Understanding the CMS Competitive Bidding Financial Health Evaluation

Understanding the CMS Competitive Bidding “Financial Health” Evaluation

CMS has released the measures that will be used to evaluate the financial stability of HME suppliers will bid under Medicare Competitive Bidding Program.

Essentially, the CBIC will use standard accounting ratios (obtained by review of the financial documents that all bidders must submit) to evaluate the “financial health” of the company. CMS and the CBIC will use the supplier’s credit history in the evaluation. According to CMS, this will determine whether the supplier will be able to participate in the program and “maintain viability for the duration of the contract period”.

VGM members have requested some definition and further clarification relative to the financial ratios. Please note the information below. If you have further questions, contact Mark Higley, VGM vice president of development, at 800.642.6065 or .

Introduction:

Most HMEs will bid as corporations. Suppliers that submit corporate tax returns are required to submit the Schedule L (balance sheet) from their tax return for the immediate one year prior to the bid date. In addition to the tax return information, HMEs are also required to submit a statement of cash flow (statement of changes in financial position), and a statement of operations (income statement) for the immediate one year prior to the bid date.

A financial ratio is an expression of the relationship between two items selected from the documents noted above. Ratio analysis is one method in which CMS will evaluate weak and strong points in an HME’s financial (and perhaps managerial) performance.

The current ratio (current assets divided by current debts) is a measure of the cash or near cash position (liquidity) of the company. It indicated if you have enough cash to pay your company’s current creditors. The higher the ratio, the more liquid the firm's position is and, hence, the higher the credibility of the firm. Cash, receivables, marketable securities, and inventory are current assets. HMEs should be realistic in valuing receivables and inventory for a true picture of their liquidity, since some debts may be uncollectible and some of the equipment inventory obsolete. Current liabilities are those which must be paid in one year.

In HME, a current ratio of 1.5 to 2.5 or more generally indicates sufficient liquidity.

Average collection period. You find this ratio by dividing accounts receivable by daily sales other than cash. (Daily billed/credit sales = annual billed/credit sales divided by 360.) This ratio tells you the length of time it takes your HME to get its cash after billing or making a sale on credit. The shorter this period the quicker the cash inflow is. A longer than normal period may mean over due and uncollectible bills. If it is greatly outside a common range (see below), you need to alter your collection policies. HMEs should develop an aging schedule to gauge the trend of collections and identify the slow payers. Slow collections hinder cash flow and also hurt your profit (e.g., you could be doing something with the money, such as taking advantage of discounts on your own payables).

In recent years a survey of the average collection period for independently owned HMEs was as follows: DME (E0260, K0001, E0143, Etc.) 66 days, Respiratory (E1390, J7619, E7619, Etc.) 48 days, and Rehab (K0800, K0856, E1010, Etc.) 88 days.

Accounts payable to sales. This ratio is obtained by dividing the accounts payable of the company by its annual net sales. This ratio gives you an indication as to how much of the HME’s supplier’s (e.g., equipment vendors) money the company is using in order to fund its sales. A low percentage would indicate a healthy ratio. A high percentage indicates the firm may be using suppliers to help finance operations. The formula: Accounts Payables to Sales Ratio = [Accounts Payables / Net Sales ] x 100.

Common ratios in HME are from 20 to 30%.

The quick ratio (or acid-test ratio) is found by dividing “quick assets” (cash and accounts receivable) by current liabilities. The

Purpose is to test the company's ability to meet its current obligations. This test doesn't include inventory to make it a stiffer test of the company's liquidity. It tells you if the HME could meet its current obligations with quickly convertible assets should sales revenues suddenly cease.

In HME, a quick ratio of 1.0 or more generally indicates sufficient liquidity

Current Liabilities to Net Worth is a measure of the extent to which the HME is using creditor funds versus their own investment to finance the business (Current Liabilities / Liabilities + Equity). A ratio of .5 or higher may indicate inadequate owner investment or an extended accounts payable period. (Note: Care should be taken not to offend your equipment vendors to the extent it affects your ability to conduct day to day business.

Return on Sales (%) measures profits after taxes on the year’s sales (profits earned per dollar of sales). The higher this ratio, the better prepared the HME business is to handle downtrends brought on by adverse conditions.

Sales to Inventory or “Inventory Turnover Ratio” is obtained by dividing annual net sales of the company by its total inventory. The ratio is regarded as a test of efficiency and indicates the rapidity with which the HME is able to move its equipment, and how fast inventory is moving the cash flow into the business. When this ratio is high, it may indicate a situation where sales are being lost because equipment is under stocked and/or customers are buying elsewhere. If the ratio is too low, this may show that equipment inventories are obsolete or stagnant.

Working capital represents the amount of day-by-day operating liquidity available to a business. Also known as operating capital, it is calculated as current assets minus current liabilities. An HME can be endowed with assets and profitability, but short of liquidity, if these assets cannot readily be converted into cash. A positive change in working capital indicates that the business has either increased current assets (that is received cash, or other current assets) or has decreased current liabilities, for example has paid off some short-term creditors.

“Quality of earnings” is a confusing financial metric to many. It is calculated by dividing cash flow from operations into the company’s net annual income plus depreciation. The official definition is “the amount of earnings attributable to higher sales or lower costs rather than artificial profits created by accounting anomalies such as inflation of inventory.” An example may help: An HME can show positive earnings on its income statement while also bearing a negative cash flow. This is not a good situation to be in for a long time, because it means that the HME has to borrow money to keep operating. And at some point, the bank will stop lending and want to be repaid. A negative cash flow also indicates that there is a fundamental operating problem: either the equipment inventory is not selling or billing/receivables are not being collected.

Operating cash flow to sales is a percent measuring capability of a HME company’s ability to convert sales into cash. It is an important indicator of an HME’s creditworthiness and productivity. If the ratio is low, then growth may not be financially possible because the company will not have enough cash flow to increase operations to meet higher demands and sales targets. If the ratio is high, then the company will be able to grow and expand because it has enough cash flow to finance additional production. The formula is Cash Provided by Operating Activities / Net Sales.

OTHER RATIOS NOT INCLUDED IN THE CBIC EVALUATION…

Total debt to net worth. This ratio (the result of total debt divided by net worth then multiplied by 100) is a measure of how the company can meet its total obligations from equity. The lower the ratio, the higher the proportion of equity relative to debt and the better the HME's credit rating will be. The HME industry average for independent companies is about 1.2 to 1.

Net sales to total assets. This ratio (net sales divided by total assets) measures the efficiency with which you are using your assets. A higher than normal ratio indicates that the firm is able to generate sales from its assets faster (and better) than the average company.

Operating profit to net sales. This ratio (the result of dividing operating profit by net sales and multiplying by 100) is most often used to determine the profit position relative to sales. A higher than normal ratio indicates that your sales are good, that your expenses are low, or both. Interest income and interest expense should not be included in calculating this ratio.

Net profit to total assets. This ratio (found by multiplying by 100 the result of dividing net profit by total assets) is often called return on investment or ROI. It focuses on the profitability of the overall operation of the firm. Thus, it allows management to measure the effects of its policies on the firm's profitability. The ROI is the single most important measure of a firm's financial position. Common industry ranges: 5% – 10%

Net profit to net worth. This ratio is found by dividing net profit by net worth and multiplying the result by 100. It provides information on the productivity of the resources the owners have committed to the firm's operations.

IMPORTANT NOTES…

All ratios measuring profitability can be computed either before or after taxes, depending on the purpose of the computations. Ratios have limitations. Since the information used to derive ratios is itself based on accounting rules and personal judgments, as well as facts, the ratios cannot be considered absolute indicators of an HME’s financial position. Ratios are only one means of assessing the performance of the company and must be considered in perspective with many other measures.