Financing maneuvers: two opportunities to boost a hospital's working capital.

Spiraling expenses, declining profits, and continued cutbacks from third-party payers increasingly limit a healthcare facility's access to capital. As a result, only a small percentage of the approximately 6,700 hospitals in the marketplace have obtained investment grade credit ratings. Current

Commercial banks are the traditional source of working capital across most industries and provide short-term financing opprotunities for hospitals. When a hospital obtains working capital from this source of unsecured lending, the amount borrowed and the cost of financing often speak to the credit-worthiness of the hospital.

With access to capital and short-term financing now difficult or expensive to obtain, health care needs creative financing options. Accounts receivable, a large and growing asset on a typical hospital balance sheet, offers several financing opportunities. While common-place in other industries, however, receivables financing in health care remains a controversial and misunderstood topic.

Estimates place net receivables available for initial financing between $50 billion and $60 billion. On a continual basis, gross revenue available for periodic financing approximates $240 billion to $260 billion, or $160 billion to $175 billion on a net basis.

While receivables financing may not be right for every healthcare organization, benefits of this form of financing often are overlooked. And two distinct accounts receivable financing techniques, factoring and asset-backed securitization, often are confused.

Factoring

Factoring accounts receivable has been practiced for centuries but gained prominence in the early 1900s in the textile, apparel, and home furnishings industries. Factoring emerged as a means for companies to receive immediate cash flow and eliminate problems involving credit and collection of accounts.

In a factoring transaction, a factor (purchaser) assumes a client's credit exposure and risk of non-payment for financial reasons. Factors rely on their credit and collection experience to minimize potential financial losses.

Factoring in health care, a relatively small portion of all factoring business, is dominated by a few firms. In a typical healthcare transaction, eligible net receivables, defined by the factor, are purchased at a discount from face value. Discounts between 5 percent and 10 percent are not uncommon in health care. Cash collections resulting from the difference between the face and discounted values of the purchased receivables are passed on to the factor.

Along with a discounted purchase, the cost to participate includes a factoring fee expressed as a percentage of sold receivables. This factoring fee may be as high as 15 percent to 20 percent of the value of sold receivables. Penalties plus interest also may be assessed for failure to comply with notification and reporting requirements stipulated in a factoring agreement.

Another distinctive feature of healthcare factoring is that the purchaser assumes full control and responsibility for collection and follow-up activities on sold accounts. The full range of services a factor provides are outlined in Exhibit 1. Depending on the level of funding sought and the types of accounts sold, a considerable amount of patient accounts servicing requirements may be shifted from a healthcare facility to the factor.

Factoring allows hospitals to receive advance funding from their receivables and reduces the collection and follow-up efforts required of patient accounting staff members. Factoring can function as an acute, short-term remedy for working capital and staffing shortfalls or provide and avenue for continual funding and patient accounting support.

Securitization

A relatively new form of working capital financing across all industries is asset-backed securitization. This method first gained acceptance in the retail credit industry--with auto loans and credit cards, in particular--by bridging the gap between factoring and unsecured lending.

Unlike traditional capital financing, asset-backed loans are open-ended. Collateral is pledged as security on a continuous basis over the life of an agreement. The securitized asset most commonly used for asset-backed loans is accounts receivable. As the 1980s ended, healthcare providers became interested in asset-backed securitization to unleash the cash flow potential of patient accounts receivable from third-party payers.

In a typical transaction, proceeds generated from the sale of A1-rated commercial paper is used to purchase receivables from a hospital. Commercial paper gains an A1 rating on the basis of the credit enhancement provided by a surety bond provider. A surety bond provider enhances the credit of commercial paper rather than a hospital's creditworthiness, as a typical tax-excempt financing may require.

From a sale through payment collection on accounts receivable, funds are managed by an asset manager, who acts as a trustee to a securitization program. The organization selling its receivables, on the other hand, is responsible for collection and follow-up activities (other than cash management) of sold accounts. Actual cash collections, maintained by the asset manager, are used to retire commercial paper notes and pay administrative program costs.

When a hospital sells receivables, eligiblity of its accounts and quality of its collateral must be assessed. Because credit ratings are provided for commercial paper, the quality of underlying collateral becomes a concern of rating agencies. Consequently, the credit rating of individual payers is more important than the hospital's rating.

Securitization transactions are structured to capitalize on the favorable creditworthiness of a payment source, because payments on sold accounts ultimately will be recieved from third-party payers. The continued quality of sold receivables is assessed by evaluating the hospital's ability to effectively service accounts and the payment source of these accounts.

Net accounts receivable eligible for sale will be advance-funded at a level between 80 percent and 90 percent, depending on the quality of the collateral. Quality of collateral varies because of diverse credit risks of commercial insurance carriers and hospitals' abilities to service accounts. The unfunded portion, called over-collateralization, helps pay program expenses and provides protection to the program if estimates of net receivables require adjustment. Nonetheless, the unfunded portion remains an asset of the seller.

When a factoring program is terminated, excess over-collateralization amounts not used to pay program expenses are returned to the seller. Interest charged to the seller is based on funded (sold) accounts. Costs of capital vary between 50 and 100 basis points below the prime lending rate, including amortization of upfront fees.

Financing benefits

In an era of enhanced financing opportunities, the key asset targeted by commercial banks, investment bankers, and private investors will be accounts receivable. Financial officers may not be content to leave their accounts receivable undeveloped as a financing asset.

Factoring and securitization of receivables have several benefits in common.

Either program yields an initial cash flow boost and opportunity for providing steady cash flow over time. Funds provided from financing can be used for several purposes, including:

* Asset acquisition;

* Facilities acquisition. A parent hospital purchases a facility, including its accounts receivable. Accounts receivable of an acquired facility can be financed to provide working capital. On the

[TABULAR DATA OMITTED]

other hand, a parent hospital can finance its own receivables to provide funds for an acquired facility;

* Constructiong financing;

* Arbitrage investments. Funds generated from financed receivables can be invested at a rate in excess of the cost of capital;

* Divestiture of a facility. After a facility is sold (fixed assets only), a parent hospital can sell receivables of this facility to provide immediate cash flow;

* Interim financing for small acquisitions until sufficient volume is reached to finance with tax-exempt bonds. Proposed U.S. Treasury regulations, however, may eliminate this benefit; and

* Interim financing for subsidiaries not eligible for tax-exempt financing. Receivables financing can provide inexpensive funds for construction projects, such as a medical office building.

Creating a steady and predictable flow of cash resulting from continuous participation in a financing program, is, of course, the primary reason why healthcare providers enter into financing programs. Predictable cash flow makes business decisions easier.

With elimination of the periodic interim payment (PIP) program for all but disproportionate-share hospitals, predictability of cash flow has become much more difficult. Bi-weekly PIP payments often were used to meet periodic operating expenses, such as payroll. Without PIP, hospitals have become more susceptible to external influences and internal efficiency of operations in registration, medical records, and patient accounting departments.

Another benefit of both financing programs is that they treat a transaction as the sale of an asset. Under Financial Accounting Standards Board Statement No. 77, accounts receivable sold as an asset can be removed from the sellers' balance sheet. Along with providing a more consistent cash flow, removing factored receivables from a seller's balance sheet means that no corresponding liability must be recorded, as would be the case with capital or working capital financing. Furthermore, debt covenants of tax-exempt revenue bonds or other long-term capital financing agreements typically are not affected, and a seller's ability to obtain additional long-term capital financing will not be hindered.

Certain private placements having non-standardized bond covenants may prohibit this type of transaction. Public offerings generally will not prohibit an asset-backed transaction if accounts receivable are sold at fair market value. Discounted purchases common in factoring, however, may not be allowed.

Where they differ

As more hospitals seriously consider converting their receivables into a source of working capital, they must decide which financing option best meets their needs at an acceptable cost and level of risk. Although both programs accomplish the same goal, their structures and incentives vary. Generally, they differ in terms of the level of advance funding, cost of participation, degree of control over account servicing, and eligibility for program participation.

Level of advanced funding. The level of funds a factor advances to a seller differs significantly between factoring and securitization. In a typical factoring transaction, advance funding approximates 50 percent of the discounted value of net eligible receivables. The remaining value of the sold asset, net of administrative fees, is paid to the seller as third-party payments are received by the factor.

Securitization, on the other hand, typically advances between 80 percent and 90 percent of neg eligible receivables. The remaining amount is overcollaterlization owned by the seller but not available for funding purposes. As a result, a typical securitized transaction will advance-fund from 30 percent to 40 percent more than factoring.

Cost of participation. Each program has a different cost structure that must be carefully considered before contracting for receivables financing begins. In a typical factoring transaction, costs to participate are based on three variables: a discount, a factoring fee, and penalties plus interest. While calculation of actual costs may be possible for the discount and fee components, penalties for delays or non-compliance with monitoring and reporting requirements imposed by the factor are not quantifiable at the beginning of a factoring relationship. As a result, a hospital selling its accounts receivables assumes an unquantifiable financial risk, which can be sizeable when factoring receivables.

Securitization, on the other hand, is structured not to substitute for a portion of the seller's collection and follow-up but to take advantage of an investment tool below prime rate. Omitting a servicing component and capitalizing on the favorable rates of the commercial paper market securitization the less expensive option.

Servicing and control. Estimates of hospitals' direct costs for performing patient accounting can range from a couple hundred thousand dollars to several million dollars, depending on bed size. Approximately half of these costs are personnel-related.

In a factoring transaction, the factor assumes control of servicing, and collecting accounts receivable, providing a benefit that a health-care organization must consider along with the higher cost of the program. Asset-backed securitization, on the other hand, is viewed as a more traditional financing mechanism without the service and control issues.

Because of staffing and workload issues confronting hospital patient accounting departments, the services provides by factors often are viewed as an attractive feature of the arrangement. On the other hand, a hospital that prefers to retain full control and responsibility for servicing accounts would find more benefits in securitization.

Program eligibility. Asset-backed securitization programs typically are limited to investment grade hospitals. Although credit ratings are provided for commercial paper, an organization's ability to obtain an A1 rating partially depends on reducing the threat of provider bankruptcy. Investment grade rated hospitals reduce that risk in the eyes of rating agencies and surety providers.

Factoring does not use commercial paper to fund receivables purchases. Consequently, credit ratings and hospital viability are less important. Program costs and service and control of the receivables function can compensate for the added risk. Troubled institutions desperately in need of greater cash flow often have pursued factoring as the "lender of last resort."

Interest in accounts receivable financing is escalating throughout the healthcare and investment banking industries. With a potential initial funding pool exceeding $500 billion, financing of healthcare receivables likely will be commonplace in the near future. Each hospital must evaluate the trade-offs between higher funding advances and lower costs of a securitization program against the benefit of services typically provided by a factor.

Sandra Ferconio is a senior associate in the division of finance and reimbursement of the Chidago, Ill., office of Coopers & Lybrand. She is a member of HFMA's First Illinois Chapter.

Michael R. Lane, CPA, is a manager in the division of finance and reimbursement in the Chicago office of Coopers & Lybrand.