A health care manager has to be aware of the financial elements of the facility that he is running. There are five areas of financial performance that the health care manager needs to be conversant with in order to run his facility efficiently and profitably. These areas include:
· Short-term solvency
Short-term solvency ratios are helpful to the health care manager as they help him to determine if the facility can be able to meet its short-term financial obligations (current liabilities). In other words, the short-term solvency ratios help the manager to analyze the ability of the firm to avoid any short-term financial distress (Salmi and Martikainen, 1994).
Various ratios are used to determine the short-term solvency of a health care facility. The most essential short-term solvency ratios are the current ratio and the quick ratio. However, there are other essential liquidity ratios that need to be covered as well.
I. Current ratio
The current ratio analyses the ability of a firm to meet its short-term financial obligations as they fall due. It is calculated by dividing the company’s current assets by its current liabilities for the same period. The available cash used to pay these short-term obligations needs to come directly from the available cash or from the conversion of current assets to cash. A company can have a high current ratio but is still unable to meet its short-term obligations. This could be because of low quality accounts receivable or the inventory can only be sold at discounted prices.
II. Quick ratio
This is a more rigorous test for short-term solvency than the current ratio because the formula does not include inventory. Inventory is usually considered the least liquid current asset and poses the greatest threat for losses. The ratio is calculated by subtracting the inventory from the current assets and then dividing the result by the current liabilities.
III. Cash flow liquidity ratio
This ratio utilizes the cash flow from operations that is derived from the company’s statement of cash flows. The numerator of the ratio includes marketable securities, cash, and cash flow from operating activities. The first two elements are the most liquid assets a company can have. The cash flow liquidity ratio needs to be constantly compared to the current and quick ratios as any contradiction between the three points to a possible solvency problem. For instance, high quick and current ratios coupled with a negative cash flow liquidity ratio translates to the inability of the company to pay high bills. The cash flow liquidity ratio is calculated by dividing the sum of cash, market securities, and cash flow from operating activities by the current liabilities (Salmi and Martikainen, 1994).
Activity ratios are also essential in determining the profitability and operational efficiency of the health care facility. They measure the capability of a company to convert different accounts into cash or sales. These accounts include the variety of capital, liability, and cash accounts available to the company. The faster a company is able to make the conversion, the more efficient it is. The activity ratios are more useful when they are compared to average activity ratios across the industry. Activity ratios usually include:
A. Accounts Receivable Turnover
Accounts receivable turnover is a ratio that measures the speed with which the company can collect its money from its debtors. The account where credit sales are recorded is referred to as the accounts receivable. The ratio can be determined by dividing the sum of the credit sales by the average accounts receivable.
B. Merchandise Inventory Turnover
This ratio measures the frequency with which a company turns over its inventory during the course of a given year. The higher the inventory turnover the better the company is as far as operational efficiency goes. A company with a higher inventory turnover rate requires a smaller investment in the inventory as compared to a company churning out the same number of sales but with a lower turnover rate. The health care facility has to be careful enough to ensure that the inventory levels are maintained at just the right levels so that the facility does not miss any sales opportunities. The inventory turnover is calculated by dividing the cost of goods sold by the inventory (Salmi and Martikainen, 1994).
C. Total Assets Turnover
This ratio encompasses the net fixed assets and current assets. It helps us understand the efficiency with which assets are utilized by the company. A low total assets turnover ratio implies that too many assets are being used to generate sales. It also points to the need of having some of the current assets liquidated or reduced. The total assets turnover is derived by dividing the sales by the total assets.
D. Fixed Assets Turnover
This ratio measures the intensity with which the company utilizes its fixed assets to generate sales and revenue. It is a measure of the productivity of the company. The term ‘fixed assets’ refers to the buildings, land, and equipment that the company owns. A low fixed assets turnover ratio implies that too much of the company’s funds are tied in investments relative to sales. The fixed assets turnover can be calculated by dividing the sales by the fixed assets.
E. Average Collection Period
This ratio indicates the average time the company takes to collect the value of the goods that it has sold on credit. If a company takes a short time to collect its debts owed then there is more liquidity in the company and increased efficiency. The longer accounts receivable are not collected, the more likely that they will never be collected leading them to be written off as bad debts. The average collection period is calculated by dividing the accounts receivable by the average daily credit sales.
· Financial Leverage
Companies usually use a mixture of debt and owners’ equity to finance every operation. The health care facility also utilizes these methods to raise funds for its operations from daily operations to planned expansions. A leverage ratio refers to the method used by a company to measure its mix of its operating costs. This analysis will help us determine how a slight change in output can affect the operating income (Salmi and Martikainen, 1994).
The leverage ratio can also be used to assess how much debt is used to finance the company’s operations. Buck wild debt levels can lead to credit downgrades while too few debts can also raise questions on the solvency of the company. If the health care facility can generate higher rate of returns than interest loans on its loans, then it can be said that debt is fuelling growth in company profits. Too few debts might indicate that the operating margins are too tight (Bernstein, 1989).
1. Debt to Equity Ratio
This is the most renowned leverage ratio. It is calculated by dividing the total debt by the total equity. A high debt to equity ratio insinuates that the company is extensively using its debt to finance its growth and operations. This can end in volatile earnings due to the increase in the interest expense. Most companies that have a high debt to equity ratio face a higher risk of bankruptcy or default on the loans. On average, a debt to equity ratio of greater than 2.0 can be viewed as a risky investment (Tamari, 1978).
2. The financial leverage ratio
This ratio is very similar to the debt to equity ratio. The only difference between the two is that the financial leverage ratio uses assets instead of debt in the numerator. Therefore, the financial leverage ratio can be derived by dividing the average total assets by the average total equity. Some experts refer to the ratio as the equity multiplier. The ratio is an essential component in a decomposed DuPont analysis for the calculation of the return on equity.
3. Degree of financial leverage
The degree of financial leverage ratio measures how sensitive the health care facility’s earnings per share to changes to the operating income. The fluctuations of the operating income are as a result of changes to the capital structure. The ratio measures the percentage change in EPS for a unit percentage change in earnings before interest and taxes. The ratio can also be calculated by dividing the earnings before interest and taxes by the result of subtracting interest from the earnings before interest and taxes.
The higher the degree of financial leverage, the more volatile the health facility’s earnings/income will be. The leverage increases the EPS and the returns of the company, which is a good thing when the operating income is seen to be rising. However, it can be a problem when there is too much pressure on the operating income.
4. Fixed-charge coverage ratio
An efficient company should have earnings that rise and fall based on the economic cycles. The earnings should also be obviously greater than the interest payments. A company whose earnings are cyclical should display a greater margin of the income over the interest payments. Also known as times interest earned ratio, the fixed-charge coverage ratio is calculated by dividing the earnings before interest and taxes (EBIT) by the interest expense of long-term debt.
It should be noted that some companies prefer using the earnings before interest, taxes, depreciation and amortization rather than the earnings before interest and taxes (EBIT). The reason being that the EBITDA makes the company’s financial position look better than would have been the case if the company had opted to use the EBIT. This is especially the case for capital-intensive ventures. The EBITDA is preferable because the amortization and depreciation costs are accrual costs that reduce the earnings. However, these costs are to be paid during another period and not the current period. Companies argue that addition of these elements gives a better picture of the company’s cash flow (Salmi and Martikainen, 1994).
Profitability simply refers to the ability of a company to generate a profit. The profitability ratio is used to measure the profitability levels of the company. The profitability ratios compare the company’s income statements to demonstrate the company’s capacity to generate profits. The ratios usually focus on the return on investments in assets including inventory among others. The profitability ratios relate to efficiency ratios in that they both show how efficiently the health care facility is using its assets to generate revenues. The profitability ratios are also significant to the going concern and the principle of solvency.
ü Gross Margin Ratio
This profitability ratio contrasts the gross margin of the business against the company’s net sales. In other words, the gross margin ratio aims to determine how profitable the company usually sells its inventory or products. This is the pure profit that is used in paying the operating expenses. The gross margin ratio is very different from the profit margin ratio as the former includes the cost of goods sold in its calculation. The profit margin ratio considers other expenses rather than the cost of goods sold. The gross margin ratio can be derived by dividing the gross margin ratio by the net sales. The gross margin is calculated by removing the costs of goods sold from the net sales. On the other hand, the net sales are derived by removing any refunds or returns from the total sales.
ü Profit Margin
This is also referred to as the return on sales ratio or the gross profit ratio. It measures the net income the health facility earns with every dollar of sales generated. The margin is arrived at by comparing the net sales and the net income of the company. The profit margin ratio can also be described as the remaining percentage of sales after all the expenses have been paid. The ratio is derived by dividing the net income by the net sales.
ü Return on Assets
Also known as, the return on total assets and it measures the net income that the total assets have produced during a period. In essence, it measures how efficient a company is in making use of its assets to produce profits. The return on assets ratio can be derived by dividing the net income by the average total assets.
ü Return on Capital Employed
The return on capital employed, commonly referred to as the ROCE, and assesses how efficient a company is in generating profits from using its capital. There is a comparison between the capital employed and the net operating profit in the calculation of the ROCE. This profitability ratio is a long-term profitability ratio because it demonstrates how effective the assets are at making profits while at the same time considering long-term financing. This makes this measure more effective than the return on equity ratio. The ROCE is calculated by dividing the net operating profit (EBIT) by the employed capital. The employed capital can be derived by subtracting the current liabilities from the total assets.
ü Return on Equity
The return on equity simply measures the capability of a firm to bring forth profits from the shareholders’ investments in the company. The ROE determines how much profit the company can generate from each dollar of the stakeholders’ equity. It is an essential indicator of how good the company is using equity to grow the company and finance its operations. The ROE is derived by dividing the net income by the shareholder’s equity.
v Price-to-book ratio/ price-equity ratio
This ratio contrasts the market value of a company’s stock against its book value. The price to book ratio can be calculated by dividing the current closing price of the stock by the current book value per share. The book value of the stock can be derived by subtracting the sum of the intangible assets and liabilities from the total assets. The calculation can also be framed as dividing the price per share by the earnings per share. Here, the earnings per share can be derived by dividing the net income by the number of shares outstanding (Salmi and Martikainen, 1994).
v Market to book ratio
This ratio demonstrates the relationship between the market value per share and the book value per share. It is derived by dividing the price per share by the book value per share. The book value per share can also be derived by dividing the total owners’ equity by the number of shares outstanding.
Bernstein, L. (1989). Financial statement analysis; theory, application, and interpretation. Richard D. Irwin 4th Ed.
Salmi, T., & Martikainen, T. (1994). A review of the theoretical and empirical basis of financial ratio analysis. Finnish Journal of Business Economics, 4(94): 426-448.
Tamari, M. (1978). Financial ratios. Analysis and prediction, Paul Elek Ltd, London.