Answered Essay: 1. Why do healthcare leaders need to understand finances and learn to use financial tools?

Q1. Why do healthcare leaders need to understand finances and learn to use financial tools?

Ans:Managing the finances of any health care business nowadays is like driving a car with foggy windows. The industry has been changing in big ways since long before the Affordable Care Act took effect. Medicare’s coding system for billing and the advent of electronic medical records are examples of these changes. Financial management in health care requires exceptional skill.

The Role of Financial Management in the Health Services Industry Until the 1960s, financial management in all industries was generally viewed as descriptive in nature, its primary role being to secure the financing needed to meet a business’s operating objectives. A business’s marketing, or planning, department would project demand for the firm’s goods or services; facilities SELF-TEST QUESTIONS 6 managers would estimate the assets needed to meet the projected demand; and the finance department would raise the money needed to purchase the required land, buildings, equipment, and supplies. The study of financial management concentrated on business securities and the markets in which they are sold and on how businesses could access the financial markets to raise capital. Consequently, financial management textbooks of that era were almost totally descriptive in nature. Today, financial management plays a much larger role in the overall management of a business. Now, the primary role of financial management is to plan for, acquire, and utilize funds (capital) to maximize the efficiency and value of the enterprise. Because of this role, financial management is known also as capital finance. The specific goals of financial management depend on the nature of the business, so we will postpone that discussion until later in the chapter. In larger organizations, financial management and accounting are separate functions, although the accounting function typically is carried out under the direction of the organization’s chief financial officer (CFO) and hence falls under the overall category of “finance.” In general, the financial management function includes the following activities: • Evaluation and planning. First and foremost, financial management involves evaluating the financial effectiveness of current operations and planning for the future. • Long-term investment decisions. Although these decisions are more important to senior management, managers at all levels must be concerned with the capital investment decision process. Such decisions focus on the acquisition of new facilities and equipment (fixed assets) and are the primary means by which businesses implement strategic plans; hence, they play a key role in a business’s financial future. • Financing decisions. All organizations must raise funds to buy the assets necessary to support operations. Such decisions involve the choice between the use of internal versus external funds, the use of debt versus equity capital, and the use of long-term versus short-term debt. Although senior managers typically make financing decisions, these choices have ramifications for managers at all levels. • Working capital management. An organization’s current, or shortterm, assets, such as cash, marketable securities, receivables, and inventories, must be properly managed to ensure operational effectiveness and reduce costs. Generally, managers at all levels are involved, to some extent, in short-term asset management, which is often called working capital management. • Contract management. Health services organizations must negotiate, sign, and monitor contracts with managed care organizations and thirdparty payers.. • Financial risk management. Many financial transactions that take place to support the operations of a business can increase a business’s risk. Thus, an important financial management activity is to control financial risk.

What Financial Management Means

In any industry, financial management involves handling routine financial operations, such as negotiating contracts, making cash available for expenses such as payroll, and maintaining a cash cushion for unexpected costs. At the company’s executive level, financial management means providing the other members of the leadership team with information to make strategic plans to prepare for the future. For example, health care providers, such as large physician practices and hospitals, may decide to offer expanded tests or treatments by buying new medical equipment. Helping to make the decision and finding the best way to pay for it are both part of financial management.

Q2. How do operating statements and balance sheets differ? How are they similar?

Ans:

Businesses produce a set of financial statements that reflect business activities, revenues and expenses for each accounting period. The three main financial statements are the balance sheet, income statement, and statement of cash flows. The cash flow statement simply shows the company’s cash activities, the balance sheet illustrates a company’s book value, and the income statement shows how assets and liabilities are used.

The balance sheet shows the company’s assets, liabilities and shareholder equity. The basic accounting formula Assets = Liabilities + Shareholder Equity provides the structure for the statement. Assets are listed first in order of liquidity, including cash, short-term investments, accounts receivable, notes receivable, inventory, and prepaid expenses. Next, long-term assets such as investments, fixed assets such as real property, other assets, and intangible assets are listed. The sum of all assets should equal the following section of the balance sheet, which lists all liabilities in order of maturity and shareholders’ equity. Investors need all of this information to determine the current value of the company.

The income statement, like the balance sheet, helps to illustrate the current value of a business. Revenues and expenses are listed on the income statement as they are accrued and categorized as operating or non-operating activities. First, sales are matched with cost of goods sold to determine gross profit. Next, operating expenses are deducted to reveal operating profit. From this point, any nonoperating revenues and expenses are listed, generating earnings before interest, taxes and amortization EBITA. Taxes are then deducted to reveal the net income. Shareholder distributions are typically made using this final sum, so investors watch it closely. Investors and analysts also pay close attention to the operating section of the income statement to gauge how efficiently management operates the main activities for the company.

A balance sheet provides detailed information about a company’s assets, liabilities and shareholders’ equity.

Assets are things that a company owns that have value. This typically means they can either be sold or used by the company to make products or provide services that can be sold. Assets include physical property, such as plants, trucks, equipment and inventory. It also includes things that can’t be touched but nevertheless exist and have value, such as trademarks and patents. And cash itself is an asset. So are investments a company makes.

Liabilities are amounts of money that a company owes to others. This can include all kinds of obligations, like money borrowed from a bank to launch a new product, rent for use of a building, money owed to suppliers for materials, payroll a company owes to its employees, environmental cleanup costs, or taxes owed to the government. Liabilities also include obligations to provide goods or services to customers in the future.

Shareholders’ equity is sometimes called capital or net worth. It’s the money that would be left if a company sold all of its assets and paid off all of its liabilities. This leftover money belongs to the shareholders, or the owners, of the company.

Both statements are closely scrutinized by investors and stakeholders as they provide a strong indication of the current health and future prospects of any company.

3. How do ratios offer more information than balance sheet data do?

Ans:Financial ratios are tools used to assess the relative strength of companies by performing simple calculations on items on income statements, balance sheets and cash flow statements. Ratios measure companies' operational efficiency, liquidity, stability and profitability, giving investors more relevant information than raw financial data. Investors and analysts can gain profitable advantages in the stock market by using the widely popular, and arguably indispensable, technique of ratio analysis.

Financial ratios provide a standardized method with which to compare companies and industries. Using ratios puts all companies on a relatively equal playing field in the eyes of analysts; companies are judged on their performance rather than their size, sales volume or market share. Comparing the raw financial data of two companies in the same industry offers only limited insight. Ratios go beyond the numbers to reveal how good a company is at making a profit, funding the business, growing through sales rather than debt and a wide range of other factors. An older company, for example, might boast 50 times the revenue of a new small business, which would make the older company seem stronger at first glance. Analyzing the two companies with ratios such as return on equity (ROE), return on assets (ROA) and net profit margin may reveal that the smaller company operates much more efficiently, generating substantially more profit per dollar of assets employed.

Definition of Accounting Ratio:

Ratio is a fraction whose numerator is the antecedent and denominator the consequent.

It is simply an expression of one number in terms of another. It may also be defined as the relationship or proportion that one amount bears to another, the first number being the numerator and the latter the denominator.

Another explanation of the ratio may be the relation of the latter to the earlier amount and computed by dividing the amount for the latter date or period by the amount of the earlier date or period.

(i) Pure ratio: e.g. a ratio between Debt and the Equity, say, 1: 1;

(ii) Ratio which refers to ratios ascertained with reference to time period—e.g., working Capital Turnover Ratio 3 times a year;

(iii) Percentage: e.g.—Net Profit of 20% on sales.

Importance of Ratio Analysis:

The interrelationship that exists among the different items in the Financial Statement are revealed by accounting ratios. Thus, they are equally useful to the internal management, prospective investors, creditors and outsiders etc.

Besides, ratios are the best tool for measuring liquidity, solvency, profitability and management efficiency of a firm. That is why the role of accounting ratios are very significant to increase the efficiency of the management, to reduce the expenditure arid to increase the rate of profit etc.

The importance of ratio analysis is discussed hereunder:

(a) Analysis and Scrutiny of the Past Result:

It helps to analyse the probable causal relation among different items after analysing and scrutinising the past result.

(b) Preparation of Budgets:

The ratios that are derived after analysing and scrutinising the past result helps the management to prepare budgets and estimates, to formulate policy, and to prepare the future plan of action and, thus, helps as a guide to harmonise among different items for preparing budgets.

(c) Time Dimension by Trend Analysis:

It helps to take time dimension into account by trend analysis, i.e. whether the firm is improving or deteriorating over a number of years that can easily be studied by the trend analysis. So, comparison can be made without difficulty by the analyst and to see whether the said ratio is high or low in comparison with the Standard or Normal Ratio.

(d) Measurement of Degree of Efficiency:

It throws light on the degree of efficiency of the management and utilisation of the assets and that is why it is called surveyor of efficiency.

(e) Inter-Firm Comparison:

It helps to make an inter-firm comparison, either between the different departments of a firm or between two firms employed in the identical types of business, or between the same firm on two different dates. Thus, the comparative analysis can be made possible between the industry average ratio and the ratio of each business unit.

(f) Testing Short-term Liquidity:

Short-term liquidity position, i.e. whether the firm is able to maintain its short-term maturing obligations or not that can be easily known by applying liquidity ratios. At the same time, long-term solvency position can also be measured by the application of leverage or profitability ratios. Thus, the ratio is an invaluable aid to the users of Financial Statements.

(g) Communication:

With the help of ratio analysis, meaningful information can be communicated to .the users of accounting information and as a result the analyst can draw right decisions.

(h) Formulating Govt. Polices:

Since ratios are the tools to measure industrial efficiency and performance the Governments takes various financial policy on the basis of the results of various related ratio analysis.

(i) Measuring Corporate Sickness:

Undoubtedly, ratio analysis helps us to measure the corporate sickness well in advance so that the management, shareholders and other interested parties may take proper steps to avoid such a situation.

(j) Testing Long-Term Solvency Position:

Long-term solvency position can be tested with the help of ratio analysis e.g. Debt-Equity ratio, Capital Gearing Ratio etc. These ratios help the analyst to assess the long-term debt paying capacity of the firm. Prospective investors, long-term creditors etc. are interested to measure the long-term solvency position before taking investment decisions

Besides, ratios are the best tool for measuring liquidity, solvency, profitability and management efficiency of a firm. That is why the role of accounting ratios are very significant to increase the efficiency of the management, to reduce the expenditure arid to increase the rate of profit etc.

The importance of ratio analysis is discussed hereunder:

(a) Analysis and Scrutiny of the Past Result:

It helps to analyse the probable causal relation among different items after analysing and scrutinising the past result.

(b) Preparation of Budgets:

The ratios that are derived after analysing and scrutinising the past result helps the management to prepare budgets and estimates, to formulate policy, and to prepare the future plan of action and, thus, helps as a guide to harmonise among different items for preparing budgets.

(c) Time Dimension by Trend Analysis:

It helps to take time dimension into account by trend analysis, i.e. whether the firm is improving or deteriorating over a number of years that can easily be studied by the trend analysis. So, comparison can be made without difficulty by the analyst and to see whether the said ratio is high or low in comparison with the Standard or Normal Ratio.

(d) Measurement of Degree of Efficiency:

It throws light on the degree of efficiency of the management and utilisation of the assets and that is why it is called surveyor of efficiency.

(e) Inter-Firm Comparison:

It helps to make an inter-firm comparison, either between the different departments of a firm or between two firms employed in the identical types of business, or between the same firm on two different dates. Thus, the comparative analysis can be made possible between the industry average ratio and the ratio of each business unit.

(f) Testing Short-term Liquidity:

Short-term liquidity position, i.e. whether the firm is able to maintain its short-term maturing obligations or not that can be easily known by applying liquidity ratios. At the same time, long-term solvency position can also be measured by the application of leverage or profitability ratios. Thus, the ratio is an invaluable aid to the users of Financial Statements.

(g) Communication:

With the help of ratio analysis, meaningful information can be communicated to .the users of accounting information and as a result the analyst can draw right decisions.

(h) Formulating Govt. Polices:

Since ratios are the tools to measure industrial efficiency and performance the Governments takes various financial policy on the basis of the results of various related ratio analysis.

(i) Measuring Corporate Sickness:

Undoubtedly, ratio analysis helps us to measure the corporate sickness well in advance so that the management, shareholders and other interested parties may take proper steps to avoid such a situation.

(j) Testing Long-Term Solvency Position:

Long-term solvency position can be tested with the help of ratio analysis e.g. Debt-Equity ratio, Capital Gearing Ratio etc. These ratios help the analyst to assess the long-term debt paying capacity of the firm. Prospective investors, long-term creditors etc. are interested to measure the long-term solvency position before taking investment decisions

Limitations of Ratio Analysis:

Even the ratio analysis is not free from snags.

There are certain limitations:

(a) Proper Comparison not Possible:

Comparison between two variables prove worthwhile provided their basis of valuation is identical. But, in reality, it is not possible, such as methods of valuation of Stock-in-Trade or charging different methods of depreciation on Fixed Assets etc. That is, if different methods are followed by different firms for their valuation, then comparison will practically be of no vise.

(b) Unreliable Data:

Ratio depends on figures of the Financial Statements. But, in most cases, the figures are window-dressed. As a result, the correct picture cannot be drawn up by the ratio analysis, although certain structural defects can be detected. Moreover, manipulation made through time of reporting which may lead to manipulate the ratio analysis as well.

(c) Trend Analysis not Always Possible:

Ratio analysis becomes more meaningful and significant if trend analysis (i.e. the analysis over a number of years) is possible instead of analysing the result of a particular year. But, in practice, it is not always possible.

(d) Not Helpful for Preparing Budgets:

Ratios are computed on the basis of past result. It does not help properly to predict the future, to prepare budgets and estimates since the business policies are constantly changing.

(e) Difficult to Ascertain Normal or Standard Ratio:

It is very difficult to ascertain the Normal or Standard ratio in order to make proper comparison. Because, it differs from firm to firm, industry to industry, and even between different seasons of the same industry. Besides, it may happen that in one firm, a current ratio of 1: 1 is found to be quite satisfactory, whereas, in another firm, even 2.5: 1 may be found unsatisfactory.

(f) Changes in Price-level:

Ratios do not present true information in case of changing price-level of the variables. In that case, ratios will present distorted figure or misleading information.

(g) Not Possible to Solve the Problems:

Analysis and interpretation of ratios helps us to locate the problems relating to the variables but cannot help us to solve such problems.

(h) Historical:

Since ratios are computed form the past data which are contained in the financial statements they cannot predict future and as such they are not the real tool to make proper comparison.

(i) Fails to Detect the Role of Negative Number:

Ratio-fails to detect the role of negative number—Arithmetical calculations gives wrong information and ratios cannot detect them.

4. What organizational aspect is demonstrated by liquidity ratios?

Ans:Liquidity ratios measure a company’s ability to pay debt obligations and its margin of safety through the calculation of metrics including the current ratio, quick ratio and operating cash flow ratio. Current liabilities are analyzed in relation to liquid assets to evaluate the coverage of short-term debts in an emergency. Bankruptcy analysts and mortgage originators use liquidity ratios to evaluate going concern issues, as liquidity measurement ratios indicate cash flow positioning.

BREAKING DOWN ‘Liquidity Ratios’

Liquidity ratios are most useful when they are used in comparative form. This analysis may be performed internally or externally. For example, internal analysis regarding liquidity ratios involves utilizing multiple accounting periods that are reported using the same accounting methods. Comparing previous time periods to current operations allows analysts to track changes in the business. In general, a higher liquidity ratio indicates that a company is more liquid and has better coverage of outstanding debts.

Alternatively, external analysis involves comparing the liquidity ratios of one company to another company or entire industry. This information is useful to compare the company’s strategic positioning in relation to its competitors when establishing benchmark goals. Liquidity ratio analysis may not be as effective when looking across industries, as various businesses require different financing structures. Liquidity ratio analysis is less effective for comparing businesses of different sizes in different geographical locations.

Solvency Versus Liquidity

Solvency relates to a company’s overall ability to pay debt obligations and continue business operations, while liquidity focuses more on current financial accounts. A company must have more total assets than total liabilities to be considered solvent and more current assets than current liabilities to be considered liquid. Although solvency is not directly correlated to liquidity, liquidity ratios present a preliminary expectation regarding the solvency of a company.

Examples of Liquidity Ratios

The most basic liquidity ratio or metric is the calculation of working capital. Working capital is the difference between current assets and current liabilities. If a business has a positive working capital, this indicates it has more current assets than current liabilities and in the event of an emergency, the business can pay all of its short-term debts. A negative working capital indicates that a company is illiquid.

The current ratio divides total current assets by total current liabilities. This ratio provides the most basic analysis regarding the coverage level of current debts by current assets. The quick ratio expands on the current ratio by only including cash, marketable securities and accounts receivable in the numerator. The quick ratio reflects the potential difficulty in selling inventory or prepaid assets in the result of an emergency.

Q5. To which type of healthcare company would the acid test ratio likely be more applicable than the current ratio? Why?

Ans:The acid-test ratio is a measure of how well a company can meet its short-term financial liabilities.

HOW IT WORKS (EXAMPLE):

Also known as the quick ratio, the acid-test ratio can be calculated as follows:

Acid-Test Ratio = (Cash + Marketable Securities + Accounts Receivable) / Current Liabilities

A common alternative formula is:

Acid-Test Ratio = (Current assets – Inventory) / Current Liabilities

The acid-test ratio is a more conservative version of another well-known liquidity metric — the current ratio. Although the two are similar, the Acid-Test ratio provides a more rigorous assessment of a company’s ability to pay its current liabilities. It does this by eliminating all but the most liquid of current assets from consideration. Inventory is the most notable exclusion, because it is not as rapidly convertible to cash and is often sold on credit. Some analysts include inventory in the ratio, though, if it is more liquid than certain receivables.

To demonstrate, let’s assume this information was pulled from the balance sheet of our theoretical firm — Company XYZ:

Using the primary quick ratio formula and the information above, we can calculate Company XYZ’s Acid-Test ratio as follows:

($60,000 + $10,000 + $40,000) / $65,000 = 1.7

This means that for every dollar of Company XYZ’s current liabilities, the firm has $1.70 of very liquid assets to cover those immediate obligations.

WHY IT MATTERS:

Obviously, it is vital that a company have enough cash on hand to meet accounts payable, interest expenses, and other bills when they become due. The higher the ratio, the more financially secure a company is in the short term. A common rule of thumb is that companies with a Acid-Test or quick ratio of greater than 1.0 are sufficiently able to meet their short-term liabilities.

In general, low or decreasing acid- test ratios generally suggest that a company is over-leveraged, struggling to maintain or grow sales, paying bills too quickly, or collecting receivables too slowly. On the other hand, a high or increasing acid-test ratio generally indicates that a company is experiencing solid top-line growth, quickly converting receivables into cash, and easily able to cover its financial obligations. Such companies often have faster inventory turnover and cash conversion cycles.

Like most other measures, acid-test ratio does have its potential drawbacks. To begin, analysts commonly point out that it provides no information about the level and timing of cash flows, which are what really determine a company’s ability to pay liabilities when due. The acid-test ratio also assumes that accounts receivable are readily available for collection, which may not be the case for many companies. Finally, the formula assumes that a company would liquidate its current assets to pay current liabilities, which is not always realistic, considering some level of working capital is needed to maintain operations.

It is also important to understand that the timing of asset purchases, payment and collection policies, allowances for bad debt, and even capital-raising efforts can all impact the calculation and can result in different acid-test ratios for similar companies. Capital needs that vary from industry to industry can also have an effect on acid-test ratios. For these reasons, liquidity comparisons are generally most meaningful among companies within the same industry.

The acid-test ratio is a strong indicator of whether a firm has sufficient short-term assets to cover its immediate liabilities. Commonly known as the quick ratio, this metric is more robust than the current ratio, also known as the working capital ratio, since it ignores illiquid assets such as inventory.

Calculated by:

BREAKING DOWN ‘Acid-Test Ratio’

Companies with an acid-test ratio of less than 1 do not have the liquid assets to pay their current liabilities and should be treated with caution. If the acid-test ratio is much lower than the current ratio, it means that current assets are highly dependent on inventory.

This is not a bad sign in all cases, however, as some business models are inherently dependent on inventory. Retail stores, for example, may have very low acid-test ratios without necessarily being in danger. At the time of writing, Wal-Mart Stores Inc.’s (WMT) acid-test ratio is 0.20, while Target Corp.’s (TGT) is 0.40. The companies’ current ratios are 0.90 and 1.20, respectively. In such cases other metrics should be considered, such as inventory turnover. The acceptable range for an acid-test ratio will vary by industry, and comparisons are most meaningful within a given industry.

For most industries, the acid-test ratio should exceed 1. Then again, a very high ratio is not always an unalloyed good. It could indicate that cash has accumulated and is idle, rather than being reinvested, returned to shareholders or otherwise put to productive use. Some tech companies generate massive cash flows and accordingly have acid-test ratios as high as 7 or 8. While this is certainly better than the alternative, these companies have drawn criticism from activist investors who would prefer that shareholders receive a portion of the profits.

Acid-test Ratio Calculation

The numerator of the acid-test ratio can be defined in various ways, but the main consideration should be gaining a realistic view of the company’s liquid assets. Cash and cash equivalents should definitely be included, as should short-term investments, for example, marketable securities. Accounts receivable are generally included, but this is not always appropriate. In the construction industry accounts receivable may take a long time to recover, and their inclusion could make a firm’s financial position seem much more secure than it is.

Another way to calculate the numerator is to take all current assets and subtract illiquid assets. Most importantly, inventory should be subtracted, keeping in mind that this will negatively skew the picture for retail businesses, as in the cases of Walmart and Target mentioned above. Other elements that appear as assets on a balance sheet should be subtracted if they cannot be used to cover liabilities in the short term, such as advances to suppliers, prepayments and deferred tax assets.

The denominator should include all current liabilities, which are debts and obligations that are due within one year.

It is important to note that time is not factored into the acid-test ratio. If a company’s accounts payable are nearly due but its receivables won’t come in for months, that company could be on much shakier ground than its ratio would indicate. The opposite can also be true.

6. Why would an organization have many days cash on hand? How could its strategic plans influence this number?

Ans:Days cash on hand is the number of days that an organization can continue to pay its operating expenses, given the amount of cash available. Managers should be aware of the days cash on hand in the following circumstances:

• When a business is starting up, and is not yet generating any cash from sales.
• During the low part of a seasonal sales cycle, when there may be no sales.
• During a transition to a new product line, when sales of the old product line are poor and declining.

A key assumption in determining days cash on hand is that there is no cash flow from sales; instead, there are just operating expenses, such as salaries, rent, and utilities. To determine the amount of these operating expenses, use the operating expenses subtotal in the income statement, and subtract all non-cash expenses (usually depreciation and amortization). Then divide by 365 to determine the amount of cash outflow per day. Finally, divide the cash outflow per day into the total amount of cash on hand. The formula is:

Cash on hand ÷ ((Operating expenses – Noncash expenses) ÷ 365)

For example, a startup company has $200,000 of cash on hand. Its annual operating expenses are $800,000, and there is $40,000 of depreciation. Its days cash on hand calculation is:

$200,000 ÷ (($800,000 Operating expenses – $40,000 Depreciation) ÷ 365 days)

= 96 Days cash on hand

There are several issues with this measurement. First, it is based on an average daily cash outflow, which is not really the case. Instead, cash tends to be spent in a lumpy manner, such as when rent or payroll are paid. Also, management tends to take drastic action to reduce expenses as cash reserves decline, so that the actual days of operation tend to be longer than indicated by this ratio. Thus, it is better to use a detailed cash flow analysis to determine the precise duration of the available cash, with regular updates.

7. How does inventory reduction affect the cash position of an organization?

Ans:

A higher, or quicker, inventory turnover decreases the cash conversion cycle (CCC). A lower, or slower, inventory turnover increases the CCC. The CCC measures the number of days it takes a company to generate and collect revenue from its inventory assets. Stated differently, the CCC measures the time it takes a company to purchase its inventory and then collect cash from its sales.

Cash conversion cycle = days inventory outstanding + days sales outstanding – days payables outstanding

A company’s inventory turnover affects the CCC in that it is used in the calculation for days inventory outstanding:

Days inventory outstanding = average inventory / cost of goods sold per day

When a company’s inventory turnover is high, meaning it cycles through inventory quickly, it reduces the average inventory, and therefore decreases the days inventory outstanding. When a company’s inventory turnover is low, meaning inventory sits on its books for an extended period of time, it increases the average inventory, and therefore increases the days inventory outstanding.

When the days inventory outstanding is low, it reduces the CCC. This means a company is able to collect cash from revenues quickly; the business is able to use its working capital in other areas. When the days inventory outstanding is high, it increases the CCC. This means it takes a company longer to collect its cash from revenues, which causes potential cash flow issues to arise when it company needs working capital.

Q7. How does inventory reduction affect the cash position of an organization?

Ans:Inventory is one of the factors that you can control to improve your small business profitability. The way you source and manage inventory can impact the different profit levels of your income statement. Ignorance of how to use inventory to your advantage prevents you from maximizing operational efficiency

Liquidity is an important measure of your company’s financial health. This calculation determines how well you can pay off your short-term debts. There are a few different ways to measure liquidity. Your company’s inventory impacts its liquidity differently depending on which calculation you use. The correct measure of inventory’s impact on liquidity depends on the type of inventory your company sells.

Inventory Cost

Purchase and production cost of inventory plays a significant role in determining gross profit. Gross profit is computed by deducting the cost of goods sold from net sales. An overall decrease in inventory cost results in a lower cost of goods sold. Gross profit increases as the cost of goods sold decreases. With all other accounts being equal, a bigger gross profit can translate into higher profits.

Inventory Method

Generally accepted accounting principles in the U.S. allow businesses to use one of several inventory accounting methods. FIFO (first-in, first-out), LIFO (last-in, first-out) and average cost are the three most commonly used inventory systems. When inventory costs are not uniform due to price fluctuations, the choice of inventory method can result to an increase or decrease in cost of goods sold.

Inventory Levels

Inventory levels can have a direct effect on cash flow. To a company with limited cash flow, tying up much needed funds in inventory that is not needed during the current accounting period has severe effects on expenditures. Some types of expenditures, such as marketing expenses, can have a considerable effect on profitability. On the contrary, not having sufficient inventory to sell can decrease revenue and affect profitability. Another disadvantage of overstocking inventory is warehousing expense — more inventory requires more labor and space.

Inventory Turnover

Inventory turnover, or the number of times inventory is sold over a given period, affects profitability. Keeping stocks that are obsolete and have a low turnover slows down sales. Keeping stocks that are having a high demand boosts sales levels. Inventory levels should consider demand levels to avoid overstocking and under stocking. Proper inventory management is vital to maximizing operational efficiency and profitability.

Q8. How does debt benefit an organization? What load of debt is considered too great?

Ans:The debt-to-equity ratio is a measure of a company’s financial leverage that relates the amount of a firms’ debt financing to the amount of equity financing. It is calculated by dividing a firm’s total liabilities by total shareholders’ equity. What is considered a “high” debt-to-equity ratio differs depending upon the industry, because some industries tend to utilize more debt financing than others. There is no single value above which would be deemed a high debt-to-equity ratio.

The financial industry, for example, typically has a higher debt-to-equity ratio. This is due to the fact that banks and other financial institutions borrow money to lend money, which results in a higher debt-to-equity ratio. Other industries that are highly capital intensive, such as services, utilities and the industrial goods sector, also tend to have higher debt-to-equity ratios.

As a result, investors must look at a company’s historical debt-to-equity ratio figures to determine if there have been significant changes that could indicate a red flag. In addition, investors must also make comparisons between other similar companies and the industry as a whole to determine if a particular firm has what could be considered a high debt-to-equity ratio.

A higher debt-to-equity ratio typically shows that a company has been aggressive in financing its growth with debt, and there may be a greater potential for financial distress if earnings do not exceed the cost of borrowed funds.

It has been conventional wisdom that, whatever its troubling side effects, the aggressive use of financial leverage pays off in higher company values. Two decades of finance-based research, which the authors summarize here, qualify that wisdom substantially. Corporate and personal tax rates, which of course vary from situation to situation, significantly affect the attractiveness of debt. So, too, do the hidden costs of higher leverage, which include the restrictions it places on a company’s flexibility in adapting financial policies to strategic goals. To assist companies in building an optimal capital structure, the authors outline a series of questions for CFOs to ask themselves before they establish a debt policy.

9. How can a public hospital have a low or negative operating margin yet have enough funds to survive and prosper?

Ans:Even the most successful businesses lose money sometimes. Economic downturns, unfortunate ventures and expansion expenditures can contribute to negative net profit margins, which occur when your business spends more than it earns during a particular period. Most companies don’t go out of business just because they have a temporary negative net profit margin. Resourceful entrepreneurs have a range of strategies for finding enough money to keep operating and correcting situations that can lead to long-term losses.

The operating profit margin ratio, or simply operating margin, measures a company’s operating profit as a percentage of its sales revenue on the income statement. In general, a high, positive operating margin is better for your small business. But if your business is new or experiences a bad quarter or year, you might have a negative operating margin. This occurs when you have negative operating profit. If your business sustains a negative operating margin for too long, you might need additional funding.

Operating Profit

Operating profit represents earnings from your core business activities before you pay non-operating expenses, such as interest and income taxes. It equals sales minus cost of goods sold minus operating expenses. Operating expenses are your selling and administrative costs, such as wages and utilities. When cost of goods sold and operating expenses exceed sales, you get negative operating profit, or an operating loss. For example, assume your small business had $800,000 in sales, $500,000 in cost of goods sold and $400,000 in operating expenses last year. Your operating profit is negative $100,000.

Operating Margin

Your operating margin equals your operating profit or loss divided by sales, times 100, and is expressed as a percentage. (See References 1, Page 95) An operating loss causes a negative operating margin, because an operating loss is a negative figure. In the previous example, you have a negative operating margin of -12.5 percent, or -$100,000 divided by $800,000, times 100. This means you lost 12.5 cents in your operations for every dollar of sales you produced during the year.

Negative Operating Margin Implications

When it comes to a negative operating margin, lower is better. The higher the negative percentage, the more severe the operating loss. When you lose more money in your operations than you generate in sales, you have to rely on your cash reserves, money from selling assets or money from new funding to pay your operating costs. Because operating profit and operating margin are measured before interest and taxes, you also need money to pay these non-operating expenses.