Healthcare Financial Management in Practice,

Healthcare Financial Management

In practice, the optimal capital structure cannot be found. Therefore, what is the logic of the optimal capital structure? What must managers do to take on additional debt financing?

The optimal capital structure takes into account the cash flows and asset structures needed for a particular business. In the healthcare context, the prediction of reimbursement, the number of patients who will be admitted, and the amount of profit generated by each patient are all important factors in predicting the overall capital structure for the hospital.

If the hospital is for-profit, then it has reduced options in accepting charitable contributions to a foundation, or in issuing tax-free bonds for capital projects. The optimum capital structure for a for-profit hospital may then involve public equity and commercial bonds, as well as bank relationships.

If a hospital is municipally-owned and therefore non-profit, the hospital can take advantage of tax-free bonds, which can be issued at lower cost. The need to take on more indigent patients can affect operating cash flow, however, so the optimum capital structure would be higher in terms of capital investment and lower in terms of operating costs in order to reflect different cash flow realities.

In a purely commercial environment, the optimal capital structure depends on satisfying the shareholders and debt holders; their optimum capital structure focuses on return on equity and overall equity appreciation (Mullins). In a non-profit environment, the focus is on higher capital costs and lower operating costs.

Detail the process for issuing bonds. Describe the roles of the necessary individuals and the overall market making process.

This answer will take the example of a hospital issuing a municipal bond, which is therefore tax-free. The first step is to complete an audit of the financials which will satisfy the investment bankers. The next step is to do a financial analysis of the project which needs to be financed by the bond. This financial analysis needs to demonstrate that the project can generate enough cash to "cover" the cost of the bond with an adequate reserve. This financial analysis can be done by one of three parties: the hospital's own CFO, the outside accounting firm, or an outside consultant.

Once the financials are put together which justify the cost and the returns of the project, a series of investment bankers is invited in to "pitch" the hospital on their expertise and analysis of the financials. This elaborate dance is a "push-me, pull-you" routine in which the investment bankers are both pitching for the bond offering, while tempering the numbers and attempting to keep the expectations of the CFO and CEO of the hospital in a reasonable place.

The next step is for the chosen investment bank to put together a "deal book," which involves a PPM (marketing book, or Private Placement Memorandum). This document contains all the analyses needed to demonstrate the marketability of the deal (VCA).

The investment banker then takes the team on a "road show," and "builds a book" of investors who would like a part of the bond offering. Once the "book" is assembled, the investment banker closes the deal and funds are transferred from escrow to the hospital's capital account.

Health care organizations compete for funds with other users of funds. What strategies should a hospital use to influence the market that they are capable of taking on more risk and are a good investment option?

Hospitals have several options, depending on their structure and their owners.

In the case of a for-profit hospital, hospitals can be quite profitable on their own if they are well-run, and focus on higher-profit procedures, such as cardiology, orthopedics, oncology and (in some cases) obstetrics. There have been some specialty hospital chains, such as MedCath (MedCath), or Cancer Treatment Centers of America, which have focused on specific disease states and bring a lower-cost, highly focused business model which can be quite profitable. These hospitals can justify an IPO and bond offerings on the commercial market without much difficulty.

Non-profit hospitals have several options available to them. Like the for-profit hospitals, they must generate a business model which demonstrates profitability (or an increase in overall cash reserves). Unlike a for-profit hospital, however, they can issue tax-free bonds (in some cases) and take charitable donations to their foundations. Such donations, when assiduously sought-after, can result in a sizable foundation whose earnings can defray some of the operating costs of the hospital.

An option available to both types of hospitals is the real-estate option. Because a hospital's nearby facilities are attractive to physicians attached to the hospital, the hospital can take an interest in building and renting out facilities to physicians, who tend to be high-paying, stable tenants. Also, the tax benefits available to those who buy and hold assets (buildings and land) may make it more reasonable for the hospital to sell and lease back its land and buildings.

Managers put together a cash budget on an annual basis. Once the budget is made, what steps must be taken to assure that it represents the financial picture for the health center during the next fiscal period.

There are three major controls over cash budgets during the fiscal year. These include:

Monthly forecast meetings, which cover the past three months' actual, the current month's "estimated," and a forecast for the following three quarters. These forecasts are then compared to budget and to previous forecasts. Since there are always things which increase or decrease cash flow, a reasonable expectation is requested if there is a significant deviation from forecast or budget in either a positive or negative direction.

Departments are made responsible for their budget attainment. In addition to the above general review, each department is made aware of their performance to budget, and reasons are sought if there are major deviations.

If the hospital is significantly "off" on its numbers, the CFO or CEO must act in order to bring the hospital back in line with its resources. This may require a re-budget during the period.

You have just been chosen to implement a new purchasing and supply system within your organization. Present a convincing argument for the system that you would use, detailing why you did not use other systems that are in practice today.

The traditional model of a general purchasing office within the hospital is being replaced by devolving responsibility to individual departments, and making them aware of their usage. Purchasing changes from a directive function to an assisting function.

Although many hospitals feel there is an advantage in joining a GPO, or general purchasing organization, the savings realized are fairly small, and offset by the dues to the GPO.

The purchasing operation in this hospital must focus less on price, and more on the overall cash flow of items we purchase and use. By reducing on-site stock and increasing turnover (i.e. The number of times per year the stock is replenished), we can reduce overall cash related to inventory, which goes to increase cash available for operations.

Purchasing can incorporate "just-in-time" technologies, using bar codes and RFI to identify the use of a product in a procedure. In a cardiac catheterization, for example, it is important to know every time a stent is used, as they can cost $2,700 per unit. By using a Pyxis-type bar-code system, it is possible to know what is being used, and replace it quickly, therefore reducing overall inventory needs.

Compare and contrast the characteristics of the four sources of short-term funds. Which is the preferable method and why?

Commercial paper: It's from overnight to one year. The advantage is ready liquidity, but it does not work well for funding on-going cash needs. The market for commercial paper can sometimes close.

Bank loans: These tend to have a longer-term horizon, and are generally part of an identified "credit line" which is used for specific purposes. These can be more expensive than commercial paper, and are usually circumscribed by conditions, such as asset coverage, which could be difficult in a credit crunch.

Accounts receivable financing: These "factoring" agencies sometimes combine billing and recovery. They attach assets and can be quite expensive, particularly if there is a factoring percentage attached to each collected bill.

Inventory financing from the supplier: The most common way to do this is through consignment. Consignment means that the product isn't paid for until it is used. The advantage is that, usually, the initial consignment stock is never paid for (i.e. The overall inventory cost is reduced).

Fifth (bonus point): Money saved. Short-term reduction in expenditure is the cheapest way to improve cash flow.

Hospital budgeting techniques are difficult to apply and interpret. Explain in detail why the decisions are difficult and what can be done in the capital budgeting process to ameliorate these issues.

Hospital budgeting is difficult because both the operating expenses and the billing and reimbursement are difficult:

Any patient walking through the door can be a significant drain on the hospital's budget. It is easy to find a heart patient taking $200,000 of hospital budget to cover. Some hospitals create a "contingency" budget, which can be offset by a few of these patients.

The percentage of non-paying patients can vary a good deal, particularly in a city- or county-owned hospital. This number may not vary, and typically in a budget the hospital CEO and/or CFO negotiates with the governmental bodies for regular subsidies to cover.

The billing cycles can be difficult to predict, particularly for Medicare and Medicaid patients, where there are famous irregular delays on payment. It is possible, as noted above, to go to outside banks or other bodies to get a/R funding to cover these contingencies

Particularly in older hospitals, the amount in the depreciation account may not be enough to cover unforeseen expenses, such as asbestos removal or deterioration. Hospitals can address this by auditing their depreciation accounts and making a better assessment of what might be needed in coming budgets.

Many organizations use a leveraged buyout vs. A merger or other type of acquisition strategy. Compare and contrast the different "purchasing" methods. Which is the best? Does one work better in a different situation than another? Explain your rationale.

An LBO must have good cash flow to cover the cost of the debt. Most LBO houses look for a 4-6-year coverage of the debt, i.e. they count on free cash flow (generally EBIT-DA) to pay back the borrowed amount in 4-6 years. Although the LBO house might make a lot of money on equity appreciation, it is debt coverage that is most important to them, and the equity appreciation is seen as a lagniappe.

Sale and leaseback makes sense if the hospital is not-for-profit, as the tax benefits accrue to the commercial buyers, and would not be used by the hospital itself.

Merger makes sense if a consolidation is needed. If two hospitals are in a price war, combining operations helps them to increase prices and negotiating leverage with PPO's and HMO's in their area. It also helps if there are redundant costs -- combining two hospitals' coronary units may result in focus in both institutions, perhaps one in surgery and the other in intervention.

Outright acquisition makes sense if there is a dominant hospital which would like to either (1) tie in referring physicians who are attached to the satellite hospital, or (2) the hospital would like to increase its bargaining power with the payors.