Distress detectors measures for predicting financial trouble in hospitals: early-warning systems that anticipate financial distress can provide management with powerful tools to help identify and rectify problems before they reach a crisis

Healthcare Financial Management, August, 2005 by Corbett A. Price, Andrew E. Cameron, Devin L. Price

How well do you know the financial condition of your organization?

Today, more than ever before, users of a hospital's financial information whether they be investors, management, board members, community leaders, or donors need to be informed of the organization's true financial condition. Early detection of financial distress is critically important if a hospital's executive team is to have time to take corrective action and pre vent further erosion of the organization's financial health.

The problem is that hospital management and boards often seek dramatic change only after the organization has reached a crisis stage. When looking at their organizations' historical financial information, they all too often fail to see the signs of a looming financial crisis. For weak hospitals, the consequences of such inaction can be disastrous.

By being more proactive and diligent in analyzing financial measures, how ever, hospital leaders often can avert a crisis. In many instances, with appropriate review and analysis, a hospital's managers, investors, and board members can discern the presence of a financial problem from existing information. Indeed, audited financial statements can often present clear signals of impending disaster.

Key Measures

The question is, which kinds of measures provide the most reliable picture of a hospital's financial health? Should you use accrual-based financial statements, such as the income statement and balance sheet, or measures based on cash flow (using information from the statement of cash flows)?

There are no definitive answers to these questions. Various academics and analysts have presented data and analysis to support each position. Several examples of corporate failure exist in which accrual-based financial ratios revealed no major problems. On the other hand, reliance purely on cash-based ratios can lead to misdiagnosing as failures companies that are not bankrupt. Examples include growth companies that consume cash yet can raise more funds through debt and equity, and large companies whose operating cycles have regular periodic peaks and valleys requiring them to invest cash ahead of the anticipated peaks.

The only prudent approach is to use a balanced reporting system incorporating both types of measures. As perhaps the most effective approach, we propose using seven financial per formance measures--two accrual-based and five cash flow based that have been the subject of much recent research on organizational financial distress. These measures are:

* The Financial Strength Index

* The modified Z score

* Operating cash flow ratio

* Funds flow coverage ratio

* Cash interest coverage ratio

* Cash flow to total debt ratio

* Total free cash flow ratio

All of these measures, detailed below, are financial ratios that can be calculated from standard financial reports the income statement, balance sheet, and statement of cash flows. Naturally, each healthcare organization's case is different, and the values of these ratios must be viewed within the context of the organization's particular situation. Numerous contextual variables should be considered, including whether the company is mature as opposed to a startup, the particular segment of the healthcare industry, and the size of the company.

Accrual-Based Measures

The accrual based measures are the FSI and the modified Z score. An early version of the FSI was described by William Cleverley and Andrew Cameron in Essentials of Health Care Finance, 5th ed. (Gaithersburg, Md.: Aspen Publishers, noon). The measure was recently updated to account for changes in availability of Medicare cost report data that resulted from CMS's implementation of prospective payment systems for hospitals. The modified Z score was described by Edward Altman in "Predicting Financial Distress of Companies: Revisiting the Z Score and ZETA Models" (working paper, July 2000, downloadable at pages.stern.nyu.edu/~ealtman/Zscores.pdf).

FINANCIAL STRENGTH INDEX

total margin - 4.0 / 4.0
  days cash on hand - 50 / 50
- debt financing % - 50 / 50
- accumulated depreciation expense % - 50 / 50

WARNING! Investigate further
if the FSI is less than 0.

FSI. The FSI is a simple measure of overall financial health that provides an excellent starting point for analyzing a hospital's condition. It is a composite measure of four critical dimensions of financial health: profitability, liquidity, financial leverage, and physical facilities.

The FSI was designed specifically for hospitals, but it transfers well to other industry sectors. The measure implies that firms with large profits, great liquidity, low levels of debt, and new physical facilities are in excellent financial condition, whereas those with poor profitability, low levels of liquidity, heavy debt financing, and old physical facilities are in poor financial condition. What constitutes a good FSI value? An FSI of >3 reflects excellent financial health; 0 to 3 indicates good financial health; -2 to 0 indicates fair financial health; and < -2 is an indicator of poor financial health. Thus, if your hospital's FSI is less than 0, you should do further analysis to determine the extent of the organization's financial problems.

MODIFIED Z SCORE

Z' = 0.717[X.sub.1]   0.847[X.sub.2]   3.107[X.sub.3]   0.420[X.sub.4]
  0.998[X.sub.5],

where

[X.sub.1] = net working capital/total assets
[X.sub.2] = retained earnings/total assets
[X.sub.3] = earnings before interest and
            tax/total assets
[X.sub.4] = book value of equity/book value of
            all liabilities
[X.sub.5] = net operating revenue/total assets

WARNING! Investigate further if the modified
Z score is less than 2.91.