Does hospital financial performance measure up? - Cover Story

Healthcare Financial Management, May, 1992 by William O. Cleverley, Roger K. Harvey

STRATEGIC PLANNING

Comparisons are continuously being made between the financial performance, products and services, of the healthcare industry and those of non-healthcare industries. Several useful measures of financial performance--profitability, liquidity, financial risk, asset management and replacement, and debt capacity, are used by the authors to compare the financial performance of the hospital industry with that of the industrial, transportation and utility sectors. Hospitals exhibit weaknesses in several areas. Goals are suggested for each measure to bring hospitals closer to competitive levels.

More than at any other time in its history, the healthcare industry is being analyzed, scrutinized, and often criticized for its performance relative to other sectors of the economy.

Since 1983, the Federal government has analyzed healthcare costs to establish prices paid to hospitals; today capital costs are being analyzed to established a similar payment plan. The hospital industry's profitability is now and will continue to be compared to non-healthcare industries in evaluating the reasonableness of these payment plans.

Contract care organizations, insurers, and public and private sector payers scrutinize hospital financial performance in an effort to control rising hospital charges. Comparisons are continuously being made between the increase in healthcare costs and the increase in costs for other products and services in the economy's "market basket."

Policymakers and healthcare watch groups continue to criticize the cost and availability of health care, frequently pointing to the industrial sector as a model for providing goods and services more effectively and efficiently.

All too often the analysis, scrutiny, and criticism of hospital performance are accompanied by comparisons with other sectors in the economy. This is particularly the case for the hospital industry's financial performance. Hospital administrators themselves understandably want to know how the financial performance of their organization compares to that of companies and industries in non-healthcare sectors.

This article expands on previous research on comparative hospital performance that was limited to the comparative profitability dimension of hospital performance.[(a)] In addition to updating the previous analysis of profitability, this article will comparatively analyze several other dimensions of hospital financial performance: liquidity, financial risk, asset management and replacement, and debt capacity. Based on hospital and non-healthcare financial data, benchmark ratio values will be presented for each of these dimensions--targets considered necessary to ensure the viability of the hospital industry relative to non-healthcare sectors.

To represent financial performance of non-healthcare sectors, financial data was collected for the 470 companies that make up three Standard and Poors' (S&P)indices: the S&P 400, which represents 400 industrial companies, the S&P Transportation Index, which tracks 20 transportation related companies, and the S&P Utilities Index, which follows 50 utility companies. The ratios selected for the comparisons for each company were calculated, and the median value for each ratio and each index was determined.

To represent the financial performance of the hospital industry, data for all years between 1985 and 1990 was selected from HFMA's Financial Analysis Service (FAS) database. This selection process resulted in a constant sample size of 1,200 hospitals. An analysis of the demographics of the data indicated that the sample was representative of region, bed size, teaching, and urban-rural characteristics of the population of all hospitals in the FAS database. The ratios selected for comparisons were then calculated for each hospital to determine the median value for each ratio.

The analysis is based on seven critical dimensions of hospital financial performance. A key financial ratio was selected to represent each dimension and median values for each ratio are compared for the sample of hospitals and for each non-healthcare sector. Appropriate targets wee then delineated for hospitals to bring their performance in line with others sectors.

Adequate profits

Few people question the need for profit in the hospital industry today, but there is considerable discussion about the amount of profit that should be earned. Some minimum level of operating profit must be earned in any business if that business is to remain viable and replace its production or service capacity.

Very simply, if a business is to survive, it must cover the replacement costs of its assets. A piece of medical equipment that cost $100,000 five years ago and now costs $250,000 must be financed with an additional $150,000. Any business that does not or cannot recover its replacement cost is ultimately financing itself toward bankruptcy.

For purposes of comparison, the price level adjusted operating margin (PLAOM) ratio was chosen to determine whether operating profits are sufficient to cover replacement costs. This also is one of the financial measures provided to HFMA Financial Analysis Service (FAS) subscribers. It is a routine operating margin measure, except that in lieu of historical cost depreciation, replacement cost depreciation is used. It is important to note that the PLAOM is actually price level adjusted depreciation based upon the consumer price index (CPI). If the replacement cost of hospital equipment and plant is increasing at a rate greater than the consumer price index, then PLAOM will overstate real profitability. A PLAOM value greater than zero would be required to cover the replacement costs of hospital assets.