Liquidity Ratio

Liquidity Ratio in Health Care Provider Finance

Liquidity ratios are the short-term solvency tests that boards, regulators, lenders and suppliers apply to hospitals, NHS trusts and other health care providers. They ask whether the money a provider holds or will soon collect is enough to pay the wages and supplier invoices due over the coming months, a separate question from whether its services are efficient or cost effective. The family takes in the current, quick and cash ratios of general finance and the days-based measures used by health care regulators and credit rating agencies, which express liquid resources as days of operating costs. Health systems watch these figures because a provider that runs out of cash can be forced to cut services that patients and commissioners rely on. The same label covers formulas that differ in what they count and in which direction of score is good, so a figure means little without its definition.

Why short-term solvency matters for health services

A provider can run efficient services and still fail if cash runs out before income arrives, because staff and suppliers expect payment on time while payers settle later. Regulators of provider markets therefore treat liquidity as a question about continuity of care. Monitor's risk assessment framework for NHS foundation trusts, as updated in August 2015, aimed to identify significant risk to the financial sustainability of a provider of key NHS services that endangers the continuity of those services.

A February 2020 consultation by NHS England and NHS Improvement on the risk assessment framework for independent providers of NHS services (IPRAF) describes commissioner requested services as services that would be hard to replace if the provider got into difficulty. Providers of these services are under financial oversight that aims to reduce their risk of failing financially and to reduce the impact on patients if one does fail.

Liquidity ratios sit outside the main tools of economic evaluation. They do not measure health gain or value for money, and a provider with weak liquidity may still deliver highly cost-effective care. They matter at implementation, since a technology that is cost effective over ten years can still need cash this year that a provider with thin reserves lacks, which links liquidity with affordability, cash flow and budget impact analysis.

The current, quick and cash ratios

The three ratios compare a stock of assets with a stock of liabilities at the balance sheet date and differ in how strictly they define assets that turn into cash quickly. Dahlquist and Knight, in the OpenStax text Principles of Finance, describe liquidity as the ability to convert assets into cash in order to meet short-term cash needs, and note that inventory is less liquid than receivables because the product must first be sold.

$$CR = \frac{CA}{CL}, \qquad QR = \frac{C + STI + AR}{CL}, \qquad CaR = \frac{C}{CL}$$

where $CR$ is the current ratio, $QR$ the quick ratio and $CaR$ the cash ratio, $CA$ is total current assets, $CL$ is total current liabilities, $C$ is cash and cash equivalents, $STI$ is short-term investments and $AR$ is accounts receivable.

The current ratio uses the same balances as working capital, current assets less current liabilities, but expresses them as a ratio. In the OpenStax account a current ratio above one means short-term obligations can be met with a buffer, while a value below one calls for attention to the composition of current assets and the timing of liabilities. The quick ratio, also called the acid-test ratio, leaves out inventory and prepaid expenses because converting them to cash can take longer, and the cash ratio counts only cash and cash equivalents. The same text warns that idle cash could otherwise earn a return and that many firms operate successfully with a cash ratio below one.

NHS finance staff apply the same tools to others. A 2014 article for the Healthcare Financial Management Association (HFMA) on the financial health of suppliers to NHS trusts lists the current and quick ratios as checks on whether a supplier can meet its payment schedule with headroom. Its quick ratio deducts only inventory from current assets, a smaller adjustment than the OpenStax formula.

Liquidity measured in days of operating costs

Health care regulators in England have used a days-based liquidity measure. Dividing liquid resources by a daily rate of spending gives the period the provider could keep operating, which can be compared across providers of different sizes.

Monitor's August 2015 framework defined liquidity as days of operating costs held in cash or cash-equivalent forms, including wholly committed lines of credit available for drawdown. It was one of four metrics in the financial sustainability risk rating for foundation trusts, with detailed definitions issued each year in Monitor's reporting templates. Monitor could consider asking for a reforecast where liquidity fell by 20% or seven days, whichever was lower.

The IPRAF consultation of February 2020 sets out the liquidity ratio then used for independent providers of commissioner requested services.

$$L = \frac{WC}{OE} \times 360$$

where $L$ is the liquidity ratio in days, $WC$ is the working capital balance and $OE$ is annual operating expenses.

The consultation scores the result on a scale where a rating of 1 is the highest level of risk and 4 the lowest. A liquidity ratio below 0 days scores 1, 0 days or more scores 2, 10 days or more scores 3 and 30 days or more scores 4, and negative working capital gives negative days.

The scoring direction did not stay fixed. NHS Improvement's Single Oversight Framework, which its board was asked in September 2016 to approve for NHS trusts and foundation trusts from 1 October, kept liquidity among its finance and use of resources metrics but scored providers on a scale where 1 was best and 4 worst. A 4 therefore meant the lowest risk under Monitor's approach and the weakest performance under the newer framework. How NHS providers obtain cash when their own resources run short is covered on the cash budget page.

Days cash on hand in United States hospital finance

In United States hospital finance, days cash on hand is a standard liquidity measure, and S&P uses it with other measures to assign credit ratings to nonprofit hospitals and health systems. A January 2024 KFF analysis of 274 nonprofit hospitals and health systems defined it as unrestricted cash and investments divided by daily cash expenses.

$$DCOH = \frac{R}{(OE-D)/365}$$

where $DCOH$ is days cash on hand, $R$ is financial reserves (unrestricted cash and investments), $OE$ is annual operating expenses and $D$ is depreciation and amortisation, which are excluded because they involve no cash payment.

KFF excluded restricted cash and investments, which are legally tied to a purpose such as building a new facility, and grouped results with S&P's standard categories. Under that rubric a standalone hospital with between 110 and 160 days is adequate and one with fewer than 80 days is highly vulnerable, with lower bands for systems. In 2022, 73% of the hospitals and systems analysed had at least strong days cash on hand and 9% were vulnerable or highly vulnerable. KFF found that 60% of those with negative operating margins still had at least strong reserves, and noted that the federal government does not collect standardised information on days cash on hand.

The Flex Monitoring Team's indicators for critical access hospitals, built from Medicare cost reports, use a similar measure. Its definitions describe the result as the number of days an organisation could operate if no cash were collected, warn that the year-end figure does not reflect uneven cash flows through the year, and note that very high values of days cash on hand or the current ratio may indicate under-investment in longer-term assets. The collection side of the same picture is measured by days in accounts receivable.

Worked example with one hospital trust and a late payment

All figures in this example are illustrative and in GBP million. A hospital trust has annual operating expenses of 540, including depreciation of 36. At its balance sheet date it holds cash of 30, receivables of 45, inventory of 9 and prepayments of 6, giving current assets of 90, against current liabilities of 75. It has no short-term investments.

1. Ratios at the balance sheet date. The current ratio is 90 / 75 = 1.20. The quick ratio on the OpenStax definition is (30 + 45) / 75 = 75 / 75 = 1.00. The HFMA version, which deducts only inventory, counts 90 less 9, or 81, and gives 81 / 75 = 1.08. The cash ratio is 30 / 75 = 0.40.

2. Days-based measures. Working capital is 90 less 75, or 15. The IPRAF liquidity ratio is 15 × 360 / 540 = 10.0 days, which scores 3 on the IPRAF scale. Cash expenses are 540 less 36, or 504 a year, so daily cash expenses are 504 / 365 = 1.381 and days cash on hand is 30 × 365 / 504 = 21.7 days.

3. A small change near a threshold. If 2 of a long-term loan becomes repayable within the year and is reclassified as a current liability, current liabilities rise to 77 and working capital falls to 13. The liquidity ratio becomes 13 × 360 / 540 = 8.7 days, and the score drops to 2 instead of 3.

4. A committed facility. Returning to the position in steps 1 and 2, suppose the trust also has an undrawn, wholly committed credit line of 10. A definition that adds such facilities to the numerator, as Monitor's 2015 description of its measure does, would count 15 + 10 = 25 and give 25 × 360 / 540 = 16.7 days. The working capital definition ignores the facility and stays at 10.0 days.

5. A commissioner pays late. Again from steps 1 and 2, suppose a payment of 12 expected before the balance sheet date arrives after it. Cash falls to 18 and receivables rise to 57, so current assets stay at 90. The current ratio stays at 1.20, the OpenStax quick ratio at (18 + 57) / 75 = 1.00 and the IPRAF liquidity ratio at 10.0 days. The cash ratio falls to 18 / 75 = 0.24 and days cash on hand to 18 × 365 / 504 = 13.0 days.

6. Interpretation. The trust looks comfortable on the current ratio, sits on the boundary between two IPRAF ratings and holds about three weeks of cash expenses, falling below two weeks when one payment is late. Measures built on working capital cannot see a delay in collection because cash and receivables are both current assets, while cash-based measures pick it up at once. The reclassification of 2 in step 3 changes the regulatory score although the position has barely moved, so the figure is read with its trend and a cash forecast.

Liquidity beside margins and solvency

Liquidity is one angle on a provider's finances, and the frameworks above pair it with others. Monitor's 2015 framework described capital servicing capacity as the degree to which generated income covers financing obligations, and the income and expenditure margin as the degree to which the organisation runs at a surplus or deficit. The 2020 IPRAF consultation proposed adding an operating margin metric because liquidity and capital servicing capacity alone did not show whether performance was stable or deteriorating.

KFF makes a similar point for United States hospitals, noting that two entities with the same operating margins may be in a much different financial position depending on their days cash on hand. Profitability measures such as return on assets and solvency measures such as debt to worth answer other questions, and the HFMA checklist lists solvency ratios separately from liquidity ratios.

Holding cash has an opportunity cost, because money kept in reserve is not spent on services or equipment, so a very high ratio can signal under-investment as easily as strength. A low ratio may limit a provider's capacity to adopt a technology that needs upfront spending even when it is good value, and the timing of provider payment shapes how quickly that cash returns.

Common misreadings

Most errors with liquidity ratios come from comparing figures that were not built the same way. The rest come from reading a single snapshot as if it described the provider's whole year or its value to patients.

1. Treating the name as a formula. Several measures go by the name of liquidity, and even the quick ratio differs between sources in whether prepayments are excluded.
2. Reading the score in the wrong direction. A 4 was the best liquidity rating under Monitor and the IPRAF and the worst under the Single Oversight Framework.
3. Assuming more is always better. Large idle balances may reflect forgone returns or under-investment.
4. Counting money that is not available. KFF excludes restricted cash, and a committed but undrawn facility raises some measures and not others.
5. Trusting a single date. A year-end figure can hide uneven cash flows, and one late payment can move cash measures sharply.
6. Reading liquidity as value for money. The ratios say nothing about health outcomes or cost-effectiveness.

Sources

• Boggan J. Stock take. Healthcare Financial Management Association; 2 April 2014. https://www.hfma.org.uk/articles/stock-take
• Dahlquist J, Knight R. Principles of Finance. OpenStax; 2022. Section 6.3, Liquidity ratios. https://openstax.org/books/principles-finance/pages/6-3-liquidity-ratios
• Flex Monitoring Team. CAHMPAS indicators and peer groups using 2010 Medicare cost report accounts (financial indicator definitions). 22 March 2022. https://cahmpas.flexmonitoring.org/wp-content/uploads/2022/03/CAHMPAS_Financial_-Indicators_Definitions.pdf
• Levinson Z, Hulver S, Godwin J, Neuman T. Most nonprofit hospitals and health systems analyzed had "adequate" or "strong" days of cash on hand in 2022, though about one in ten did not. KFF; 9 January 2024. https://www.kff.org/health-costs/issue-brief/most-nonprofit-hospitals-and-health-systems-analyzed-had-adequate-or-strong-days-of-cash-on-hand-in-2022-though-about-one-in-ten-did-not/
• Monitor. Risk assessment framework. Updated August 2015. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/455893/RAF_revised_25_August.pdf
• NHS England and NHS Improvement. Consultation on proposed updates to the risk assessment framework for independent sector providers of NHS services. February 2020. https://www.england.nhs.uk/wp-content/uploads/2020/08/IPRAF_consultation.pdf
• NHS Improvement. NHS Improvement's Single Oversight Framework. Board paper BM1687 with the framework as Appendix 1, 29 September 2016. https://www.england.nhs.uk/wp-content/uploads/2019/09/BM1687_Single_Oversight_Framework_.pdf