March (Part I) & April (Part II) 2003 issue of Trustee Magazine
 
Finance
Dangerous Times Ahead for Hospital Boards
By Joshua Nemzoff

Long before your CEO says he or she thinks you need to hire a turnaround firm to save your troubled institution, you should be able to answer these basic questions:

  • How do we know if our hospital is in trouble?
  • What should we do when we realize a problem exists?
  • What are our options?

As a board member of a not-for-profit organization, it is your fiduciary responsibility to protect and preserve its assets. If the hospital does not survive, it will be on your watch, and blaming management or claiming ignorance is not a valid excuse.

Survival of the Fittest

The hospital industry is a classic service sector example of Darwin’s theory of “survival of the fittest.” Hospitals doing well three years ago are now losing money so fast they cannot keep track of it. The number of U.S. hospitals with financial problems is staggering.

The factors contributing to this problem are clear. Hospitals are extremely labor and capital intensive organizations with high fixed costs. When revenues go down by 10 percent for example, expenses may go down by only 5 percent. Hospitals cannot simply raise rates to increase revenues.

Competition is strong in many markets, and managed care rates are limiting revenues. The Balanced Budget Act is cutting Medicare reimbursement. Insurance costs are rising exponentially. The nursing shortage is necessitating the use of agency and overtime staff at substantially higher costs. To add insult to injury, the cost of complying with HIPAA will make Y2K look like a bargain.

The signs of a hospital in a death spiral are unmistakable: First, the hospital’s market share declines, and, as a result, revenue drops. The hospital’s expenses increase at a rate greater than revenue. Cash begins to dry up, and the hospital’s financial ratios start to look weak.

Without strong financials, the hospital cannot get an investment grade rating. It now has no access to its only form of capital, tax-exempt debt. The hospital’s ability to compete is now severely impaired because it cannot invest in capital in a very capital-intensive industry. The ratios drop even further, and the hospital trips a bond covenant, putting it in technical default.

At this point, the hospital is losing money, running out of cash, and losing market share. As a result, it cannot develop new programs, buy new technology or recruit physicians. Its competition is getting stronger at its expense. This would ordinarily be the time the CEO would bring up the idea of the turnaround firm. This does not happen overnight, however.

Warning Signs

Imagine you live in a house with a monthly mortgage payment of $3,000. Last year your take-home pay was $6,000 a month. You had, in essence, two times debt service coverage, and you had $3,000 to spend on things besides your mortgage. This year, you got a new job, and your take-home pay is $3,600 per month. You now have 1.2X debt service coverage and only $600 a month to spend on other things. You have three choices: find a new job, sell the house, or engage in a new life experience called bankruptcy. If you are on the board of a hospital that has 1.2X coverage, you had better sell the house.

Before you get to that point, identifying a set of financial ratios that can indicate whether your hospital is about to be in serious trouble can be extremely helpful. Three key ratios can tell you when it is time to start thinking about your survival:

  • EBDIT (earnings before depreciation, interest and taxes ) margin
  • Debt service coverage
  • Days cash on hand.

EBDIT is the same number as income available for debt service, i.e., the amount of earnings a hospital has before paying its annual debt service. EBDIT margin is EBDIT divided by net patient service revenues. A hospital with an EBDIT margin of 5 percent is about to be in trouble, depending on its debt level. For example, an “Investment Grade” rated hospital, one that is considered high quality by Standard and Poors, Moody’s, or Fitch, has an EBDIT margin of 10 to 11 percent. Obviously, a hospital with very low debt could have a low EBDIT margin but strong debt service coverage and would not necessarily be in trouble. Conversely, a hospital with a 10 percent margin could be in big trouble if it has substantial levels of debt. In any event, if your EBDIT margin is anywhere near 5 percent, you may have a problem, especially if the trend is downward.

Debt service coverage is the amount of times EBDIT covers your annual principal and interest payments, i.e., debt service. A hospital with debt service coverage of less than 1.5X is potentially in trouble, especially if the trend is downward. If your EBDIT margin is 5 percent or less and your coverage is 1.5X or lower, you are probably about to have a very serious problem.

Days cash on hand is the amount of available cash a hospital has to meet its needs (e.g., payroll, vendors, etc). A hospital with 30 days of cash on hand would run out of cash at the end of that period without additional cash flow. A hospital with less than 60 days of cash on hand is not a healthy hospital. If it also has low EBDIT margins, and low coverage, chances are very good that its days cash on hand will drop quickly.

These three ratios are linked. If your EBDIT margin is low, and you have even an average level of debt, your debt service coverage will be low. If your debt service coverage is low, you are eroding your balance sheet, and cash on hand goes down. As this process moves forward, it usually accelerates and your organization’s survival is at stake.

Finance – Part II

 

People who have had near-death experiences report seeing a white light at the end of a tunnel. Hospital boards in a death spiral report seeing a turnaround specialist.

Think about this: If your management team, your CPA firm, your attorneys or your investment bankers could actually fix a hospital with disintegrating ratios, don’t you think they would?

Management usually tells you they can fix it. Sometimes, they believe they can. In other cases, they don’t want to lose their jobs by admitting they do not know what to do.

What about your accountants, lawyers and bankers? They have two problems. First, for the individuals representing these firms, you are probably one of their largest clients, and they do not want to lose your business and their jobs.

Second, in their minds, they don’t work for the board, they work for management. They hesitate to go over management’s heads to the board because this would be tantamount to professional suicide. Here is the bottom line: they may not tell you what is happening until either (a) you figure it out, or (b) it is too late. These two possibilities sometimes occur at the same board meeting.

Of course, you can call in consulting firms, and they might just solve your problem for you. If you are concerned that your hospital may not survive without some substantial improvements in operating performance, you probably should engage one of these firms. But when your ratios start dropping to the levels mentioned previously, you need to start thinking of other options. So who is going to solve this problem? The board of trustees.

The Options

If you refuse to think about giving up control of the hospital, you don’t have any options. You need to take your chances, hire those consultants, trust in management, your accountants and lawyers, and ride out the storm. After all, what is the worst that can happen? Ever been in Federal Bankruptcy Court when they give you your new title, “Debtor in Possession”?

But if you realize that your hospital, like many others in the country is not going to make it alone, you need to consolidate with another organization through a sale, merger or joint venture. If you figure it out early enough, you may even be the buyer, not the seller.

Identifying your options is easy. Selecting an option is easy. Implementing an option? Well that is rather difficult, and many organizations have failed for lack of experience, or the infamous “merger curse.”

The merger curse happens when two hospital CEOs have dinner at a quiet location, usually 20 to 30 miles away from town so they won’t be seen. They decide that it would be a great idea to merge because of the potential synergies. The next day, they issue a press release and announce they are merging the hospitals. They are not closing any services, they will have no layoffs, and they are forming the “Office of the Parent” to be housed in the new corporate headquarters furnished with $10,000 Baker desks and Herman Miller chairs. At this point, they have removed every possible benefit of merging, and “cursed” the deal.

The key issue is how to get to the point where YOU the trustee become the decision-maker in the merger process. If you are going to be held accountable for what happens, it is a good idea to direct what happens.

The Plan

To ensure the survival of your health care organization, you need to take the following steps:

1. Take control of the situation and inform management that they are not in charge of this process.

2. Hire an experienced consultant to help you identify, select and, most importantly, implement the best option., i.e., buy, sell, joint venture, merge or consolidate. This should occur very quickly and can usually be accomplished in a single board meeting.

3. Hire an experienced transaction attorney and an experienced communications firm. Don’t use your general counsel or your own public relations department because there’s a good chance neither will have experience in these areas and won’t be aware of many of the intricacies of hospital mergers and acquisitions. Moreover, by going outside the hospital, you’ll avoid the potential of a conflict of interest (i.e., if the merger succeeds, they might lose their jobs).

4. Implement the option you select, and don’t let anyone get in your way.

Conclusion

The single issue that stops hundreds of boards from entering into this simple process is that they do not want to give up control of their hospitals. Control is not the main reason that boards hold on until it is too late–it is the only reason.

Think about who has given up control in the past few years, however. Tulane University, George Washington University and Georgetown all gave up control. Catholic Health East sold in Florida. Catholic Health Initiatives sold in Albuquerque, N.M. Ascension sold in Norfolk, Va. Baptist sold in San Antonio. Health Midwest is selling in Kansas City. The list goes on and on. They all sold because they did not think they were going to survive. But the majority waited too long, and thus their ability to provide quality care was greatly compromised.

Board members must learn to recognize the warning signs of a hospital in trouble and determine what you should do before management confirms that you are in trouble. Saying you did not know the ship was going down is not going to help you. That is what the Enron board said.

This article 1st appeared in the March & April, 2003 issue of Trustee magazine.

 

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