Capital allocation three cases of financing the future: three CFOs share how they assess pressing capital needs in an era of tight resources - Feature Story - Cover Story

Healthcare Financial Management, Oct, 2003 by Richard L. Clarke, Rick Wolfert

When it comes to capital, executives of hospitals and health systems are between a rock and a hard place--capital projects loom large, and capital resources are tight. There is no lack of worthy proposals for new facilities, increased services, and technology upgrades. But these come at a time when many hospitals are struggling to find the cash or credit to underwrite these projects.

In the past year, the aggregate total hospital margin hit 4 percent, its lowest mark since 1993, according to a report by the American Hospital Association (AHA). (a) Operating margin was 2 percent, down from 4 percent in 1996. The AHA report notes that, at present, one third of all hospitals experience negative total margins.

This funding shortage isn't for lack of business. Inpatient admissions in community hospitals rose from about 31 million in 1996 to about 33 million in 2000, and outpatient visits grew from 441 million to 523 million during that same period, according to the AHA report. In areas of high population, midnight census of l00 percent and daily census of 120 percent are not uncommon.(b) Rather, increased staffing cost, increased malpractice/liability insurance expense, flat government payments, increased need for capital projects (some of which offer no quantifiable return on investment), increased need for information technology (IT), and the timing of equipment upgrades have all coalesced to stress hospital liquidity as never before. Capital budgets are under pressure to increase, without being able to project a proportionate increase in revenue.

Hospitals Respond

For many hospitals, current capital projects run the gamut from those that contribute to an organization's growth and profitability, such as the addition of a new clinical service, to those the organization depends upon to remain viable, such as clinical IT and the replacement of aged or unserviceable facilities and equipment. Successful not-for-profit hospitals are able to vet capital projects so that organizational requirements for growth, stability, and community service are achieved. Specific processes vary by institution, but they have a common thread: the CFO is facilitator of a process that elicits opinions and expertise from all constituents--physicians, nurses, staff, and community members.

An example is Advocate Health Care, Oak Brook, Ill., which serves Chicago and its suburbs. The health system's list of current projects includes a new cardiovascular program at one of its hospitals. The program is expected to provide a needed service in the community, expand the hospital's market share, and bring a financial return.

Another project is a planned renovation and expansion of an ambulatory surgery center. The project will not create a significant return, but loss of the service would be financially harmful to the institution. One project with which the system struggled to come to terms was replacement of its phone system. Advocate has a patchwork of systems, with inconsistent reliability. The new system is a significant expenditure, says Lawrence J. Majka, Advocate's executive vice president and CFO. There's no quantifiable return, but also no choice--healthcare facilities need a working phone system.

On the West Coast, California-based Santa Barbara Cottage Hospital is pursuing a daunting project at its flagship Santa Barbara facility--the $345 million rebuilding of its original building, built in the 1920s, long before the advent of the state's strict seismic safety codes. Another wing, built in the 1970s, also must be replaced. Replacement of the building constitutes a huge investment for the 436-bed hospital, one of three in the Cottage Health System.

The hospital realizes that the new construction won't have a big payback, but it is a necessity for complying with state regulations and to make sure the hospital survives the next earthquake. "The payback will be in a generation," says Joan Bricher, CFO of Cottage Health System.

In Philadelphia, Northeastern Hospital has its own panel of projects under way, including an emergency department renovation and expansion that costs $2.5 million, and a new MRI that will run $2 million. These funds are hard to raise for the hospital, which has limited cash reserves and borrowing capacity. The hospital, part of four-hospital Temple University Health System, serves a primarily urban population, and Medicaid is the primary payer. The hospital has been profitable for seven years, but must continue to build its credit rating after nearly closing in 1994 (Northeastern joined Temple in 1995).

Planned equipment upgrades and new technologies include a picture archive and communications system (PACS), new digital radiology equipment, and clinical order-entry systems. The hospital also must replace its elevators, sprinkler systems, and other infrastructure items. The hospital deferred these projects as long as it could, but simply could not put them off any longer.

Decision-Making Process

The complexity of hospitals as organizations coupled with the scarcity of" funding make adherence to a disciplined, consistent capital allocation process critically important. The key to effective capital allocation for both profitable and profitless projects is a rational, clear, and open allocation and prioritization process.