aupha press healthcare finance an introduction to accounting and financial management 3rd

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HEALTHCARE
FINANCE
AUPHA
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HEALTHCARE
FINANCE
An Introduction to
Accounting and
Financial Management
Third Edition
Louis C. Gapenski
AUPHA
HAP
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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 © 2005 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.
0908070605 54321
Library of Congress Cataloging-in-Publication Data
Gapenski, Louis C.
Healthcare finance : an introduction to accounting and financial
management / 3rd ed.
p. cm.
Includes bibliographical references and index.
ISBN 1-56793-232-0 (alk. paper)
1. Health facilities—Finance. 2. Health facilities—Accounting.
I. Title.
RA971.3.G3695 2004
362.1'068'1—dc21 2004054241
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. ⅜
ϱ
™
Project manager: Jane C. Williams; acquisitions manager: Janet Davis; cover
design: Matt Avery
Health Administration Press
A division of the Foundation

of the American College of
Healthcare Executives
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Association of University Programs
in Health Administration
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Arlington, VA 22201
(703) 894-0940
BRIEF CONTENTS
Preface xiii
PART I The Healthcare Environment
1 Introduction to Healthcare Finance 3
2 The Financial Environment 21
PART II Financial Accounting
3 Financial Accounting Basics and the Income Statement 53
4 The Balance Sheet and Statement of Cash Flows 87
PART III Managerial Accounting
5 Managerial Accounting Basics, Cost Behavior,
and Profit Analysis 121
6 Cost Allocation 157
7 Pricing and Service Decisions 187
8 Planning and Budgeting 219
PART IV Basic Financial Management Concepts
9 Time Value Analysis 253
10 Financial Risk and Required Return 287
PART V Long-Term Financing

11
Long-Term Debt Financing 325
12 Equity Financing 359
13 Capital Structure and the Cost of Capital 389
PART VI Capital Investment Decisions
14 The Basics of Capital Budgeting 425
15 Project Risk Assessment and Incorporation 461
PART VII Other Topics
16 Current Asset Management and Financing 491
17 Analyzing Financial Performance 527
18 Lease Financing and Business Valuation 561
Index 591
About the Author 603
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; Health Services Settings, 8;
Regulatory and Legal Issues, 14; Organization of the Book, 16; How to
Use This Book, 17
2 The Financial Environment 21
Alternative Forms of Business Organization, 21; Alternative Forms of
Ownership, 26; Organizational Goals, 29; Tax Laws, 32; Third-Party
Payers, 34; Managed Care Plans, 37; Alternative Reimbursement
Methods, 39
PART II Financial Accounting
3 Financial Accounting Basics and the Income Statement 53
Historical Foundations of Financial Accounting, 54; The Users of Financial
Accounting Information, 55; Regulation and Standards in Financial

Accounting, 56; Basic Concepts of Financial Accounting, 59; Accounting
Methods: Cash Versus Accrual, 62; Recording and Compiling Accounting
Data, 65; Income Statement Basics, 67; Revenues, 69; Expenses, 73; Net
Income, 76; Net Income Versus Cash Flow, 78; Income Statements of
Investor-Owned Firms, 79; A Look Ahead: Using Income Statement
Data in Financial Statement Analysis, 80
4 The Balance Sheet and Statement of Cash Flows 87
Balance Sheet Basics, 88; Assets, 90; Liabilities, 96; Equity, 98; Fund
Accounting, 102; The Statement of Cash Flows, 102; Transactions, 106;
Another Look Ahead: Using Balance Sheet Data in Financial Statement
Analysis, 111
PART III Managerial Accounting
5 Managerial Accounting Basics, Cost Behavior,
and Profit Analysis 121
The Basics of Managerial Accounting, 121; Cost Classifications: Fixed and
Variable, 123; Cost Behavior, 124; Cost Classifications: Semi-Fixed, 127;
Profit (CVP) Analysis, 128; Breakeven Analysis, 133; Operating
Leverage, 136; Profit Analysis in a Discounted Fee-for-Service
Environment, 138; Profit Analysis in a Capitated Environment, 143; The
Impact of Cost Structure on Financial Risk, 150
6 Cost Allocation 157
Direct Versus Indirect (Overhead) Costs, 157; Introduction to Cost
Allocation, 158; Cost Allocation Basics, 159; Cost Allocation
Methods, 162; Direct Method Illustration, 164; The Impact of Changing
Cost Drivers, 171; Step-Down Method Illustration, 174; Activity Based
Costing, 176; Final Thoughts on Cost Allocation, 180
7 Pricing and Service Decisions 187
Healthcare Providers and the Power to Set Prices, 188; Price Setting
Strategies, 189; Target Costing, 191; Setting Prices on Individual
Services, 192; Setting Prices Under Capitation, 193; Setting Managed

Care Plan Premium Rates, 201; Using Relative Value Units (RVUs) to Set
Prices, 206; Making the Service Decision (Contract Analysis), 208
8 Planning and Budgeting 219
The Planning Process, 220; Introduction to Budgeting, 223; Budget
Types, 223; Budget Decisions, 226; Constructing a Simple Operating
Budget, 228; Variance Analysis, 231; The Cash Budget, 239
PART IV Basic Financial Management Concepts
9
Time Value Analysis 253
Time Lines, 254; Future Value of a Lump Sum (Compounding), 255;
Present Value of a Lump Sum (Discounting), 259; Opportunity
Costs, 261; Solving for Interest Rate and Time, 263; Annuities, 265;
Perpetuities, 268; Uneven Cash Flow Streams, 269; Using Time Value
Analysis to Measure Financial Returns, 272; Semiannual and Other
Compounding Periods, 276; Amortized Loans, 279
10
Financial Risk and Required Return 287
The Many Faces of Financial Risk, 288; Introduction to Financial
Risk, 289; Risk Aversion, 290; Probability Distributions, 291; Expected
and Realized Rates of Return, 292; Stand-Alone Risk, 293; Portfolio Risk
and Return, 295; Measuring the Risk of Investments Held in
Portfolios, 304; Portfolio Betas, 309; Relevance of the Risk
Measures, 310; Interpretation of the Risk Measures, 312; The
Relationship Between Risk and Required Return, 312
PART V Long-Term Financing
11 Long-Term Debt Financing 325
The Cost of Money, 325; Common Long-Term Debt Instruments, 327;
Debt Contracts, 331; Bond Ratings, 333; Credit Enhancement, 335;
Interest Rate Components, 335; The Term Structure of Interest
Rates, 339; Debt Valuation, 341

12 Equity Financing 359
Equity in For-Profit Businesses, 359; Types of Common Stock, 362;
Procedures for Selling New Common Stock, 363; The Market for
Common Stock, 365; Regulation of Securities Markets, 367; The
Investment Banking Process, 369; Equity in Not-for-Profit
Businesses, 371; Common Stock Valuation, 373; Security Market
Equilibrium, 379; Informational Efficiency, 380; The Risk/Return
Trade-Off, 383
13 Capital Structure and the Cost of Capital 389
Capital Structure Basics, 389; Impact of Debt Financing on Accounting
Risk and Return, 390; Capital Structure Theory, 393; Identifying the
Optimal Capital Structure in Practice, 396; Not-for-Profit Businesses, 398;
Cost of Capital Basics, 399; Cost of Debt Capital, 401; Cost of Equity
Capital, 403; The Corporate Cost of Capital, 412; An Economic
Interpretation of the Corporate Cost of Capital, 414
PART VI Capital Investment Decisions
14 The Basics of Capital Budgeting 425
Importance of Capital Budgeting, 425; Project Classifications, 426; The
Role of Financial Analysis in Healthcare Capital Budgeting, 427; Overview
of Capital Budgeting Financial Analysis, 428; Cash Flow Estimation, 428;
Cash Flow Estimation Example, 435; Breakeven Analysis, 442;
Profitability (Return on Investment) Analysis, 443; Some Final Thoughts
on Breakeven and Profitability Analyses, 446; Capital Budgeting in
Not-for-Profit Businesses, 446; The Post Audit, 449; Using Capital
Budgeting Techniques in Other Contexts, 450
15 Project Risk Assessment and Incorporation 461
Types of Project Risk, 462; Relationships Among Stand-Alone, Corporate,
and Market Risk, 464; Risk Analysis Illustration, 464; Sensitivity
Analysis, 465; Scenario Analysis, 469; A Subjective Approach to Risk
Assessment, 472; Incorporating Risk Into the Decision Process, 472;

Making the Final Decision, 475; Adjusting Cash Outflows for Risk, 476;
Subsidiary Costs of Capital, 478; An Overview of the Capital Budgeting
Decision Process, 479; Capital Rationing, 481
PART VII Other Topics
16 Current Asset Management and Financing 491
An Overview of Short-Term Financial Management, 491; Current Asset
Investment and Financing Policies, 493; Cash Management, 498;
Marketable Securities Management, 501; Long-Term Securities
Management, 502; Receivables Management, 503; Supply Chain
Management, 508; Short-Term Financing, 510
17 Analyzing Financial Performance 527
The Statement of Cash Flows, 528; Ratio Analysis, 531; Tying the Ratios
Together: Du Pont Analysis, 542; Other Analytical Techniques, 544;
Market Value Added and Economic Value Added, 545;
Benchmarking, 547; Operating Indicator Analysis, 549; Limitations of
Financial Performance Analysis, 551
18 Lease Financing and Business Valuation 561
Leasing Basics, 561; Tax Effects, 563; Balance Sheet Effects, 565; Lease
Evaluation, 567; Motivations for Leasing, 574; Business Valuation, 578
Index 591
About the Author 603
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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 joint MBA/MHA program.
The move prompted me to write my first healthcare finance textbook, Un-
derstanding Health Care Financial Management. The book was designed for
use in health services administration financial management 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
courses in nontraditional and clinician-oriented programs in which students
do not have a formal background in financial issues. 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 fi-
nancial 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 empha-
sis 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.
xiii
xiv Preface
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. Finally, the book is written under the premise
that providers will be under increasing financial pressure to provide cost-
effective services. Thus, considerable emphasis is placed on financial decision
making within a managed care environment.
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 self-improvement.
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 six ethics minicases that can be used to highlight ethical issues in a
healthcare finance setting.
Preface xv
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
exclusively in a single area, such as patient accounts, would benefit from hav-
ing a broader understanding of finance principles and hence would find this
book useful.
Changes in the Third Edition
Since the publication of the second edition of this book, I have used it nu-
merous times in various settings. In addition, I have received many comments
from users at other universities. The overall reaction of students, other profes-
sors, and the marketplace in general has been overwhelmingly positive—every
comment received indicates that the basic concept of the book is sound. Even
so, nothing is perfect, and the healthcare environment is evolving at a dizzying
pace. Thus, many changes have been made to the book; the most important
of which are listed here:
• The book was updated and clarified throughout. Particular care was
taken to include the most recent information on reimbursement
and to update the real-world examples. In addition, there is no
doubt that text material improves as it is repeatedly edited. Like all
books, the second edition had some “rough spots,” and

considerable effort was expended to improve these discussions.
• New sections have been added that deal with the Sarbanes-Oxley
Act and the revenue cycle.
• In addition, the variance analysis coverage has been changed to
separate the analysis into revenue and cost sides.
• Most importantly, the book was “cut and trimmed” as necessary to
create a better flow of material. Over time, textbooks tend to “gain
weight” as new material is added. However, a large book is usually
not a better book, because many students get overwhelmed before
they are able to grasp the key concepts.
• The lecture presentation software was updated and improved based
on continuous usage and suggestions from adopters and students
alike.
All in all, these changes improve the quality and value of the book without
affecting its basic concept and approach to learning.
xvi Preface
Ancillary Materials
Two important teaching aids accompany this book. These materials can be ob-
tained through the Health Administration Press web site www.ache.org/pubs/
hcfin3.cfm. For access information, please email
• Instructor’s Manual. A comprehensive manual is available to
instructors who adopt the book. The manual includes a sample
course outline and solutions to the end-of-chapter questions and
problems.
• Lecture Presentation Software. A set of PowerPoint
©
slides that
cover all the essential issues contained in each chapter is also
available. Concepts, graphs, tables, lists, and calculations are
presented in about 40 slides per chapter, much as an instructor

might do on a blackboard. However, the slides are more crisp,
clear, and colorful, and can be displayed on a screen almost
instantaneously. Furthermore, hard copies of the slides can be
provided to students for use as lecture notes. Many instructors will
find these slides useful, either as is or as customized to best meet
the situation at hand.
Acknowledgments
This book reflects the efforts of many people. First and foremost, I would like
to thank Mark Covaleski of the University of Wisconsin, who made signifi-
cant contributions to the accounting content of the book. In fact, without
his materials, advice, and counsel, the book could not have been written. In
addition, Anna McAleer of Arcadia University (formerly Beaver College) pro-
vided many useful comments for improving both the text and the Instructor’s
Manual.
Colleagues, students, and staff at the University of Florida provided in-
spirational support, as well as more tangible support, during the development
and class testing of the text. Last, but certainly not least, the Health Admin-
istration Press staff was instrumental in ensuring the quality and usefulness of
the book.
Errors in the Book
In spite of the significant effort that has been expended by many individuals
on this book, it is safe to say that some errors exist. In an attempt to create
the most error-free and useful book possible, I strongly encourage both in-
structors and students to write me at the address below with comments and
suggestions for improving the book. I certainly welcome your input.
Preface xvii
Conclusion
In the environment faced by healthcare providers today, good finance is more
important than ever to the economic well-being of the enterprise. Because of
its importance, managers of all types and at all levels should be thoroughly

grounded in finance principles and applications; but this is easier said than
done. I hope that Healthcare Finance: An Introduction to Accounting and Fi-
nancial Management will help you understand the finance problems currently
faced by healthcare providers and, more importantly, that it will provide guid-
ance on how best to solve them.
Louis C. Gapenski, Ph.D.
Box 100195
Health Science Center
University of Florida
Gainesville, Florida 32610–0195
September 2004
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PART
I
The Healthcare Environment
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CHAPTER
1
INTRODUCTION TO
HEALTHCARE FINANCE
Learning Objectives
After studying this chapter, readers will be able to:
• Define the term healthcare finance as it is used in this book.
• Discuss the role of finance in health services organizations and how
this role has changed over time.
• Describe the major players in the health services industry.
• Describe the organization of this book and the learning aids
contained in each chapter.
Introduction
In today’s healthcare environment, where financial realities play an important

role in business decision making, it is vital that managers at all levels under-
stand the basic concepts of healthcare finance and how these concepts are
used to enhance the financial well-being of the organization. In this chapter,
we introduce readers to the book, including its goals and organization. Fur-
thermore, we present some basic background information about the health
services system. We sincerely hope that this book will be a significant help
to you in your quest to increase your professional competency in the very
important area of healthcare finance.
Defining Healthcare Finance
What is healthcare finance? Surprisingly, there is no single answer to that
question because the definition of healthcare finance depends, for the most
part, on the context in which the term is used. Thus, in writing this book, our
first step was to decide how to define “healthcare finance.”
We began by examining the healthcare sector of the economy, which is
second in size only to the real estate sector and consists of a diverse collection
of industries that involve, either directly or indirectly, the healthcare of the
population. The major industries in the healthcare sector include:
• Health services. The health services industry consists of providers
of health services such as medical practices, hospitals, clinics,
nursing homes, and home health care agencies.
3
4 Healthcare Finance
• Health insurance. The health insurance industry includes
government programs and commercial insurers as well as
self-insurers.
• Managed care. Managed care includes organizations such as health
maintenance organizations (HMOs) that incorporate both
insurance and health services (provider) functions.
• Medical equipment and supplies. These industries include the
makers of durable medical equipment, such as diagnostic

equipment and wheel chairs, and expendable medical supplies, such
as disposable surgical instruments and bandages.
• Pharmaceuticals and biotechnology. These industries develop
and market drugs and other therapeutic products.
• Other. This category includes a diverse collection of businesses
ranging from consulting firms to educational institutions to
government and private research agencies.
Most users of this book will become (or already are) managers at health
services organizations, or at companies such as insurance companies, managed
care organizations, and consulting firms that deal directly with such organiza-
tions. Thus, to create a book that has the most value to its primary users, we
focus on finance as it applies within the health services industry. Of course, the
principles and practices of finance cannot be applied in a vacuum but must be
based on the realities of the current healthcare environment, including how
healthcare services are financed. Furthermore, insurance involves payment to
healthcare providers; much of managed care involves utilization management
of healthcare providers, either directly or through contracts; and most con-
sulting work is done for providers; so the material in this book is also relevant
for managers in other industries related to health services.
Now that we have defined the healthcare focus of this book, the term
finance must be defined. Finance, as the term is used within the health services
industry, and as used in this book, consists both of the accounting and financial
management functions. (In many settings, accounting and financial manage-
ment are separate disciplines.) Accounting, as its name implies, concerns the
recording, in financial terms, of economic events that reflect the operations,
resources, and financing of an organization. In general, the purpose of ac-
counting is to create and provide to interested parties, both internal and exter-
nal, useful information about an organization’s financial status and operations.
Whereas accounting provides a rational means by which to measure a
business’s financial performance and assess operations, financial management,

or corporate finance, provides the theory, concepts, and tools necessary to help
managers make better financial decisions. Of course, the boundary between
accounting and financial management is blurred; certain aspects of accounting
involve decision making, and much of the application of financial management
theory and concepts requires accounting data.
Chapter 1: Introduction to Healthcare Finance 5
Self-Test
Questions
1. What is meant by the term healthcare finance?
2. What is the difference between accounting and financial management?
Purpose of the Book
Many books cover the general topics of accounting and financial management,
so why is a book needed that focuses on health services finance? The reason is
that while all industries have certain individual characteristics, the health ser-
vices industry is truly unique. For example, the provision of healthcare services
is dominated by not-for-profit organizations, both private and governmental,
and such entities are inherently different from investor-owned businesses. Also,
the majority of payments made to healthcare providers are not made by the
individuals who use the services but by third-party payers (e.g., an employer,
commercial insurance company, or government program). Throughout the
book, the ways in which the unique features of the health services industry
influence the application of finance principles and practices are emphasized.
This book is designed to introduce students to healthcare finance,
which has two important implications. First, the book assumes no prior knowl-
edge of the subject matter; thus, the book is totally self-contained, with each
topic explained from the beginning in basic terms. Furthermore, because clar-
ity is so important when concepts are first introduced, the chapters have been
written in an easy-to-read fashion. None of the topics are inherently difficult,
but new concepts often take some effort to understand. This process is made
easier by the writing style used.

Second, because this book is introductory, it contains a broad overview
of healthcare finance. The good news here is that the book presents virtually all
the important healthcare finance principles that are used by managers in health
services organizations. The bad news is that the large number of topics covered
prevents us from covering principles in great depth or including a wide variety
of application illustrations. Thus, students that use this book are not expected
to fully understand every nuance of every finance principle and practice that
pertains to every type of health services organization. Nevertheless, this book
provides a sufficient knowledge of healthcare finance so that readers will be
able to function better as managers, judge the quality of financial analyses
performed by others, and incorporate sound principles and practices into
personal finance decisions.
Naturally, an introductory finance book does not contain everything
that a healthcare financial manager must know to competently perform his
or her job. Nevertheless, the book is useful even for those working in financial
positions because it presents an overview of the finance function. Often, when
working in specific areas of finance, it is too easy to lose sight of the context
of one’s work. This book will help provide that context.