Can somebody help me with 17.3. i posted every thing the book has about ratio analysis. I did not understand how to answer the question.

wore this Image Sell some of the existing b. Assume that the company has a current of the above actions would improve this 17.2 Southwest Physicians, a medical group practic formed. It will need $2 million of total acts to in revenues. Furthermore, the group expects to ha of 5 percent. The group is considering two financial First, it can use all-equity financing by requiring each contribute his or her pro rata share. Alternatively, the finance up to 50 percent of its assets with a bankom that the debt alternative has no impact on the expected pole margin, what is the difference between the expected DE group finances with 50 percent debt versus the expected to finances entirely with equity capital? 17.3 Riverside Memorial's primary financial statements are presents exhibits 17.1, 17.2, and 17.3. Chapter 17: Financial Condition Analy are Rints Calculate Riverside's financial ratios for 2014. Assume that Riverside had $1,000,000 in lease payments and $1,400,000 in debt principal repayments in 2014. (Hint: Use the book discussion to identify the applicable ratios.) b. Interpret the ratios. Use both trend and comparative analyses For the comparative analysis, assume that the industry average data presented in the book are valid for both 2014 and 2015, 17.4 Consider the following financial statements for BestCare HMO, a. not-for-profit managed care plan: BestCare HMO Statement of Operations and Change in Net Assets, Year Ended June 30, 2015 (in thousands) Revenue: Premiums earned Coinsurance 242 Interest and other income $28,613 $26,682 1,689 000 - 55,735000 in cash to pay open short term dct, and capital case obtions e d from operating activities: 5647 Meron 1.139 Statement of D en accounts receivable sin inventories in accounts payable in accrued expenses cash flow from operations 6953 (438) 229 $9.098 Year Ended December 31, 2015 thousands Cashflows from investing activities: bestment in property and equipment ement in short-term securities cash flow from investing 15 4.293) 2,000) 56,293 5 2,098 (2.150) (3.262) Cash flows from financing activities: Booperating income payment of long-term debt payment of notes payable Capital lease principal repayment et cash flow from financing 15 3.637 S 832) se decrease in cash and equivalents 3.095 wiring cash and equivalents $ 2,263 ong cash and equivalents hcare Finance 2015 $ 106,502 3.328 Revenues: Patient service revenue Less: Provision for bad debts Net patient service revenue Premium revenue Other revenue Net operating revenues $103.174 2 5.232 3,644 $ 112,050 $56.79 Expenses: Nursing services Dietary services General services Administrative services Employee health and welfare Malpractice insurance Depreciation Interest expense Total expenses Operating income Nonoperating income $ 58,285 5.424 13,198 11,427 10,250 1,320 4.130 1,542 $ 105.576 $ 6,474 2,098 4.14 11.65 11.585 10.705 1,204 4,025 $102.16 1.99 Net income $ 8,572 Profitability Ratios Profitability is the net result of a large number of managerial pob sions, so profitability ratios provide one measure of the above performance of a business. Serial policies and des aggregate financi 2015 WIBIT 17 5 and equivalents 2.26) 4.000 21,840 accounts receivable 3.98 December 2015 and current assets $ 31,280 $145.158 25,160 $119.998 5283 Sigorts a property and equipment ted depreciation property and equipment 21.030 $119.835 $ 151,278 $148,650 payable and expenses payable current liabilities en debt $ 4.707 5,650 2.975 $ 13,332 $ 28.750 1,832 $ 30,582 $ 107,364 $ 5,145 5.421 6,237 $ 16,803 $ 30,900 2.155 $ 33,055 $ 98.792 lease obligations la long-term liabilities sets equity) abilities and net assets 5148,650 $ 151,278 ization to generate to delse the same, the so to revenues. Rave 5 percent, indicating aware also reports It meaning that 25 p o generate revenues from all sources and to control expenses same, the higher the total margin, the lower the expenses Riverside's total margin is well above the industry average dicating good expense control. How good the orts quartiles; for total margin, the upper quartile 25 percent of hospitals had total margins higher than uns better than average, it was Net income 2,098 $ 8,572 Melasse srial policies of the aggregate Profitability Ratios Profitability is the net result of a large number of managerial pol Profitability ratiossions, so profitability ratios provide one measure of the a A group of ratios performance of a business. that measure different dimensions of Total Margin a business's profitability. The total marrin, often called the total profit margin or just profit is net income divided by all revenues, including both operating revenu nonoperating income: related 50 p data sou percent 34 per Total margin- Net income Total revenues Industry average = 5.0%. $8,572 $114,148 8 = 0.075 - 7.5% chapter baba busine should Note that total revenues are defined as net operating revenues par nonoperating income, so Total revenues - $112,050 + $2,098 - $114,14. Riverside's total margin of 7.5 percent shows that the hospital makes cents on each dollar of revenue. The total margin measures the abiny my the they of managerial policies easure of the area to generate te the total mare the same, else the from all sources and to com er the total margin, the lower the expenses e ide's total margin is well above the industry ating good expense control. How good? The industry rts quartiles, for total margin, the upper quartile was 4 25 percent of hospitals had total margins higher than gh Riverside's total margin was better than average, it was et margin or just profit ng both operating tevens revenues Riverside 30 percent, indicatin are also reports gu meaning that 25 percent. Although R a good as the 8,572 14,148 -0.075 - 75% Although industry avera ter, it should dural businesses should strive good as the top 25 percent of hospitals. h industry average figures are discussed in detail later in the hould be noted here that the industry average is not a magic number esses should strive to achieve. Some well-managed businesses will the average, while other good firms will be below it. However, if a a's ratios are far removed from the average for the industry, its managers the concerned about why this difference occurs. Note also that according andard practice, we are calling the comparative data averages, but in real they are median values. Median values are better for comparisons because heart not biased by extremely high or low values in the industry data set net operating revenues plus 2,050 + $2,098 = $114,148 that the hospital makes 75 in measures the ability of the Riverside's relatively high total margin could mean that the him charges are relatively high, its costs are relatively low, it has relatively nonoperating revenue, or a combination of these factors ar play ough operating indicator analysis would help pinpoint the cause of of Riverside's high total margin Return on Ed Operating Margin Another useful margin ratio is the operating margin, which is defined as per ating income divided by patient-related (operating) revenues: Operating margin- Operating income Net operating revenues Industry average - 3.5%. $6,474 $112,050 -0.058 -55% average Lar of ed is espec NGHIT capital Rivers avera the The advantage of operating margin is that it focuses on core business activities and hence removes the influence of financial gains and losses, which are unrelated to operations and often are transitory. Riverside's total margin was 7.5 percent, while its operating margin was only 5.8 percent, compared to the industry average of 3.5 percent. Removing nonoperating income pe marily unrestricted contributions and investment returns) lowers profitability, but Riverside's core operations are more profitable than the industry average which is good news. Note, though, that the format of many healthcare orga nizations' financial statements makes this ratio difficult to determine without additional information. Furthermore, the definition of operating margin varies depending on data availability. hos: depending on data availability Return on Assets The ratio of net income to total acts measures the just called N N (ROA): Return on assets Net income Total assets Industry average = 4.8% $8,572 S151,2780057-5 Riverside's 5.7 percent ROA, which means that each generated 5.7 cents in profit, is well above the 4.8 percent hospital industry. ROA tells managers how productively in a a business is using its assets. The higher the ROA, the greater the for each dollar invested in assets and hence the more producten ROA measures both a business's ability to control expenses a. the total margin, and its ability to use its assets to generate d help pinpoint the cause, These factors act income to total equity net measures the Return on Equity The ratio of net incom (ROE): margin, which is defined operating) revenues: Net income Return on equity = Total equity Industry average = 8.4%. $8,572 S107,364 0.080 -8.0% $6,474 ues $112,050 -0.058. is that it focuses on core buito of financial gains and losses, whic ansitory. Riverside's total marge Riverside's 8.0 percent ROE is slightly below the 8.4 percent industry average. The hospital was able to generate 8.0 cents of income for cach dol- lar of equity investment, while the average hospital produced 8.4 cents. ROE is especially meaningful for investor-owned businesses because owners are concerned with how well the business's managers are using owner supplied capital, and ROE answers this question. For not-for-profit businesses such as Riverside, ROE tells its board of trustees and managers how well, in financial ferme, its community-supplied capital is being used. Riverside's 2015 margin measures and ROA were above the industry averages, yet the hospital's ROE is below the average. As we explain later in the section on Du Pont analysis, this seeming inconsistency is a result of the hospital's low use of debt financing. was only 5.8 percent, compare ving nonoperating income per sent returns) lowers profitabin, itable than the industry averag, ormat of many healthcare org difficult to determine without tion of operating margin and Liquidity Ratios One of the first concerns of most managers, and the major concern of a firm's creditors, is the business's liquidity. Will the business be able to meet its cash obligations as they come due? Liquidity ratios are designed to answer that question. Riverside has debts totaling more than 513 million (ie, its current end off within the coming year. Will the hospital Will the business be able to meet Liquidity ratios are designed to debes totaling more than 513 million current ust be paid off within the coming year. Will the hospital be the of business to camentsA full liquidity analysis requires the use of a meetis cash discussed in Chapter 10. However, by relating the amount ins the or current assets to current obligations, ratio analysis provides come due and other -use, rough measure of liquidity. Ratio man is calculated by dividing current assets by current liabilities: Current assets $31,280 = 2.3, or 2.3 times. Current ratio * Current liabilities $13,332 th dollar of average for a financial the net income active the Industry average = 2.0. as expressed by evenue The current ratio tells managers that the immediate liquidation of Rev. made's current assets at book value would provide $2.30 of cash for every would be $1 of current liabilities. If a business is getting into financial diffic begin paying its accounts payable more slowly, building up short loans (notes payable), and so on. If these current liabilities rise for current assets, the current ratio will fall, and this could spell trol the current ratio is an indicator of the extent to which short-term da gations are covered by assets that are expected to be converted to che near term, it is a commonly used measure of liquidity. Riverside's current ratio is slightly above the average for the ho industry. Because current assets should be converted to cash in the near futu it is highly probable that these assets could be liquidated at close to the stated values. With a current ratio of 2.3, the hospital could liquidate cu assets at only 43 percent of book value and still pay off current credit full. (To determine the minimum proportion of current assets that much converted to cash to meet current obligations, divide the number 1 byte current ratio. For Bayside, 1 + 2.3 -0.43, or 43 percent. This proportions confirmed by noting that 0.43 x $31,280,000 - $13,332,000, the amoun of current liabilities.) Days Cash on Hand The current ratio measures liquidity on the basis of balance sheet account and hence is a static measure of liquidity. However, the true measure of 1 vediny. However, the true Days Cash on Hand The current ratio measures liquidity on the h e is a static measure of liquidity How i 's Inquidity is whether it can meet its pay quidity is more related to cash inflows and liabilities. The dawcb- band rate moves closer determine liquidity Cash and equivalents Short-term Days cash on hand (Expenses - Depreciation)/365 $2.263. $4,000 $6,263 (5105,576 - $4,130) / 365 $27791 Industry average = 30.6 days. Indus Fort The denominator of the equation estimates average daily by stripping out noncash expenses (depreciation) from reported and then dividing by 365, the number of days in a year. The num cash and securities that are available to make those cash payme Riverside's days cash on hand is lower than the industry average, position as measured by days cash on hand is worse than that of the hospital. For Riverside, the two measures of liquidity, current ratio and danca on hand, give conflicting results. Perhaps the average hospital hasi proportion of cash and equivalents and short-term investments in the the balar et defir Creo the cushio ton. Con Chapter in and this cold well to which to cted to be convert financial condition analvais oual i than de portable judem ther, that the of liquidity. above the average for the verted to cathin the uld be liquidated at the he hospital could at undees Riverside. More analysis would be required be adement concerning Riverside's liquidity position. Remember that the cash budget, which we discussed in Chapter 16, is the primary used by managers to ensure liquidity "hted to see d still pay off current on of current acts that ons, divide the number Debt Management (Capital Structure) Ratios The extent to which an organization uses debt financing, or financial lever an important measure of financial performance for several reasons. First, by maling funds through debt, owners of for profit businesses can maintain control with a limited investment. For not-for-profit organizations, debt financing allows mare services to be provided than if the organization were solely financed with contributions and earnings. Next, creditors look to equity capital to provide margin of safety, if the owners (or community) have provided only a small proportion of total financing, the risks of the enterprise are borne mainly by is creditors. Finally, if a business carns more on investments financed with borrowed funds than it pays in percentage interest, its ROE is increased Debt management ratios fall into two categories: or 43 percent. This proper 200 - $13,332,000, the me Debt ratios A grou that thee abu- fina 1. Capitalization ratios. These ratios use balance sheet data to determine the extent to which borrowed funds have been used to finance assets. 2. Coverage ratios. Here, income statement data are used to determine the extent to which fixed financial charges are covered by reported basis of balance sheet mus wever, the true measure di ayments as they come des cal profits. utflows than it is to a to those factors thao The two sets of ratios are complementary, so most financial statement Livered try reported es are complementary, vestments most financial state 365 56,205 The Most of rati cane roth the 527793 atlo 1. Total Debt to Total Assets (Debt Ratio) total assets (total liabilities and equity), called the the percentage of total capital provided by creditors liation Ratio 22.5 of total debt to total measures the Debt ratio Total debt Total assets $43,914 S151,278 0.290, or 29.07% daily cash esperes wted total expenses ae numerater in the 42.3% Industry average ayments. Because lulitics. In essence, deb erage, its liquidi at of the average ratio, debt typically is defined as all debt, including current essence, debt is defined here as everything on the capital side lance sheet except equity. However, as illustrated by the next ratio nitalization ratios have several variations, many of which use dif rent definitions of what constitutes debt. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors' losses in the event of bankruptcy and liquida Conversely, owners of for-profit firms may seek high leverage either to tio and days case tal has a greater is in its current capitals permar Cover: leverage up returns or because selling new stock would degree of control. In not-for-profit organizations, manag leverage to offer more services. Riverside's debt ratio is 29.0 percent. This means that is supplied somewhat less than one-third of the business's total another way, each dollar of assets was financed with 29 cents consequently, 71 cents of equity. The c ity is defined as I so Riverside's equity ratio is 71 percent.) Because the average det hospital industry is more than 40 percent, Riverside uses significantly than the average hospital. The low debt ratio indicates that the hospic find it relatively easy to borrow additional funds, presumably at favorite Note that the debt-to-equity ratio, defined as Total debt Total is a close relative of the debt ratio. These ratios are transformation another and provide the same information but with a different with the debt ratio and debt-to-equity ratio increase as a business uses proportion of debt financing, but the debt ratio rises linearly and approude a limit of 100 percent, while the debt-to-equity ratio rises at a faster approaches infinity. Lenders, in particular, prefer to use the debt-too ratio rather than the debt ratio because it tells them how much capital cod The inter beca inte EB tors have provided to the organization per dollar of equity capital. The hig this ratio, the riskier the creditors' position. Other analysts tend to prefer this debt ratio because it makes it easier to visualize the liabilities and equity ma on the balance sheet. los Tin Other analysis att cause it makes it easier to Visualize the on the balance sheet del Capitalization Ratio 2: Debt-to-Capitalization Ratio The debt-to-capitalisation ratio, which is long term debita capital (long-term debt plus equity), focuses on the proper in a business's permanent (long-term) capital structure. This the long-term Webt-to-capitalisation ratio or just capitalisan that we have included capital lease obligations in our definitie debt because such obligations are similar in nature to long term proportion talisation dcfatica Debt-to-capitalization ratio Long-term debt Long-term debt + Equity $30,582 $30,582 + S107,364 0.222.o 22.2% Industry average = 34.6%. Many analysts believe that the debt-to-capitalization ratio best relem the capital structure of a business. This belief is based on the fact that businesses use as much spontaneous free credit (current liabilities less shortum bank loans) as they can get. Furthermore, short-term interest-bearing, der typically is used only to fund temporary current asset needs. Thus, the me manager ca This means that e business's total ced with 29 cents of an a tio is defined as se the average det al structure of at reflected by Riverside's debt-to-cap industry average of 346 ratio that focuses on permanent l's debt-to-capitalization is 222 of 34.6 percent. This low use of debet ent capital mix confirms the conclusion made a t the the permanent capita has unused debt capacity. side uses significant dicates that the ho presumably at favo as Total debt - Total s are transformations with a different t as a business USC Coverage Ratio 1: Times Interest Earned Ratio interest earned (TIE) ratio is determined by dividing car e stand taxes (EBIT) by interest charges. EBIT is used in the because it represents the amount of accounting income that is walkie top interest expense. For a not-for-profit organization, which does not ERIT - Net income + Interest expense, whereas for a for-profit ERIT - Net income + Interest expense Taxes. Riverside's TIE bois 6.6 o ises linearly and are atio rises at a faster at $8,572 +$1,542 S1,542 510,114.66. $1,542 EBIT Interest expense Industry average =4.0. - to use the debt-to- m how much capital equity capital. The high analysts tend to probert - liabilities and equins The TIE ratio measures the number of dollars of accounting income (as opposed to cash flow) available to pay cach dollar of interest expense. In essence, it is an indicator of the extent to which income can decline before it is less than annual interest costs. Failure to pay interest can bring legal action by the firm's creditors, possibly resulting in bankruptcy in m nd 6.6 times, so it has 56.60 of accounting Listy werage TIE w Other analysts tendo of equity capital alize the liabilities and EBIT Interesten y average - 4.0. tion Ratio ong-term debt divided by es on the proportion of the al structure. This tattoo er just capitalization as ns in our definition of long the do w available to pay cadh dollar or of the extent to which income and Acest costs. Failure to pay interest can bringe The TIE as e d to cash flow it is an indicar re than annual interes w the fim's free Riverside's interest come to pay cach doll mature to long-term debe is four times, the hospital is cwering it high margin of safety: 77 used on the ald easily expand its use of debt fin um debt ebt + Equity th r editors, possibly resulting in bank crest is covered 6.6 times, so it has 56.60 of Sh dollar of interest expense. Because the industry ospital is cowering its interest charges by archive Thus, the TIE ratio reinforces the previous conclusions chat-to-capitalization ratiosnamely, that the hospital the debt and debt-to-capitalization ratio and its use of debt financing tos are often better measures of a firm's debu ratios because coverage ratios discriminate between low me hinterest rate debt. For example, a medical group rastice miche million of 4 percent debt on its balance sheet, while another might million of 8 percent debt. If both practices have the same income and both would have the same debt ratio. However, the group that pays 4 trent interest would have lower interest charges and hence would be in bet- ter financial condition than the group that pays 8 percent. This difference in capitalization ratios debe and high-interest rate have $10 million of 4 luve $10 million 7,364 -0.222 or 22 financial condition is captured by the TIE ratio. italization ratio best relles based on the fact that rent liabilities less shortcom term interest-bearing det Coverage Ratio 2: Cash Flow Coverage Ratio Although the TIE ratio is easy to calculate, it has three major deficiencies. First, leasing is a common form of financing, and the TIE ratio ignores lease et needs. Thus, the "true" MUT Finance and Asse o the payments, which, like debt payments, are contractual obl many debt contracts require that principal payments be made the loan, rather than only at maturity. Thus, most organizations fixed financial charges associated with debt financing besides ments. Finally, the TIE ratio ignores the fact that accounting income measured by EBIT or net income, does not reflect the actual cash able to meet a business's fixed payments. These deficiencies are com the cash flow coverage (CFC) ratio, which shows the amount by flow covers fixed financial requirements. Here is Riverside's 2015 assuming the hospital had $1,368,000 of lease payments and $2.000 required debt principal repayments: Note $112. unces CFC ratio = EBIT +Lease payments + Depreciation expense Interest expense + Lease payments + Debt principal/l-1 $10,114 +$1,368 + $4,130 515,6122 $1,542 +$1,368 +$2,000/(1-0) S4,910 Industry average = 2.3. sted avera as pr indu Like its TIE ratio, Riverside's CFC ratio exceeds the industry standard sho al fixaduments with 51.542 + 1,368 52.000/(1-0) 0 $15.612 54,910 Industry average = 2.3. class! should be rewaring both Riverside base fixed asset til Before conder be punted on ser ratio for com plance sheet reflex and depreciation has pot to be seriously Like its TIE ratio, Riverside's CFC ratio en indicating that Riverside is better at covering total fine flow than is the average hospital. This fact should be re tors and to management as it reinforces the view that the debt capacity You may be wondering why there is a (1 - 1) term debt principal. The reason is that investor owned firms mus repayments with after-tax dollars and hence must earn more to both pay taxes and make the principal repayment. The Arred which results from dividing by 1 - 7 gives the amount of preta are needed to cover the required principal repayments. Thus, the which contains pretax dollars in the numerator, now has pretax della denominator and hence is consistent in format - Topp more poeta The gred much of its planta the same physical of fixed assets, we fuedase umove with inflation thar Total Asset Turn: The foal auf business's assets Toto Asser management ratios Financial statement analysis ratios that measure how effectively a firm is managing its assets. Asset Management (Activity) Ratios The next group of ratios, the asset management ratios, is designed to a sure how effectively a business's assets are being utilized. These rates answer whether the amount of each type of asset reported on the blue sheet seems reasonable, too high, or too low in view of current for projecte operating levels. Riverside and other hospitals must borrow or raison capital to acquire assets. If they have too many assets for the volume of vices provided, their capital costs will be too high and their profits will be depressed. Conversely, if the level of assets is too low, volume may be vital services not offered. gain, note Tenues Each lg beses accounting, strellect the actual cash These deficiencies at shows the amount by ed Asset Turnover Ratio Theo es the wization alues fonet rata, also called the of property and equipment and to net fixed assets (property and equipment ere is Riverside's 2015 ase payments and 52.55 Fixed asset turnover - Total revenues Net fixed assets 114,148 $119.998 - 0.95 Industry average - 2.2 s + Depreciation expense ments + Debt principals Note that total $112,050 $2,098 0 $15,612 -0) $4.910 =32 xceeds the industry stante tal fixed payments with at total revenues include both operating and nonoperating revenues 50 - $2,098 - $114,148. Also, net fixed assets are listed on the bal e sheet as net property and equipment. Riverside's ratio of 0.95 indicates that each dollar of fixed assets gener 95 cents in total revenue. This value compares poorly with the industry raec of 2.2 times, indicating that Riverside is not using its fired productively as is the average hospital. (The lower-quartile value for the industry is 1.1; thus, Riverside falls in the bottom 25 percent of all hospitals in its fixed-asset utilization.) Before condemning Riverside's management for poor performance, it should be pointed out that a major problem arises from the use of the fixed tumover ratio for comparative purposes. Recall that most asset values listed on the balance sheet reflect historical costs rather than current market values. Inflation and depreciation have caused the values of many assets that were purchased in the past to be seriously understated. Therefore, if an old hospital that had acquired of its plant and equinment wears ago is compared to a new hospital with the same physical capacity, the old hospital, because of a much lower book value fixed assets, would report a much higher turnover ratio. This difference in of the inability of financial statements to deal be reassuring both to mi that Riverside has untap - 1) term applied firms must make pe ir pretur dolor For Your Consideration wir will probably huwele ures in the near future. On the (ACP) and day ons out the interpretation retis calculated previously example, on the two comparative data for th Hospital Financial and pe d ic lished annually by Op r ea of days that it takes theory, the denomine Without too much patient services retro e has not been include collected either before ot affect receivable Comparative and Trend Analyses When conducting financial ratio analysis, the alue of a particular ratio, in the absence of her information, reveals almost nothing acut a business's financial condition. For cumple, if it is known that a nursing home management company has a current ratio of Does it matter how the lead is the a cost to using more than necessary! Why 2.5, it is virtually imposible to say whether is the disadvantage of generating too much dat this is good or bad. Additional data are needed to help interpret the results of this ratio analy In the discussion of Riverside's financial rations, the focus was on comparative Trendan Analysis that is, the hospital's ratios were compared with the average ratios for A ratio technic the industry. Another useful ratio analysis tool is trend analysis, in which the trend of a single ratio is analyzed over time. Trend analysis gives dues about whether value over al situation is improving holding constant, or deteriorating tem analyses in a single graph it is dete examir ent accounts receivable of service revenue 165 S21,840 O 205 S282.67 hould be reasugb che view that Wivende total dhe cams that vende o g e hope de falls in the 25 per s is a ( -1) tem apps owned firms must make nice must earn more pretas cpayment. The groep ll; thus, tation) e condemning be pointed out the ao for com short reflect list depreciation have caused the obscriously unde each of its plant and e same physical capac of feed assets, would repor in Riverside's management per bata major problem are from the other ative purposes. Recall that matc hes istorical costs rather than current market ed the values of many acts that were purchased understated. Therefore, if an old hospital that had and equipment years ago is compared to a new how capacity, the old hospital, because of a much lower book would report a much higher turnover ratio. 'Tvis difference in is more reflective of the inability of financial statements to deal than of any inefficiency on the part of the new hospital's managers. the amount of prctas delas repayments. Thus, the code ator, now has pretax dollars in mat. with inflation than of any tutal Asset Turnover Ratio alat ter to measures the turnover, or utilization of all of a The total s's assets. It is calculated by dividing total (all) revenues by total assets. ment ratios, is designed to no cing utilized. These ratios heis asset reported on the balance view of current (or projected Total revenues Total asset turnover Total assets Industry average = 0.97. $114,148 $151,278 Is must borrow or raise cquit y assets for the volume of so high and their profits will be Again, note that total revenues include both operating and nonoperating fonues o low, volume may be lost or Each dollar of total assets generated 75 cents in total revenues. River total asset ratio is below the industry average, but not as far below as its R ROA 2012 2013 2014 2015 10.0 6.7 2.4 8.0 3.8 S percent RC which sh apstal to obt cakulated dir Tying the Financial Ratios Together: Du Por SON. How Du Ponto and financia ROE Financial ratio analysis provides a great deal of informatie financial condition, but it does not provide an overview, nor de ratios together. Du Pont analysis, so named because mar Company developed it, provides an overview of a business's final helps managers and investors understand the relationships the analysis decomposes return on equity, one of the most of a business's profitability, into the product of three other to has an important economic interpretation. The result is the Dee cause manage siness's found lationships among Du Pont analysis A financial statement analysis tool that decomposes return on equity into three components: profit margin, total asset turnover, and quity multiplier. Key Equ The D. into th The sure and ROE = Total margin x Total asset turnover x Equity multiple Net income Net income Total revenues Totales Total equity Total revenues Total assets Tocal equn par m: 2015 data are used to S 572 58.572 5114.16 107 364 5114,145 515127 80% = 7.5% X 0.75 2013 2014 nght side is niet ROE-ROA XE Du Pont equation, the product of the first return on assets (ROA), the equation can be Equity multiplier. Riverside's 2015 total manews be hospital made 7.5 cents profit on each dollar of total hermore, assets were turned over (or created revenues 0.75 so the hospital earned a return of 7.5% x 0.75 -5 on alue for ROA, when rounded, is the same as was calculated 2015 cent, so the hospital the year, so the hospital Carned a Return on Equity (ROE) Industry Quartile Median Upper Court -.6% 8.6% 8.6 13,3% 13.3 in our ratio analysis discussion If the hospital used only equity financing, its 5.6 percent ROA would equal its ROE. However, creditors supplied 29 percent of Riverside's capital while the equity holders (the community) supplied the rest. Because the 5.6 percent ROA belongs exclusively to the suppliers of equity capital, which comprises only 71 percent of total capital, Riverside's ROE is higher than its 5.6 percent ROA. Specifically, ROA must be multiplied by the equitywali plier, which shows the amount of assets working for each dollar of equity capital, to obtain the ROE of 8.0 percent. This 8.0 percent ROE could be calculated directly: ROE - Net income Total equity - 58,572 - S107,364 - 8.0%. However, the Du Pont equation shows how total margin, which ation; measures expense control total asset turnover, which measures at n and financial leverage, which measures debt wilisation, interact to determine ROE. 7.2 12.0 12.1 7.2 7.4 T ather. Du Pont Analysis wore this Image Sell some of the existing b. Assume that the company has a current of the above actions would improve this 17.2 Southwest Physicians, a medical group practic formed. It will need $2 million of total acts to in revenues. Furthermore, the group expects to ha of 5 percent. The group is considering two financial First, it can use all-equity financing by requiring each contribute his or her pro rata share. Alternatively, the finance up to 50 percent of its assets with a bankom that the debt alternative has no impact on the expected pole margin, what is the difference between the expected DE group finances with 50 percent debt versus the expected to finances entirely with equity capital? 17.3 Riverside Memorial's primary financial statements are presents exhibits 17.1, 17.2, and 17.3. Chapter 17: Financial Condition Analy are Rints Calculate Riverside's financial ratios for 2014. Assume that Riverside had $1,000,000 in lease payments and $1,400,000 in debt principal repayments in 2014. (Hint: Use the book discussion to identify the applicable ratios.) b. Interpret the ratios. Use both trend and comparative analyses For the comparative analysis, assume that the industry average data presented in the book are valid for both 2014 and 2015, 17.4 Consider the following financial statements for BestCare HMO, a. not-for-profit managed care plan: BestCare HMO Statement of Operations and Change in Net Assets, Year Ended June 30, 2015 (in thousands) Revenue: Premiums earned Coinsurance 242 Interest and other income $28,613 $26,682 1,689 000 - 55,735000 in cash to pay open short term dct, and capital case obtions e d from operating activities: 5647 Meron 1.139 Statement of D en accounts receivable sin inventories in accounts payable in accrued expenses cash flow from operations 6953 (438) 229 $9.098 Year Ended December 31, 2015 thousands Cashflows from investing activities: bestment in property and equipment ement in short-term securities cash flow from investing 15 4.293) 2,000) 56,293 5 2,098 (2.150) (3.262) Cash flows from financing activities: Booperating income payment of long-term debt payment of notes payable Capital lease principal repayment et cash flow from financing 15 3.637 S 832) se decrease in cash and equivalents 3.095 wiring cash and equivalents $ 2,263 ong cash and equivalents hcare Finance 2015 $ 106,502 3.328 Revenues: Patient service revenue Less: Provision for bad debts Net patient service revenue Premium revenue Other revenue Net operating revenues $103.174 2 5.232 3,644 $ 112,050 $56.79 Expenses: Nursing services Dietary services General services Administrative services Employee health and welfare Malpractice insurance Depreciation Interest expense Total expenses Operating income Nonoperating income $ 58,285 5.424 13,198 11,427 10,250 1,320 4.130 1,542 $ 105.576 $ 6,474 2,098 4.14 11.65 11.585 10.705 1,204 4,025 $102.16 1.99 Net income $ 8,572 Profitability Ratios Profitability is the net result of a large number of managerial pob sions, so profitability ratios provide one measure of the above performance of a business. Serial policies and des aggregate financi 2015 WIBIT 17 5 and equivalents 2.26) 4.000 21,840 accounts receivable 3.98 December 2015 and current assets $ 31,280 $145.158 25,160 $119.998 5283 Sigorts a property and equipment ted depreciation property and equipment 21.030 $119.835 $ 151,278 $148,650 payable and expenses payable current liabilities en debt $ 4.707 5,650 2.975 $ 13,332 $ 28.750 1,832 $ 30,582 $ 107,364 $ 5,145 5.421 6,237 $ 16,803 $ 30,900 2.155 $ 33,055 $ 98.792 lease obligations la long-term liabilities sets equity) abilities and net assets 5148,650 $ 151,278 ization to generate to delse the same, the so to revenues. Rave 5 percent, indicating aware also reports It meaning that 25 p o generate revenues from all sources and to control expenses same, the higher the total margin, the lower the expenses Riverside's total margin is well above the industry average dicating good expense control. How good the orts quartiles; for total margin, the upper quartile 25 percent of hospitals had total margins higher than uns better than average, it was Net income 2,098 $ 8,572 Melasse srial policies of the aggregate Profitability Ratios Profitability is the net result of a large number of managerial pol Profitability ratiossions, so profitability ratios provide one measure of the a A group of ratios performance of a business. that measure different dimensions of Total Margin a business's profitability. The total marrin, often called the total profit margin or just profit is net income divided by all revenues, including both operating revenu nonoperating income: related 50 p data sou percent 34 per Total margin- Net income Total revenues Industry average = 5.0%. $8,572 $114,148 8 = 0.075 - 7.5% chapter baba busine should Note that total revenues are defined as net operating revenues par nonoperating income, so Total revenues - $112,050 + $2,098 - $114,14. Riverside's total margin of 7.5 percent shows that the hospital makes cents on each dollar of revenue. The total margin measures the abiny my the they of managerial policies easure of the area to generate te the total mare the same, else the from all sources and to com er the total margin, the lower the expenses e ide's total margin is well above the industry ating good expense control. How good? The industry rts quartiles, for total margin, the upper quartile was 4 25 percent of hospitals had total margins higher than gh Riverside's total margin was better than average, it was et margin or just profit ng both operating tevens revenues Riverside 30 percent, indicatin are also reports gu meaning that 25 percent. Although R a good as the 8,572 14,148 -0.075 - 75% Although industry avera ter, it should dural businesses should strive good as the top 25 percent of hospitals. h industry average figures are discussed in detail later in the hould be noted here that the industry average is not a magic number esses should strive to achieve. Some well-managed businesses will the average, while other good firms will be below it. However, if a a's ratios are far removed from the average for the industry, its managers the concerned about why this difference occurs. Note also that according andard practice, we are calling the comparative data averages, but in real they are median values. Median values are better for comparisons because heart not biased by extremely high or low values in the industry data set net operating revenues plus 2,050 + $2,098 = $114,148 that the hospital makes 75 in measures the ability of the Riverside's relatively high total margin could mean that the him charges are relatively high, its costs are relatively low, it has relatively nonoperating revenue, or a combination of these factors ar play ough operating indicator analysis would help pinpoint the cause of of Riverside's high total margin Return on Ed Operating Margin Another useful margin ratio is the operating margin, which is defined as per ating income divided by patient-related (operating) revenues: Operating margin- Operating income Net operating revenues Industry average - 3.5%. $6,474 $112,050 -0.058 -55% average Lar of ed is espec NGHIT capital Rivers avera the The advantage of operating margin is that it focuses on core business activities and hence removes the influence of financial gains and losses, which are unrelated to operations and often are transitory. Riverside's total margin was 7.5 percent, while its operating margin was only 5.8 percent, compared to the industry average of 3.5 percent. Removing nonoperating income pe marily unrestricted contributions and investment returns) lowers profitability, but Riverside's core operations are more profitable than the industry average which is good news. Note, though, that the format of many healthcare orga nizations' financial statements makes this ratio difficult to determine without additional information. Furthermore, the definition of operating margin varies depending on data availability. hos: depending on data availability Return on Assets The ratio of net income to total acts measures the just called N N (ROA): Return on assets Net income Total assets Industry average = 4.8% $8,572 S151,2780057-5 Riverside's 5.7 percent ROA, which means that each generated 5.7 cents in profit, is well above the 4.8 percent hospital industry. ROA tells managers how productively in a a business is using its assets. The higher the ROA, the greater the for each dollar invested in assets and hence the more producten ROA measures both a business's ability to control expenses a. the total margin, and its ability to use its assets to generate d help pinpoint the cause, These factors act income to total equity net measures the Return on Equity The ratio of net incom (ROE): margin, which is defined operating) revenues: Net income Return on equity = Total equity Industry average = 8.4%. $8,572 S107,364 0.080 -8.0% $6,474 ues $112,050 -0.058. is that it focuses on core buito of financial gains and losses, whic ansitory. Riverside's total marge Riverside's 8.0 percent ROE is slightly below the 8.4 percent industry average. The hospital was able to generate 8.0 cents of income for cach dol- lar of equity investment, while the average hospital produced 8.4 cents. ROE is especially meaningful for investor-owned businesses because owners are concerned with how well the business's managers are using owner supplied capital, and ROE answers this question. For not-for-profit businesses such as Riverside, ROE tells its board of trustees and managers how well, in financial ferme, its community-supplied capital is being used. Riverside's 2015 margin measures and ROA were above the industry averages, yet the hospital's ROE is below the average. As we explain later in the section on Du Pont analysis, this seeming inconsistency is a result of the hospital's low use of debt financing. was only 5.8 percent, compare ving nonoperating income per sent returns) lowers profitabin, itable than the industry averag, ormat of many healthcare org difficult to determine without tion of operating margin and Liquidity Ratios One of the first concerns of most managers, and the major concern of a firm's creditors, is the business's liquidity. Will the business be able to meet its cash obligations as they come due? Liquidity ratios are designed to answer that question. Riverside has debts totaling more than 513 million (ie, its current end off within the coming year. Will the hospital Will the business be able to meet Liquidity ratios are designed to debes totaling more than 513 million current ust be paid off within the coming year. Will the hospital be the of business to camentsA full liquidity analysis requires the use of a meetis cash discussed in Chapter 10. However, by relating the amount ins the or current assets to current obligations, ratio analysis provides come due and other -use, rough measure of liquidity. Ratio man is calculated by dividing current assets by current liabilities: Current assets $31,280 = 2.3, or 2.3 times. Current ratio * Current liabilities $13,332 th dollar of average for a financial the net income active the Industry average = 2.0. as expressed by evenue The current ratio tells managers that the immediate liquidation of Rev. made's current assets at book value would provide $2.30 of cash for every would be $1 of current liabilities. If a business is getting into financial diffic begin paying its accounts payable more slowly, building up short loans (notes payable), and so on. If these current liabilities rise for current assets, the current ratio will fall, and this could spell trol the current ratio is an indicator of the extent to which short-term da gations are covered by assets that are expected to be converted to che near term, it is a commonly used measure of liquidity. Riverside's current ratio is slightly above the average for the ho industry. Because current assets should be converted to cash in the near futu it is highly probable that these assets could be liquidated at close to the stated values. With a current ratio of 2.3, the hospital could liquidate cu assets at only 43 percent of book value and still pay off current credit full. (To determine the minimum proportion of current assets that much converted to cash to meet current obligations, divide the number 1 byte current ratio. For Bayside, 1 + 2.3 -0.43, or 43 percent. This proportions confirmed by noting that 0.43 x $31,280,000 - $13,332,000, the amoun of current liabilities.) Days Cash on Hand The current ratio measures liquidity on the basis of balance sheet account and hence is a static measure of liquidity. However, the true measure of 1 vediny. However, the true Days Cash on Hand The current ratio measures liquidity on the h e is a static measure of liquidity How i 's Inquidity is whether it can meet its pay quidity is more related to cash inflows and liabilities. The dawcb- band rate moves closer determine liquidity Cash and equivalents Short-term Days cash on hand (Expenses - Depreciation)/365 $2.263. $4,000 $6,263 (5105,576 - $4,130) / 365 $27791 Industry average = 30.6 days. Indus Fort The denominator of the equation estimates average daily by stripping out noncash expenses (depreciation) from reported and then dividing by 365, the number of days in a year. The num cash and securities that are available to make those cash payme Riverside's days cash on hand is lower than the industry average, position as measured by days cash on hand is worse than that of the hospital. For Riverside, the two measures of liquidity, current ratio and danca on hand, give conflicting results. Perhaps the average hospital hasi proportion of cash and equivalents and short-term investments in the the balar et defir Creo the cushio ton. Con Chapter in and this cold well to which to cted to be convert financial condition analvais oual i than de portable judem ther, that the of liquidity. above the average for the verted to cathin the uld be liquidated at the he hospital could at undees Riverside. More analysis would be required be adement concerning Riverside's liquidity position. Remember that the cash budget, which we discussed in Chapter 16, is the primary used by managers to ensure liquidity "hted to see d still pay off current on of current acts that ons, divide the number Debt Management (Capital Structure) Ratios The extent to which an organization uses debt financing, or financial lever an important measure of financial performance for several reasons. First, by maling funds through debt, owners of for profit businesses can maintain control with a limited investment. For not-for-profit organizations, debt financing allows mare services to be provided than if the organization were solely financed with contributions and earnings. Next, creditors look to equity capital to provide margin of safety, if the owners (or community) have provided only a small proportion of total financing, the risks of the enterprise are borne mainly by is creditors. Finally, if a business carns more on investments financed with borrowed funds than it pays in percentage interest, its ROE is increased Debt management ratios fall into two categories: or 43 percent. This proper 200 - $13,332,000, the me Debt ratios A grou that thee abu- fina 1. Capitalization ratios. These ratios use balance sheet data to determine the extent to which borrowed funds have been used to finance assets. 2. Coverage ratios. Here, income statement data are used to determine the extent to which fixed financial charges are covered by reported basis of balance sheet mus wever, the true measure di ayments as they come des cal profits. utflows than it is to a to those factors thao The two sets of ratios are complementary, so most financial statement Livered try reported es are complementary, vestments most financial state 365 56,205 The Most of rati cane roth the 527793 atlo 1. Total Debt to Total Assets (Debt Ratio) total assets (total liabilities and equity), called the the percentage of total capital provided by creditors liation Ratio 22.5 of total debt to total measures the Debt ratio Total debt Total assets $43,914 S151,278 0.290, or 29.07% daily cash esperes wted total expenses ae numerater in the 42.3% Industry average ayments. Because lulitics. In essence, deb erage, its liquidi at of the average ratio, debt typically is defined as all debt, including current essence, debt is defined here as everything on the capital side lance sheet except equity. However, as illustrated by the next ratio nitalization ratios have several variations, many of which use dif rent definitions of what constitutes debt. Creditors prefer low debt ratios because the lower the ratio, the greater the cushion against creditors' losses in the event of bankruptcy and liquida Conversely, owners of for-profit firms may seek high leverage either to tio and days case tal has a greater is in its current capitals permar Cover: leverage up returns or because selling new stock would degree of control. In not-for-profit organizations, manag leverage to offer more services. Riverside's debt ratio is 29.0 percent. This means that is supplied somewhat less than one-third of the business's total another way, each dollar of assets was financed with 29 cents consequently, 71 cents of equity. The c ity is defined as I so Riverside's equity ratio is 71 percent.) Because the average det hospital industry is more than 40 percent, Riverside uses significantly than the average hospital. The low debt ratio indicates that the hospic find it relatively easy to borrow additional funds, presumably at favorite Note that the debt-to-equity ratio, defined as Total debt Total is a close relative of the debt ratio. These ratios are transformation another and provide the same information but with a different with the debt ratio and debt-to-equity ratio increase as a business uses proportion of debt financing, but the debt ratio rises linearly and approude a limit of 100 percent, while the debt-to-equity ratio rises at a faster approaches infinity. Lenders, in particular, prefer to use the debt-too ratio rather than the debt ratio because it tells them how much capital cod The inter beca inte EB tors have provided to the organization per dollar of equity capital. The hig this ratio, the riskier the creditors' position. Other analysts tend to prefer this debt ratio because it makes it easier to visualize the liabilities and equity ma on the balance sheet. los Tin Other analysis att cause it makes it easier to Visualize the on the balance sheet del Capitalization Ratio 2: Debt-to-Capitalization Ratio The debt-to-capitalisation ratio, which is long term debita capital (long-term debt plus equity), focuses on the proper in a business's permanent (long-term) capital structure. This the long-term Webt-to-capitalisation ratio or just capitalisan that we have included capital lease obligations in our definitie debt because such obligations are similar in nature to long term proportion talisation dcfatica Debt-to-capitalization ratio Long-term debt Long-term debt + Equity $30,582 $30,582 + S107,364 0.222.o 22.2% Industry average = 34.6%. Many analysts believe that the debt-to-capitalization ratio best relem the capital structure of a business. This belief is based on the fact that businesses use as much spontaneous free credit (current liabilities less shortum bank loans) as they can get. Furthermore, short-term interest-bearing, der typically is used only to fund temporary current asset needs. Thus, the me manager ca This means that e business's total ced with 29 cents of an a tio is defined as se the average det al structure of at reflected by Riverside's debt-to-cap industry average of 346 ratio that focuses on permanent l's debt-to-capitalization is 222 of 34.6 percent. This low use of debet ent capital mix confirms the conclusion made a t the the permanent capita has unused debt capacity. side uses significant dicates that the ho presumably at favo as Total debt - Total s are transformations with a different t as a business USC Coverage Ratio 1: Times Interest Earned Ratio interest earned (TIE) ratio is determined by dividing car e stand taxes (EBIT) by interest charges. EBIT is used in the because it represents the amount of accounting income that is walkie top interest expense. For a not-for-profit organization, which does not ERIT - Net income + Interest expense, whereas for a for-profit ERIT - Net income + Interest expense Taxes. Riverside's TIE bois 6.6 o ises linearly and are atio rises at a faster at $8,572 +$1,542 S1,542 510,114.66. $1,542 EBIT Interest expense Industry average =4.0. - to use the debt-to- m how much capital equity capital. The high analysts tend to probert - liabilities and equins The TIE ratio measures the number of dollars of accounting income (as opposed to cash flow) available to pay cach dollar of interest expense. In essence, it is an indicator of the extent to which income can decline before it is less than annual interest costs. Failure to pay interest can bring legal action by the firm's creditors, possibly resulting in bankruptcy in m nd 6.6 times, so it has 56.60 of accounting Listy werage TIE w Other analysts tendo of equity capital alize the liabilities and EBIT Interesten y average - 4.0. tion Ratio ong-term debt divided by es on the proportion of the al structure. This tattoo er just capitalization as ns in our definition of long the do w available to pay cadh dollar or of the extent to which income and Acest costs. Failure to pay interest can bringe The TIE as e d to cash flow it is an indicar re than annual interes w the fim's free Riverside's interest come to pay cach doll mature to long-term debe is four times, the hospital is cwering it high margin of safety: 77 used on the ald easily expand its use of debt fin um debt ebt + Equity th r editors, possibly resulting in bank crest is covered 6.6 times, so it has 56.60 of Sh dollar of interest expense. Because the industry ospital is cowering its interest charges by archive Thus, the TIE ratio reinforces the previous conclusions chat-to-capitalization ratiosnamely, that the hospital the debt and debt-to-capitalization ratio and its use of debt financing tos are often better measures of a firm's debu ratios because coverage ratios discriminate between low me hinterest rate debt. For example, a medical group rastice miche million of 4 percent debt on its balance sheet, while another might million of 8 percent debt. If both practices have the same income and both would have the same debt ratio. However, the group that pays 4 trent interest would have lower interest charges and hence would be in bet- ter financial condition than the group that pays 8 percent. This difference in capitalization ratios debe and high-interest rate have $10 million of 4 luve $10 million 7,364 -0.222 or 22 financial condition is captured by the TIE ratio. italization ratio best relles based on the fact that rent liabilities less shortcom term interest-bearing det Coverage Ratio 2: Cash Flow Coverage Ratio Although the TIE ratio is easy to calculate, it has three major deficiencies. First, leasing is a common form of financing, and the TIE ratio ignores lease et needs. Thus, the "true" MUT Finance and Asse o the payments, which, like debt payments, are contractual obl many debt contracts require that principal payments be made the loan, rather than only at maturity. T