The Georgia Scroll
April 1998

Financial Policy Formation
Pilots Strategic Planning and Financial Viability
By: Ed Ollie, CHE, FHFMA, MM, CPA, CFO
Phoebe Putney Memorial Hospital

Designing, implementing and executing financial policy, establishes targets and benchmarks for directing and assessing an organizations short- and long-term economic viability. Using sound financial policy maximizes the effective and efficient use of limited resources. It also underlines the need for management to consider the impact of annual and strategic decisions on long-term targets and the long-term financial strength of an organization.

Many significant changes are currently underway in the health care industry. The rapid rate of change in this environment is placing a growing emphasis on Board-CEO accountability for resource utilization and it’s organizations long term viability. In addition, the changes in federal and state regulations and the impact of managed care are increasing the challenge of achieving positive financial performance. These factors are increasing the importance of focusing the boards’ attention on the organizations’ long term financial position. This focus is accomplished through the development and integration of sound financial policy in the strategic planning and financial planning process. It also provides board members a policy vehicle to communicate direction to management, protect assets and maintain the financial integrity of the organization.

Short- and long-term success is maximized through financial policy when closely linking strategic planning and financial planning. The interactive nature of these two processes – strategic planning and financial planning – is illustrated in Exhibit 1. Strategic planning should precede financial planning. Inverting the relationship may limit creativity. It most certainly will limit opportunities because it does not include the optimal use of cash, credit and capital structure.

STRATEGIC PLANNING

Developing a strategic vision and business mission, establishing objectives, and setting priorities are basic direction-setting tasks. A well-conceived strategy establishes organizational identity, long term direction, and provides the work force with a sense of purpose and the future direction of the organization. The board and management, through this process, strive to craft a strong market position with a sustainable competitive advantage. While there are many keys to success in strategic planning and execution – entire books are written on the subject – a major factor is effective and efficient resource management. Strategic plans must be subject to a financial template. This template includes financial policy targets and other standard quantitative analysis. Design, implementation and execution of financial policy is essential to successful strategic planning and thus reaching the organization’s short- and long-term goals.

Operating, Capital Project and Capital Equipment Budgets

Annually, management prepares three budgets; operating, capital projects and capital equipment. The challenge is to translate the strategic plan into what must be done, how to execute it, and produce the desired results. The translation is interactive and dynamic. Strategic plans, five-year or annual, must be flexible for unanticipated strategic and market changes. The ability to modify or update the plan during the course of the year is essential. The operating budget represents projections for the Statement of Operations and Statement of Cash Flows for the fiscal year. The capital Projects and Capital Equipment Budgets represent the planned uses of cash for the fiscal year. The translation of a five-year strategic plan to an annual strategic plan with respect to the related Statements of Operations, Cash Flows, capital projects and capital equipment budgets is where financial policy ensures an organizations long-term economic viability.

FINANCIAL POLICY

Integrating strategic planning and financial planning begins with identifying and establishing key financial policies. The three major areas of the balance sheet – assets, liabilities and equity – are the focus of financial policy. Within each major area specific financial ratios are used as benchmarks and for setting targets. Financial ratios are used because they represent an easy and effective way to conveniently summarize large quantities of financial data. The illustration in Exhibit 2 displays the major areas of the balance sheet, three financial policies, three categories of financial ratios and the primary and secondary ratios for each financial policy.

Asset Growth is the first financial policy and measures growth in Total Assets. However, of the major components of Total Assets – cash, accounts receivable and property plant and equipment – cash is the primary focus. Cash targets are established through a Cash Reserve Analysis (see Exhibit 3). This financial policy does not formally address the importance of effective accounts receivable management. However, because undesirable growth in accounts receivable may appear as favorable asset growth, it is important to set performance targets for accounts receivable management. Establishing targets for cash reserves and accounts receivable will ensure the desired growth in Total Assets.

Debt Policy is the second financial policy and establishes the combination of debt and equity invested in assets. Debt capacity is limited and should be managed through guidelines established by the boards’ appetite for leverage and risk. The primary focus of this policy measures the proportion of debt to equity invested in asset growth. The primary focus of Debt Policy is achieved through the ratio Long Term Debt to Equity and a secondary focus through the ratio Debt Service Coverage. Together these ratios establish the capital structure of the organization.

Profitability Objective is the third financial policy. The integrative nature of financial policy is most apparent by observing the influence of the Profitability Objective on the ratios for Debt Policy. The purpose of this policy is to establish comprehensive, organization wide, short- and long-term profitability targets. In its simplest form, this can mean achieving annual profitability through rate setting, but meeting comprehensive targets requires efforts far more reaching than rate setting. It requires successful strategies for acquiring patient volume, managing expenses and gaining market share. The primary ratio for setting the Profitability Objective is Return On Equity. It has specific project and overall organization applicability for the short- and long-term. A secondary ratio is Operating Margin. Both ratios measure profitability, but the focus of the Operating Margin ratio is measuring profitability from operations. Managing operating income and its relationship to total income focuses management on the profitability of its core business.

FORMULAS FOR COMPUTING THE RATIOS

Exhibit 3 presents the formulas for computing the primary and secondary ratios for each financial policy. The analysis for Cash Reserves is a multiple step approach and includes data to facilitate understanding. The other ratios are basic standard industry formulas and do not require data to facilitate an understanding.

INTERPRETING THE GRAPHS

The graphs of both primary and secondary ratios in Exhibits 4 – 6 are the results from an organization which has incorporated financial policy with strategic planning and financial planning since 1992. The performance reflected in 1997 is the cumulative effect of successfully integrating strategic planning, financial planning and financial policy. The financial strength and long term viability of the organization has reached new plateaus because financial policy has allowed the organization to meet and exceed the goals of its’ strategic plan.

Conclusion

Financial policy is providing the targets and benchmarks for achieving the organizations economic viability. Limited resources are being utilized efficiently and effectively in achieving the organizations strategic initiatives. The organizations credit rating by Standard & Poor’s and Moody’s has increased from A- to A+ and A to A1 respectively. The goal of improving financial performance is being achieved. Integrating strategic planning, financial planning and financial policy is achieving strategic goals and short- and long-term economic viability.

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Last modified: June 22, 2001