2So You Want To Purchase Something………. The available alternativesCash availableCost InformationBenefit InformationRisk Profile
3Which Project to Fund? Solvency Incremental management time required Public imageMedical staff approval
4Which to Fund - UCSF Style Required by code or regulationsPatient or employee safetyRevenue generation or cost avoidanceReplacement
5Justification Need - relative to attainment of mission and goals Economic feasibilityAcceptability (vis-à-vis established priorities or other criteria)
6Sources of Cash From Operations From Investments From Debt Collections from A/RCash salesFrom InvestmentsFrom DebtFrom Charitable donationsFrom selling assets
7Uses of Cash Payroll Accounts Payables Payment on debt Capital purchasesInvestment
8Liquidity Concerns Increase the level of cash and investment reserves Restructure debtArrange a line of credit against a collateralShorten A/R CycleLengthen Payment Cycle
9Working Capital Relationship between Current Assets Current Liabilities
10Current Assets Cash and investments A/R Inventories Other current assetsA Balance Sheet Parameter
11Current Liabilities A/P Accrued salaries and wages Accrued expenses Notes payableCurrent position on long term debtA Balance Sheet Parameter
12Management of the A/R Minimize lost charges Minimize late charges Minimize write-offsMinimize the A/R days to an acceptable level
13Management of A/P Minimize the amount of vendors Track the invoice to purchase order to the receiverMaximize payment cycle or gain financial incentive for shorter payment cycle
14Cash Budget - 4 Activities Purchasing of resources (Capital equipment)Production/sale of serviceBillingCollection
15Rule of ThumbMinimize the A/R cycle and lengthen the A/P cycle within limits. By doing so, there is usually a positive cash flow within the organization
16Financial Ratio Analysis Are the fundamental analytical tools for interpreting financial statementsFour classes of ratios:LiquiditySolvencyFunds managementProfitability
17Liquidity RatiosLiquidity is measured by its ability to raise cash from all sources (credit, sale of assets, and operations)Used to appraise a company’s ability to meet its current obligations using existing cash and current assetsTypically, it is assumed that the higher the ratio, the more protection the company has against liquidity problems
18Liquidity Ratios Current Ratio is current assets / current liabilities What is the current ratio for XYZ Corporation?Acid-Test or Quick Ratio is quick assets / current liabilitiesMeasures the ability of a company to use its “near-cash” or quick assets to meet its current liabilitiesWhat is the acid-test ratio for XYZ Corporation?
19Comparative Balance Sheet ($000’s) XYZ CorporationComparative Balance Sheet ($000’s)ASSETSYEAR ONEYEAR TWOCurrent assets:Cash2030Accounts receivable (net)95Inventory130110Total current assets245235Fixed assets:Land10Building and equipment (net)120100Total fixed assets (net)Other assets:Goodwill and organizational costsTotal Assets385355LIABILITIESCurrent liabilities:Accounts payable5040Estimated income taxes payableTotal current liabilities60Long-term liabilitiesMortgage bonds, 10 percentLong-term debt275255Total Liabilities
20Income Statement ($000’s) XYZ CorporationIncome Statement ($000’s)Gross Sales$11,516Less: Returns and allowances10Net Sales1,506Less: Cost of goods sold1,004Gross profit502Operating expenses400Operating profit102Interest5Profit before taxes97Income tax expense47Net income50
21Accounts Payable Management The day’s payables ratio becomes meaningful when compared to the credit terms given by the suppliers.To calculate the day’s payables:Purchases / DayThen, Accounts payable / Purchases per day = Day’s PayablesInventory Turnover is important to managementInventory turnover = cost of sales / average inventory
22Solvency RatiosThese ratios generate insight into a company’s ability to meet long-term debt payment schedules“Times Interest Earned” isOperating profit (before interest expense) / Long-term debt interestWhat is XYZ Corporation’s Times Interest Earned Ratio?The ratio indicates the extent to which operating profits can decline without impairing the company’s ability to pay the interest on its long-term debt.
23Solvency RatiosDebt-to-equity ratios – relationship of borrowed funds to ownership funds is an important solvency ratio. Capital from debt and other creditor sources is more risky for a company than equity capital.One common ratio isTotal Liabilities / Total AssetsWhat is XYZ Corporation’s Debt-to-equity ratio?
24Funds Management Ratios The financial situation of a company is affected in large measure on how its investments in accounts receivable, inventories, and fixed assets are managedReceivables to Sales:Accounts receivable (net) / Net salesAverage Collection Period:Accounts receivable / Net sales x Days in the annual period = Collection periodAverage Accounts Payable Period:Accounts payable / Purchases
25Profitability RatiosProfit margin (Gross or Net)ROI
26Making The Right Decision Life of capital assetsMeeting the “expected demand”Investment of cash
27Types of Investments Replacement of damaged equipment Replacement of obsolete equipmentExpansionNew technology, services and marketsSafety improvementOthers
285 Steps in Capital Budgeting Identify the initial costForecast operating cash flowsAssess the riskMeasure the investment’s worthAssess the profitability
294 Questions - Initial Cost Analysis What is the invoice price?Additional expenses?Revenues from sales of old equipment?How tax is owed?
30Case Study – Identifying the Project’s Initial Costs East Oz Community Hospital is planning to buy anultrasound unit for $200,000. The unit has astraight-line depreciation life of 5 years. The oldultrasound unit is being sold for $50,000. It wasbought by the Hospital brand new 3 years ago for$100,000. The hospital must pay $2,000 fordelivery and $11,000 for training and calibration.The tax rate for capital gains is 34 percent. Networking capital for the hospital does not change withthis purchase. What is the initial cost for the project?
31Forecasting the Cash Flows Calculate additional net earningsCalculate tax benefits of depreciationIncremental cash flow = additional net earnings + additional tax benefits
32Case Study – Forecasting Cash Flows East Oz Community Hospital is considering replacingtheir CT scanner with a newer, multi-slice, highly efficient,higher resolution state-of-the-art CT scanner. Theexisting scanner was purchased 3 years ago for $500,000.The new machine is $750,000. For each machine assumea 5-year straight-line depreciation. The capital gainstax rate is 34 percent. What are the incremental cashflows associated with the purchase of the new CTscanner?
33Payback AnalysisThe payback is the number of years needed to recover the initial investment
34Payback Analysis Easy to use Easy to understand The shorter the payback time, the less risky is the investmentIgnores the time value of moneyIgnores the cash inflows produced after the initial investment is recovered
35Net Present Value (NPV) NPV = Present value - Initial InvestmentPositive or zero NPV, accept the projectNegative NPV, reject projectImportance on determining the right discount rate
36NPV Uses cash flows instead of earnings Recognizes the time value of moneyPositive NPV’s increases the value of the organizationFuture cash predictions are difficult to makeNPV assumes the same discount rate throughout the life of the projectIn a capital budget, go for the NPV with the greatest (+)In a operating budget, go for the NPV with thegreatest (-)
37NPV PV = Future Value / (1 + Discount Rate) ** (# of years)
38Case Study - NPVA project will have an annual cash flow over the first 3years of $6,000, $4,000 and $2,000. If the discount rateis 10% and the initial investment is $15,000, do yourecommend funding this project?
39Discount Rate Prediction Riskier projects have a higher discount rateWhen interest rate and inflation rates are up, the discount rate will be higherLonger life of the project, higher the discount rate
40Risk Assessment - Sensitivity Analysis The purpose is to find out how sensitive various indicators are to changeA riskier project is more sensitive to change
41Case Study – Sensitivity Analysis East Oz Community Hospital is considering two short-term projects. The first project has a cash flow of$1,000 in Year One of the project and $1,500 for YearsTwo and Three. Correspondingly, the second projecthas a cash flow of $1,800 in Year One and $700 inYears Two and Three. The initial investment for eachproject is $1,600. If the discount rate changes from10 percent to 12 percent, which project is riskier?
42Average Rate of Return (ARR) Measures the relationship between the new earnings of a project to the average investment.ARR = Average annual future net earnings / One-half of initial investment
43ARR Easy to Use Easy to understand The higher the ARR, the less risky the investmentIgnores the time value of moneyUses earnings instead of cash flowIgnores depreciationIgnores value of salvageIgnores time sequence of net earnings
44Case Study – Average Rate of Return The net earnings for a project over the next 5 years are$10,000 per year. If the initial investment is $60,000,what is the average rate of return?
45Internal Rate of Return IRR is a discount rate that makes the present value of cash flows equal to the initial investmentThe rate below where projects are rejected is called the cutoff rate.Predicts a firm’s opportunity to reinvest future cash flows from the project
46IRR Simple to use Takes into account the time value of money May give unrealistic rates of return
47Case Study – Internal Rate of Return The nursing department projected an annual cash flowfor a new outreach program to be $2,500 for 6 years.The initial investment for the program is $17,500. Whatis the IRR and should the program be accepted if thecutoff rate is 10 percent?
48Profitability IndexPI = Present value of cash flows / Initial investmentProject with a PI greater than one is accepted
49Case Study – Profitability Index East Oz Community Hospital is considering a project withan annual cash flow of $5,000 for the next 5 years. Theinitial investment is $20,000. Using the PI method anda discount rate of 10 percent, should the project beaccepted?
50Equivalent Annual Cost Present value of operating cost + Present value of investment costPresent value of annuity
51Equivalent Annual Cost Comparison of 2 alternate projects with different livesBe aware of changing conditionsEquivalent annual cost is not identical to reportable accounting costs, such as depreciation costs
52Present Value of an Annuity When faced by a steady and constant stream of future payments or receipts, decision makers want to evaluate the present value of these figures.Employ a present value annuity factorNOTE = An annuity is a series of equal payments (or receipts) made at any regular interval of time.
53Present Value of Annuity Present value of an annuity =Amount of Annuity(1+Discount Rate)**NN = Number of years or periods
54Case Study – Equivalent Annual Cost East Oz Community Hospital would like to replace theirfire sprinkler system. One system cost $5,000 with anannual maintenance cost of $500 over the 10-year lifeto the system. The second system cost $10,000 andrequires only $200 per year for maintenance. However,this second system has a 20-year life. The discountfactor is 10 percent and ignores cost reimbursement.Which one would be better?