Does hospital financial performance measure up?

STRATEGIC PLANNING

Comparisons are continuously being made between the financial performance, products and services, of the healthcare industry and those of non-healthcare industries. Several useful measures of financial performance--profitability, liquidity, financial risk, asset management and

More than at any other time in its history, the healthcare industry is being analyzed, scrutinized, and often criticized for its performance relative to other sectors of the economy.

Since 1983, the Federal government has analyzed healthcare costs to establish prices paid to hospitals; today capital costs are being analyzed to established a similar payment plan. The hospital industry's profitability is now and will continue to be compared to non-healthcare industries in evaluating the reasonableness of these payment plans.

Contract care organizations, insurers, and public and private sector payers scrutinize hospital financial performance in an effort to control rising hospital charges. Comparisons are continuously being made between the increase in healthcare costs and the increase in costs for other products and services in the economy's "market basket."

Policymakers and healthcare watch groups continue to criticize the cost and availability of health care, frequently pointing to the industrial sector as a model for providing goods and services more effectively and efficiently.

All too often the analysis, scrutiny, and criticism of hospital performance are accompanied by comparisons with other sectors in the economy. This is particularly the case for the hospital industry's financial performance. Hospital administrators themselves understandably want to know how the financial performance of their organization compares to that of companies and industries in non-healthcare sectors.

This article expands on previous research on comparative hospital performance that was limited to the comparative profitability dimension of hospital performance.[(a)] In addition to updating the previous analysis of profitability, this article will comparatively analyze several other dimensions of hospital financial performance: liquidity, financial risk, asset management and replacement, and debt capacity. Based on hospital and non-healthcare financial data, benchmark ratio values will be presented for each of these dimensions--targets considered necessary to ensure the viability of the hospital industry relative to non-healthcare sectors.

To represent financial performance of non-healthcare sectors, financial data was collected for the 470 companies that make up three Standard and Poors' (S&P)indices: the S&P 400, which represents 400 industrial companies, the S&P Transportation Index, which tracks 20 transportation related companies, and the S&P Utilities Index, which follows 50 utility companies. The ratios selected for the comparisons for each company were calculated, and the median value for each ratio and each index was determined.

To represent the financial performance of the hospital industry, data for all years between 1985 and 1990 was selected from HFMA's Financial Analysis Service (FAS) database. This selection process resulted in a constant sample size of 1,200 hospitals. An analysis of the demographics of the data indicated that the sample was representative of region, bed size, teaching, and urban-rural characteristics of the population of all hospitals in the FAS database. The ratios selected for comparisons were then calculated for each hospital to determine the median value for each ratio.

The analysis is based on seven critical dimensions of hospital financial performance. A key financial ratio was selected to represent each dimension and median values for each ratio are compared for the sample of hospitals and for each non-healthcare sector. Appropriate targets wee then delineated for hospitals to bring their performance in line with others sectors.

Adequate profits

Few people question the need for profit in the hospital industry today, but there is considerable discussion about the amount of profit that should be earned. Some minimum level of operating profit must be earned in any business if that business is to remain viable and replace its production or service capacity.

Very simply, if a business is to survive, it must cover the replacement costs of its assets. A piece of medical equipment that cost $100,000 five years ago and now costs $250,000 must be financed with an additional $150,000. Any business that does not or cannot recover its replacement cost is ultimately financing itself toward bankruptcy.

For purposes of comparison, the price level adjusted operating margin (PLAOM) ratio was chosen to determine whether operating profits are sufficient to cover replacement costs. This also is one of the financial measures provided to HFMA Financial Analysis Service (FAS) subscribers. It is a routine operating margin measure, except that in lieu of historical cost depreciation, replacement cost depreciation is used. It is important to note that the PLAOM is actually price level adjusted depreciation based upon the consumer price index (CPI). If the replacement cost of hospital equipment and plant is increasing at a rate greater than the consumer price index, then PLAOM will overstate real profitability. A PLAOM value greater than zero would be required to cover the replacement costs of hospital assets.

The data Exhibit 1 show that the relative trends in all industries have been down, especially from 1988 to 1990, with a slight recovery for the hospital industry in 1990. The data also clearly show that the hospital industry has reported lower values for price level adjusted operating margins that the other industries.

Some might argue that the comparisons are unfair because some of the biggest and best firms in the S&P groups are being compared with hospitals. This criticism is not valid because the hospital data come from a sample of hospitals that were more than twice as profitable as the average U.S. hospital, with average profitability determined from the 5,000-plus hospitals in HFMA's Medicare Cost Report data base.

The values for the hospital industry are very inadequate to meet normal replacement needs and may signal one of two future problems. The hospital industry may have to increase its debt financing to acquire new plant and equipment, or the average age of the hospital plant and equipment base may increase, which ultimately may have a negative effect upon quality of care.

Reasonable return

For most investor-owned firms, a key test of performance is the rate of return on the investor's equity (ROE). Adequate ROE is critical for voluntary hospitals as well as for investor-owned hospitals because without adequate rates of return, a voluntary hospital cannot add new funds to either working capital or fixed capital. Ultimately, equity growth is the key to sustained asset growth in any business. No business, except the government, which has the luxury of being able to print money, can continue to finance its growth with debt. Adequate ROE remains a critical indicator of success and survival for all hospitals.

It is important to remember that ROE reflects both operating and nonoperating fits for both hospitals and the S&P firms, although to a lesser degree. To the extent that some hospitals are able to subsidize poor operating results with investment income or contributions, these effects would be included in ROE values.

The median ROE for hospitals shown in Exhibit 2 is significantly below that of non-healthcare industries and trending downward until 1989. The comparison is not as poor as it seems to appear, however, because most S&P firms will experience lower growth in equity than their ROE because many firms pay dividends out of earnings.

A key question is "what is a reasonable ROE target for most hospitals?" ROE is related to expected long-term growth in total asset investment. Since the average surviving hospital is expected to generate a compounded annual growth rate in total assets of approximately 10 percent over the next 10 years, a target of 10 percent for ROE is appropriate. The current hospital median ROE is below this value. Hospitals growing at rates greater than their ROE will be forced to finance their assets with more debt--with the resulting higher debt ratios and higher financial risk.

Reasonable liquidity

Illiquid firms often fail because they can no longer pay their bills, including interest and principal payments. Liquidity is important, but it must be put in proper perspective. An illiquid firm that is profitable will probably survive, but an illiquid firm that is unprofitable will almost certainly fail. This happens because profitable firms can acquire short-term financing to weather temporary liquidity problems.

While profitability is more important than liquidity, liquidity is an important management objective. For comparison, the current also (current assets divided by current liabilities) was chosen to measure the liquidity dimension of financial performance (Exhibit 3).

At the present time, liquidity does not appear to be a problem in the hospital industry. Hospital current ratios have been relatively stable during the last five years and are considerably higher than for other industry groups.

One assumption is that accounts receivable remain in control and collectable. More days in accounts receivable financed by permanent capital will result in high current ratios, but if receivables are stretched too long or are uncollectable, then liquidity problems will ensue even when the current ratio is high. As will be seen later, time in accounts receivable has grown by six days in the last six years and appears to be precariously long today.

Debt capacity

It is not prudent to exhaust all debt capacity. Doing so will impair financial flexibility and resiliency in a period of financial distress. It is commonplace today to read about the collapse of a company that took on too much debt. Long-term debt to equity was chosen as the ratio to measure this area.

The long-term debt to equity ratio for the hospital industry appears to have been stable during the last six years (Exhibit 4). This trend contrasts with the trend for non-healthcare industries. The increasing amount of high long-term debt is especially noteworthy in the transportation group where deregulation and cutthroat competition have depressed operating margins.

All fiscally responsible hospitals should define their debt policies explicitly. A 10-year average long-term debt to equity ratio of no more than 75 percent is a reasonable target. Most hospitals should strive to keep their long-term debt to equity ratio below 150 percent in any year, unless little or no competition exists in the hospital's primary market.

Plant upgrading

Most businesses with old plants are unable to compete with firms with newer plants and equipment, since these business usually benefit from the cost efficiencies and quality associated with new facilities and technology. In the hospital industry, newer plants and equipment typically attract both patients and physicians who often associate quality with newer facilities. In fact, older hospitals have a track record of failure that far exceeds that of new hospitals. While it is dangerous to overinvest in facilities, it is also suicidal to underinvest in capital when competition exists.

The average age of plants is used as the measure of the age and technology level for the hospital sample and non-healthcare industries.

The data (Exhibit 5) clearly show that the hospital industry is not replacing its plant assets as frequently as it has historically. Compared to non-healthcare industry facilities, the hospital plants are much older.

A target average age-of-plant value should be no higher than nine years. Hospitals with average-age-of-plant values that exceed nine years have a clear need for major new capital. Ideally, hospitals should have a long-term capital program accompanied by a realistic program of financing to ensure plant replacement.

Quick receivables collection

Prompt payment of receivables by customers is desirable in any business. Longer receivables payment periods translate into greater investment of capital and therefore greater cost. This principle is better demonstrated in the hospital industry than any other because slow payment problems with major third-party payers frequently create colossal cash flow problems.

Average days in accounts receivable was used to measure this important dimension of financial performance. The number of days in accounts receivables for hospitals is significantly greater than the number of days for non-healthcare industries and has been increasing rapidly during the last six years (Exhibit 6). Knowing that the industry average is 75 days does not mean that this value should be a target. Hospitals should establish goals to minimize future increases in days in accounts receivable and, in some cases, bring them down. Targets need to be defined and performance should be monitored carefully. A target of 64 days--the lower quartile value for hospitals in HFMA's FAS database--is recommended.

The worst payment delays are incurred due to patients with commercial insurance and those who are self payers. Hospitals with heavy Medicare business volume should actually have lower days in accounts receivables values. Both these considerations should be taken into account in establishing bill payment targets.

Replacement funds reserve

Most young couples anticipating home ownership know that they must set aside funds for a down payment to keep their debt service to a minimum. Unfortunately many businesses, and especially hospitals, appear to have ignored this simple principle of finance. Excessive debt financing was dangerous in the past, but with today's competitive conditions and low utilization rates, it can be fatal. Increasing competition, fixed prices, and the loss of capital cost passthroughs can create nightmare scenarios for over-leveraged hospitals.

What amount of funds should a hospital accumulate for replacement needs? The first consideration should be what proportion of replacement needs might be debt financed. That proportion should then be subtracted from one and multiplied by the current replacement cost of depreciated assets. For example, if a hospital decided to debt finance 60 percent of its replacement needs at a time when current replacement costs were $50 million, the amount of replacement funds that should be set aside should equal $20. million (1.0-.60) x $50 million.

HFMA's replacement viability ratio is used to assess the adequacy of present replacement funding. The replacement viability ratio measures the adequacy of replacement funds to meet replacement needs, assuming 50 percent debt financing. A value of 1.0 for the replacement viability ratio indicates that present funds are sufficient. Current replacement viability ratio values are presented in Exhibit 7.

Reviewing the comparative replacement viability data alone suggests that the hospital industry is relatively healthy compared to other industries. However, this is not the case. The non-healthcare industries have one major advantage over the voluntary hospital group in that they can raise equity capital through the sale of new equity shares. In practice, non-healthcare investor-owned firms frequently delay or avoid accumulating reserves for replacement; instead they pay dividends to their investors to raise stock prices and later raise capital through stock offerings. Investor-owned firms have access to equity markets while voluntary hospitals have only internally generated funds and contributions.

The 1990 median replacement viability value of 0.44 for the hospital industry suggests that the average hospital would have to debt finance 78 percent of its replacement costs. This value seems to be excessive. Most hospitals should strive for a replacement viability ratio of 1.0.

Replacement funding is an important management/board policy that has only recently received the attention it deserves. A hospital should compute its replacement viability ratio on an annual basis and communicate past and current ratio values to its board.

Action plan

All too frequently, analysis, scrutiny, and criticism of the hospital industry are conducted out of context. By identifying seven dimensions of financial performance and comparatively analyzing the hospital industry's performance compared with the performance of three non-healthcare industry sectors, it is possible to identify relative weakness in the hospital industry's financial profile and suggest target ratio values to transform those weakness and threats into opportunities and goals. This exercise extends beyond performance ratios within the hospital industry. Any criticism of hospital performance is designed to be constructive and to offer healthcare industry constituents positive directions for improved financial performance.

EXHIBIT 1. Operating margin is lower for hospitals
                        1985   1986   1987   1988   1989   1990
Hospital median         1.5%    .6%    .2%   -.2%    .1%    .8%
Industrial median       2.3%   2.5%   3.1%   3.8%   3.4%   3.0%
Transportation median   1.7%   2.4%   1.6%   2.4%    .7%    .9%
Utilities median        8.2%   8.6%   7.8%   6.4%   3.9%   4.2%
EXHIBIT 3. Current ratio is higher for hospitals
                        1985   1986   1987   1988   1989   1990
Hospital median         2.06   2.08   2.06   2.08   2.06   2.0
Industrial median       1.84   1.79   1.75   1.72   1.67   1.5
Transportation median   1.23   1.10   1.02    .95    .84    .69
Utilities median         .95    .91    .94    .89    .87    .85
EXHIBIT 5. Average age of plant in years is high for
hospitals
                        1985   1986   1987   1988   1989   1990
Hospital median         6.85   6.98   7.18   7.35   7.50   7.62
Industrial median       5.20   5.12   5.19   5.16   5.34   5.48
Transportation median   5.85   5.52   6.69   6.02   6.24   6.61
Utilities median        3.81   4.10   4.16   4.48   4.88   5.25
EXHIBIT 6. Days in accounts receivable are longer for
hospitals
                        1985   1986   1987   1988   1989   1990
Hospital median         68.5   69.3   71.4   74.6   77.1   74.5
Industrial median       53.7   52.8   55.3   56.5   56.6   56.0
Transportation median   49.0   46.0   43.5   43.0   34.0   30.9
Utilities median        68.7   60.7   59.8   65.7   68.0   65.1
EXHIBIT 7. Replacement viability is poor for hospitals
                        1985   1986   1987   1988   1989   1990
Hospital median         .439   .471   .463   .420   .428   .438
Industrial median       .313   .316   .314   .365   .333   .293
Transportation median   .080   .101   .078   .104   .109   .148
Utilities median        .097   .151   .144   .211   .135   .198

(a) Cleverly, William O., PhD, CPA, and Roger K. Harvey, DBA, "Profitability: Comparing hospital results with other industries," Healthcare Financial Management, March 1990, pp. 45-52.

William O. Cleverley, PhD, CPA, is a professor of hospital and health administration at Ohio State University, Columbus. He is also the author of HFMA's Hospital DATA-PLUS Services reports and a member of HFMA's Central Ohio Chapter. Roger K. Harvey, DBA, is an emeritus professor of finance at Ohio State University and president of Value Associates, Columbus, Ohio.