A case for better standards - hospital financial management - column

Healthcare Financial Management, August, 1991 by Richard L. Clarke

People frequently ask me, "How are hospital doing?"

Different groups come to different conclusions. The Bush Administration apparently believes that hospitals are doing well enought to endure budget cuts in addition to those contained in the multi-year budget deal forged just eight months ago. Hospitals and some members of Congress, believing that hospitals have been subjected to enough budget balancing efforts, argue against additional cuts.

Unfortunately, most of the budget debate in Washington, D.C., is carried out by lawyers and politicians--groups not necessarily known for their financial expertise. Statistics most often cited by those individuals involve simple profitability measures, such as operating margin or total margin.

Some observers would say that an average total margin of 4.7 percent, as reported by the American Hospital Association for 1990, is more than adequate for hospitals. But is it? And, although these measures are important, financial managers know you cannot diagnose the financial health of a hospital by using total margin any better than you can diagnose a patient by merely taking his or her pulse. Better and more complete measures are needed.

Most hospitals record equipment and buildings--capital assets--on a cost basis. Because of this, some understatement of the current value of these assets occurs. And therefore, some understatement of expenses occurs. To compensate for this problem, HFMA and other groups calculate the current value of these assets by adjusting them for estimated inflation, what we call price level adjustments.

Using this technique, an important ratio to consider is operating margin, price level adjusted. It relates operating profit (or loss in many cases) to operating revenue, with inflation adjustments to certain expenses (such as depreciation). according to HFMA's Financial Analysis Service hospital database, the median value for this ratio in 1990 was 0.5 percent, just above the level recorded for the past several years. For 1990, hospitals in our database only broke even from operations, after price level adjustments were made.

Total margin, price level adjusted, another profitability measure that uses operating and nonoperating profit (or bottom line), was calculated at slightly greater than 1 percent for 1990, certainly not a significant profit level.

A third ratio, return on investment, price level adjusted, is somewhat complex but measures an important return. It is calculated by adding capital costs of interest and depreciation to the bottom line, then dividing the result by price level adjusted total assets.

This measure sounds like a mouthful, but it eliminates biases that may be caused by the amount and type of asset financing and the age of assets. The return should be at least equal to the cost of debt and equity capital. The 1990 level of approximately 10 percent has been increasing and generally exceeds the cost of capital for many hospitals, which is good. If new Medicare capital regulations are enacted, however, the cost of capital for hospitals may increase--and the return may become inadequate.

Does declining occupancy of hospital beds mean inefficient asset use? The ratio of fixed asset turnover, price level adjusted, provides a better understanding of asset use. It relates a hospital's total activity or operating revenue to the current value of plant and equipment used to create the revenue. It is a more complete measure of asset utilization than bed occupancy or measures that only deal with one facet of operations.

The 1990 median ratio of fixed asset turnover, price level adjusted, was 1.4 times, a 12 percent improvement in utilization since 1988. It shows that hospitals are using their assets more effectively today than anytime in the past few years.

Finally, the replacement viability ratio is a key indicator of a hospital's future financial health. It reflects cash reserves available to meet replacement needs, which are calculated by making a price level adjustment to accumulated depreciation and by assuming that 50 percent of future capital expenditures will be financed with debt. A ratio of one indicates that sufficient reserves exist to meet replacement needs.

The 1990 value of .422 shows that more than 78 percent of future capital expenditures must be financed with debt. Again, with the potential that future Medicare payments for capital will be relatively fixed, hospitals may be limited in their ability to borrow to replace and enhance plant and equipment.

Although these ratios are most complex than traditional measures, quality financial management requires better, truer standards. Now more than ever before, the industry looks to use to provide them.