Key financial ratios can foretell hospital closures

Healthcare Financial Management, Nov, 1993 by Monty L. Lynn, Paul Wertheim

For both one and two years prior to closure, the ratio for liquidity fails to add significant explanatory power, given that the model already contains ratios from the other ratio categories. The variables for leverage, capital efficiency, and asset availability, however, each add significantly to the predictive power of the combined model. Thus, the liquidity measure could be omitted and the resulting three-variable model would still retain a high predictive accuracy.

Applications

One obvious application of this study is use of the individual ratios or the combined model by CFOs, hospital boards, and administrators, as a leading indicator of financial crisis. Timely detection of critical problems could prompt earlier or more aggressive development of financial, tactical, and strategic courses of action for improving financial health. Conversely, a hospital wishing to communicate a sound financial condition to stakeholders could use the model to support such a contention. The model or individual ratios also could be useful to potential buyers assessing the desirability of possible hospital acquisitions and mergers.

When measuring how susceptible a given hospital is to closure, it is necessary to compare that hospital's ratios to comparable industry norms. The ratio means given in Exhibit 1 for open and closed hospitals might be used as reference points if an institution in question is similar to the average sample hospital--that is, is small to medium in size.

Standard deviations of these norms are wide, however, reflecting the variability in size, location, and other qualities of the sample hospitals. Great care should be taken in interpreting these norms. Larger hospitals or specialty hospitals would be advised to generate their own set of financial ratio norms from an adequate sample of closely comparable institutions.

a. Bruda, D., "AHA's Tally of Hospital Closings Drops Again," Modern Healthcare, May 10, 1993, p.3.

b. Kwon, I., Safranski, S.R., Martin, D.G., and Walker, W.R., "Causes of Financial Difficulty in Catholic Hospitals," Health Care Management Review, 1988, Vol. 13, pp. 29-37.

c. Cleverley, W.O., and Nilsen, K., "Assessing financial position with 29 key ratios," Healthcare Financial Management, 1980, Vol. 34, No. 1., pp. 30-36.

d. Cleverley, W. O., "Financial Flexibility: A Measure of Financial Position for Hospital Managers," Hospital and Health Services Administration, 1984, Vol. 29, No. 1, pp. 23-27. Cleverley, W.O., "Predicting Hospital Failure with the Financial Flexibility Index," Healthcare Financial Management, 1985, Vol. 39, No. 5, pp. 29-38.

e. Mullner, R.M., and Whiteis, D.G., U.S. Urban and Rural Community Hospital Closures, 1980-1987, Center for Health Services Research, University of Illinois School of Public Health, Chicago, 1988.

f. The total number of U.S. community hospitals which closed during 1986 and 1987 was 142. Thus the sample constituted 50 percent of the total population of closures.

g. Logit is similar to linear regression except that it is more appropriate for classifying dichotomous data. Logit also overcomes some of the restrictive assumptions of discriminant analysis. Care was taken to avoid overestimating the ability of ratios to predict closure by using a statistical method called the Lachenbruch procedure. For additional description of the statistical methodology and results see Wertheim, P., and Lynn, M.L., "Development of a Prediction Model for Hospital Closure Using Financial Accounting Data," Decision Sciences, 1993, Vol. 24, pp. 529-546.