CHAPTER 1Introduction to Healthcare
Financial Management
Chapter 1 focuses on the institutional setting for the
delivery of healthcare services. It is important to
understand the framework under which health services
are delivered, because this framework has a profound
influence on the practice of finance.
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College of Healthcare Executives. Not for sale.
Introduction
◼Financial management provides the theory,
concepts, and tools necessary to help managers
make better financial decisions.
◼Health services industry is truly unique:
⚫Not-for-profit organizations
⚫Third-party payer system
⚫Extent of governmental involvement
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Goal of the Course
The primary goal of the course is to enable you
to:
⚫Judge the validity of financial analyses performed by
others.
⚫Incorporate sound financial management theory and
principles in your own managerial and personal
decision making.
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College of Healthcare Executives. Not for sale.
The Role of Finance
The primary role of finance is to plan for,
acquire, and utilize resources to maximize the
efficiency and value of the organization.
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Finance Activities
◼ Evaluation and planning
◼ Long-term investment decisions
◼ Financing decisions
◼ Working capital management
◼ Contract management
◼ Financial risk management
Does the importance of the finance role and
activities change over time?
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College of Healthcare Executives. Not for sale.
Organizational Goals
• In proprietorships and partnerships, owners and
managers are the same individuals and hence have
the same goals.
• The primary goal of investor-owned corporations is
shareholder wealth (stock price) maximization.
• The primary goal of not-for-profit corporations is
generally given by a mission statement, often in
terms of service to the community.
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College of Healthcare Executives. Not for sale.
Agency Relationships
• An agency relationship exists whenever a principal hires
an agent to act on his or her behalf.
• Within investor-owned corporations, agency
relationships exist between:
•Shareholders and managers
•Shareholders and creditors
Are there any agency relationships in not-for-profit
corporations?
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College of Healthcare Executives. Not for sale.
The Agency Problem
• Managers are naturally inclined to act in their own best
interests; hence, an agency problem arises.
• The following factors tend to lessen the problem in forprofit corporations:
• Managerial incentives
• The threat of firing
• The threat of takeover
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College of Healthcare Executives. Not for sale.
Organizational Stakeholders
• All businesses, whether investor owned or not for profit,
have stakeholders.
• Stakeholders are parties that have an interest (usually financial) in
the business.
• Not-for-profit managers must satisfy all stakeholders.
• For-profit managers are primarily concerned with satisfying
stockholders.
Who are some stakeholders of not-for-profit hospitals?
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College of Healthcare Executives. Not for sale.
FP Versus NFP Financial Goals
• The primary financial goal of investor-owned corporations
stems from their organizational goal: shareholder wealth
(stock price) maximization.
• The primary financial goal of not-for-profit corporations
is to ensure the financial viability of the organization.
Does the difference in financial goals lead to appreciably
different behavior?
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College of Healthcare Executives. Not for sale.
Tax Laws
• Some understanding of tax laws is necessary because
taxes influence:
• Financing decisions
• The operating cash flows available to an investor-owned
business
• The ability to raise contribution capital
• There are several types of taxes:
• Federal versus state versus local
• Personal versus corporate
• Ordinary income versus capital gains
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College of Healthcare Executives. Not for sale.
Personal Taxes on Ordinary Income
Individuals pay federal and often state taxes on salaries,
interest and dividends earned, and other income at rates
that can approach 50 percent.
• Interest on nonfederal government bonds (called municipals or
“munis”), including bonds issued by NFP providers, is not
taxable.
• Dividends may be taxed at a lower rate (generally 15 percent)
than ordinary income. Check current tax laws.
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College of Healthcare Executives. Not for sale.
Taxable Versus Muni Bonds
Jane Green has a combined federal and state tax
rate of 20 percent, and Joe Brown has a combined
rate of 40 percent. Each is considering buying a
$1,000 bond:
FP Healthcare offers a 10 percent interest rate on its taxable
bonds.
NFP Healthcare issues similar-risk municipal bonds with a 7
percent interest rate.
Which bond should each person buy?
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College of Healthcare Executives. Not for sale.
Taxable Versus Muni Bonds
After-tax return on a bond: AT = BT x (1 – T)
Jane
Before-tax yield
Tax
After-tax yield
FP
Healthcare
10%
2%
8%
Joe
Before-tax yield
Tax
After-tax yield
10%
4%
6%
NFP
Healthcare
7%
0%
7%
7%
0%
7%
Personal tax rates influence the types of
bonds bought by individual investors.
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College of Healthcare Executives. Not for sale.
Self-Check
The exemption of municipal bonds from
federal taxes allows not-for-profit healthcare
providers to borrow at lower interest rates
than otherwise would be possible.
◼True
◼False
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College of Healthcare Executives. Not for sale.
Personal Taxes on Capital Gains
Capital assets are stocks, bonds, real estate, plant, and
equipment.
• If a capital asset is sold for more than its purchase price, then
that is a capital gain; if the asset is sold for less than the
purchase price, a capital loss occurs.
• Short-term capital gains are taxed at ordinary income rates,
while long-term capital gains are taxed at lower rates
(generally 20 percent).
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College of Healthcare Executives. Not for sale.
Corporate Taxes
• Investor-owned corporations pay federal tax on corporate
income at a rate of 21 percent and state tax at rates up to
12 percent.
• Not-for-profit corporations, for the most part, are not
subject to taxation.
• Not-for-profit corporations have two additional tax
benefits:
• Can issue tax-exempt (municipal) bonds.
• Can receive tax-exempt contributions.
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College of Healthcare Executives. Not for sale.
Unrelated Business Income
• Unrelated business income (UBI) occurs when a taxexempt organization has income from a business that is:
• Not related to its charitable purpose
• Carried on in a for-profit manner
• UBI generally is taxed the same as a for-profit business.
• Some exceptions, such as businesses run by volunteers
and sales to employees, apply.
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College of Healthcare Executives. Not for sale.
Interest and Dividend Income Received
by an Investor-Owned Corporation
◼ Interest is taxed as ordinary income.
◼ 70 percent of dividends is excluded.
◼ To illustrate, assume a FP corporation has
$100,000 of taxable income from operations,
$5,000 of interest income, $10,000 of dividend
income, and has a combined federal and state tax
rate of 30 percent.
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College of Healthcare Executives. Not for sale.
Operating income
Interest income
Taxable dividend income
Taxable income
$100,000
5,000
3,000*
$108,000
Federal tax = $108,000 (0.30)
= $32,400
*Dividends – Exclusion
= $10,000 – 0.7($10,000) = $3,000
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College of Healthcare Executives. Not for sale.
Interest and Dividend Income Received
by a Not-for-Profit Corporation
◼ Like ordinary business income, interest and
dividend income typically is not taxed.
◼ However, NFPs cannot issue tax-exempt bonds
for the sole purpose of investing the proceeds
in securities.
Why might NFPs be inclined to do so?
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College of Healthcare Executives. Not for sale.
Interest and Dividend Income Paid
by an Investor-Owned Corporation
◼Interest paid to debtholders is tax deductible, so
$1 of pretax earnings is required to pay each
dollar of interest expense.
◼Dividends paid to stockholders are not tax
deductible, so [$1 / (1 – T)] of pretax earnings
is required to pay each dollar of dividends.
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College of Healthcare Executives. Not for sale.
Self-Check
The US tax system favors equity over debt
financing.
◼True
◼False
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College of Healthcare Executives. Not for sale.
Depreciation – FP Corporation
Hosp A
Revenue
Costs
Depreciation
Taxable income
Taxes at 30%
After-tax income
Add depreciation
Net cash flow
$1,000
700
100
$ 200
60
$ 140
100
$ 240
Why are the net cash flows different?
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College of Healthcare Executives. Not for sale.
Hosp B
$1,000
700
200
$ 100
30
$ 70
200
$ 270
Depreciation – NFP Corporation
Hosp A
Revenue
Costs
Depreciation
Taxable income
Taxes at 30%
After-tax income
Add depreciation
Net cash flow
$1,000
700
100
$ 200
0
$ 200
100
$ 300
Why are the net cash flows the same?
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College of Healthcare Executives. Not for sale.
Hosp B
$1,000
700
200
$ 100
0
$ 100
200
$ 300
Book Depreciation
• Depreciation calculated for book (financial
reporting) purposes is different from depreciation
calculated for tax purposes.
• For book purposes, the straight-line method
generally is used:
Depreciation expense =
Capitalized cost – Salvage value
Useful life
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College of Healthcare Executives. Not for sale.
Northside’s X-ray machine has a
price of $100,000, costs $10,000 to
deliver and install, and is
estimated to be worth $5,000 at
the end of its ten-year useful life.
What is the book depreciation expense?
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College of Healthcare Executives. Not for sale.
$100,000
+
$10,000
–
$5000
Depreciation =
10 years
= $10,500 per year.
Thus, Northside’s income statement would
include an annual charge of $10,500 for wear and
tear of the machine over its ten-year useful life.
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College of Healthcare Executives. Not for sale.
Tax Depreciation
•The Modified Accelerated Cost Recovery
System (MACRS) is used for tax purposes.
•It has two alternative calculation methods:
• Standard (accelerated) method, which is typically
used, because it maximizes the value of
depreciation
• Alternative straight-line method
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College of Healthcare Executives. Not for sale.
MACRS Components
• Depreciable basis. The total amount to be depreciated.
(Note that salvage value is not considered.)
• Recovery period (class life). The number of years over
which the asset is depreciated.
• Recovery allowances. The percentage of the depreciable
basis that is depreciated in each year.
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College of Healthcare Executives. Not for sale.
Northside’s X-ray machine has a
price of $100,000, costs $10,000 to
deliver and install, and falls into
the MACRS five-year class.
What is the annual tax depreciation expense for years 1-6?
(Note: The machine is depreciated over six years because
MACRS uses a half-year convention.)
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College of Healthcare Executives. Not for sale.
Year
1
Basis
$110,000
2
110,000
32%
35,200
52,800
3
110,000
19%
20,900
31,900
4
110,000
12%
13,200
18,700
5
110,000
11%
12,100
6,600
6
110,000
6%
6,600
0
100%
$110,000
Total
Allowance Depreciation
20%
$ 22,000
Book
Value
$88,000
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Self-Check
If a business sells an asset for more than its tax
book value, then the firm:
a.
b.
c.
d.
e.
Took too little depreciation.
Will increase its taxable income.
Will reduce its taxable income.
Calculated depreciation incorrectly.
Had Al Capone as its CPA.
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College of Healthcare Executives. Not for sale.
Health Reform and
Financial Management
• Accountable care organizations (ACOs)
• Industry consolidation
• Population health
• Clinical integration
• Technology
• Staffing shortages
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College of Healthcare Executives. Not for sale.
Three Key Learning Points
• The primary financial goal of investor-owned firms is
shareholder wealth maximization, and the primary goal
of most not-for-profit firms is to fulfill a mission, which
requires financial viability.
• The value of any income stream depends on the amount
of usable, or after-tax, income. Thus, tax laws play an
important role in financial management decisions.
• The Patient Protection and Affordable Care Act aims to
provide all Americans with access to affordable health
insurance options and transform the healthcare system to
increase quality and reduce costs.
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College of Healthcare Executives. Not for sale.
CHAPTER 1 EXTENSION
This chapter extension focuses on alternative forms of
business organization, with emphasis on those that
provide healthcare services.
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College of Healthcare Executives. Not for sale.
Forms of Business Organization
There are four major categories of business organization
(legal forms of businesses):
• Proprietorship
• Partnership
• Corporation
• Hybrid forms
How important is the organizational form to healthcare
finance?
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College of Healthcare Executives. Not for sale.
Proprietorships and Partnerships
• Advantages
• Ease of formation
• Subject to few regulations
• Lower total taxes than corporations
• Disadvantages
• Difficult to transfer ownership
• Unlimited liability
• Limited life
• Difficult to raise capital
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College of Healthcare Executives. Not for sale.
Corporations
• Advantages
• Unlimited life
• Easy transfer of ownership
• Limited liability
• Ease of raising capital
• Disadvantages
• Double (or triple) taxation for investor-owned corporations
• Cost of formation and reporting
• C versus S corporations
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College of Healthcare Executives. Not for sale.
Hybrid Forms of Organization
• Limited partnership (LP)
• General partners have control.
• Limited partners are liable only for their initial contribution.
• Not commonly used by healthcare providers.
• Limited liability partnership (LLP)
• Partners share general business liability.
• Partners are liable only for their own malpractice actions.
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College of Healthcare Executives. Not for sale.
Hybrid Forms of Organization (cont.)
• Limited liability company (LLC)
• Members are taxed like partners.
• Liability like stockholders.
• Professional corporation (PC) or professional
association (PA)
• Owners have benefits of incorporation.
• Owners are still liable for malpractice.
• Often used by individual clinicians.
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College of Healthcare Executives. Not for sale.
Forms of Ownership
• In most industries, the only form of ownership is the
investor-owned (for-profit) business.
• In the health services industry, a significant proportion
of businesses are organized as not-for-profit
corporations.
How important is the form of ownership
to healthcare finance?
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College of Healthcare Executives. Not for sale.
Investor-Owned Corporations
• Investors become owners by purchasing shares of
common stock.
• Primary market transactions
• Initial public offerings (IPOs)
• New common stock sales
• Secondary market transactions
• On exchanges
• In the over-the-counter market
• Stockholders have:
• Right of control
• Claim on residual earnings and residual liquidation proceeds
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College of Healthcare Executives. Not for sale.
Not-for-Profit Corporations
• If a business meets a stringent set of requirements, it
can qualify as a not-for-profit (nonprofit)
corporation; such firms also are called tax-exempt or
501(c)(3) or (c)(4) corporations.
• These corporations:
• Generally have no shareholders and, hence, do not have a
single clientele to which managers are responsible.
• Receive various tax subsidies.
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Organizational Structures
• Holding companies
• Multihospital systems
• Corporate alliances
• Integrated delivery systems
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Holding Companies
• A holding company is a corporation formed for the sole
purpose of owning the stocks of other companies.
• In a typical holding company, the subsidiary companies
issue their own debt, but their equity is held by the
holding company, which, in turn, sells stock to
individual investors.
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College of Healthcare Executives. Not for sale.
Holding Companies (cont.)
• Advantages
• Control with fractional ownership
• Isolation of risks
• Separation of FP and NFP subsidiaries
• Disadvantages
• Partial multiple taxation
• Ease of forced divestiture
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College of Healthcare Executives. Not for sale.
Multihospital Systems
Multihospital systems generally are credited with these
advantages:
• Better access to capital
• Elimination of duplicated services
• Economies of scale
• Access to special skills
• Ability to recruit and retain personnel
• Increased political power
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College of Healthcare Executives. Not for sale.
Corporate Alliances
• Corporate alliances occur when two business entities
combine for a limited purpose.
• The most common forms of alliance are purchasing
groups and joint ventures.
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College of Healthcare Executives. Not for sale.
Integrated Delivery Systems
• Integrated delivery systems allow for the vertical
integration of multiple services.
• Such systems may have a single owner or may be
created by contractual arrangements among individually
owned providers.
• In either case, success requires a system focus as
opposed to a single provider focus.
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College of Healthcare Executives. Not for sale.
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