Finance in Healthcare

Like other investors, healthcare organizations face numerous risks that demand rational decision-making. Understanding the factors behind these risks and knowing which accounting methodologies to apply for different organizations is critical to optimal resource utilization. Instead of a single investment, an organization should make multiple investments to minimize risk and uphold accrual accounting for accurate financial representation.

Project Risks

Stand-alone/Intrinsic Risk

An organization can decide to invest in one or multiple projects at any given time. One faces a stand-alone risk if one invests in a single project/investment (Brigham and Ehrhardt, 2011). This risk represents the chance of losing money, and realizing a return lower than one’s expectations. The size of that risk determines the extent to which an investor can take it. However, one does not always know how much – the dollar return – and how long an investment takes to gain the expected return, necessitating a theoretical approach. Probability theory allows such calculations by enabling investors to assign a rate of return to every possible outcome in the market, say low versus high demand, which produces various performance levels in the context of competition, governmental regulations, and other factors. These rates depend mainly on the nature of the investment. For instance, treasury securities involve virtually no risk because investors get their promised returns irrespective of market performance.

In contrast, stocks of a start-up company may or may not pay dividends because the owners reinvest all incomes to accelerate growth. The shares of a start-up company are hazardous, and one needs a relatively high expected rate of return to invest in such stocks. To calculate the expected rate of return, one could list all the possible outcomes (say high, low, and moderate demand) and their corresponding probabilities – creating a probability distribution. Out of this distribution, one could form a payoff matrix by multiplying each outcome with its corresponding probability. The sum of these products is the expected rate of return. The following table illustrates a payoff matrix for stocks of two companies facing three possible outcomes: low, moderate, and high demand and their corresponding probabilities. The assumption is that demand is the only factor affecting returns.

Table 1: Calculating the expected rate of return

Source: (Brigham and Ehrhardt, 2011)

From the table, the first company experiences a more extended range of potential returns than the second company despite both having an equal expected rate of return. If one were to graph the various probabilities against their outcomes, the first company would have a more outstretched graph than the second company, meaning the latter would have a higher likelihood of getting the expected return rate. In other words, the second company’s stocks are less risky than the first company’s stocks. A definite method for determining the amount of risk from the probability theory is to calculate standard deviation, which shows how much returns deviate from the expected return, that is, how tight a probability distribution is. The closer this distribution is, the lower the risk (Brigham and Ehrhardt, 2011). Calculating standard deviation involves the steps illustrated in the following table. First, calculate the expected rate of return as shown above. Secondly, find the difference between the expected rate and each rate under various outcomes. Thirdly, square these deviations and multiply the product by the probability of each possible outcome. The sum of these products gives the variance of the probability distribution, and its square root is the standard deviation.

Table 2: Calculating the standard deviation

Source: (Brigham and Ehrhardt, 2011)

From the table, the second company has a lower standard deviation than the first company, confirming the tighter probability distribution. Assuming a normal distribution, meaning that the probabilities of the various outcomes occur, like height, weight, or other typical variables, the actual return from an investment falls within one standard deviation of its expected rate 68.26 percent of the time (Brigham and Ehrhardt, 2011). In other words, one can expect to realize the ideal return 68.26 out of a hundred times if the returns from the investment follow a normal distribution. For the first company, there is a 68.26 percent that the actual returns will range from -43.09 percent to 73.09 percent (15 percent plus or minus 58.09%). There is a 95.46 percent chance of actual ret range from -101.18 to 131.18 and a 99.74 percent that the actual returns will range from -159.27 to 189.27. The second company has a 68.26 percent that actual returns will range from -8.24 to 38.24, a 95.46 percent from -31.48 to 61.48, and a 99.74 percent from -54.72 to 84.72.

The above tables implicitly depict a positive correlation between a company’s stocks’ standard deviation and risk. In other words, shares with a high standard deviation have a high perceived stand-alone risk, meaning an investor is likelier to lose from such an investment. On the contrary, stocks with a small standard deviation have a low perceived stand-alone risk, meaning one can confidently make such an investment. Therefore, the standard deviation offers a rational approach to evaluating the worthiness of a single commitment. However, investors, in practice, choose from multiple investments with diverse standard deviations and expected returns, necessitating a more complex risk assessment. One solution to such complications is the coefficient of variation, which combines the standard deviation and the expected returns, producing a more reliable risk measure (Brigham and Ehrhardt, 2011). The following formula calculates CV, which becomes crucial when an investor faces investment alternatives with varying expected returns. CV = standard deviation/anticipated rate of return.

Portfolio Risk

Usually, organizations invest in a portfolio – meaning multiple investments – rather than a single investment. The rationale behind portfolios is to minimize risk by leveraging the association between the trends of various stocks. Although stock prices generally tend to increase or decrease together, they hardly change in exact proportions (Brigham and Ehrhardt, 2011). These trends, in turn, depend largely on economic performance. Generally, most stocks tend to perform well under good economic environments. However, a few stocks perform well during recessions, allowing investors to avert risk by choosing various investments. For instance, during the 2020 Coronavirus-induced recession, Netflix exhibited an unusual stock price trend, where prices generally increased (Trefis Team, 2020). Explanations for these unusual movements include the increase in video subscriptions due to increased stay at home following lockdowns. Other industries that may have witnessed the unusual stock price movements include healthcare, real estate, and food staples. One defining characteristic of these industries is that they are essential – most people use the products and services offered by these companies despite income declines. In other words, these companies experience inelastic prices, meaning price changes accompany virtually no changes in demand. Due to these unusual trends, it is vital for an investor to combine typical investments with the rather unusual ones to “defend” oneself from rough economic occurrences. For optimal defense, an investor should combine stocks with perfectly negatively correlated stocks, whose prices change in entirely different directions at any time (Brigham and Ehrhardt, 2011). Since stocks generally correlate positively, an investor should consider the following overall rules of thumb. First, one must never invest in one organization/project/industry because doing so exposes their money to the stand-alone risk discussed above. Depending on circumstances like recessions due to pandemics and a failure in key markets, one could lose all the investment. For instance, companies that primarily invested in housing became bankrupt due to the 2007-9 financial crises, a reality vividly revealed by Lehman Brothers. Instead, one should consider a diversified portfolio whose members tend to cancel out. Such a portfolio should involve companies in different industries and at various growth levels, alternating large versus small; high-growth versus value, etc. Secondly, one should consider increasingly larger portfolios to guarantee diversification and risk aversion potential.

Market Risk

In addition to portfolio risk, which can subside with diversification, organizational assets risk deterioration due to unavoidable circumstances. The defining feature of these circumstances is that they are systematic, meaning they are inherent in the broader market, not a portion of it. Typical sources of such risk include decisions regarding inflation, interest rates, and employment (Nguyen et al., 2020). The war in Ukraine provides an excellent case for market risk. with curtailed foreign exchange, hardly peaceful domestic climate, and mandatory mobilization, organizations in this country face a rather uniform, extended impediment to their daily operations that differs considerably from firm-level strikes, marketing programs, and other events that single-out any individual organization. Among other metrics, capital budgeting experts analyze the beta, which represents the risk attributable to a single investment, that is, stock. Precisely, the beta coefficient measures how much risk a single stock contributes to the market portfolio, the portfolio incorporating all the stocks available in a market (Brigham and Ehrhardt, 2011). According to Karačić and Bukvić (2014), the beta coefficient is critical to risk analysis for various types of investments. Three items are crucial to beta: the standard deviation of a single stock’s return (stand-alone risk), the standard deviation of an overall market’s return, and the correlation between a stock’s returns and the market’s return. Beta’s notation and formula, b_i = (σ_i/σ_m)*r_im, suggests that holding all other factors constant, a stock’s standard deviation correlates positively with beta and, thus, its relevant risk. Similarly, a stock whose returns correlate positively with the market’s returns correlates positively with its relevant risk. However, the amount of risk a stock contributes to a market portfolio negatively correlates with the market return’s standard deviation. Therefore, one should choose stocks with as low standard deviations as possible.

Accounting Bases

Cash Accounting

A company that uses cash accounting recognizes revenues when it receives cash, not when it earns it. Such a company recognizes expenses when it pays for them, not when it incurs them. In other words, the company records cash as soon as it receives it from customers and expenses when it pays to creditors and suppliers. A primary weakness of this approach is its lack of use of the matching principle, which simultaneously accounts for revenues and their corresponding expenses in one period (Accounting Tools, 2022). As such, it exposes an accountant to the risk of delaying to report a profit or loss. However, this approach offers a few advantages. First, it is simple. Since the company only recognizes revenues and expenses when it receives cash and when it pays, one needs only a checkbook to record inflowing or outflowing cash. Therefore, the company does not need trained accountants to account for its money. Secondly, the method allows a company to record only the revenue in its control, not unrealized revenue. Thus, a not-for-profit organization only records the pledges, contributions, or other sources for which it really gets cash. Such recordings provide a realistic image of what the company has, not what it expects. In other words, the cash basis is conservative (Gross, McCarthy, and Shelmon, 2005). Thirdly, a company that uses the cash accounting method has no disclosure requirements under the Generally Accepted Accounting Principles (GAAP), unlike their counterparts who use the accrual basis.

It follows, from the above-mentioned strengths and limitations, that the cash basis is suitable for small organizations without much financial details. As the organization grows, accountants face a growing need for more sophisticated records to reflect the growing transactions. Those transactions, in turn, require trained professionals that incur significant salaries and other employment costs. A small organization neither requires this high-level expertise nor has the finances to pay for those services. Besides, small organizations often exist under a sole manager, who can accurately account for their daily transactions. As the company grows, it falls under the management of multiple people, who need various documents to account for daily transactions. An example of a small organization that could use cash accounting is a small not-for-profit organization, which needs to record dividends, pledges, and contributions as it receives them and taxes, scholarships, and other expenses as they become due. For such an organization it would be impractical to record contributions and pledges before receiving them as they might deceive the owner about the company’s actual position. However, the failure to match up transactions exposes the company to the risk of wrongly stating its true financial situation.

Accrual Accounting

A company that uses accrual accounting recognizes revenues when it earns them, not when it receives cash. Such a company recognizes expenses when it incurs them, not when it pays for them. The primary strength of this methodology is its use of the matching principle, which recognizes expenses together with their corresponding revenues in the same accounting period (Accounting Tools, 2022; Zimmerman and Bloom, 2016). In accounting, every transaction has corresponding impacts on assets, liabilities, and capital. If one recognizes revenues without their corresponding expenses, they may delay or accelerate the reporting of profits in a given accounting period because the impact of a transaction does not reflect in the other items. Simultaneous recognition ensures that a company promptly reports its profits. Therefore, a company that incurs a sales commission in one month and pays it in the next should record it in the first month, when the associated sale took place. Such an approach minimizes the chances of reporting the wrong profits or losses. It also decreases profit and loss fluctuations from one reporting period to another (Accounting Tools, 2022). An example of an occasion where the matching principle is critical is when a company writes off depreciation due to the purchase of capital equipment. Since such equipment (assets) involves significant sums, recognizing them in one period might significantly affect the reported profits or losses. Instead, the company should divide up the purchase cost to the number of years it anticipates the equipment to last and write off that rate per year. That way, each year experiences a reasonable impact on profits or losses.

A major advantage the accrual basis enjoys is the ability to account for uncollected income and unmet obligations, thereby depicting the true financial position. As an organization grows, it incurs various debts without meeting them in the current accounting period. Failure to recognize these debts may deceive the company by inflating its profits. In a similar way, failure to recognize income when the company earns it might delay its profits, which could discourage investors. Such occurrences are important when a company incurs or earns significant finances that could affect profit or loss considerably. Therefore, accrual accounting is suitable for medium and large corporations that frequently deal with significant transactions a company might lose track of by not promptly recognizing.

Conclusion

An organization making a single investment faces a stand-alone risk, the most significant risk that could lead to total loss. One can minimize this risk by diversifying their investment to include various investments in various industries. Portfolio risk is the type of risk facing a diversified investment, and it declines with the level of diversification. However, one cannot avert all risk because of systematic market factors beyond an organization’s control. Market risk is the portion of risk that remains after diversification. In light of this risk, one should consider investments with minimal standard deviations and that which minimally correlate with market returns. One should prefer accrual accounting to depict the true financial situation for more established companies with many transactions. For small companies, cash accounting is preferable.

References

Accounting Tools. (2022, October 14). Matching principle definition. https://www.accountingtools.com/articles/the-matching-principle

Brigham, E. F., & Ehrhardt, M. C. (2011). Financial management: Theory and practice (13^th edition). South-Western Cengage Learning.

Gross, M. J., McCarthy, J. H., & Shelmon, N. E. (2005). Financial and accounting guide for not-for-profit organizations. John Wiley & Sons.

Karačić, D., & Bukvić, I. B. (2014). Research of investment risk using Beta coefficient. Opatija, 2014, 521.

Nguyen, T. C., Vu, T. N., Vo, D. H., & McAleer, M. (2020). Systematic risk at the industry level: A case study of Australia. Risks, 8(2), 36.

Trefis Team. (2020, April 2). Netflix stock up 14% in 2020 at $375 despite Covid-19; is it sustainable? Forbes. https://www.forbes.com/sites/greatspeculations/2020/04/02/netflix-stock-up-14-in-2020-at-375-despite-covid-19-is-it-sustainable/?sh=227f48a930e4

Zimmerman, A. B., & Bloom, R. (2016). The matching principle revisited. Accounting Historians Journal, 43(1), 79-119.