Financing maneuvers: two opportunities to boost a hospital's working capital - factoring and asset-backed securities - Special Report

Healthcare Financial Management, Oct, 1991 by Sandra Ferconio, Michael R. Lane

Spiraling expenses, declining profits, and continued cutbacks from third-party payers increasingly limit a healthcare facility's access to capital. As a result, only a small percentage of the approximately 6,700 hospitals in the marketplace have obtained investment grade credit ratings. Current trends in the market suggest that, while investment grade status not only is difficult to achieve and increasingly difficult to maintain, it remains criticafor acquiring capital financing.

Commercial banks are the traditional source of working capital across most industries and provide short-term financing opprotunities for hospitals. When a hospital obtains working capital from this source of unsecured lending, the amount borrowed and the cost of financing often speak to the credit-worthiness of the hospital.

With access to capital and short-term financing now difficult or expensive to obtain, health care needs creative financing options. Accounts receivable, a large and growing asset on a typical hospital balance sheet, offers several financing opportunities. While common-place in other industries, however, receivables financing in health care remains a controversial and misunderstood topic.

Estimates place net receivables available for initial financing between $50 billion and $60 billion. On a continual basis, gross revenue available for periodic financing approximates $240 billion to $260 billion, or $160 billion to $175 billion on a net basis.

While receivables financing may not be right for every healthcare organization, benefits of this form of financing often are overlooked. And two distinct accounts receivable financing techniques, factoring and asset-backed securitization, often are confused.

Factoring

Factoring accounts receivable has been practiced for centuries but gained prominence in the early 1900s in the textile, apparel, and home furnishings industries. Factoring emerged as a means for companies to receive immediate cash flow and eliminate problems involving credit and collection of accounts.

In a factoring transaction, a factor (purchaser) assumes a client's credit exposure and risk of non-payment for financial reasons. Factors rely on their credit and collection experience to minimize potential financial losses.

Factoring in health care, a relatively small portion of all factoring business, is dominated by a few firms. In a typical healthcare transaction, eligible net receivables, defined by the factor, are purchased at a discount from face value. Discounts between 5 percent and 10 percent are not uncommon in health care. Cash collections resulting from the difference between the face and discounted values of the purchased receivables are passed on to the factor.

Along with a discounted purchase, the cost to participate includes a factoring fee expressed as a percentage of sold receivables. This factoring fee may be as high as 15 percent to 20 percent of the value of sold receivables. Penalties plus interest also may be assessed for failure to comply with notification and reporting requirements stipulated in a factoring agreement.

Another distinctive feature of healthcare factoring is that the purchaser assumes full control and responsibility for collection and follow-up activities on sold accounts. The full range of services a factor provides are outlined in Exhibit 1. Depending on the level of funding sought and the types of accounts sold, a considerable amount of patient accounts servicing requirements may be shifted from a healthcare facility to the factor.

Factoring allows hospitals to receive advance funding from their receivables and reduces the collection and follow-up efforts required of patient accounting staff members. Factoring can function as an acute, short-term remedy for working capital and staffing shortfalls or provide and avenue for continual funding and patient accounting support.

Securitization

A relatively new form of working capital financing across all industries is asset-backed securitization. This method first gained acceptance in the retail credit industry--with auto loans and credit cards, in particular--by bridging the gap between factoring and unsecured lending.

Unlike traditional capital financing, asset-backed loans are open-ended. Collateral is pledged as security on a continuous basis over the life of an agreement. The securitized asset most commonly used for asset-backed loans is accounts receivable. As the 1980s ended, healthcare providers became interested in asset-backed securitization to unleash the cash flow potential of patient accounts receivable from third-party payers.

In a typical transaction, proceeds generated from the sale of A1-rated commercial paper is used to purchase receivables from a hospital. Commercial paper gains an A1 rating on the basis of the credit enhancement provided by a surety bond provider. A surety bond provider enhances the credit of commercial paper rather than a hospital's creditworthiness, as a typical tax-excempt financing may require.