Financing healthcare capital expenditures

Healthcare Purchasing News, Nov, 2004 by Bill Zadrozny

Although subject to certain considerations unique to their industry, hospitals still must determine how they intend to differentiate themselves from the competition. Once this all-important question has been answered, buy-in, as articulated in a vision statement, must be obtained from all stakeholders. Then, the finance team can begin to create a capital plan designed to implement the hospital's vision within the limiting factors germane to the hospital, such as its credit strength, access to and cost of capital, acquisition and retention of the right doctors and staff, desired technologies, and many other considerations.

Prioritizing capital expenditures to align with the future each hospital imagines for itself is a rigorous and merciless process that will establish the framework and timeline for funding needs. This plan must be dynamic in order to consider market risks and opportunities, as well as deviations from the hospital's financial projections.

The recent HFMA series, "Financing the Future" (1) indicates that hospitals widely expect to increase capital spending at a much greater pace than during the five year period, 1997 to 2001. Significantly, over four fifths of hospital CFOs felt funding these capital needs would be more difficult. This sentiment is all the more alarming as it was expressed during a period of record low interest rates.

In the HFMA report, the three most frequently cited areas for capital expenditures were digital radiology systems, computerized physician order entry systems, and other major information technology. These projects will be financed in a period of likely rising interest rates and an ever-accelerating pace of technological change.

The question becomes, "Given the various primary sources of capital available to the hospital, what is the most efficient way to acquire the use of these three capital expenditure technologies?" Following is a discussion that considers the various key primary sources of capital as outlined in the HFMA studies against these three capital projects, his helpful to keep in mind that rating agency analysts and credit providers favorably view hospitals that have die ability to access a wide variety of capital sources such as cash, the bond market, philanthropy, and lease and loan financings.

Cash

Nearly one-third of hospitals have negative total margins. An overwhelming majority believe that Medicare/Medicaid reimbursements are inadequate. These two statements alone suggest prudence in cash expenditures and a watchful eye on the "burn rate". Indeed, they might be an argument for conserving cash. Moreover, assets funded with cash will appear on the balance sheet with negative implications for certain measurements, such as return on assets. All of these projects are subject to reasonably rapid obsolescence with amortization patterns similar to IT equipment, but with radiology systems having greater residual value at the end of any four or five year period.

With full ownership comes asset management, requiring the life cycle attention of already thinly-stretched healthcare finance professionals. Additionally, cash on hand as well as cash forecasted from operating activities can be a hedge against sudden physical plant replacement/additions, payor reimbursement pressures, labor issues, unforeseen demographic shifts like the loss of a major employer in the hospital's service area, M&A opportunities and general financial volatility.

A quick review of the generally robust cash positions among corporations across other American industries is revealing. Having weathered the tech bubble, finance executives are prepared to trade criticism from stock investors and equity analysts for a cushion against an uneven economic recovery, higher sustainable oil prices, rising borrowing costs, and a downturn in consumer spending. Against a future whose transparency is increasingly opaque, healthcare finance executives should be cautious in both the amount and purpose for which cash is consumed by capital projects.

Tax-exempt bonds

While bond issuance remains a major source of capital, accounting for nearly $20 billion in new financing in 2003, the outlook for this market is not upbeat. The combination of those weaker hospital credits coupled with rising interest rates will either limit access to capital or increase the cost of capital. Hospitals that are below investment grade or that cannot increase debt capacity cannot use this funding option. Due to time constraints and issuance costs, this option may not be the most attractive for projects costing a few million dollars. In addition in increasing leverage ratios, the funded assets will be on balance sheet and subject to the considerations noted in the comments above on "Cash". Lastly, there is the possibility for a mismatch between bond maturity and the useful lives of the three projects.

Philanthropy

Just under 50% of the hospitals surveyed in the HFMA studies indicated a greater prospective reliance on philanthropy. However, dedicated staff needs to be retained to concentrate on this endeavor. The willingness of donors to contribute material sums depends on their current portfolio returns, the perception of how rosy the future will be, and the identification of a donor with a vision similar to that of the hospital. For hospitals not currently engaged in focused philanthropic activity, it may be a while before meaningful unrestricted money can be added to the hospital's coffers. The considerations for using this source of cash for our three projects are identical to those noted under the "Cash" discussion, and, of course, this source over a long term capital plan deployment is unreliable.