Financial Ratios Analysis and Comparison Paper

 

Prior to completing this assignment, review Chapter 10 and 12 in your course text.

You are a mid-level manager in a health care organization and you have been asked to prepare a report, with appropriate exhibits, for the senior financial officer.

• Discuss the roles played by financial ratios in general and analyze the commonly used financial ratios by categories.
• Additionally, select a local hospital and compare its financial ratios for the most recent three years against the national norms for this type of institution. Include analytical comments and how the organization compares to the national norms as well as any suggestions as to how results could be improved.

Your paper must include an introduction, thesis, and conclusion. Your paper must be four to five double-spaced pages in length (excluding title and reference pages) and formatted according to APA style as outlined in the Ashford Writing Center.  Utilize three scholarly and/or peer-reviewed sources (excluding the course text) that were published within the last five years. Cite your sources within the text of your paper and provide complete references for each source used on the reference page.

Chapter 10 Accounting for Inflation LEARNING OBJECTIVES After studying this chapter, you should be able to do the following: 1. Discuss the major types of asset valuation. 2. Describe the alternative units of measurement in financial reporting. 3. Define the major financial reporting alternatives. 4. Describe the uses of financial report information. 5. Describe the difference between monetary and nonmonetary accounts. REAL-WORLD SCENARIO Lydia Renee is the CEO of a large metropolitan hospital that has come under recent attacks from the local press regarding profit levels at her hospital. Last year Lydia’s hospital earned more than $10 million, which was described in the local press as “obscene” because the hospital is tax exempt. Lydia tried to explain that all the earnings for the hospital were earmarked for future investment and replacement of physical facilities, but the local reporter was adamant about profiteering at Lydia’s hospital. Lydia’s CFO, William Olin, has told her that the need for profit is directly related to the existence of inflation in the cost of plant and equipment that the hospital needs to purchase. For example, a new digital mammography unit was recently acquired for $750,000 to replace an older unit acquired 5 years ago for $350,000. The hospital recognized historical cost depreciation on this older mammography unit of $70,000 per year ($350,000/5), but the real replacement cost of the equipment was much larger. Mr. Olin showed Lydia that firms with heavy investments in plant and equipment such as hospitals must make positive profits because the historical accounting costs of depreciation grossly understate true replacement costs. Mr. Olin then recast the hospital’s financial statements using the principles of “constant purchasing power accounting” to demonstrate that the hospital actually incurred a modest loss of $1,000,000 in the most recent year. Lydia understands the nature of the purchasing power adjustments that Mr. Olin has made but is seeking a way to communicate this in a clear manner to the local press. To adjust for the effects of changing price levels, the Financial Accounting Standards Board (FASB) has issued a number of pronouncements over the last 35 years. In September 1979 the FASB issued Statement 33, which required large public enterprises to provide supplemental information on the effects of changing price levels in their annual financial reports. In particular, Statement 33 required firms to disclose primarily current cost and constant dollar earnings; certain other income statement items; and current cost of inventory, property, plant, and equipment in notes to the financial statements. This was a major step for the FASB and represented for the first time that firms were required to report price-level effects in their financial reports. In 1986, when the inflation rate had subsided to less than 5%, the FASB substantially modified its initial position set forth in Statement 33 with the publication of Statement 89. This pronouncement left much of Statement 33 intact, except that it designated the reporting as voluntary. Consequently, most publicly traded companies stopped disclosing inflation-adjusted earnings. In Statement 89 business enterprises were encouraged, but not required, to report supplementary information on the effects of changing prices in the following areas for the most recent 5 years: • Net sales and operating revenues, using constant purchasing power • Income from continuing operations on a current cost basis • Purchasing power gains or losses from holding monetary items • Increases in specific prices of net plant, property, and equipment net of inflation • Foreign currency translation adjustments on a current cost basis • Net assets (assets less liabilities) on a current cost basis • Income per common share from continuing operations on a current cost basis • Cash dividends per common share • Market price per common share at year end The rationale for these changes in financial reporting stems from the inaccuracy and inability of present historical cost reporting to measure financial position accurately in an inflation-riddled economy. Although the U.S. inflation rate has been low in recent years, inflationary pressures can increase at any time and will never be removed entirely. Many countries around the world still experience high inflation. Mexico and Brazil have required some accounting inflationary adjustments for over 20 years. Furthermore, some analysts expect a worldwide shortage of energy sources by 2020, which might lead to a long-term increase in inflation rates. Thus, inflation accounting will continue to be relevant. Most people understand the effects that general inflation has on their purchasing power, and they realize that a dollar of 1997 is not equivalent to a dollar in 2007. Most of us will intuitively make price-level adjustments to account for differences. A person who had a salary of $50,000 in 1997 and a salary of $50,000 in 2007 knows that their overall financial position has eroded because of increases in the Consumer Price Index (CPI). The accounting profession’s task is to make its financial statement adjustments easy to understand by most people who use and rely on these statements as scorecards of business success. The major purpose of this chapter is to discuss and describe the major alternatives for reflecting the effects of inflation in financial statements. Specific methods are described, and the adjustments that need to be made to convert historical cost statements are illustrated. This discussion should provide a basis for understanding and using financial statements that have been adjusted for inflation. LEARNING OBJECTIVE 1 Discuss the major types of asset valuation. REPORTING ALTERNATIVES Methods of financial reporting can be categorized using two dimensions: the method of asset valuation and the unit of measurement. In Chapter 8 we discussed five major principles of accounting, two of which are cost valuation and a stable monetary unit. When historical cost values do not change and inflation or deflation does not exist, accountants can feel very comfortable using unadjusted historical cost as the method for valuing assets acquired by the firm. If asset values do change or the monetary unit is not stable, then alternative asset valuation rules may be needed. Two alternative methods of asset valuation are acquisition (or historical) cost and current (or replacement) value. Asset valuation at acquisition cost means that the value of the asset is not changed over time to reflect changing market values. Amortization of the value may take place, but the basis is the acquisition cost. Depreciation is recorded, using the acquisition (historical) cost of the asset. Use of an acquisition cost valuation method postpones the recognition of gains or losses from holding assets until the point of sale or retirement. Current valuation of assets revalues the assets in each reporting period. The assets are stated at their current value rather than their acquisition cost. Likewise, depreciation expense is based on the current value, not the historical cost. Current valuation recognizes gains or losses from holding assets before sale or retirement. If it was easy to obtain objective measures of current asset values, all assets would be restated to current value, but in many cases objective measures of current value may not be obtainable. LEARNING OBJECTIVE 2 Describe the alternative units of measurement in financial reporting. There are also two major alternative units of measurement in financial reporting: nominal (unadjusted) dollars and constant dollars measured in units of general purchasing power. Use of a nominal dollar unit of measurement simply means that the attribute being measured is the number of dollars. From an accounting perspective, a dollar of one year is no different from a dollar of another year. No recognition is given to changes in the purchasing power of the dollar because purchasing power is not measured. The major outcome associated with the use of this measure unit is that gains or losses, regardless of when they are recognized, are not adjusted for changes in purchasing power. For example, if a piece of land that was acquired for $1 million in 1987 sold for $3 million in 2007, it would have generated a $2 million gain, regardless of changes in the purchasing power of the dollar during the 20-year period. A constant dollar measuring unit reports the effects of all financial transactions in terms of constant purchasing power. The unit that is usually used is the purchasing power of the dollar at the end of the reporting period or the average during the fiscal year. The measurement is made by multiplying the unadjusted, or nominal, dollars by a price index to convert to a measure of constant purchasing power. During periods of inflation, when using a constant dollar measuring unit, gains from holding assets are reduced, whereas losses are increased. Thus, in the previous land sale example, the initial acquisition cost would be restated to 2007 purchasing power units to reduce the gain in Exhibit 10-1. Because the CPI increased from 114.4 in 1987 to 202.4 in 2007, we restate the 1987 cost by the conversion factor (202.4/114.4, or 1.769). Exhibit 10-1 Restatement of Land Cost Unadjusted historical cost    Sale of land in 2007 (CPI = 202.4) $3,000,000    Purchase of land 1987 (CPI = 114.4) $1,000,000    Unadjusted gain on sale $2,000,000 Purchasing power cost    Sale of land in 2007 (CPI = 202.4) $3,000,000    Conversion factor (CPI 2007/CPI 1987) 1.769    Restated cost of land $1,769,000    Adjusted gain on sale $1,231,000 Constant dollar measurement has a further significant effect on financial reporting: The gains or losses created by holding monetary liabilities or monetary assets during periods of purchasing power changes are recognized in the financial reporting. Monetary assets and liabilities are defined as those items that reflect cash or claims to cash that are fixed in terms of the number of dollars, regardless of changes in prices. Almost all liabilities are monetary items, whereas monetary assets consist primarily of cash, marketable securities, and receivables. Purchasing power gains or losses are recognized on monetary items because there is an assumption that the gains or losses are already realized, because repayments or receipts are fixed. For example, an entity that owed $25 million during a year when the purchasing power of the dollar decreased by 10% would report a $2.5 million (0.10 × $25 million) purchasing power gain. All gains or losses would be recognized, regardless of the asset valuation basis used. LEARNING OBJECTIVE 3 Define the major financial reporting alternatives. The interfacing of the valuation basis and the unit of measurement basis produces four alternative financial reporting methods (Table 10–1). Each of the four methods is a possible basis for financial reporting. The unadjusted historical cost (HC) method represents the present method used by accountants; the other three methods are alternatives that provide some degree of inflationary adjustment not present in the HC method. The HC-general price level adjusted (HC-gPL) method is often referred to as constant dollar accounting, whereas the current value-general price level adjusted (Cv-gPL) method is referred to as current cost accounting. Table 10-1 Alternative Financial Reporting Bases   Asset Valuation Method   Unit of Measurement Acquisition Cost Current Value Nominal dollars Unadjusted historical cost (HC) Current value (CV) Constant dollars Historical cost-general price level adjusted (HC–GPL) Constant dollar accounting Current value-general price level adjusted (CV–GPL) Current cost accounting Table 10–2 summarizes the effects the four reporting methods would have on the three critical income statement items: depreciation expense, purchasing power gains or losses, and unrealized gains in replacement values. Table 10-2 Major Effect of Alternative Reporting Methods on Net Income Measurement   Impact Variables   Reporting Methods Depreciation Expense Purchasing Power Gains/Losses Unrealized Gains in Replacement Value HC No change No change/not recognized No change/not recognized HC-GPL Increase/GPL depreciation recognized Gain or loss/depends on the net monetary asset position No change/not recognized CV Increase/will recognize replacement cost No change/not recognized Gain/will recognize increase in replacement cost CV-GPL Increase/will recognize current replacement cost Gain or loss/depends on the net monetary asset position Gain/will recognize increase in replacement cost but will reduce amount by changes in the GPL LEARNING OBJECTIVE 4 Describe the uses of financial report information. USES OF FINANCIAL REPORT INFORMATION The measurement of financial position is an important function, and its results are useful to a great variety of decision makers, both internal and external to the organization. Changes in financial reporting methods unquestionably alter the resulting measures of financial position reported in financial statements. These changes are likely to produce changes in the decisions that are based on the financial reports (Figure 10–1). Figure 10-1 Financial Data in Decision Making Lenders represent an important category of financial statement users who may change their decisions on the basis of a new financial reporting method. The lender’s major concern is the relative financial position of both the individual firm and the industry. A decrease in the relative financial position of the industry could seriously affect both the availability and the cost of credit. If, for a variety of reasons, new measurements of financial position make the healthcare industry appear weaker than other industries, financing terms could change. Particularly for the healthcare industry, which is increasingly dependent on debt financing, the importance of changes in financial reporting methods cannot be overstated. Research on the results of changing to an HC-GPL or constant dollar accounting method has shown that the relative financial positions of individual firms and industries are also likely to change. Changes in financial reporting methods also could have an effect on decisions reached by regulatory and rate-setting organizations. As a result of such changes, comparisons of costs across institutions may be more meaningful than they were previously. For example, depreciation in firms that operate in relatively new physical plants cannot be compared with the unadjusted historical depreciation costs of older facilities. Without financial reporting adjustments, new facilities may appear to have higher costs and thus be less efficient, whereas, in fact, the opposite may be true. The actions of interested community leaders who have access to and make decisions based on financial statements also might be affected by reporting method changes. For example, suppose that individual, corporate, and public agency giving is in part affected by reported income. Many, in fact, regard reported income as a basic index of need, and the relationship between income and giving seems logical. Thus, because each of the alternative financial reporting methods we discussed produces a different measure of income, total giving in each case could be affected. Internal management decisions also might change with a new financial reporting method. Perhaps the most obvious example of such a change is rate setting. Organizations that have control over pricing decisions and are not reacting to market-determined prices should set prices at levels at least high enough to recover their costs. The use of any of the three alternative methods of reporting increases reported cost levels and therefore increases rates. CASE EXAMPLE: WILLIAMS CONVALESCENT CENTER In the remainder of this chapter we show how adjustments are made in the income statement and balance sheet of Williams Convalescent Center, a 120-bed skilled and intermediate care facility, to take into account the effects of inflation. The center’s two financial statements are shown in Table 10–3 and 4. Note that values are reported for each of the following three reporting methods: HC, HC-GPL, and CV-GPL. In this discussion we do not describe or apply the CV method. The accounting profession presently is not seriously considering this method, and it is not likely to be considered in the future. The CV method suffers from a serious flaw: It does not recognize the effects of changing price levels on equity. In short, the CV method treats increases in the replacement cost of assets as a gain and does not restate them for changes in purchasing power. Table 10-3 Statement of Income for Williams Convalescent Center (000s Omitted)   HC 20Y4 Constant Dollar (HC-GPL) 20Y4 Current Cost (CV-GPL) 20Y4 Operating revenue $3,556 $3,625 $3,625 Operating expenses 3,253 3,316 3,316 Depreciation 74 164 185 Interest 102 104 104 Net income $127 $41 $20 Purchasing power gain from holding net monetary liabilities during the year — $43 $43 Increase in specific prices of property, plant, and equipment during the year — — $136 Less effect of increase in general price level — — $144 Increase in specific prices over (under) increase in the general price level — — ($8) Change in equity due to income transactions $127 $84 $55 Table 10–5 presents values for the CPI, the price index presently used by the accounting profession to adjust financial statements for the effects of inflation. Price Index Conversion Both methods we selected to adjust the financial statements of the Williams Convalescent Center (CV-GPL and HC-GPL) use purchasing power as the unit of measurement. This means that unadjusted dollars are not the measurement unit for reporting accounting transactions and that all reported values in the financial statements are expressed in dollars of a specified purchasing power. Usually, the purchasing power used is the period end value. In our case example Williams Convalescent Center uses purchasing power as of December 31, 20Y4, as its unit of measurement. This means we restate all accounts to a purchasing power of 315.5, the CPI value at 20Y4. Table 10-5 Consumer Price Index, Year-End Values Year CPI 19X0 119.1 19X1 123.1 19X2 127.3 19X3 138.5 19X4 155.4 19X5 166.3 19X6 174.3 19X7 186.1 19X8 202.9 19X9 229.9 20Y0 258.4 20Y1 283.4 20Y2 292.4 20Y3 303.5 20Y4 315.5 Restatement of nominal or unadjusted dollars to constant dollars is a relatively simple process, at least conceptually. All that is required are the following three pieces of information: 1. The unadjusted value of the account in historical or nominal dollars 2. A price index that reflects the purchasing power in which the unadjusted value is currently expressed 3. A price index that reflects the purchasing power at the date the account is to be restated For example, Williams Convalescent Center’s long-term debt at December 31, 20Y3, is $1,203 (see Table 10–4). To express that amount in constant dollars as of December 31, 20Y4, the following adjustment would be made: Table 10-4 Balance Sheet for Williams Convalescent Center (000s Omitted)   HC     20Y3 20Y4 Constant Dollar (HC-GPL) 20Y4 Current Cost (CV-GPL) 20Y4 Current assets            Cash $98 $21 $21 $21    Accounts receivable 217 249 249 249    Supplies 22 27 27 27    Prepaid expenses 36 36 36 36   Total current assets $373 $333 $333 $333 Property and equipment            Land 200 200 530 525    Building and equipment 2,102 2,228 4,948 5,570     2,302 2,428 5,478 6,095    Less accumulated depreciation 783 844 1,874 2,186    Investments 161 596 596 596      Total assets $2,053 $2,513 $4,533 $4,838      Current liabilities 412 493 493 493    Long-term debt 1,203 1,478 1,478 1,478    Partner’s equity 438 542 2,562 2,867     $2,053 $2,513 $4,533 $4,838   Unadjusted amount × 20Y4 CPI/20Y3 CPI or $ 1 , 203 × 315.5 303.5 = $ 1 , 251 The value of the beginning long-term debt for the center would be $1,251, expressed in purchasing power as of December 31, 20Y4. The previously described adjusted method is the same for all other accounts. The price index to which the conversion is made is usually the price index at the ending balance sheet date (December 31, 20Y4, in our example). The price index from which the conversion is made represents the purchasing power in which the account is currently expressed. This value varies depending on the classification of the account as either monetary or nonmonetary. LEARNING OBJECTIVE 5 Describe the difference between monetary and nonmonetary accounts. Monetary Versus Nonmonetary Accounts When restating financial statements from one based on an HC method to one based on a constant dollar method, it is critical to distinguish between monetary accounts and nonmonetary accounts. Monetary accounts are automatically stated in current dollars and therefore require no price-level adjustments. Monetary items, discussed earlier in this chapter, consist of cash, claims to cash, or promises to pay cash that are fixed in terms of dollars, regardless of price-level changes. Nonmonetary accounts require price-level adjustments to be stated in current dollars. Because of the fixed nature of monetary items, holding them during a period of changing price levels creates a gain or loss. For example, if a firm holds cash during a period of inflation, the firm will experience a monetary loss because the purchasing power of the cash has eroded over the holding period. Conversely, if a firm has a monetary liability during a period of inflation, it will experience a gain because it will repay the liability with dollars of a lower purchasing power; n constant dollar accounting purchasing power is the unit of measurement, not unadjusted dollars. This can be seen in Table 10–6, which includes data from the Williams Convalescent Center. The data in Table 10–6 assume that a repayment of long-term debt and new issue occurred at the midpoint of the year, June 30, 20Y4. The price index at that point would have been approximately 309.5. This resulted from taking the average of the beginning and ending values (303.5 + 315.5) ÷ 2. In constant dollars the Williams Convalescent Center would have reported $1,531 of long-term debt as of December 31, 20Y4. However, the actual value of the long-term debt at that date was $1,478. The difference of $53 represents a purchasing power gain to the center during the year. Because the price level increased during 20Y4, the value of the long-term debt actually owed by the center declined when measured in constant purchasing power. Nonmonetary asset accounts must be restated to purchasing power as of the current date. The price index at the time of acquisition represents the price index from which the conversion is made. The price index at the current date represents the index to which the conversion is made. To illustrate the adjustment, assume that the building and equipment account of the Williams Convalescent Center has the age distribution presented in Table 10–7. Table 10-6 Computation Purchasing Power Gains and Losses (000s Omitted)   Unadjusted Historical Dollars Conversion Factor Constant Dollars Beginning long-term debt (12/31/Y3) $1,203 315.5/303.5 $1,251    –Repayment (6/30/Y4) 152 315.5/309.5 155    +New debt (6/30/Y4) 427 315.5/309.5 435 Ending long-term debt (12/31/Y4) $1,478   $1,531    –Actual ending long-term debt (12/31/Y4)     $1,478    Purchasing power gain     $53 The data in Table 10–7 show that assets with a historical cost of $2,228 represent $4,948 of cost when stated in dollars as of December 31, 20Y4. The latter value is much more meaningful than the former as a measure of actual asset cost in 20Y4. It provides the center with a measure of cost that is expressed in dollars as of the current date and thus better represents its actual investment. Depreciation expense also should be restated in 20Y4 dollars to accurately portray the center’s actual cost of using its building and equipment in the generation of current revenues. Table 10-7 Restatement of Nonmonetary Assets Year Acquired Cost Conversion Factor Constant Dollar Cost (12/31/Y4) 19X0 $1,500 315.5/119.1 $3,974 19X8 401 315.5/202.9 624 20Y1 201 315.5/283.4 224 20Y4 126 315.5/315.5 126   $2,228   $4,948 Adjusting the Income statement Operating Revenues If one assumes that revenues are realized equally throughout the year, the restatement is significantly simplified. If the assumption is valid––and in most cases it is––it means that the revenues can be considered realized at the midpoint of the year, in our case June 30, 20Y4. As already noted, the price index at June 30, 20Y4, can be assumed to be the average of the beginning and ending price index, or 309.5. The restated operating revenue is calculated as follows: Operating revenues × 20Y4 CPI ÷ 20Y4 mid-year CPI or $3,556 × 315.5 ÷ 309.5 = $3,625 Operating Expenses Based on the same assumption that we used with operating revenues, the adjustment for operating expenses is as follows: $3,253 × 315.5 ÷ 309.5 = $3,316 Operating expenses do not include depreciation or interest. Separate adjustments for these two items may be required. Depreciation The depreciation expense adjustment is different from the earlier adjustments in two ways. First, depreciation expense represents an amortization of assets purchased over a long period, usually many years. This means that the midpoint conversion method used for operating revenues and operating expenses is clearly not appropriate. Second, the adjustment methods for the HC-GPL or constant dollar and CV-GPL or current cost methods diverge. Depreciation expense may vary considerably because the current cost of the assets may differ dramatically from the constant dollar cost. Remember, a price index represents price changes for a large number of goods and services; specific price changes of individual assets may vary significantly from that index. For example, the general price level may have increased 20% in the last 5 years, but the cost of a specific piece of equipment may have increased 50% during the same period. Constant Dollar Adjustment We estimate the depreciation expense value for Williams Convalescent Center under the constant dollar method by using the relationship of constant dollar buildings and equipment cost in Table 10–7 to historical cost. This gives us a multiplier of restated cost to historical cost that we can then apply to historical cost depreciation. The multiplier from Table 10–7 is calculated as follows: Constant dollar cost Historical cost = $ 4 , 948 / $ 2 , 228 = 2.221 We then multiply this factor times the historical depreciation expense of $74 to yield a constant dollar depreciation expense of $164. Current Cost Adjustment The identification of the current cost of existing physical assets is a subjective and complex process. To many individuals the current cost method provides little additional value compared with the constant dollar method. Whether it will be eventually eliminated and replaced by the constant dollar method is not clear at this time. The first issue to address is the definition of current cost. By and large, current cost can be equated to the replacement cost of the assets. In short, we must determine what the cost of replacing assets in today’s dollars would be. This could be estimated through a variety of techniques using, for example, insurance appraisals or specific price indexes. In the case of Williams Convalescent Center, we assume that a recent insurance appraisal indicated a replacement cost of $5,570 for buildings and equipment. With this estimate, depreciation expense could be adjusted as follows: Appraisal cost Historical cost × Depreciation expense = Restated depreciation expense or $ 5 , 570 $ 2 , 228 × $ 74 = $ 185 Interest Expense We again assume that interest expense is paid equally throughout the year. This assumption produces the following interest expense adjustment: $102 × 315.5 ÷ 309.5 = $104 Purchasing Power Gains or Losses A purchasing power gain results if one is a net debtor during a period of increasing prices, whereas a purchasing power loss results if one is a net creditor during such a period. In most healthcare firms, purchasing power gains result because liabilities exceed monetary assets. A firm is thus paying its debts with dollars that are of less value than the ones it received. To calculate purchasing power gains or losses, net monetary asset positions must first be calculated. The net monetary position for Williams Convalescent Center is presented in Table 10–8. The actual calculation of the purchasing power gain for Williams Convalescent Center is presented in Table 10–9. Because the center was in a net monetary liability position during the year, it experienced a purchasing power gain of $43. This value is not an element of net income; rather, it is shown below the net income line in Table 10–3. It thus affects the change in equity. Table 10-8 Net Monetary Asset Schedule   Beginning (12/31/Y3) Ending (12/31/Y4) Monetary assets        Cash $98 $21    Accounts receivable 217 249    Prepaid expenses 36 36    Investments 161 596      Total monetary assets $512 $902   Monetary liabilities        Current liabilities $412 $493    Long-term 1,203 1,478   Total monetary liabilities $1,615 $1,971   Net monetary assets ($1,103) ($1,069) Increase in Specific Prices Over General Prices The adjustment to consider—an increase in specific prices over general prices––is made only in the current cost method. The constant dollar method does not recognize any increases (or reductions) in prices that are different from the general price level. In short, no gains or losses from holding assets are permitted in the constant dollar method. The calculations involved in this adjustment can be complex. In our Williams Convalescent Center example, we make some assumptions to simplify the arithmetic without impairing the reader’s conceptual understanding of the adjustment. We assume the following data: Insurance appraisal of buildings and equipment, 12/31/Y3: $5,015 Insurance appraisal of buildings and equipment, 12/31/Y4: $5,570 Appraised value of land, 12/31/Y3: $500 Appraised value of land, 12/31/Y4: $525 New equipment bought on 12/31/Y4: $126 Table 10–10 shows the increase in specific prices over general prices. These data show that, during 20Y4, the value of physical assets held by Williams Convalescent Center did not increase more than the general price level. In fact, there was an $8,000 decline in the specific prices of assets held by the firm when compared with the increase in general price level during the year. This may be a positive sign for the center if it is not contemplating a sale. The replacement cost for its assets is increasing less than the general price level. Therefore, revenues could increase less than the general price level and replacement could still be ensured. Adjusting the balance sheet Monetary Items None of the monetary items—cash, accounts receivable, prepaid expenses, investments, current liabilities, or long-term debt––requires adjustment. The values of these items already reflect current dollars. Land In our discussion of the increase in specific prices over the general price level in the Williams Convalescent Center’s income statement, we assumed an appraisal value for land of $525. That value is used here with the current cost method. With the constant dollar method, we assume that the land was acquired in 19X0 for $200. To restate that amount to purchasing power as of December 31, 20Y4, the following calculation is made: $200 × 315.5 ÷ 119.1 = $530 Buildings and Equipment Values for the center’s buildings and equipment and the related accumulated depreciation already have been cited for the current cost method. We assume those same values here. This produces a value for buildings and equipment of $5,570 (000s omitted) based on an appraisal. The value for accumulated depreciation was derived as follows: = Adjusted accumulated depreciation Unadjusted accumulated depreciation × Appraisal value  −  Current year acquisitions Historical cost  −  Current year acquisitions  = or $ 2 , 186 = $ 844 × ( $ 5 , 570 − $ 126 ) ( $ 2 , 228 − $ 126 ) Table 10-9 Purchasing Power Gain (Loss) Schedule   Actual Dollars Factor Conversion Constant Dollars Beginning net monetary liabilities $1,103 315.5/303.5 $1,147    –Decrease 34 315.5/309.5 35 Ending net monetary liabilities $1,069   $1,112    –Actual $1,069     Purchasing power gain     $43 Table 10-10 Increase in Specific over General Prices Schedule   Building and Equipment Land Total Ending appraised value less acquisitions of $126 $5,444 $525 $5,969    –Accumulated depreciation on appraised value 2,186 0 2,186 Ending net appraised value $3,258 $525 $3,783 Beginning appraised value $5,015 $500 $5,515    –Accumulated depreciation on appraised value 1,868 — 1,868 Beginning net appraised value $3,147 $500 $3,647 Beginning net appraised value restated for general price level (315.5/303.5)     $3,791 Increase in specific prices over general price level ($3,783 less $3,791)     ($8) 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

return on assets and return on equity for Williams Convalescent Center. Table 10-11 Effect of Alternative Reporting Methods on Financial Measures   Historical Cost Constant Dollar Current Cost Return on assets Net income/total assets  5.1%  0.9%  0.40% Revised return on assets Change in equity due to income transaction/total assets 5.1 1.9 1.1 Return on equity Net income equity 23.4 1.6 0.7 Revised return on equity Change in equity due to income transactions/equity 23.4 3.2 1.9 These reductions are so drastic they would prompt an investor to seriously question the continuation of the present investment, let alone replacement. More profitable avenues of investment very likely may be available. To the extent that our Williams Convalescent Center example is representative of many healthcare firms (and it probably is), decisions regarding health care business continuation must be evaluated seriously. It is imperative that health care companies, like all other businesses, adjust their financial reports to reflect inflation. Whether the method used is current cost or constant dollar is not the issue. The important point is that ignoring the effects of inflation is unwise at best. ASSIGNMENTS Use the data and information presented in Exhibit 10-2 to answer the following questions: 1. What index was used to restate to constant dollars? 2. What method was used to determine current cost values? 3. Is the American Medical Firm (AMF) a net debtor or a net creditor? 4. In 2001 AMF showed a minus $24 million value for the increase in specific prices over general prices. What does this mean? 5. Why are AMF’s net operating revenues in 2004 identical for the HC, constant dollar, and current cost methods of reporting? 6. Why is depreciation expense greater in the current cost method than in the constant dollar method? SOLUTIONS AND ANSWERS 1. AMF used the CPI, which is required by FASB Statement 33 to restate historical costs to constant dollars. 2. AMF used specific price indexes to restate historical costs to current costs. This method contrasts with the use of appraisals discussed in the chapter example. 3. AMF is a net debtor. It has experienced a purchasing power gain in each year from 2000 to 2004. Because prices were increasing during that period, AMF must have had a net monetary liability position in each year. 4. In 2001 the specific prices of AMF’s fixed assets must have increased less than the general price level as determined by using the CPI. 5. AMF does not restate revenues or expenses to the fiscal year end, December 31. Instead, they restate to the midpoint of the fiscal year, June 30. Because it is usually assumed that revenues are received equally throughout the year, the midpoint (June 30) represents the index from which the conversion is made. Because AMF is converting to the midpoint index, the adjustment is 1.0. 6. Depreciation expense under the current cost method exceeds depreciation expense under the constant dollar method because the current cost value of depreciable assets exceeds the constant dollar value of depreciable assets. Exhibit 10-2 Supplementary Financial Information for American Medical Firm (AMF) EFFECTS OF CHANGING PRICES The company’s financial statements have been prepared in accordance with generally accepted accounting principles and reflect historical cost. The goal of the supplemental information that follows is to reflect the decline in the purchasing power of the dollar resulting from inflation. This information should be viewed only as an indication, however, and not as a specific measure of the inflationary impact. The constant dollars were calculated by adjusting historical cost amounts by the CPI. Current costs, however, reflect the changes in specific prices of land, buildings, and equipment from the date acquired to the present; they differ from constant dollar amounts to the extent that prices in general have increased more or less rapidly than specific prices. The current cost of buildings and equipment was determined by applying published indices to the historical cost. Net income has been adjusted only for the change in depreciation expense. Other operating expenses, which are the result of current transactions, are, in effect, recorded in amounts approximating purchasing power on the primary financial statements. Depreciation index was determined by applying primary financial statement depreciation rates to restated building and equipment amounts. Because only historical costs are deductible for income tax purposes, the income tax expense in the primary financial statements was not adjusted. During a period of inflation, the holding of monetary assets (cash, receivables, etc.) results in a purchasing power loss, whereas owing monetary liabilities (current liabilities, long-term debt, deferred credits, etc.) results in a gain. Net monetary gains or losses are not included in the adjusted net income amounts reported. Consolidated Statement of Income Adjusted for Changing Prices ($ IN MILLIONS)   For the Year Ended December 31, 2004       As reported in Primary Statements (Historical Cost) Adjusted for General Inflation (Constant $) Adjusted for Changes in Specific Prices(Current Costs)     Net operating revenue $2,065 $2,065 $2,065     Operating and administrative expenses $1,698 $1,698 $1,698     Depreciation and amortization 84 98 111     Interest 91 91 91     Total cost and expenses $1,873 $1,887 $1,900     Income from operations $192 $178 $165     Investment earnings $24 $24 $24     Income before taxes on income $216 $202 $189     Taxes on income $95 $95 $95     Net income $121 $107 $94     Effective income tax rate 44% 47% 50% Changing price gains not included in adjusted income:    Increase in specific prices (current cost) of property, plant, and equipment held during the year*     $139     Less effect of increase in general price level     68     Excess of increase in specific prices over increase in the general price level     $71     FINANCIAL DATA ADJUSTED FOR EFFECTS ON CHANGING PRICES ($ IN MILLIONS)   2004 2003 2002 2001 2000 Net operating revenues              Adjusted for general inflation $2,065 $1,852 $1,271 $1,070 $832 Net income              Adjusted for general inflation 107 85 73 54 36    Adjusted for changes in specific prices 94 73 64 46 27 Earnings per share              Adjusted for general inflation 1.54 1.29 1.18 .95 .82    Adjusted for changes in specific prices 1.35 1.12 1.04 .82 .61 Purchasing power gain from holding net monetary liabilities during the year 28 15 16 22 32 Increase in specific prices of property, plant, and equipment over (under) increase in the general price level 71 85 16 (24) .77 Net assets at year end (total assets less total liabilities)              Adjusted for general inflation 1,095 972 756 657 413    Adjusted for changes in specific prices 1,332 1,162 894 809 470 Cash dividends declared per common share Adjusted for general inflation $0.43 $0.39 $0.34 $0.28 $0.21 Market price per common share at year end: adjusted for general inflation $20.24 $29.41 $12.39 $24.30 $11.66 Average CPI—all urban consumers 303.9 293.4 280.3 257.5 230.0 * As of December 31, 2004, current cost of property, plant, and equipment, net of accumulated depreciation, was $1,915 (historical cost $1,349). “Property, plant, and equipment” in both the previous and following data includes land held for expansion.

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. 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           Total asset turnover 1.78 1.19 1.06     Fixed asset turnover 11.89 53.84 2.26     Current asset turnover 6.40 5.59 4.57 Profitability           Total margin percentage 3.07 4.07 2.09     Return on equity percentage 12.75 14.29 16.75 LONG-TERM CARE FACILITIES AND NURSING HOMES It is not always clear what types of firms individuals are referring to when they talk about the long-term care industry. For our purposes we refer primarily to nursing homes, both skilled and intermediate-care facilities. The nursing home industry has experienced significant growth during the last decade, and expectations about the aging of America have led many analysts to project even more rapid growth in the future. Growth in the nursing home industry is inextricably linked to government payment and regulatory policy. As of 2007 there were over 15,827 nursing homes in the United States, and of those more than 65% were investor owned. Investor-owned presence in the nursing home industry is much larger than it is in the hospital industry, where only 17% of hospital capacity is investor owned. Many of the investor-owned nursing homes are part of large national chains, such as Kindred Healthcare, Sun Healthcare Group, and Odyssey Healthcare. However, many investors may own as few as 1 or 2 nursing homes to as many as 20. Most of the large investor-owned chains became involved in the industry when the government started to finance a sizable percentage of nursing home care through the Medicaid program. Heavy government financing provided a stable source of payment that was not present before Medicaid. Table 12-2 Industry Composition, 2008 Industry/Firm Most Recent evenue (millions) Health insurance       UnitedHealth Group $81,186     WellPoint, Inc. $61,251     Aetna $30,951 Nursing       Kindred Healthcare $4,151     Sun Healthcare Group, Inc. $1,824     Odyssey Healthcare $616 Investor-owned hospitals       Universal Health Services $5,022     Community Health Systems $10,840     Tenet Healthcare $8,663 LEARNING OBJECTIVE 2 Discuss the sources of revenue for the nursing home industry. Financing of nursing home care is a critical driver of nursing home supply as it is for most other health care sectors. Table 12–3 summarizes sources of financing trends for nursing homes as of 2007. Table 12-3. Financing Percentages for Nursing Home Expenditures   1995 2000 2005 2007 Private financing 43 43 37 38     Insurance 8 8 7 7     Out-of-pocket 28 30 26 27     All other 7 5 4 4 Public 57 57 63 62     Medicare 9 11 16 18     Medicaid 46 44 45 42     All other 2 2 2 2 Source: Reprinted from the Centers for Medicare & Medicaid Services, National Health Expenditure Data. Retrieved July 6, 2010, from http://www.cms.gov. The data in Table 12–3 reflect the dramatic increase in the percentage of nursing home financing derived from public sources and a corresponding reduction in private financing. The percentage of Medicare financing increased sharply in the first half of the 1990s as hospitals discharged more patients into nursing home settings to cut their costs per case and to maximize their profit per Medicare case. Much of this shift probably was related to the financial incentives created by the Medicare program when the government shifted to a per case payment system in 1983. Although the federal government pays more than 50% of Medicaid nursing home costs, actual nursing home payments for Medicaid patients are set by the states. There is wide variation among the states between retrospective and prospective systems. In many states there may be a mix of both systems. For example, capital costs may be paid on a retrospective basis, whereas all other costs may be paid on a prospective basis. Many states also use a case-mix-adjustment methodology to provide higher payments for nursing homes treating more severely ill patients. Medicaid payments from states are usually the second largest state expenditure and, as a result, are subject to dramatic changes based on the economic condition in the state. When economic times are bad and states have a difficult time meeting their budgets, one of the areas usually affected is nursing home payments. The level of nursing home beds by state varies dramatically. Many states have used the supply of nursing home beds as a means to control state expenditures for nursing home care. The number of nursing home beds per 1,000 people older than 85 years ranges from 184.8 in West Virginia to 504.4 in Indiana (Centers for Medicare & Medicaid Services, Division of Payment Systems, 1999, http://www.cms.gov). Licensure laws and certificate of need have been the primary means for controlling nursing home beds in most states. Rates of payment for Medicaid patients also serve as an indirect method of controlling nursing home capacity. As rates are held down, less capital becomes available for expansion and renovation. Major national nursing home chains have been known to sell all their nursing homes in certain states where they believed that reasonable profits would be difficult to obtain because of restrictive state payment policies. It is expected that demand for nursing home care will increase dramatically in the next 30 years as the baby boomers reach the age of 75 plus, which is the age at which nursing home demand peaks. Nursing homes are also diversifying and expanding their product lines. For example, many nursing homes are becoming continuing care retirement communities (CCRCs). In a CCRC there is a continuum of care that runs the gamut from independent living to assisted living to skilled care. CCRCs also have discovered that their resident populations are desirable targets for health maintenance organizations (HMOs) that are seeking to expand their Medicare risk contracts. The CCRC is in a strong position to market itself to a managed care group because of the economies of scale provided from its continuum of care and its personal relationship to a Medicare population. At the same time, hospitals are looking for ways to expand their revenue base and have begun to develop skilled care units and other subacute units that can expand their business along the continuum of care and compete with existing nursing homes. In many respects some of the historical distinctions among healthcare industry segments are becoming blurred as vertical integration accelerates. The financial statements in Tables 12–4 and 12–5 reflect the operations of Friendly Village, a church-owned CCRC. A review of these financial statements gives the reader some idea of the nature of business operations in this type of healthcare organization. A CCRC usually provides three levels of care: nursing home care, assisted living, and independent living. Often, residents progress through these three levels of care. An elderly person may enter the CCRC in an independent-living status and occupy one of the independent-living apartments. These apartments often are similar to apartments in other settings except residents are all retired and keep active through a variety of social activities. As the health of a resident erodes, that resident may move to an assisted-living environment. In an assisted-living environment some healthcare services are provided to enable the resident to maintain daily activities. For example, medication administration, medical monitoring, or some help with daily living functions such as bathing, toileting, and cooking may be required. Many residents are prolonging admission into an assisted-living center, and assisted-living residents are becoming similar to the nursing home residents of 10 years ago. The last level of care is nursing home services, either intermediate or skilled. Table 12-4. Friendly Village and Subsidiary Consolidated Balance Sheets   June     2010 2009 Assets     General funds     Current assets         Cash and cash equivalents $228,693 $173,134     Investments (at cost-approximate market value of $293,000 in 2010 and $530,000 in 2009) 199,811 409,393     Cash and investments that have limited use 634,918 310,629     Receivable-Friendly Church entrance-fee fund 2,151,994 2,169,635     Resident and patient accounts receivable, less allowance for doubtful accounts (2010—$195,000; 2009—$115,000) 803,634 445,291     Mortgage escrow deposits 30,891 81,961     Inventories, prepaid expenses, and other assets 118,565 144,093     Total current assets $4,168,506 $3,734,136 Assets that have limited use         Cash and investments (at cost, which approximates market value):         Under bond indenture agreement-held by trustee $5,103,399 $662,217     Repair and replacement—held by trustee 283,179 355,392     Resident deposits 292,762 284,749   $5,679,340 $1,302,358     less cash and investments required for current liabilities (634,918) (310,629)   $5,044,422 $991,728     Receivable-Friendly Church fee-fee fund, less portion classified as current assets 5,862,673 5,142,678   $10,907,095 $6,134,406     Property and equipment, less allowances for depreciation $13,312,799 $10,747,006     Unamortized debt financing costs 551,700 226,100     Total general funds $28,940,101 $20,841,648 Donor-restricted funds         Cash and investments (at cost-approximate market value of $1,121,000 in 2010 and $1,210,000 in 2009) $1,206,604 $1,075,115     Receivable-Friendly Foundation 198,414 189,608     Due from general funds 196,594 188,578     Due from nurse scholarship recipients 14,357 6,064     Due from employee hardship recipients 3,266 0     Total donor-restricted funds $1,619,235 $1,459,364 Liabilities and fund balances     General funds     Current liabilities         Accounts payable $888,489 $694,390     Interest payable 340,460 220,318     Salaries, wages, and related liabilities 759,495 696,458     Funds held for others 30,562 30,077     Due to donor-restricted funds 196,594 188,597     Estimated third-party settlement 45,842 441     Current portion of deferred entrance fees 824,000 987,251     Current portion of note payable to Friendly Church fee-fee fund 28,291 40,889     Current portion of long-term liabilities 426,163 374,663 Total current liabilities $3,539,897 $3,233,083 Deferred entrance fees, less current portion 2,975,343 4,284,149 Deposits—residents 288,040 274,578 Note payable to the fee-fee fund, less current portion 635,776 666,549 Long-term liabilities, less current portion 15,972,531 8,265,908 Refundable entrance fees 28,110 29,907 Obligation to provide future services and use of facilities 190,550 190,550 General fund balance 5,309,854 3,942,682 Total general funds 28,940,101 $26,365,697 Donor-restricted funds         Fund balances           Sustaining fund $751,708 $692,320       Foundation fund 198,413 189,608       Medical-memorial fund 344,657 336,169       Specific-purpose fund 196,595 188,597       Nurse-scholarship fund 47,451 45,624       Employee-hardship fund 12,227 7,066       Pooled-income fund 68,184 0       Total donor-restricted funds $1,619,235 $1,459,383 Many CCRCs also may have specialized units to treat patients with Alzheimer’s disease or who have experienced a stroke. The income statement of Table 12–5 reports revenues from a variety of sources. The largest share is from the nursing home and is referred to as routine healthcare center services ($6,214,764 in 2010). The second largest source of revenue is fees generated from care and services provided to residents of the assisted-living center or the independent-living apartments ($4,039,897 in 2010). Some other revenue is generated from entrance fees and consists of $1,080,635 from an amortization of entrance fees and $287,261 from investment income earned on the entrance fee fund. Some residents pay entrance fees upon entrance into the independent-living or assisted-living center. These deposits guarantee that a nursing home bed will be available if needed and that the rate for that nursing home bed will be less than the nursing home’s current rates. For example, the CCRC may guarantee the resident to pay only 50% of the posted rate for a nursing home bed if needed. Table 12-5. Friendly Village and Subsidiary Consolidated Statements of Revenues and Expenses of General Funds     Year Ended June 30         2010 2009 Revenues         Routine healthcare center services—net $6,214,764 $5,863,469   Care and service fees—net 4,039,897 3,795,875   Amortization of entrance fees 1,080,635 987,252   Other medical services 690,593 676,216   Applicant fees 6,386 6,077   Investment income on restricted funds 287,261 97,265   Other 284,761 209,449 Total revenues   $12,604,296 $11,635,603 Expenses         Salaries and wages $5,903,470 5,581,287   Employee benefits 1,052,944 964,048   Purchased services 1,023,900 976,639   Other medical services 780,176 763,314   Supplies 1,076,176 953,586   Repairs and maintenance 137,898 109,047   Utilities 600,423 534,664   Equipment rental 7,757 4,881   Interest and amortization 1,312,727 793,622   Provision for doubtful accounts 65,718 25,415   Taxes 388,164 370,308   Insurance-property, liability, and general 78,830 93,782   Other 84,098 87,618 Total expenses   $12,512,281 $11,258,211 Gain from operations before depreciation and other operating revenues   $92,015 $377,392 Other operating revenues and expenses         Unrestricted contributions 19,807 67,504   Investment income on entrance-fee-fund, net(1) 2,174,411 774,901   Gain from operations before depreciation $2,286,233 $1,219,797   Provision for depreciation (922,501) (825,221)   Gain from operations $1,363,732 $394,577 Nonoperating loss         Loss on disposal of property and equipment (51,082) (10,096) Excess of revenues over expenses & nonoperating loss $1,312,651 $384,480 The amount of the entrance fee may be based on age at entrance. The fund is then amortized or recognized as income as the patient ages or dies. There is also income earned on the deposits that is recognized as income each year. The entrance fee fund is listed several times in the balance sheet depicted in Table 12–4. On the asset side, there is a receivable from the church, which holds the entrance fees, in both the current asset and assets that have limited-use sections. On the liability side, there are accounts in both the current and noncurrent sections that represent deferred entrance fees. We discuss below what these accounts represent because they are one of the most confusing accounting aspects of CCRCs. The expense structure of a CCRC or nursing home is similar to other healthcare providers and is labor intensive. At Friendly Village salaries and wages plus benefits constitute slightly more than 50% of total expenses. Also, notice that depreciation is not shown in the expense section but is separately shown as other expense. This is not uncommon for not-for-profit CCRCs that often regard capital as a gift and do not regard replacement of the existing assets as an operating expense. Perhaps the most unusual feature of a CCRC’s financial statement relates to the entrance fee fund and the deferred revenue that results from the receipt of those moneys upon admission to the retirement community. To understand the concepts of entrance fees and their amortization and deferred revenue recognition, we use a simple example and then relate those concepts to the data for Friendly Village. Let’s assume that a resident enters the CCRC at the beginning of the year and contributes $35,000 to the entrance fee fund. This amount is amortized over the expected life of the resident, which we will assume to be 7 years. During the year the resident spends 20 days in the SNF and is required to pay only 60% of the $150 per day charge, or $90 per day. This means that a payment of $60 per day for 20 days, or $1,200, will be paid to the SNF for 40% of the residents’ charges by the entrance fee fund. Finally, assume that the $35,000 entrance fee fund earned investment income during the year in the amount of $2,000. The following entries would be made: Entry No. 1 Record receipt of the $35,000 entrance fee Increase entrance fee fund by $35,000 Increase deferred revenue by $35,000 Entry No. 2 Record transfer of money to SNF Increase unrestricted cash by $1,200 Decrease entrance fee fund by $1,200 Entry No. 3 Record annual amortization of entrance fee fund Increase revenue account amortization of entrance fees by $5,000 Decrease deferred revenue by $5,000 Entry No. 4 Record the investment income earned during the year Increase entrance fee fund by $2,000 Increase investment income on entrance fee fund by $2,000 These are the accounting entries made to reflect activities related to the entrance fee fund and the deferred revenue account relating to the entrance fee fund. The entrance fee fund is an asset account that represents the funds available to meet contractual commitments to provide future healthcare services to residents. The deferred revenue account is a liability account that represents the estimated present value of future contractual obligations to provide healthcare services to residents. LEARNING OBJECTIVE 3 Discuss the major sources of revenue and expenses of medical groups. MEDICAL GROUPS Expenditures for physician and clinical services amounted in 2007 to approximately $479 billion and are second only to hospital expenditures. Physician expenditures have been increasing more rapidly than expenditures of most other sectors of the healthcare industry, which has increased the relative importance of physicians. However, it is not just the absolute level of expenditures made to physicians that make doctors an important element in our healthcare industry. It is widely believed that doctors directly or indirectly control up to 85% of all healthcare expenditures. Doctors admit and discharge patients to hospitals, prescribe drugs, order expensive diagnostic imaging services, and schedule rehabilitative services. The stroke of a doctor’s pen directs a massive amount of healthcare resources to or away from an individual patient. Managed care plans realized the demand-influencing behavior of physicians early and have attempted to incorporate incentives for cost control in physician payment plans. Although few would debate the importance of physicians in controlling healthcare costs, physicians have yet to realize their importance in the medical marketplace because of their lack of organization. Of the 300,000 physicians in the United States, two-thirds operate in one- or two-person practices. It is difficult for physicians to realize their central role in cost and quality decision making in healthcare negotiations. This is because most of them are part of delivery organizations that are too small to exert much, if any, bargaining leverage in healthcare negotiations. Physicians are slowly realizing this weakness and are now becoming part of larger organizations being developed by hospitals, health plans, large practice management companies, and large physician-controlled medical groups. Table 12–6 presents some data on sources of financing for the physician sector of the healthcare industry. Perhaps the most significant trend is the dramatic reduction in the percentage of physician expenditures financed by out-of-pocket payments from patients. From 1985 to 2007 the percentage dropped from 27% to 10%. It is not exactly clear what caused this decrease, but the decline of indemnity coverage and the corresponding increase in HMO and preferred provider organization plans may be possible causes. Many HMO plans require a low copayment or no copayment for routine office visits, whereas most traditional indemnity programs have a coinsurance and deductible provision. For example, indemnity programs may require a subscriber to make all routine physician payments until some deductible is met, for example, $500. This might change in the years ahead if consumer-driven health plans with large deductibles become more pervasive. Table 12-6. Financing Percentages for Physician Expenditures   1985 1995 2005 2007 Private financing 71 68 66 66   Insurance 37 48 49 49   Out-of-pocket 27 12 10 10   All other 7 8 7 7 Public financing 29 32 34 34   Medicare 19 19 20 20   Medicaid 4 7 7 7   All other 6 5 6 6 Source: Reprinted from the Centers for Medicare & Medicaid Services. Physicians do receive a much larger percentage of their total revenue from the private sector than do most other major healthcare sectors. In 2007 physicians received 66% of their total revenues from the private sector, whereas hospitals received only 41%. Medicare covers nearly 100% of hospital service charges for the elderly but is subject to a 20% coinsurance payment for most physician services. Most Medicare beneficiaries finance this payment with supplemental insurance, which creates a shift from public to private financing. Physician expenditures are increasing because there is increasing usage of physician services. Table 12–7 documents the increasing number of healthcare visits as Table 12-7. Healthcare Visits Per Year, 2006: Percent Distribution by Age Group Age Group None 1–3 4–9 10 or More Under 18 years 10.9 57.2 24.6 7.3 18–44 25.3 45.8 17.8 11 45–64 16.4 44.3 23.6 15.7 65–74 6.7 34.6 36.6 22.1 Older than 74 5.3 31.5 35.7 27.6 Source: National Center for Health Statistics. Based on a summary measure that combines information about visits to doctors’ offices or clinics, emergency departments, and home visits. Retrieved July 6, 2010, from http://www.cdc.gov. people get older. The number of visits within age groups also is increasing (not shown). As the population ages, demand for physician services is expected to increase sharply. The substitution of ambulatory care for inpatient care also further accelerates demand for physicians. As we discussed earlier, physicians are beginning to align themselves with larger groups and are moving quickly from one- or two-person practices to these larger groups. Some of this movement is a reflection of personal tastes. Physicians who practice in larger groups can make arrangement for weekend or evening coverage. Large group practices often provide their doctors with better consultative services and also reduce administrative burden, permitting greater patient-contact time. Lifestyle considerations may be an important cause of physicians joining larger groups, but the primary cause is related to economics. Physicians have seen hospitals and health plans merge and become more and more dominant in the local healthcare marketplace. Before increasing physician organization to counterbalance these large bargaining entities, physicians perceived themselves as being at a disadvantage. LEARNING OBJECTIVE 4 List and describe the major organizational types of physician groups. Physicians can choose whether to align with other physicians or to remain independent. If they choose to align with other physicians, there are four primary organizational alternatives for them to consider: • Alignment with other medical groups • Alignment with hospitals • Alignment with health plans • Alignment with physician practice management firms Alignment with physicians is, in some respects, most appealing to physicians because their control is maximized in this type of organizational setting. Often, the critical limitation is capital. To achieve large-scale integration and development of new information systems and administrative structures, massive amounts of both financial and human capital are required. Only recently have outside investors come forward to provide this external capital. For integration with other physicians to be successful, a physician activist is needed who will not only arrange the financing of capital needs but who will also provide the administrative leadership. Hospitals have the financial capital to create large groups, but in some cases their administrative experiences with physician practice management are limited. This limitation, coupled with differing incentives, can lead to organizational conflict. In a managed care environment the objective is to empty hospital beds, not fill them, and this often leads to conflict between hospitals and doctors. Hospitals also have been dominated by specialists, but primary care physicians are the key in managed care markets. Primary care physicians often believe that hospitals do not understand them or their needs. Health plans also have the capital to put together large medical groups, but a conflict may arise between the incentives of health plans and its employee doctors. The health plan has a strong incentive to reduce fees or salaries of its doctors while also controlling utilization. Physicians do not react favorably to lower income and also object to mandates or controls over their practice patterns. Physician practice management firms are a relatively recent development that has evolved to meet the needs of both the physicians and the marketplace. Some of these firms are publicly traded and can have capital and management pools to draw on to develop large, integrated organizations. Physician practice management firms usually offer physicians some type of profit sharing and also provide for an equity stake in the firm. This equity participation can make the attraction of merger or acquisition by a physician practice management firm hard to resist. In short, physician practice management firms often can afford to pay large sums of money to acquire physician practices and also promise physicians a strong degree of autonomy. The financial statements in Tables 12–8 and 12–9 provide financial information for Waverly Health Clinic (WHC), a hospital-owned network of eight primary care clinics with 24 full-time physicians and 122 nonphysician employees. The clinic recorded 101,542 patient encounters during the past year with an average resource-based relative value scale relative value unit (RBRVS RVU) of 1.5 per patient encounter. WHC is a separately incorporated for-profit subsidiary of the hospital, and all its physicians are salaried with profit and productivity incentives. Table 12-8 Balance Sheet, WHC, December 31, 2008 Assets     Current assets       Cash $375,570     Net accounts receivable $1,453,343     Prepaid expenses $147,785     Other current assets $753,497   Total current assets $2,730,195     Net property, plant, & equipment $1,911,545     Intangible assets $194,609     Total assets $4,836,350 Liabilities and equity       Current liabilities     Accounts payable $173,175         Withheld taxes $87,235         Employee benefits withheld $3,379         Accrued salaries and wages $345,578         Other current liabilities $101,436     Total current liabilities $710,804 Equity           Contributed capital $8,481,937         Retained earnings ($4,356,391) Total equity $4,125,546 Total liabilities and equity $4,836,350 Table 12-9 Income Statement, WHC, Year Ending December 31, 2008 Revenue           Gross physician charges $13,691,347         Other revenue $2,952,073         Adjustments and write-offs ($3,170,855) Net revenue $13,472,565         Operating expenses     Personnel expense $6,179,382     Supplies expense $540,956     Occupancy expense $2,530,195     Purchased services $275,422     General and administrative expense $1,189,032 Total operating expense $10,714,987 Physician expense $4,583,294 Total expense $15,298,281 Net Profit ($1,825,716) The financial statements of WHC provide some interesting information about physician practices, especially those owned by hospitals. We can see that the practices lost $1,825,716 in the current year. It is not unusual for hospital-owned physician practices to lose money. Revenues from the practice are often less than expenses. Many hospital executives argue that although the direct revenues and expenses of the practice may show a loss, there are substantial benefits realized from operating the practice. These benefits result from the admitting and referral patterns of the acquired physician practices, which raise volume at the hospital. Greater interrogation with the physicians themselves also may result in better cost control, which is important for managed care contracts. Although all this may be true, in many cases it is simply poor management that creates the financial loss. Most of these acquired practices were profitable before hospital acquisition, yet once they become hospital owned and operated, they suddenly become unprofitable. A review of the financial information for WHC can help shed some light on the most common reasons for lack of profitability. Table 12–10 shows values for WHC expressed on a per physician full-time equivalent (FTE) basis, compared with national values for primary care medical group practices derived from a study by the Medical Management Association in 2008. Table 12-10 Comparative Operating Norms for WHC Indicator WHC Value Medical Management Association Median Operating expense per physician FTE $445,457 $473,639 Revenue per physician FTE $561,356 $637,677 Physician compensation per physician FTE $190,970 $269,024 Support staff per physician FTE 5.08 4.54 Operating expenses to net revenue percent 79.50% 66.27% RBRVS RVUs per physician FTE 9,850 12,572 Source: Cost Survey for Multispecialty Practices, Medical Group Management Association, 2008. WHC has fewer operating expenses than does a typical medical group. Some of this is due to staffing. WHC has 5.08 support staff persons per physician FTE, whereas the national norm is close to 4.54. The bottom line is that WHC spends $28,182 ($473,639 – $445,457) per physician FTE below what a typical medical group would spend for operating expenses. However, WHC generates $78,054 less revenue per physician FTE than the national norm. Therefore, it is clear that the real issue is related to low physician productivity. WHC physicians generated lower RBRVS RVUs than expected when compared with national averages—9,850 versus 12,572. WHC is losing money because its physicians see fewer patients. On a positive note, operating expenses are well below the national average. It is doubtful that these same physicians practiced in this manner when they were in private practice. The critical factor for the long-term success of owning physician practices is directly related to the incentive structures used for physicians. Ideally, incentives should promote and not destroy physician entrepreneurial spirit. LEARNING OBJECTIVE 5 Describe alternative health maintenance organization arrangements. HEALTH PLANS Most individuals in the United States are covered by either public or private health insurance. In some cases both public and private coverage may be combined. For example, many Medicare beneficiaries have obtained private health insurance to pay for health expenses not covered by Medicare. At the end of 2008, most of the 40 million Medicare beneficiaries had obtained Medicare supplemental insurance from private insurance companies. Although the vast majority of Americans have health insurance of some type, many Americans do not have either public or private health insurance. The Bureau of the Census estimated that approximately 46.3 million Americans were uninsured in 2008. This large pool of non-covered Americans creates costs of treatment that must be paid by someone. To date, it is not clear who will be responsible for paying for this group of people. Will it be the government, the health plans, or the providers? The cost of private health insurance has been rapidly increasing during the last 20 years, as Table 12–11 shows. Health insurance companies always have been big business, but the amount of money spent in selling, administration, reserve retention, and profit has increased greatly. In 2008 administrative costs accounted for approximately 13.3% of private health insurance payments. Table 12–11 shows that the cost of private health insurance in relation to administrative costs have generally increased over the past three decades. It is this administrative cost that has caused much discussion among policy analysis. It is argued that most of these monies spent for administration and profit are not necessary and add to the cost of health care in the United States. Table 12-11 Private Insurance Trends Year Personal Health Care Expenditures (Millions) Private Health Insurance Payments (Millions) Administrative and Net Cost of Private Health Insurance (Millions) Administrative Cost (%) 2008 1,952,255 691,179 91,978 13.3% 2000 1,139,192 402,802 51,983 12.9% 1990 607,563 204,664 29,080 14.2% 1980 214,786 61,205 7,642 12.5% The cost of private health insurance may not be wasteful, however. The nature of risk and regulation in the industry may require these levels of expenditures. Insurance companies agree to provide a benefits package of services for some specified sum of money. If costs of services exceed this amount, the insurance company loses money. This is often referred to as underwriting risk. In addition, insurance companies are regulated and are required to maintain certain reserve balances to protect policyholders in the event of a financial catastrophe. The only alternative to private health insurance would be some type of government-financed and -managed program. Government costs might be just as high or higher. Healthcare insurance companies come in many different forms. The Health Insurance Association of America (now known as America’s Health Insurance Plans) categorizes healthcare insurance firms as commercial, Blue Cross Blue Shield, and HMOs. The trend toward managed care has blurred some of these distinctions. Commercial insurance companies often provide an HMO option, as do most Blue Cross Blue Shield plans. HMOs have broadened their coverage plans to include more traditional indemnity programs, and most provide some point-of-service option whereby enrollees can go outside the HMO network for care if they are willing to pay higher copayments or deductibles. In their 1995 Source Book of Health Insurance Data, the Health Insurance Association of America defined managed care as a system that integrates the financing and delivery of appropriate healthcare services to covered individuals. The most common examples of managed care organizations are HMOs and preferred provider organizations. A preferred provider organization typically offers more flexibility than does an HMO by allowing more provider choice, but it attempts to direct patients to providers with whom it has negotiated special contracts. Usually, five types of HMOs are defined in the literature (also discussed in Chapter 7): 1. Staff model: Physicians practice as employees of the HMO and are usually paid a salary. 2. Group model: HMO pays the physician group a per capita rate, which the physician group then distributes among its members. 3. Network model: HMO contracts with two or more groups and pays them on a per capita rate, which the groups then distribute to individual physicians. 4. Independent practice association model: HMO contracts with individual physicians or with associations of independent physicians and pays them a per capita rate or a negotiated fee-for-service rate. 6. Mixed model: This model combines two or more of the previous options. The information in Tables 12–12 and 12–13 presents financial statements for a small hospital-owned HMO. It is important to point out that financial and operating information on any HMO is usually available publicly by contacting the Department of Insurance in the state where the HMO operates. In fact, this is the source of the financial information used in our example. Table 12-12 Hospital HMO Balance Sheet   2010 2009 Assets         Current assets         Cash and cash equivalents $1,363,932 $1,719,453         Short-term investments 1,709,056 1,495,481         Premiums receivable 813,427 1,233,975         Investment income receivables 29,054 45,339         Amounts due from affiliates 7,727 2,588         Total current assets $3,923,197 $4,496,836 Other assets             Restricted cash and other assets $177,966 $139,059         Long-term investments 708,941 957,306     Total other assets $886,907 $1,096,365 Property and equipment         Total property and equipment 397,842 247,047     Total assets $5,207,946 $5,840,247 Liabilities and net worth     Current liabilities         Accounts payable $406,163 $539,624     Claims payable (reported and unreported) 1,063,696 1,209,314     Unearned premiums 101,056 161,318     Aggregate write-ins for current liabilities 10,300 13,390     Total current liabilities 1,581,216 1,923,646 Other liabilities         Amounts due to affiliates 1,677,791 2,283,933     Total liabilities 3,259,007 4,207,579 Net worth         Total net worth 1,948,939 1,632,668     Total liabilities and net worth $5,207,946 $5,840,247 The data in Tables 12–12 and 12–13 reveal a lot about the structure of an HMO. First, note that a small percentage of the total assets of the HMO are invested in property, plant, and equipment—less than 8%. HMOs are not fixed-asset intensive; the bulk of their investment is in cash and investments. Our HMO has $1,948,939 in equity at the end of 2010, which represented about 37% of the total assets. This gives the appearance of a debt-laden organization relative to the financial standards listed in Table 12–1, but it should be noted that a loan due to an affiliate in the amount of $1,677,790 also exists. The sponsoring hospital granted this loan and, in some ways, reflects equity. A large portion of this loan was paid off during 2010, which can be seen from the decline in the loan balance from $2,283,933 in 2009 to $1,677,791 at the end of 2010. The income statement in Table 12–13 depicts a large decrease in net income, from $808,199 in 2009 to $208,471 in 2010. One reason for this decline is the drop in member months, from 191,465 in 2009 to 174,967 in 2010. Table 12–14 analyzes the expenses on a per member per month (PMPM) basis. Table 12-13 Hospital HMO Statement of Revenue, Expenses, and Net Worth   2010 2009 Member months 174,967 191,465   Revenues         Premium $21,509,196 $22,008,779     Fee-for-service 0 0     Title XVIII-Medicare 0 0     Investment 60,784 27,422     Aggregate write-ins for other revenues 47,038 76,537 Total revenues $21,617,019 $22,112,738 Expense       Medical and hospital         Physician services $1,582,006 $1,689,578     Other professional services 1,835,226 1,788,844     Outside referrals 4,300,561 4,344,071     Emergency room and out-of-area 963,382 1,425,666     Inpatient 7,865,005 7,462,942     Aggregate write-ins for other medical and hospital expenses 2,811,346 2,794,410 Subtotal $19,357,525 $19,505,512   Reinsurance expenses net of recoveries 376,541 370,753 Total medical and hospital $19,734,067 $19,876,264 Administration       Compensation $902,617 $781,656   Occupancy, depreciation, and amortization 83,809 105,994   Aggregate write-ins for other administration expenses 688,055 540,625   Total administration $1,674,481 $1,428,275   Total expenses 21,408,548 21,304,540 Net income (loss) $208,471 $808,199 The decline in net income for our HMO example is the direct result of premiums on a PMPM basis increasing less than expenses. Although not the largest increase, administration expenses increased sharply on both an absolute basis and a PMPM basis. Much of the cost in this area is fixed and cannot be reduced when volume declines. Inpatient expenses also sharply increased. It is not clear from this information whether the cause is higher rates per hospital visit or higher utilization. Additional information in the insurance filing not produced in our tables shows that inpatient days in 2010 were 4,187, or 287 days per 1,000 members. Table 12-14 PMPM Profitability   2010 2009 Premium $122.93 $114.9 Expense         Physician services $9.04 $8.83     Other professional services 10.49 9.34     Outside referrals 24.58 22.68     ER and out-of-area 5.51 7.45     Inpatient 44.95 38.98     Other medical and hospital 16.07 14.60     Reinsurance net of recoveries 2.15 1.94 Total medical and hospital $112.79 $103.80     Administration 9.57 7.46 Total expenses $122.35 $111.26 Net income $0.5 $3.6 ER, emergency room. In 2009 inpatient days per 1,000 members were 278, or 4,447 total days. The average price per inpatient day paid in 2010 was $1,878 ($7,865,005/4,187) compared with $1,678 ($7,462,942/4,447) in 2009. Therefore, both increased use and higher per diems paid to the hospitals contributed to the inpatient expense increase. The American Association of Health Plans publishes the HMO Industry Profile, which provides numerous financial, operating, and utilization statistics. For example, the 1996 edition of this book provides utilization information for enrollers younger than 65 years (Table 12–15). Table 12-15 Inpatient HMO Use Rates Utilization Measure Use Rate per 1,000 Members Acute inpatient discharges 68.7 Acute inpatient days 258.8 Ambulatory encounters 4.3 SUMMARY This chapter briefly examined the financial and operating characteristics of alternative healthcare firms. Although the concepts of financial analysis are the same across all firms, there are some industry specifics that alter the interpretation of financial results. It is important to become familiar with the industry sector being analyzed before reaching general conclusions regarding the performance of any given firm. ASSIGNMENTS 1. Using the information provided in Table 12–16 for UnitedHealth, a major HMO, discuss some of the primary observations that you would conclude regarding the financial performance of the firm. Relate your discussion to the values presented in Table 12–1. Table 12-16 UnitedHealthcare Group, Inc., 2008 (Data in Millions) Balance sheet data     Current assets       Cash & short-term investments $8,209     Net accounts receivable 1,929     Inventory 2,199     Other current assets 3,436 Total current assets $14,990     Net fixed assets 2,181     Long-term investments 13,366     Goodwill and other intangible assets 22,417     Other assets 2,861 Total assets $55,815   Liabilities and equity       Total current liabilities $19,761     Long-term debt 11,338     Other liabilities 3,936     Equity 20,780 Total liabilities & equity $55,815 Income statement data     Total revenue $81,186 Expenses       Depreciation & amortization $981     Other operating expense 74,942     Total operating expense $75,923     Interest expense 639     Net income before taxes $4,624     Income tax 1,647   Discontinued operation loss 0 Net income after tax $2,977 2. Using the information in Table 12–17 for Kindred Healthcare, a major nursing home firm, discuss some of the primary observations that you would conclude regarding the financial performance of the firm. Table 12-17 Kindred Healthcare, Inc., 2008 (Data in Thousands)   Balance Sheet Data       12/31/2008 12/31/2007 12/31/2006 Assets         Current assets           Cash & cash equivalents $337,778 $264,570 $248,722     Net accounts receivable 611,032 598,108 588,166     Other current assets 153,825 150,969 156,560       Total current assets $1,102,635 $1,013,647 $993,448     Property, plant, and equipment, net 735,960 683,338 551,230     Goodwill 72,244 69,100 107,852     Intangible assets 64,367 79,956 117,345     Other assets 1,309,190 1,247,158 1,239,700       Total assets $2,181,761 $2,079,552 $2,016,127 Liabilities         Total current liabilities 625,270 $629,942 $606,998     Long-term debt 349,433 275,814 130,090     Other liabilities 187,804 202,412 184,749     Deferred long-term liability charges 104,279 109,260 98,712   Total liabilities $1,266,786 $1,217,428 $1,020,549 Total stockholders’ equity $914,975 $862,124 $995,578 Income Statement Data   12/31/2008 12/31/2007 12/31/2006 Revenue $4,151,396 $4,179,891 $4,090,365 Expenses         Salaries, wages, and benefits 2,409,673 2,358,914 2,217,582     Supplies 320,410 546,075 671,857     Rent 344,952 343,717 294,186     Other operating expenses 868,026 743,497 660,731     Other income (17,407) (7,701) 0     Investment income (7,101) (16,109) (14,491)     Depreciation 121,413 120,421 116,182       Earnings before interest and taxes $111,430 $91,077 $144,318       Interest expense 15,373 17,044 13,920     Income before taxes $96,057 $74,033 $130,398       Income tax expense 37,164 34,385 51,417       Net income from continuing operations $58,893 $39,648 $78,981     Discontinued operations, net of income taxes (22,608) (86,518) (270)       Net income $36,285 ($46,870) $78,711 SOLUTIONS 1. Table 12–18 provides financial ratio values for UnitedHealth for 2008. UnitedHealth is achieving values of profitability that are on par with industry averages. UnitedHealth’s high return on equity results from judicious use of debt in its capital structure relative to their profit margin. Their current liquidity position also appears adequate, with favorable days in receivables relative to industry averages. UnitedHealth also appears to be using assets efficiently, although their fixed asset efficiency is low relative to industry averages. Table 12-18 Financial Ratios UnitedHealthcare, 2008 Financial Ratio 2008 Industry Average Liquidity         Current ratio 0.76 0.74     Days in receivables 8.67 16.6     Days’ cash-on-hand 105.1 146.9 Capital structure         Debt financing % 62.8% 65.2%     Long-term debt to capital% 35.3% 30.9%     Cash flow to debt % 11.3% 9.0%     Times interest earned* 8.23 8.7 Activity         Current asset turnover 5.4 5.6     Fixed asset turnover 37.2 53.8     Total asset turnover 1.5 1.2 Profitability         Return on equity % 14.3% 14.3% Total margin % 3.7% 4.1% * Times interest earned is net income before interest and taxes divided by interest. 2. Table 12–19 provides financial ratios for Kindred Healthcare for the last 3 years. Kindred has an uneven performance over the past 3 years. On average, Kindred has experienced profit margins that are low compared with industry averages. In addition, Kindred’s return on equity is relatively low compared with industry averages, likely due to its relatively low use of leverage in its capital structure. Coverage of existing debt obligations appears to be more than adequate when compared with industry averages. Short-term liquidity at Kindred also appears to be improving over the 3-year period and is adequate compared with industry averages. Kindred also has lower relative asset efficiency. Much of this is due to low fixed-asset efficiency. The low values for fixed-asset turnover may be a reflection of a newer plant-and-equipment base. Table 12-19 Financial Ratios, Kindred Healthcare, 2008 Financial Ratio 2008 2007 2006 Industry Average Liquidity             Current ratio 1.8 1.6 1.6 1.4     Days in receivables 53.7 52.2 52.5 56.7     Days’ cash-on-hand 31.3 24.2 23.6 35.2 Capital structure             Debt financing % 58.1% 58.5% 50.6% 62.8%     Long-term debt to capital % 27.6% 24.2% 11.6% 42.7%     Cash flow to debt % 12.4% 6.0% 19.1% 11.4%     Times interest earned* 7.2 5.3 10.4 4.87 Activity             Current asset turnover 3.76 4.12 4.12 1.78     Fixed asset turnover 5.64 6.12 7.42 11.9     Total asset turnover 1.90 2.01 2.03 6.40 Profitability             Return on equity % 4.0% –5.4% 7.9% 12.7%     Total margin % 0.9% –1.1% 1.9% 3.1% * Times interest earned is net income before interest and taxes divided by int