many healthcare organization executives, this measure is often the operating margin (operating income divided by revenues). Although operating margin is important, we believe that relying on this as a measure of success can be misleading in many situations. For example, low operating margins may not always be bad and high operating margins may not always be good. LEARNING OBJECTIVE 3 Explain what is most important in long-term financial success. What should be the primary criterion for financial success in healthcare organizations? We believe that a financially successful organization is capable of generating the resources needed to meet its mission. This creates two immediate questions. First, what are resources? Second, what level of resources is needed to fulfill the mission? Economic resources that are owned or controlled by a business firm are referred to as assets and include such items as supplies, equipment, buildings, and other factors of production that must be present to produce health services. Human resources are not usually shown as assets because the firm does not own an individual, but human resources also are required in the production of products or services. Resources or assets owned by a healthcare organization are shown in its balance sheet, which provides a listing of its assets and the pattern of financing used to acquire those assets. The level of resources required by a healthcare organization depends largely on the range and quantity of health services envisioned in the mission statement. In situations when there is no scientific standard for

resource requirements, benchmarking against other healthcare organizations may be used to partially address the issue of resource need. A hospital or healthcare firm can find itself in a situation when it may have too little investment in assets to meet the production needs for services, or it may have excessive investment in assets of a certain category. Resources can be financed with either debt or equity funds, as any balance sheet clearly shows. A financially successful organization must therefore be capable of generating the amount of funds through debt and/or equity that is needed to finance the required level of resources. Figure 11–1 depicts a simple balance sheet that illustrates these concepts. In this example our healthcare organization needs to increase its investment in assets, or resources, by $100 million (to a total of $200 million) over the next 7 years to fulfill its mission. This level of future investment should be a byproduct of the firm’s strategic plan. A strategic plan should provide some information about projected service levels, which in turn should drive expected investment. Strategic financial planning is the topic of Chapter 13. The rate of annual compounded asset growth for the example in Figure 11–1s approximately 10% per year. This rate equals the average rate of asset growth in many voluntary not-for-profit hospitals during the last 5 years. Although this growth rate may seem high, remember that this rate incorporates replacement of assets at higher prices, new technology, entry into new product lines requiring new investment, and increases in working capital such as accounts receivable. The healthcare organization depicted in Figure 11–1 has chosen a financing mix of 50% equity and 50% debt.

Figure 11-1 Sustainable Growth This means that 7 years later, the target financing mix will be $100 million of debt and $100 million of equity to finance the $200 million investment in assets. If an organization must grow to meet its mission, then, given our discussion, it must be sensitive to how quickly it grows (the asset growth rate) and how it grows (the mix of debt and equity financing). The principle of sustainable growth states that no business entity can generate a growth rate in assets (10% in our example) that is greater than its growth rate in equity (also 10% in our example) for a prolonged period. It may be possible to generate new asset growth of 15% for several years when equity growth is only 5% by changing the percentages of equity and debt financing. There is no mystery in the

principle of sustainable growth, and it is not some esoteric finance concept that bears no relationship to reality. Any business will have its asset growth rates limited by its ability to generate new equity growth. To not believe in the validity of this concept implies that a firm could always increase its percentage of debt financing to any level. There are no exceptions to this theorem. It is not something that represents a nice target; it is a fundamental principle of business from which no one is exempt. Some governmental healthcare organizations may argue that they always generate growth rates in equity less than their asset growth because they get capital funds directly from their governmental sponsors. Those transfers represent a transfer of equity and are a part of equity growth. To be clear, the most important aspect of long-term financial success is sustainable growth. LEARNING OBJECTIVE 4 Explain the primary financial objective of a healthcare firm. If sustainable growth (equity growth that meets or exceeds asset growth) is an organization’s long-term financial goal, then there is no other financial objective that is more important than equity growth. Healthcare organizations that expect low rates of equity growth in the future most likely will not be able to provide the level of resources sufficient to meet their mission. If your healthcare organization anticipates growth rates in equity of only 5% over the next decade, it is almost certain that your asset growth potential will be no greater than 5%. Although the objective is not to add assets or investments for the sake of growth, health-care organizations that remain viable must add new investments. Healthcare organizations with low rates of growth in equity most likely will experience most of their asset growth in working capital areas such as accounts receivable and supplies. These firms will invest very little in renovation and replacement of existing equipment and plant and very little in new capital required for entry into new markets. If they are surrounded by firms that are not experiencing low equity growth rates, their market share will decrease as their relative delivery capability deteriorates. Growth rate in equity can be expressed as follows:

Change in equity Equity

= Net income

Equity

× Change in equity

Net income

Most voluntary not-for-profit healthcare organizations do not have a source of equity other than net income. This means that no transfers of funds from government or large restricted endowments exist to increase the firm’s change in equity from the level of reported net income. In these situations the term change in equity/net income equals one; therefore, growth rate in equity can be defined as net income divided by equity, or return on equity (ROE). ROE is therefore the primary financial criterion that should be used to evaluate and target financial performance for voluntary not-for-profit healthcare organizations when transfers of new equity are not likely. ROE is also the primary financial criterion that should be used to evaluate and target financial performance for taxable for-profit firms. In sum, to answer our first question of “what is most important” in dashboard creation, we believe that organizations must focus on sustainable growth to be viable long term. Sustainable growth, and equity growth in particular, can be measured by ROE. Therefore, the most important long-term financial metric that can be included on a financial dashboard is ROE. In the remaining portions of this chapter, we explore how the relationships that drive ROE impact the rest of the financial dashboard. LEARNING OBJECTIVE 5 Describe the critical drivers of financial performance.

Question Two: What Are the Critical Drivers of Performance?

At present, we only have one measure on our financial dashboard: ROE. If improving ROE is our goal, it is important to understand the underlying performance relationships that impact that growth. ROE is simply defined as follows: ROE =

Net Income Equity

( or Net Assets

)

However, ROE can be factored into a number of components that help executives analyze and improve their ROE values. The following equation also defines ROE: R O E =

Operating income +

Nonoperating income Revenue

× Revenue Assets

× Assets Equity

This alternative formula tells us that an organization can improve its ROE in a variety of ways. First, it can improve its operating margins (operating income divided by revenue). Second, it can increase its nonoper-ating gain ratio (nonoperating income divided by revenue). Third, it can increase its total asset turnover (revenue divided by assets). Fourth, it can reduce its equity financing ratio (equity divided by assets). Operating margin improvement is an important strategy for improving ROE, but it is not the only way that ROE can be increased

and sustainable growth achieved. Figure 11–2 depicts the critical relationships affecting financial performance in most healthcare firms. If we assume that ROE, or business unit value, is the primary measure of financial performance success, the schematic in Figure 11–2 provides a roadmap of the critical drivers of performance. The schematic shows that the three primary determinants of value are profit, investment, and cost of capital. These three primary determinants of value can be related to a set of macro drivers, and then ultimately to a number of micro value drivers that enable measurement and modeling for effective dashboard reporting. It is important for every healthcare firm interested in developing a set of measures to monitor and evaluate performance to start with a model similar to the one defined in Figure 11–2. Without this type of framework, many executives simply try to define a set of measures from those that currently exist or could be created. Defining measures without understanding key relationships can be dangerous. For example, reporting man-hours per discharge without adjusting for case-mix intensity can lead to erroneous conclusions and potentially bad decisions. Know your business before you determine how best to capture the essence of its performance. LEARNING OBJECTIVE 6 Discuss the importance and types of performance measures. Question Three: What Are the Most Relevant Metrics? Understanding the relationships that drive performance permits one to define performance measures that should focus management attention on areas that need to be corrected. There is always a dilemma encountered in the definition of the measures used for reporting. First, the absolute number of measures used must be limited. The used measures should have a high probability of problem/ opportunity detection. For example, in our sample hospital’s dashboard report, we assess the probability of a supply or drug cost problem by examining costs for four high-profile diagnosis-related groups (DRGs). Second, the measures should be naturally related to

the key driver map developed earlier (Figure 11–2). In the case of our dashboard report we identify 13 critical performance driver categories:

Figure 11-2 Micro and Macro Drivers • 1.Market factors • 2.Pricing • 3.Coding • 4.Contract negotiation

• 5.Overall cost • 6.Labor costs • 7.Departmental costs • 8.Supply and drug costs • 9.Service intensity • 10.Nonoperating income • 11.Investment efficiency • 12.Plant obsolescence • 13.Capital position

Third, the measures used should be capable of external validation or benchmarking. Measuring current performance with past performance may be helpful in some cases, but ideally comparative industry benchmarks should be available. Our “hospital dashboard” report contains 49 measures that are related to the 13 critical performance driver categories. Each of these measures can be related to external comparative data as well as comparisons with individual market area competitors. Benchmarking data from competitors are extremely valuable. We discuss the measures used for each of the 13 performance drivers when we begin our case discussion.

Question Four: What Benchmarking Data Should Be Used? Comparative benchmarking data are crucial ingredients to the success of any dashboard reporting system. Ideally, a business would like some comparative reference points. How am I doing with respect to similar firms in my industry? How am I doing relative to my primary competitors? Identifying measures that are able to capture the nuances of revenue or cost drivers is nice but may be of

little value if no external comparative benchmarks can be found. For example, most hospitals would like to measure and compare nursing cost on an acuity-adjusted basis, but uniform benchmarks are not

currently available. In this situation direct nursing cost per patient day may be the best that one can do. The measures used in this chapter for our case hospital allow external comparisons and competitor comparisons because the databases used in measure definition are publicly available in the following sources:

• •Medicare Cost Reports • •Standard analytical outpatient file • •MedPAR file

CASE EXAMPLE: HARRIS MEMORIAL HOSPITAL For the remainder of this chapter we illustrate the use of financial analysis techniques through a case example: Harris Memorial Hospital and Harris Community Foundation (HCF), which we also used in Chapter 9. We use the audit for HCF in Appendix 9–A to calculate many of the financial ratios in our dashboard. HCF has one primary competitor in its market: Eastside Healthcare. The primary hospital for HCF is Harris Memorial Hospital, a 430-bed facility. The primary hospital for Eastside Healthcare is Eastside Medical Center, a 170- bed facility. Many of the metrics on our dashboard relate only to the primary hospitals. These metrics are calculated from the public data sources (cost reports, standard analytical outpatient file, MedPAR) and do not directly tie to the audit in Appendix 9–A. In sum, when examining our sample dashboard you can practice calculating the metrics when the data source is listed as “Audit” but cannot practice calculations for the other data sources. In the end, it is most important to understand how to interpret the metrics, not simply how they are calculated. Our dashboard can be found in Table 11–1.

Table 11-1 Dashboard for Harris Memorial Hospital

Data Element Data Sour ce

Formula Harris Memo

rial Hospit

al

Easts ide

Medic al

Cente r

U.S. Medi

an

Overview Return on equity Audit Excess of revenue over

expenses/net assets 9.0 9.0 5.6

Financial Strength Index®

Audit [Total margin – 4%/4%] [days cash on hand – 120/120] [50% – debt financing %/50%] [9 – average age of plant/9]

1.4 0.1 –1.0

Total margin Audit Excess of revenues over expenses/ operatingrevenue nonoperating gains

7.0 6.9 1.9

Market factors Inpatient revenue %

Publi c

Gross inpatient revenue/gross patient revenue

30.5 61.9 54.0

Surgical cases %

Publi c

Medicare surgical discharges/Medicare total discharges

35.6 38.3 23.3

Market share % Publi c

Net patient revenue/ sum of net patient revenue in county

87.0 57.8 32.6

Medicaid days %**

Publi c

Medicaid patient days/ total patient days

23.2 12.4 14.7

Medicare days %**

Publi c

Medicare patient days/ total patient days

42.3 59.7 49.5

Revenue growth (last year) %

Audit (Operating revenue current year – operating revenue prior year)/operating revenue prior year

6.5 10.5 4.6

Pricing Average charge perMedicare discharge (CMI = 1.0)*

Publi c

All Medicare inpatient charges/(number ofdischarges × CMI)

14,421 14,73414,977

Average charge per visit (RW = 1.0)*

Publi c

Average Medicare visit charge/average relative weight

192 223 239

Routine room rate*

Publi c

Average charge for routine care

816 627 781

Chest x-ray (71020)*

Publi c

Average charge for chest x-ray

226 245 202

Coding factors Change in Medicare CMI %

Publi c

Percentage change in Medicare case mix index (2 years)

–1.9 –2.6 2.2

Medicare CMI Publi c

Measure of the costliness of cases treated bya hospital relative to the national average of all Medicare hospital cases, using DRG weights as a measure of relative costliness of cases

1.7644 1.74391.3727

CC/MCC capture rate (2008)

Publi c

The number of Medicare cases in MS- DRGs with a CC or MCC designation divided bythe total Medicare cases (2008)

0.5 0.5 0.5

Injectable drug without administration %

Publi c

Claim chosen if pharmaceutical item requiring injection or infusion present without the administration procedure

24.1 8.1 14.4

Contract negotiation Nongovernment payers %

Publi c

Percent of revenue from sources other than Medicare or Medicaid

34.4 27.9 33.1

Markup (charges/cost)

Publi c

(Gross patient revenue other operatingrevenue)/total operating expenses

2.9 2.9 2.6

Deduction % Publi c

Contractual allowances/gross patient revenue

60.7 67.5 61.7

Cost position

Hospital Cost Index®

Publi c

[(Average cost per Medicare discharge/ U.S. Median) × IP revenue %] [(average costper visit/U.S. median) × OP revenue %]

117.4 78.9 100.9

Average cost per Medicare discharge (CMI = 1.0)*

Publi c

Medicare inpatient costs/(Medicare discharges × CMI)

5,603 5,054 5,504

Average cost per visit (RW = 1.0)*

Publi c

Average Medicare visit costs/average relative weight

82 40 66

Labor costs Net patient revenue per FTE*

Publi c

Net patient revenue/ FTEs

179,127106,963119,924

FTEs per adjusted patient day

Publi c

FTEs/(adjusted patient days/365)

4.1 6.7 4.8

Salary per FTE* Publi c

Salaries/FTEs 67,933 44,38746,175

Departmental cost Direct cost per routine day*

Publi c

Direct routine costs/ routine patient days

299 263 311

Direct cost per ICU/CCU day*

Publi c

Direct ICU and CCU costs/ICU and CCU patient days

573 740 693

Overhead cost %

Publi c

Overhead expenses/ total expenses

25.0 21.0 32.0

Capital related costs per adjusted patient day*

Publi c

Old and new capital- related costs/adjusted patient days

132.0 133.0 102.0

Supply and drug cost MS-DRG 247 supply cost

Publi c

Perc cardiovasc proc w drug-eluting stent w/o MCC

3,676 6,878 5,141

MS-DRG 470 supply cost

Publi c

Major joint replacement or reattachment of lower extremity w/o MCC

4,696 6,912 5,989

MS-DRG 194 pharmacy cost

Publi c

Simple pneumonia and pleurisy w CC

1,138 728 795

MS-DRG 603 pharmacy cost

Publi c

Cellulitis w/o MCC 993 745 691

Service intensity Medicare length ofstay (CMI = 1.0)

Publi c

Medicare inpatient days/(Medicare discharges × CMI)

2.7 2.5 3.5

Ancillary cost per Medicare discharge (CMI = 1.0)

Publi c

Medicare ancillary costs/(Medicare discharges × CMI)

3,981 3,787 3,007

Nonoperating income Days cash on hand

Audit (Cash and cash equivalents long-term investments)/((total expenses – depreciation)/365)

219 29 33

Investment income/ investment %

Audit Investment income/ total investments

5.9 0.0 1.9

Portfolio in equities %

Audit Equity investments/ total investments

58.7 n/a 50.0

Investment efficiency Days in A/R Audit Net accounts

receivable/(net patient revenue/365)

Inventory/net patient revenue %

Audit Inventory/net patient revenue

0.9 2.9 1.9

Revenue/net fixed assets

Audit Operating revenue/net fixed assets

1.52 1.87 2.45

Plant obsolescence Average age of plant

Audit Accumulated depreciation/ depreciation expense

11.1 10.7 9.3

2-yr change in net fixed assets

Audit (Net fixed assets – net fixed assets(2 yr prior))/net fixed assets (2 yr prior)

37.2 44.6 5.0

Capital position Long term debt/ equity %

Audit Long-term debt/net assets

72.1 37.8 31.2

Average cost of equity %

Publi c

Risk-free rate on U.S. government obligations estimated beta of firm × market risk premium

9.1 7.8 7.6

CMI, case-mix index; MCC, major complication and comorbidity. *Wage index adjusted metric to remove differences in cost of living **Medicaid and Medicare Days % include government-sponsored health maintenance organization (HMO) days

Dashboard: Overall Performance Three measures of overall performance are identified in Table 11–1:

• •Return on equity (ROE) • •Financial Strength Index® (FSI) • •Total margin (TM)

For all three of these measures, larger values are desirable. A quick review of the data in Table 11–1 reveals a strong position for Harris when compared with U.S. medians. There may be some financial and operating issues that need to be addressed if Harris is to continue as a financially strong healthcare provider. Before we discuss these measures, we define them and compute values for 20X7:

Debt financing % Audit (Total assets – net assets)/total assets

47.5 31.6 47.1

Cash flow to total debt %

Audit (Net income depreciation)/total liability

17.1 29.6 10.5

Debt service coverage

Audit (Net income depreciation interest)/ (principal payment interest)

6.9 n/a n/a

Harris’s value for ROE is 9.0%, which indicates that the firm has a positive bottom line. A review of the data in Appendix 9–A shows that Harris has reported sizable balances of both operating and nonoperating income in 20X7 and 20X6. total margin measures the return on revenue from both operating and nonoperating sources. Harris is realizing positive returns in both areas, but nonoperating returns in 20X7 were lower than those in 20X6. The final overall measure is the Financial strength index. This index attempts to measure the four areas of financial position that collectively determine a firm’s financial strength:

• •Profits––measured by total margin (normalized average target: 4%)

• •Liquidity––measured by days cash on hand (normalized average target: 120 days)

• •Debt expense––measured by debt financing percent (normalized average target: 50%)

• •Age of physical facilities––measured by average age of plant (normalized average target: 9 years)

Simply stated, firms that have high profits, lots of cash, little debt, and new plants have great financial strength. Firms with losses, little cash, lots of debt, and old physical facilities will not be in business long. Each of the four measures is “normalized” around a predefined average for the measure. This permits us to add the four measures to create a composite indicator of total financial strength. Harris has a very strong overall Financial Strength Index due primarily to its favorable total margin position and its strong cash position. Harris’s strong cash position is also a factor that impacts total margin. In 20X7 nearly 50% of Harris’s total net income was derived from investment income. Debt levels at Harris are also below normative values, which further enhances its overall financial strength. A critical objective for Harris in coming years will be to maintain its current financial position. We now focus our attention on reviewing the 13 critical drivers of performance listed earlier to identify possible areas of opportunity for Harris. Market Factors Many factors influence the financial performance of a healthcare provider, as Figure 11–2 shows. Market factors play an important role in the final financial performance of any business. Six measures of market factors are identified in Table 11–1:

• 1.Inpatient revenue • 2.Surgical cases • 3.Market share • 4.Medicaid days • 5.Medicare days • 6.Revenue growth

Inpatient revenue at Harris is only 30.5% compared with 61.9% at Eastside and 54.0% nationwide. In most situations a higher percentage of inpatient revenue is desirable because profit margins are usually higher on inpatient product lines. For example, many U.S. hospitals make positive margins on Medicare inpatients, but most hospitals lose money on Medicare outpatients.

Harris does a lot of surgery compared with U.S. averages but less than Eastside does. Usually, surgical inpa-tient cases are more profitable than are medical cases. Market share is perhaps the most critical measure of performance in the market factor category. High market share often leads to higher realized prices and lower cost per unit. If a healthcare provider had no competitors and operated as a monopoly, it could conceivably dictate price to all payer groups except Medicare and Medicaid. The market share position of Harris is higher than that of Eastside. Harris enjoys greater market share, which may give it a better contract negotiation position. Because this market is dominated by only two providers, both hospitals should be able to demand and receive favorable contract terms because neither hospital has the capacity to service the entire market. In addition to the ability to negotiate more favorable reimbursement terms, higher market share also can provide significant improvements in profits because of lower cost per unit. Greater volume spreads fixed costs among more patients. Medicare and Medicaid percentages provide an indication of payer- segment importance. Usually, Medicaid is perceived as a less desirable payer, whereas Medicare in many hospitals is a desirable payer, especially for acute inpatient care. Harris appears to have an unfavorable relationship here. It has much higher Medicaid volume compared with its competitor and U.S. averages, whereas it has lower percentages of Medicare. Harris’s geographical location has placed it closer to the Medicaid population than its primary competitor. Losses on Medicaid patients are substantial and, when combined with Medicare losses, create a need for higher payments from the limited private-payer base. Revenue growth at Harris is above U.S. averages but below Eastside. This is most likely a result of Harris’s greater growth in Medicaid volume. Although revenue growth is desirable, revenue growth in profitable product lines is critical. Harris has experienced growth in some less profitable lines such as Medicaid, and this can hurt overall profitability. Conclusions reached from our review of market factors are as follows:

• •Harris must concentrate growth strategies in product lines that are profitable, especially inpatient surgical areas.

• •If market share enhancement is not feasible, cost cutting must be pursued or unprofitable product lines must be eliminated.

• •Reduced reliance on Medicaid business is desirable. Pricing Factors Pricing can still have a sizable influence on a health-care firm’s profitability, even considering that many payers have fixed-fee reimbursement schedules. Of concern to many is the price elasticity of healthcare services. In simple terms, will volume drop if I raise prices? This is a difficult question to answer, but in many cases price elasticity is believed to be negligible for many healthcare services. If a healthcare firm’s prices are lower than its competitors’, the issue of price elasticity becomes less important. The first objective is therefore to determine whether your prices are above or below your competitors’. The four pricing measures are all developed from public data sets and are presented in Table 11–1. The data show that Harris has prices below its competitor’s––with the exception of room rates. Average charge per Medicare discharge (case-mix index = 1.0) defines the average price for a Medicare discharge with a case-mix weight of 1.0. Table 11–2 provides a simple example to illustrate how this measure is developed. Adjusting charges or cost to a case weight of 1.0 permits meaningful comparisons across firms. Table 11–1 also indicates that this measure for the U.S. median is stated in the hospital’s wage index of 0.8304. This removes potential cost-of-living issues that might impair comparability. Charges for a specific discharge or an outpatient encounter are the product of two factors:

Table 11-2 Illustration of Case-Mix Weighting

DRG Cas e

Weig ht

No. of

Cas es

Aggreg ate

Case Weight

Total Char ges

1 0.80 10 8.00 $64,000 2 1.20 10 12.00 96,000 3 1.60 10 16.00 128,000

30 36.00 $288,000

Average Charge per Case

=

$288,000

30

=

$9,600

Average Charge per Case (case-mix index = 1.0)

=

$288,000

36

=

$8,000

• •Intensity of service • •Charges for specific procedures

(Cleverley 243-254) Cleverley, William O. Essentials of Health Care Finance, 7th Edition. Jones & Bartlett Learning, 20101022. VitalBook file.

Chapter 12 Financial Analysis of Alternative Healthcare Firms LEARNING OBJECTIVES After studying this chapter, you should be able to do the following:

• 1.List some of the major nonhospital and nonphysician sectors of the healthcare industry.

• 2.Discuss the sources of revenue for the nursing home industry.

Average Case Weight =

36

30

=

1.2

• 3.Discuss the major sources of revenue and expenses of medical groups.

• 4.List and describe the major organizational types of physician groups.

• 5.Describe alternative health maintenance organization arrangements.

REAL-WORLD SCENARIO Laura Rose has been recently appointed to the Board of ElderCare, a large, for-profit operator of skilled nursing facilities (SNFs) around the country. Laura’s first committee assignment is to the Treasury Committee because of her prior business experience. Although Laura had extensive experience as a hospital administrator, she had relatively little familiarity with the SNF industry. Upon reviewing ElderCare’s recent financial statements, she was concerned about the dramatically declining financial position. She noticed that revenues were declining on per facility and per patient bases. Meanwhile, the company’s debt had been downgraded, and its borrowing costs had risen substantially. She is aware that Medicare implemented a SNF prospective payment system as part of the Balanced Budget Act of 1997. Payment increases by Medicare and Medicaid have not kept pace with increases in costs in recent years. She wonders whether this might be a factor in the company’s financing issues. In general, profitability in the long-term care industry has declined significantly in recent years, and several industry leaders had filed for bankruptcy protection. Although some believe that SNF prospective payment systems were largely to blame, other factors, such as ill-advised acquisitions, excessive long-term debt, and poor balance sheets, probably contributed as well. In essence, she is unsure whether ElderCare’s financing difficulties are unique to management issues at ElderCare or whether they reflect more general market conditions and economic and reimbursement trends.

To understand the issue better, Laura needs to estimate the direct financial impact of SNF reimbursement. She asked the ElderCare

treasury and controller’s office staff to prepare an analysis of the financial performance of selected long-term care facilities over the period 2006 to 2010. In particular, she wants to know how SNF-bond ratings have been affected by prospective payment systems and what other factors might have contributed to the industry’s deteriorating financial performance. In Chapter 11 we discussed the measures and concepts of financial analysis in some detail, but most of the examples and industry standards were from the hospital sector. The hospital industry is by far the largest sector in the healthcare industry, but it is not the only sector; its rate of growth in recent years has been slower than in other areas. This chapter provides some additional information about alternative health-care firms. LEARNING OBJECTIVE 1 List some of the major nonhospital and non-physician sectors of the healthcare industry. First, we discuss the financial characteristics of the following three specific alternative sectors:

• 1.Nursing homes • 2.Medical groups • 3.Health plans

It is impossible to describe all the specific operating characteristics for these three sectors in one chapter, but we highlight the important differences that affect financial measures. It is important to remember that the financial measures and concepts discussed in Chapter 11 are still applicable. For example, the concept and measurement of liquidity are the same for a hospital as they are for a health plan. However, operating differences between health plans and hospitals produce different values and standards. Health plans have much lower days in receivables than do hospitals and are required to carry much higher cash balances to meet transaction needs, namely claims payment. It is not just the higher relative growth rates of non-hospital sectors that cause us to separately examine the topic of financial analysis for alternative health-care firms. Many of the alternative healthcare firms have been consolidating through both horizontal and vertical mergers

and have now become major corporations in our nation’s economy. For example, UnitedHealth Group, Aetna, and Wellpoint are among the largest corporations in the country, employing large numbers of people and absorbing significant amounts of capital to finance their continued growth. Much financial analysis and discussion are now devoted to these firms because of their almost continuous needs for financing. Major brokerage houses now have analysts who devote their time to narrow sectors of the healthcare industry, such as home health firms or medical groups. Table 12–1 presents 2008 financial ratio medians for two of the three sectors, along with comparative values for the investor-owned hospital-industry sector. We calculated ratio averages by computing the ratio average for three large publicly traded firms in each industrial group. Table 12–2 shows the composition for each of the three groups.

Table 12-1 Financial Ratio Medians, 2008 Nursing Homes

Health Insurers

Investor- Owned ospitals

Liquidity Current 1.41 0.74 1.50 Days in receivables 56.65 16.60 52.04 Days-cash-on-hand 35.21 146.92 14.67 Capital structure Debt financing percentage 62.81 65.22 81.79 Long-term debt to capital 42.72 30.95 73.74 Cash flow to debt percentage

11.39 9.00 9.57

Times interest earned 4.87 8.69 2.82 Activity