Selling accounts receivable to fund working capital - hospitals

Healthcare Financial Management, May, 1993 by Timothu J. Kincaid

The sale of accounts receivable by hospitals and other healthcare providers--and the securing of those receivables--has been the subject of considerable recent discussion. New developments and revised analyses of the financial and legal aspects of the sale of receivables make a continuing review of this financial management tool advisable.

The working capital needs of hospitals often can be significant, and those needs have been increasing in recent years. If the expected healthcare reform proposals of the Clinton administration are enacted, there will be additional burdens placed on hospital working capital.

Lines of credit are used by almost half of the hospitals in the United States to fund working capital requirements.(a) Funding working capital through bank lines, however, has its limitations. Since working capital is more often than not provided by banks,(b) the regulatory limitations imposed by the Comptroller of the Currency (such as limits on loans to one borrower) may restrict the ability of certain banks to provide increased levels of working capital lines of credit.

In addition, since such lines of credit are based, in part, on the financial health of the borrower, a weakened financial statement is likely to reduce the availability of these lines of credit. The increased use of lines of credit also tends to further weaken financial positions, thereby reducing or eliminating other financing options.

Use of accounts receivable to fund working capital

When exploring alternative sources of working capital, it is appropriate to examine the assets that can be used to generate funds. The two largest asset groups of most hospitals are their accounts receivable and their property, plant, and equipment. The conversion of property, plant, and equipment to working capital can be accomplished in several ways, including refinancing at lower interest rates, negotiating a sale-leaseback, or borrowing against the collateral of those facilities. These options, while worthwhile in some circumstances, may be of limited use to many hospitals for any of a variety of reasons.(c)

Accounts receivable, on the other hand, eventually are converted to cash that can be used for working capital. The real issue is whether that conversion can be accelerated. Seeking more efficiency and speed from the existing accounts receivable collection team is one way to accelerate the generation of working capital from accounts receivable, but such effort can only accelerate collections to a point and does not offer immediate cash for the accounts receivable.

Selling versus borrowing

There are two ways to gain immediate cash from accounts receivable: borrowing against the collateral of the receivables or selling the receivables themselves. While both options provide immediate cash, the sale of accounts receivable has several advantages over borrowing.

Borrowing against receivables does not improve a balance sheet. It adds debt on a one-to-one ratio to the cash proceeds of the loan. The sale of those receivables substitutes cash (plus, in some instances, other receivables) for the receivables sold.

When a hospital borrows against receivables, the lender may impose restrictive covenants. Such covenants may limit the hospital's ability to incur additional debt or otherwise limit the financial flexibility of the borrower. Further, the lender may require a security interest in all of the hospital's receivables, even if the loan is only for a relatively small percentage of those receivables. A purchaser of accounts receivable, on the other hand, generally has no need to place stringent requirements on the seller that would reduce the hospital's other financing options.

An advantage of selling over borrowing is that the sale generally will not violate negative pledge covenants in capital financing documents. Such covenants, which are not unusual, prohibit hospitals from pledging assets to secure other loans.

When borrowing, the financial health of a hospital is important to a lender even if the loan is fully secured by the accounts receivable. A hospital's bankruptcy could result in substantial delays for the lender in realizing on its collateral.(d) A purchaser of accounts receivable, on the other hand, has less reason to be concerned about the possibility of bankruptcy, inasmuch as the purchaser owns the accounts receivable, and they should not be part of the hospital's bankruptcy estate if the sale was properly structured.

A hospital borrowing against accounts receivable remains at risk for collection delays. A hospital selling its accounts receivable may, depending on the terms of the sale, transfer a substantial portion of that risk to the purchaser.

Finally, a healthcare provider borrowing against accounts receivable remains responsible for the collection of those receivables and must maintain the necessary staff to perform that function. A purchaser of the accounts receivable may, however, assume that responsibility. To the extent that the hospital desires and is permitted by the purchaser to collect the receivables, the purchaser may be willing to reduce the discount at which the purchase is made.