The Importance of Management Understanding of Capital Budgeting

The Importance of Management Understanding of Capital Budgeting

            The importance of management understanding of capital budgeting is essential in the health

care industry.  Unlike other industries health care firms have greater needs in management

investment.  For this reason this paper will be based on the comprehension of capital budgets and the

formulation in testing the sensitivity of forecasts regarding alternative scenarios (Cleverley, Song, &

Cleverley, 2011, p 490).

Cash management is very important in the health care industry, more so than in other industries. 

Financial executives believe that in cash management that reducing accounts receivables or the

collection cycle shortened will result in better control, but in reality cash management should focus

on the acceleration of receivables and also the complete cash conversion cycle as shown below.

           

Cash Conversion Cycle

Regarding the cash aspect or working capital of the cash conversion cycle it is important to understand what it is used for, such as:

·      Current assets

o   Cash and investments

o   Accounts receivables

o   Inventories

o   Other current assets

·      Current liabilities

o   Accounts payable

o   Accrued salaries and wages

o   Accrued expenses

o   Notes payable

o   Current position of long-term debt

After determining the working capital the cash budget focuses one the purchasing of resources, the production/sale of service, billing, and collection all of which are part of the cash conversion cycle.  The purchasing of resources includes the purchase of supplies and labor.  The production and sales of service require no inventory and include the length of stay and final release of patient, which can be viewed as the final point of sale (Cleverley, Song, & Cleverley, 2011, pp. 491-492).  Billing on the other hand shows the interval between release of patient and the generation of a bill (Cleverley, Song, & Cleverley, 2011, p 492).  Collection refers to the generation of the bill to the actual collection of monies by either the patient or the patient’s third-party payer.  Understanding and managing the cash conversion cycle is critical to minimizing what is required of the investment of working capital. It is also necessary to develop a sound cash budget, which includes outflows and inflows of projections during the planning process. 

            The importance of management to comprehend the formulation in testing the sensitivity of forecasts may be the most important in cash budgeting.  Cash budgeting of revenue forecast in healthcare include too functions: volumes by product line and expected prices by payer.  These include two categories of methods used to develop estimates of volume: subjective forecasts and statistical forecasts (Cleverley, Song, & Cleverley, 2011, p 492).  Subjective forecasts depend on the understanding and knowledge of the forecaster in the reliability and estimation of product line volumes.  Subjective forecasting is the most reliable method of forecasting when future volumes deviate from historical patterns.  A scenario of subjective forecasting may be when medical staff members are surveyed regarding the staffs expected utilization for the next year (Cleverley, Song, & Cleverley, 2011, p 509).   Statistical forecasts is basically infers the future can be predicted using a mathematical extrapolation of the past (Cleverley, Song, & Cleverley, 2011, p 509).  This process can be misleading if there is a change in the forecast.  These two methods are the most critical to the revenue budgetary process as shown below.

Integration of the Budgetary Process

                                                                                          

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Cash Budget

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Budgeted Financial Statement

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Revenue and Expenses

         As stated throughout, cash budgets are forecasts and as with anything there is no guarantee that

the results of these forecast will be achieved. This is why it is so important that management test the

sensitivity of forecasts regarding alternative scenarios, such as slowdown in collection or declines in

revenue. If a slowdown in collection or decline in revenue can affect cash flow resulting in an

immediate revision of the cash budget. For instance, if payment of a patient’s bill is delay for 60

days by Medicaid must be revised to reflect a new pattern of payment (Cleverley, Song, & Cleverley,

2011, p 510).

         In conclusion, the importance for management to comprehend capital budgets and

formulation in testing the sensitivity of the forecast regarding alternative scenarios, such as

slowdown in collections and declines in revenues are critical in the understanding of capital

budgeting.