Working Capital Management

Chapter 5

Learning Objectives

• Define working capital and the revenue cycle

• Understand working capital and revenue cycle management

• Construct a cash budget

• Understand receivables and payables management

Working Capital

• Working capital refers to both current assets and current liabilities

• Net working capital refers to the difference between current assets and current liabilities

• In day to day operations there is an ongoing flow of cash incoming and outgoing

• In healthcare payments where payment for services may be out 2 months or more, there must be sufficient cash on hand to pay bills

Working Capital Cycle

Working Capital Management Strategies

• Defined as the amount of working capital an organization must keep as a cushion

• 2 components:

• Asset Mix-amount of working capital an organization keeps on hand relative to its potential working capital obligations

• Financing Mix-how an organization chooses to finance its working capital needs

Asset Mix Strategy

• Continuum between aggressive and conservative

• Aggressive-attempts to maximize returns by investing excess funds in non-liquid assets expected to have high earnings

• Conservative-minimizes its risk of having insufficient short-term funds by maintaining higher liquidity

Aggressive Conservative

Goal Maximize returns Minimize risk

Liquidity Low High

Risk High Low

Return High Low

Financing Mix Strategy

• 3 rules to follow to decide between short term and long term borrowing to finance working capital needs:

• Finance short term working capital needs with short term debt

• Finance long term working capital needs with long term financing

• Finance fluctuating needs for working capital by employing a mixed strategy

Short-Term Long–term

Interest Rate Lower Higher

Interest Cost Lower Higher

Profit Higher Lower

Volatility Risks Variable Fixed

Cash Management

• Refers to currency and cash equivalents (interest-bearingsavings and checking accounts

• 3 major reasons to hold cash:

• Daily operations purposes: meeting daily operationspurposes requires holding cash to pay day-to-day bills.

• Precautionary purposes: holding cash to meet unexpecteddemands, such as unforeseen maintenance.

• Speculative purposes: holding cash to take advantage ofunexpected opportunities, such as buying a competing grouppractice that has decided to sell.

Sources of Temporary Cash• 2 primary sources of short term funds are:

1. Bank Loans-lines of credit, commitment fees, compensating balances, transaction notes

2. Extension of credit from suppliers (trade payables)

Lines of credit:

a. Normal line of credit: an agreement established by a bank and aborrower that establishes the maximum amount of funds thatmay be borrowed and the bank may loan the funds at its ownfreedom of choice.

b. Revolving line of credit: an agreement established by a bank anda borrower that legally requires the bank to loan money to theborrower at any time requested, up to a pre-negotiated limit.

commitment fees: is a percentage of the unused portion of the credit line that is charged to the potential borrower.

Trade credit discount

• Compute the approximate annual interest cost of not taking a discount, using each of the following scenarios?

a. 2/10 net 20b. 2/10 net 30c. 2/10 net 40d. 2/10 net 50e. 2/10 net 60

ADiscount percent

BDiscount

period (days)

CPayment

due (days)

DDays/Year

EApproximate Interest Rate

[A/(1-A) x D/(C-B)

2% 10 20 365 74.5%

2% 10 30 365 37.2%

2% 10 40 365 24.8%

2% 10 50 365 18.6%

2% 10 60 365 14.9%

Trade credit discount

• Compute the approximate annual interest cost of not taking a discount, using each of the following scenarios?

a. 1/15 net 20b. 1/15 net 30c. 1/15 net 40d. 1/15 net 50e. 1/15 net 60

ADiscount percent

BDiscount

period (days)

CPayment

due (days)

DDays/Year

EApproximate Interest Rate

[A/(1-A) x D/(C-B)

1% 15 20 365 73.7%

1% 15 30 365 24.6%

1% 15 40 365 14.7%

1% 15 50 365 10.5%

1% 15 60 365 8.2%

Trade credit discount

• Compute the approximate annual interest cost of not taking a discount, using each of the following scenarios?

a. 2/5 net 30b. 2/10 net 30c. 2/15 net 30d. 2/20 net 30

ADiscount percent

BDiscount

period (days)

CPayment

due (days)

DDays/Year

EApproximate Interest Rate

[A/(1-A) x D/(C-B)

2% 5 30 365 29.8%

2% 10 30 365 37.2%

2% 15 30 365 49.7%

2% 20 30 365 74.5%

• Compensating balances: the borrower is required to maintain a designated dollar amount on deposit with the bank.

• The effect of compensating balance is to increase the true of effective interest rate that the borrower must pay.

• 𝒆𝒇𝒇𝒆𝒄𝒕𝒊𝒗𝒆 𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒓𝒂𝒕𝒆 =(𝒊𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆 𝒐𝒏 𝒂𝒎𝒐𝒖𝒏𝒕 𝒃𝒐𝒓𝒓𝒐𝒘𝒆𝒅+𝒕𝒐𝒕𝒂𝒍 𝒇𝒆𝒆𝒔)

(𝒂𝒎𝒐𝒖𝒏𝒕 𝒃𝒐𝒓𝒓𝒐𝒘𝒆𝒅−𝒄𝒐𝒎𝒑𝒆𝒏𝒔𝒂𝒕𝒊𝒏𝒈 𝒃𝒂𝒍𝒂𝒏𝒄𝒆)

• Transaction notes: is a short-term, unsecured loan made for some specific purpose such as financing inventory purchases.

2. Trade Credit or Payables:

a. Trade credit: short term credit offered by the supplier of a good or service to the purchaser.

b. Trade payables: short term debt that results from supplies purchased on credit for a given length of time.

This allows an organization to use the supplier’s money to pay for the purchase up until the time it pays the supplier the amount owed.

Example: • On January 2, 20X1, Uptown Hospital established a line of

credit with First Union National Bank. The terms of the line ofcredit called for a $400,000 maximum loan with an interest rateof 3 percent. The compensating balance requirement is 5percent of the total line of credit (with no additional feescharged).

• What would be the effective interest rate for Uptown Hospitalif 50 percent of the total amount were used during the year?

• What would be the effective interest rate if only 25 percent ofthe total loan were used during the year?

• How would the answer to question a change if the additionalfees were $500?

• How would the answer to question b change if the additionalfees were $1,000?

Solution:

AInterest rate

[Given]

BLine ofcredit

[Given]

CPortion of credit borrowed[Given]

DAmount borrowed

B x C

EInterest expense to borrowA x D

FAdditional fees

[Given]

GCompensating balance percent[Given]

HCompensating balance

B X G

IEffectiveInterestRate[(E+F)/(D-H)]

3% $400,000 50% $200,000 $6,000 $0 5% $20,000 3.3%

3% $400,000 25% $100,000 $3,000 $0 5% $20,000 3.8%

3% $400,000 50% $200,000 $6,000 $500 5% $20,000 3.6%

3% $400,000 25% $100,000 $3,000 $1000 5% $20,000 5.0%

Revenue Cycle Management

• Several hindrances can delay the billing process and collection of cash. For example:

• 1. patients who use more than one name or who have had name changes.

• Address change or no address or phone number on file.

• Lack of clarity about who is responsible for paying the bill, or outdated insurance information.

• Specific requirements demanded by various insurers, such as retrospective reviews.

• Successful cash management is driven by a billing process that must be timely and accurate.

• Ensuring a timely and accurate billing process determines the success of cash management

Revenue Cycle Management

Methods to Monitor Revenue Cycle Performance

Example

Solution a.

Cost to Collect Accounts Receivable: Unadjusted

Formula

A. Net patient revenues Given $225,000,000

B. Cash collections Given $210,000,000

C. Cash as percentage of net patient revenues

[B / A] 93.3%

D. Costs incurred in collection Given $8,000,000

E. Cost to collect [D / B] 3.8%

Solution b. Cost to Collect Accounts Receivable:

Adjusted for Human Intervention

Formula

F. Cash collections Given $210,000,000

G. Percentage cash collections requiring

human intervention

Given 35%

H. Cash collections incurring human

intervention

[F x G] $73,500,000

I. Costs incurred in collection Given $8,000,000

J. Less Electronic Data Interchange (EDI)

costs

Given ($600,000)

K. Revised costs incurred in collection [I - J] $7,400,000

L. Cost to collect for requiring human

intervention

[K / H] 10.1%

M. Cost to collect standard Given 3.0%

Interpretation:

• Penn's unadjusted cost to collect of 3.8% (Row E) is close tothe industry standard of 3% (Row M).

• However, after adjusting for those cash collections thatinvolve human intervention, the cost to collect

• rises dramatically to 10.1% (Row L), which is well above a 3%standard.

• The hospital should invest in updating its software andhardware IT services to try to improve its

• electronic data cash collections.

• This may require the provider to work within stricter healthplan claims requirements to achieve greater

• cash collections electronically, which in turn would decreasethe need for as much human intervention.

Collecting cash payments

• More and more of the payment responsibility with copays anddeductibles resides with the patient at time of service

• By electronically accepting cash payments, providers avoid thecosts of billing and carrying accounts receivable

• Additional avenues for collecting payments include: decentralizedcollection centers, lockboxes, wire transfers

Investing Cash on a Short Term Basis

• Treasury Bills

• Negotiable Certificates of Deposit

• Commercial Paper

• Money Market Mutual Funds

Forecasting Cash Surpluses and Deficits

• In planning financially timing of cash flows in and out must be known.

• Forecast of the above is useful for short term planning

• Cash Balance-The amount of cash an organization must have on hand at the end of the current period to ensure that it has enough cash to cover expected outflows during the next forecasting period.

Accounts Receivable Management

• Most is paid by a third party payer making up about 75% of ahealth care providers current assets

• Providers continuously face the problem of trying to control alargely external process in order to ensure the timely payment ofaccounts.

• Timely and accurate billing is essential and an internal process

• Aging schedule

• Receivables as a percentage of revenue is a means to judge themanagement’s success in collecting revenues

Example

Givens (in '000)

1 Time Sep Aug Jul Quarter

2 Days outstanding 1-30 31-60 61-90 1-90

3 Net accounts receivable $5,000 $3,000 $12,000 $20,000

4 Net patient revenue $12,000 $6,000 $20,000 $38,000

Calculations: Formula Sep Aug Jul Quart

er

A. Aging schedule [a] 25% 15% 60%

B. Days [Given 2] 30 30 30 90

C. Average daily patient revenue [Given 4 / B] $400 $200 $667 $422

D. Days in accounts receivable [Given 3 / C] 47

E. Receivables as percent of

revenues

[Given 3 /

Given 4]

42% 50% 60%

[a] [Given 3] (month) / [Given 3] (quarter)

Givens (in '000)

5 Time Dec Nov Oct Quarter

6 Days outstanding 1-30 31-60 61-90 1-90

7 Net accounts receivable $13,000 $1,000 $6,000 $20,000

8 Net patient revenue $20,000 $6,000 $12,000 $38,00

Calculations: Formula Sep Aug Jul Quart

er

F. Aging schedule [b] 65% 5% 30%

G. Days [Given 6] 30 30 30 90

H. Average daily patient revenue [Given 8 / G] $667 $200 $400 $422

I. Days in accounts receivable [Given 7 / H] 47

J. Receivables as percent of

revenues

[Given 7 /

Given 8]

65% 17% 50%

[b] [Given 7] (month) / [Given 7] (quarter)

Fraud and Abuse

• Comply with laws and regulations related to patient billing,cost reporting , physician transactions and occupationalhealth and safety to ensure fraud and abuse are eradicated.

• HHS, CMS and OIG have programs and approaches to helpminimize fraud and abuse as well as structure for complianceprograms

Summary

• Working capital is needed because it turns the capacity of a health care organization into services and revenues.

• All health care organizations must have sufficient working capital available to meet everyday needs.

• Working capital management strategies must chosen and utilized to meet the financial needs of the health care organization.