Healthcare Finance: An Introduction to Accounting and Financial Management 4th edition

679 Pages·2007·4.45 MB·English

by  Louis C. Gapenski

An introduction to
accounting and
financial
management

louis c. gapenski

HEALTHCARE
FINANCE

FOURTH EDITION

Like its predecessors, this textbook teaches the reader the fundamental concepts
of healthcare finance, including both financial management and accounting.

fourth edition features
•
New or expanded coverage of

- Municipal bond pools

- Cost of capital for not-for-profit and small businesses

- Modified internal rate of return

- Supply chain management

- Health savings accounts
•
Current information on reimbursement, along with updated real-world examples
•
Easy-to-grasp spreadsheet illustrations of the calculations throughout the book
•
Learning aids, including a glossary; self-test questions; and end-of-chapter key

concepts, questions, and problems

companion website
Go online to access additional learning tools, including:
•
Bonus chapter on distributions to owners of for-profit businesses
•
Bonus chapter that covers capitation, rate setting, and risk sharing
•
Appendixes that provide lists of financial and operating indicator ratios

and their definitions
The companion website can be accessed at ache.org/books/HCFinance4.

companion casebook
Cases in Healthcare Finance, also published by Health Administration Press, is an
ideal supplement to this text. Through real-world cases, it provides the opportunity
to bridge the gap between learning concepts in a lecture setting and actually
applying these concepts on the job. Be better prepared to deal with the multitude
of issues that arise in the practice of healthcare finance.

also available from health administration press
Understanding Healthcare Financial Management, Fifth Edition
by Louis C. Gapenski, Ph.D., in collaboration with George H. Pink, Ph.D.

Healthcare Finance

FOURTH EDITION
gapenski

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HEALTHCARE
FINANCE

Fourth Edition

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AUPHA

HAP
Editorial Board

Sandra Potthoff, Ph.D., Chair
University of Minnesota

Simone Cummings, Ph.D.
Washington University

Sherril B. Gelmon, Dr.P.H., FACHE
Portland State University

Thomas E. Getzen, Ph.D.
Temple University

Barry Greene, Ph.D.
University of Iowa

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

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

Tim McBride, Ph.D.
St. Louis University

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

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

Dawn Oetjen, Ph.D.
University of Central Florida

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

Lydia M. Reed
AUPHA

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

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

Frederick J. Wenzel
University of St. Thomas

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HEALTHCARE
FINANCE

An Introduction to
Accounting and
Financial Management

Fourth Edition

Louis C. Gapenski

AUPHA

HAP

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Your board, staff, or clients may also benefit from this book’s insight. For more
information on quantity discounts, contact the Health Administration Press Mar-
keting Manager at [phone].

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

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

Copyright © 2008 by the Foundation of the American College of Healthcare
Executives. Printed in the United States of America. All rights reserved. This book
or parts thereof may not be reproduced in any form without written permission
of the publisher.

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Library of Congress Cataloging-in-Publication Data

Gapenski, Louis C.
Healthcare finance : an introduction to accounting and financial
management / Louis C. Gapenski.—4th ed.
p. cm.
Includes bibliographical references and index.
ISBN 978-1–56793-280-5 (alk. paper)
1. Health facilities—Finance—Textbooks. 2. Health
facilities—Accounting—Textbooks. I. Title.
[DNLM: 1. Financial Management, Hospital. 2. Accounting. 3. Capital
Financing. 4. Health Facilities—economics. WX 157 G211h 2007]
RA971.3.G3695 2007
362.1068'1—dc22
2007015110

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

Acquisitions manager: Janet Davis; Project manager: Jane Calayag

Health Administration Press
A division of the Foundation
of the American College of
Healthcare Executives
One North Franklin Street
Suite 1700
Chicago, IL 60606
[phone]

Association of University Programs
in Health Administration
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Arlington, VA 22201
[phone]

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BRIEF CONTENTS

Preface xiii

PART I The Healthcare Environment

1 Introduction to Healthcare Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 3

2 The Financial Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

PART II Financial Accounting

3 Financial Accounting Basics and the Income Statement . . . . . . . . 59

4 The Balance Sheet and Statement of Cash Flows . . . . . . . . . . . . . . 93

PART III Managerial Accounting

5 Managerial Accounting Basics, Cost Behavior,
and Profit Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

6 Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

7 Pricing and Service Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

8 Planning and Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

PART IV Basic Financial Management Concepts

9 Time Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

10 Financial Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . 301

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PART V Long-Term Financing

11 Long-Term Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

12 Equity Financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

13 Capital Structure and the Cost of Capital . . . . . . . . . . . . . . . . . . . 411

PART VI Capital Investment Decisions

14 The Basics of Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 451

15 Project Risk Assessment and Incorporation . . . . . . . . . . . . . . . . . . 491

PART VII Other Topics

16 Current Asset Management and Financing . . . . . . . . . . . . . . . . . . 523

17 Financial Condition Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561

18 Lease Financing and Business Valuation. . . . . . . . . . . . . . . . . . . . . 597

Glossary 627

Index 647

About the Author 659

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DETAILED CONTENTS

Preface xiii

PART I The Healthcare Environment

1 Introduction to Healthcare Finance . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Defining Healthcare Finance, 3; Purpose of the Book, 5; The Role of
Finance in Health Services Organizations, 6; The Structure of the Finance
Department, 8; Health Services Settings, 9; Regulatory and Legal
Issues, 15; Current Challenges, 17; Organization of the Book, 17; How to
Use this Book, 19

2 The Financial Environment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

Alternative Forms of Business Organization, 25; Alternative Forms of
Ownership, 30; Organizational Goals, 34; Tax Laws, 36; Third-Party
Payers, 38; Managed Care Plans, 42; Alternative Reimbursement
Methods, 44

PART II Financial Accounting

3 Financial Accounting Basics and the Income Statement . . . . . . . . 59

Historical Foundations of Financial Accounting, 60; The Users of
Financial Accounting Information, 61; Regulation and Standards in
Financial Accounting, 62; Basic Concepts of Financial Accounting, 65;
Accounting Methods: Cash Versus Accrual, 68; Recording and Compiling
Accounting Data, 71; Income Statement Basics, 74; Revenues, 75;
Expenses, 79; Net Income, 82; Net Income Versus Cash Flow, 84; Income
Statements of Investor-Owned Firms, 85; A Look Ahead: Using Income
Statement Data in Financial Statement Analysis, 86

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4 The Balance Sheet and Statement of Cash Flows . . . . . . . . . . . . . . 93

Balance Sheet Basics, 94; Assets, 96; Liabilities, 102; Equity, 104; Fund
Accounting, 108; The Statement of Cash Flows, 108; Transactions, 112;
Another Look Ahead: Using Balance Sheet Data in Financial Statement
Analysis, 117

PART III Managerial Accounting

5 Managerial Accounting Basics, Cost Behavior, and Profit
Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .127

The Basics of Managerial Accounting, 127; Cost Classifications: Fixed and
Variable, 129; Cost Behavior, 130; Cost Classifications: Semi-Fixed, 133;
Profit (CVP) Analysis, 134; Breakeven Analysis, 139; Operating
Leverage, 142; Profit Analysis in a Discounted Fee-for-Service
Environment, 144; Profit Analysis in a Capitated Environment, 149; The
Impact of Cost Structure on Financial Risk, 156

6 Cost Allocation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 163

Direct Versus Indirect (Overhead) Costs, 163; Introduction to Cost
Allocation, 164; Cost Allocation Basics, 165; Cost Allocation
Methods, 169; Direct Method Illustration, 171; Changing to a Better
Cost Driver, 177; Step-Down Method Illustration, 180; Activity-Based
Costing, 182; Final Thoughts on Cost Allocation, 186

7 Pricing and Service Decisions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 193

Healthcare Providers and the Power to Set Prices, 194; Price Setting
Strategies, 195; Target Costing, 197; Setting Prices on Individual
Services, 198; Setting Prices Under Capitation, 199; Setting Managed
Care Plan Premium Rates, 207; Using Relative Value Units (RVUs) to Set
Prices, 212; Making Service Decisions (Contract Analysis), 214

8 Planning and Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 225

The Planning Process, 226; Operational Planning, 229; Introduction to
Budgeting, 231; Budget Types, 232; Budget Decisions, 235; Constructing
a Simple Operating Budget, 237; Variance Analysis, 240; The Cash
Budget, 248

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PART IV Basic Financial Management Concepts

9 Time Value Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

Time Lines, 264; Future Value of a Lump Sum (Compounding), 265;
Present Value of a Lump Sum (Discounting), 270; Opportunity
Costs, 273; Solving for Interest Rate and Time, 275; Annuities, 277;
Perpetuities, 282; Uneven Cash Flow Streams, 283; Using Time Value
Analysis to Measure Return on Investment (ROI), 286; Semiannual and
Other Compounding Periods, 290; Amortized Loans, 294

10 Financial Risk and Required Return . . . . . . . . . . . . . . . . . . . . . . . . 301

The Many Faces of Financial Risk, 302; Introduction to Financial
Risk, 303; Risk Aversion, 305; Probability Distributions, 305; Expected
and Realized Rates of Return, 307; Stand-Alone Risk, 308; Portfolio Risk
and Return, 311; Measuring the Risk of Investments Held in
Portfolios, 319; Portfolio Betas, 325; Relevance of the Risk
Measures, 326; Interpretation of the Risk Measures, 327; The
Relationship Between Risk and Required Return, 328

PART V Long-Term Financing

11 Long-Term Debt Financing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341

The Cost of Money, 341; Common Long-Term Debt Instruments, 343;
Debt Contracts, 348; Bond Ratings, 350; Credit Enhancement, 352;
Interest Rate Components, 352; The Term Structure of Interest
Rates, 356; Economic Factors That Influence Interest Rate Levels, 358;
Debt Valuation, 359

12 Equity Financing. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 379

Equity in For-Profit Businesses, 379; Types of Common Stock, 383;
Procedures for Selling New Common Stock, 383; The Market for
Common Stock, 386; Regulation of Securities Markets, 387; The
Investment Banking Process, 389; Equity in Not-for-Profit
Businesses, 391; Common Stock Valuation, 393; Security Market
Equilibrium, 400; Informational Efficiency, 401; The Risk/Return
Trade-Off, 404

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13 Capital Structure and the Cost of Capital . . . . . . . . . . . . . . . . . . . 411

Capital Structure Basics, 411; Impact of Debt Financing on Accounting
Risk and Return, 412; Capital Structure Theory, 415; Identifying the
Optimal Capital Structure in Practice, 418; Not-for-Profit Businesses, 420;
Cost of Capital Basics, 422; Cost of Debt Capital, 423; Cost of Equity
Capital, 425; The Corporate Cost of Capital, 434; Cost of Capital
Estimation for Small Businesses, 436; An Economic Interpretation of the
Corporate Cost of Capital, 439

PART VI Capital Investment Decisions

14 The Basics of Capital Budgeting . . . . . . . . . . . . . . . . . . . . . . . . . . . 451

Project Classifications, 452; The Role of Financial Analysis in Healthcare
Capital Budgeting, 453; Overview of Capital Budgeting Financial
Analysis, 454; Cash Flow Estimation, 454; Cash Flow Estimation
Example, 461; Breakeven Analysis, 468; Return on Investment
(Profitability) Analysis, 469; Some Final Thoughts on Breakeven and
Profitability Analyses, 475; Capital Budgeting in Not-for-Profit
Businesses, 475; The Post-Audit, 478; Using Capital Budgeting
Techniques in Other Contexts, 479

15 Project Risk Assessment and Incorporation . . . . . . . . . . . . . . . . . . 491

Types of Project Risk, 492; Relationships Among Stand-Alone, Corporate,
and Market Risk, 493; Risk Analysis Illustration, 494; Sensitivity
Analysis, 496; Scenario Analysis, 499; Qualitative Risk Assessment, 502;
Incorporating Risk into the Decision Process, 503; Making the Final
Decision, 506; Adjusting Cash Outflows for Risk, 507; Divisional Costs of
Capital, 509; An Overview of the Capital Budgeting Decision
Process, 510; Capital Rationing, 512

PART VII Other Topics

16 Current Asset Management and Financing . . . . . . . . . . . . . . . . . . 523

An Overview of Short-Term Financial Management, 523; Current Asset
Investment and Financing Policies, 525; Cash Management, 530;
Marketable Securities Management, 534; Long-Term Securities
Management, 535; Receivables Management, 536; Supply Chain
Management, 541; Short-Term Financing, 544

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17 Financial Condition Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 561

Financial Statements, 562; Financial Ratio Analysis, 565; Tying the
Financial Ratios Together: Du Pont Analysis, 577; Other Analytical
Techniques, 579; Operating Indicator Analysis, 580; Limitations of
Financial Ratio and Operating Indicator Analyses, 583; Economic Value
Added (EVA), 584; Benchmarking, 585; Key Performance Indicators and
Dashboards, 586

18 Lease Financing and Business Valuation. . . . . . . . . . . . . . . . . . . . . 597

Leasing Basics, 597; Tax Effects, 599; Financial Statement Effects, 601;
Lease Evaluation, 603; Motivations for Leasing, 611; Business
Valuation, 615

Glossary 627

Index 647

About the Author 659

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PREFACE

S

ome 20 years ago, after years of teaching corporate finance and writing
related textbooks and casebooks, I began teaching healthcare financial
management in the University of Florida’s Master of Health Adminis-
tration (MHA) program. The move prompted me to write my first healthcare
finance textbook, Understanding Health Care Financial Management. The
book was designed for use in health services administration financial manage-
ment courses in which students had prerequisite courses in both accounting
and corporate finance. In general, such courses are case courses, so this book
served primarily as a reference tool when working healthcare finance cases.
In recent years, I expanded my healthcare finance teaching to include
other courses in traditional, nontraditional, and clinician-oriented programs
in which students do not have a formal educational background in healthcare
finance. Finance courses in these programs require a book that provides basic
information on foundation topics. Furthermore, these courses often are part
of programs that contain just one healthcare finance course, so the course must
cover both accounting and financial management. In reviewing the books
available for use in such courses, I found some that were strong in accounting
and others that were strong in financial management; however, I could not
find one that gave equal emphasis to both components of healthcare finance.
This situation prompted me to write Healthcare Finance: An Introduction to
Accounting and Financial Management.

Concept of the Book

My goal in writing this book was to create a text that introduces students
to the most important principles and applications of healthcare finance, with
roughly equal coverage of accounting and financial management. Further-
more, because the book is intended for use primarily in clinical and health
services administration programs, in which students are trained primarily for
professional positions within healthcare providers, its focus is on healthcare
finance as practiced within such organizations. The examples within the book
are based on such organizations as hospitals, medical practices, clinics, home
health agencies, nursing homes, and managed care organizations.
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Another consideration in writing the book is that most readers would
be seeing the material for the first time. Thus, it is very important that the
material be explained as clearly and succinctly as possible. I have tried very
hard to create a book that readers will find user-friendly—one that they will
enjoy reading and can learn from on their own. If students don’t find a book
interesting, understandable, and useful, they won’t read it.
The book begins with an introduction to healthcare finance and a
description of the current financial environment in which providers operate.
From there, it takes students through the basics of financial and managerial
accounting. Here, my goal is not to turn clinicians or generalist managers into
accountants, but to present those accounting concepts that are most critical
to managerial decision making. The book then discusses the basic foundations
of financial management before progressing to demonstrate how healthcare
managers can apply financial management theory and principles to help make
better decisions, where better is defined as decisions that promote the financial
well-being of the organization.

Intended Market and Use

The book is not targeted for specific types of educational programs. Rather,
it is designed to teach students, in one course, the fundamental concepts
of healthcare finance, including both accounting and financial management,
with emphasis on provider organizations. Thus, the book can be used in a
wide variety of settings: undergraduate and graduate programs, traditional
and executive programs, on-campus and distance learning programs, and even
independently for professional development.
The key to the book’s usefulness is not the educational program but
the focus of the course. If the course is a stand-alone course designed to
cover both healthcare accounting and financial management, the book will
fit. In fact, the book can be easily used across a two-course healthcare finance
sequence, especially in modular programs where each course is two credit
hours. Typically, such a sequence begins with an accounting course and ends
with a financial management course. This book, supplemented by cases (and
possibly readings), would work well in such a sequence. The ideal casebook
for use here is Cases in Healthcare Finance by Louis C. Gapenski, which is
part of Health Administration Press’s healthcare finance series. The casebook
contains 30 cases that focus on the topics contained in this textbook, along
with eight ethics mini-cases that can be used to highlight ethical issues in a
healthcare finance setting.
The book should also be useful to practicing healthcare professionals
who, for one reason or another, must increase their understanding of health-
care finance. Such professionals include clinicians who have some management
responsibilities as well as line managers who now require additional finance
skills. Finally, many members of financial staffs, especially those who work