Question

Working Capital Challenges

Healthcare organizations strive to manage working capital in such a way that they can reliably cover their short-term expenses while also getting the best possible benefits from their capital. In managing working capital, healthcare organizations face some common challenges, as well as other challenges that are particular to the institution.

What challenges would a for-profit facility that has a constant stream of revenue face in managing its capital? How would these challenges differ from a military hospital that is given its funding at the beginning of the year?

Answer 1

Many doctors are being forced to live off of Small Business Loans and Bank Loans to survive. In addition, they're faced with the pressure to switch from a capitated payment environment (HMO/PPO/Medicaid) versus a fee-service environment just to make ends meet. A for-profit facility with a constant stream of revenue may have more interest payments to make on loans used to pay for any updated equipment; in addition, they may have difficulty liquidating current assets to pay off current liabilities in order to have enough working capital to invest in new current assets. As a result, depending on if the for-profit facility is getting paid via HMO, PPO, or Medicaid versus a base fee, the facility may not get paid as often as they would like through a capitated payment agencies and would have less cash on hand to invest in new current assets and the cash would have to be used to pay creditors, shareholders, or limited partners. In addition to cash issues, for-profit facilities may have challenges competing against government supported health facilities that may have cheaper prices than they have. As a result, the facility would have to spend more money in marketing or advertising to gain more customers or to keep the current customers interested to continue doing business with their facility.

Increased financial pressures on hospitals have elevated the importance of working capital management, that is, the management of current assets and current liabilities, for hospitals' profitability. Efficient working capital management allows hospitals to reduce their holdings of current assets, such as inventory and accounts receivable, which earn no interest income and require financing with short-term debt. The resulting cash inflows can be reinvested in interest-bearing financial instruments or used to reduce short-term borrowing, thus improving the profitability of the organization.

First on most lists of factors explaining the growth of investor ownership and multi-institutional systems is ''access to capital." Although capital costs represent a relatively small proportion of health care costs (on average, approximately seven percent of hospital costs under the Medicare program), capital expenditures (for example, for new technologies) often translate into higher operating costs. Access to capital by health care institutions is crucial not only to their own future but to the future shape and configuration of the health care system itself. Access to capital is also integral to the topic of this report, because it is affected (by definition and in practice) by whether institutions are for-profit, not-for-profit, or government owned.

Hospitals and health systems are under constant pressure to reduce costs while also improving quality and maintaining a strong workforce. With this comes an array of financial challenges, as reimbursement levels continue to change and healthcare becomes more consumer-centric.

1. Recruiting and retaining physicians. This is particularly a challenge for rural facilities and goes hand in hand with cost structure. Productivity-based [regarding physician compensation] and now [there is a] need to convert over to more value-based [compensation] with the physicians, and [the challenge is] how do we keep them satisfied and us financially viable? Also the challenge in recruiting physicians to more remote areas.
2. Driving revenue growth amid competition. Competition in the area by investing in service lines to spur revenue growth. Successful strategies for revenue growth, including considering new ways to do work or additional programs/services, and then ensuring there are tangible ways to measure success.
3. Revenue cycle challenges. Healthcare organizations are forced to rely more on revenue from patients due to the rise in popularity of high-deductible health plans. This means these organizations must focus more on how they collect dollars from patients to maximize reimbursement. There are creative approaches to addressing this issue with technology, although "there's still a long way to go." Overall, health systems should pay attention to automation and specifically use analytics that provide meaningful information to improve the revenue cycle. Technology and automation as a way to address revenue cycle challenges, however, health systems against putting in technology for technology's sake. "It's not just a matter of automation. It's got to be automation, it's got to be done the right way, and it's got to have" return on investment.
4. Employee engagement with respect to financial challenges. If health systems can have analytics around cost and quality outcomes, employees can be more informed and make better decisions that can ultimately lead to an improved financial picture for the organization. As far as linking employee engagement with patient experience, organization is holding staff accountable for issues patients faced while receiving care. Employee engagement and patient experience "go hand and hand" in helping to improve an organization's finances. "But the other piece I've picked up along the way is engagement without accountability equals entitlement."

Like any form of organized economic activity, health care organizations need financial capital to carry out their functions. Before an organization can provide services or undertake a new program, it must use financial capital to purchase or rent space, equipment, supplies, labor, and so forth—that is, to prepay for certain inputs used in the production of health services. Normally, these prepayments are expected to be recovered eventually through cash revenues earned by rendering health services or, in the case of some public or not-for-profit institutions, from nonoperating revenues (e.g., charitable contributions, governmental appropriations, income of subsidiary organizations).

At any point in time, the dollar amounts of the unrecovered prepayments are listed as "assets" on the organization's statement of financial position (or balance sheet). A health care provider's assets include not only real capital assets such as movable and fixed equipment, land, and buildings but also supplies, certain financial assets (cash, marketable securities, and accounts receivable), and any other form of prepayment such as prepaid interest and rent. Assets for which recovery of the prepayment through earned revenues is expected within a year are usually grouped under the heading of "current assets" or working-capital assets. Prepayments expected to be recovered through revenues earned over a longer span of time are referred to as fixed or long-lived assets. The latter consist mainly of equipment, structures, and land owned by the organization and represent a substantial (but far from the total) amount of the total financing that an organization needs in order to operate.

Access to financial capital is essential to any health care organization that would respond to changes in its community, acquire new technologies and replace old equipment, renovate or replace deteriorated facilities, offer new programs or new services, or make changes to improve productivity or enhance quality. Much attention has been given to the aggregate future needs for financial capital among hospitals. Assessments of the ability of health care organizations to raise needed capital vary as well.

Clearly, with overall hospital occupancy at sixty six percent, there are many areas of the country in which the supply of hospital beds is excessive. However, even if a significant number of hospitals should close, there are many purposes for which other health care institutions will have substantial needs for capital funds in the future. Debt must be retired. Facilities and equipment must be kept current and in good repair. Some hospitals (or portions thereof) will need to be reconfigured; alternative sites will have to be developed for long-term care and ambulatory care; and other steps will be necessary if hospitals are to become more comprehensive health care organizations. Also, certain areas of the country have rapid population growth, and new facilities or expansions of existing hospitals may be needed.

Thus, health care institutions have and will continue to have substantial capital needs, and access to capital translates directly into institutional ability to grow and even to survive. Differences among health care sectors in their access to capital will shape the future makeup of the health care system.

Financing for the current and long-lived assets owned by a health care provider can be obtained from the following sources:

• philanthropy (or an endowment set up from philanthropic funds received in the past)
• grants or other appropriated money from government
• funds accumulated from past operations
• the sale of short-term and long-term debt instruments
• the sale of ownership certificates (stock).

One other source available in some instances is funds from the sale of assets already owned.

Thus, whether an institution has access to financial capital depends on at least one of three things: whether it can attract philanthropy (a source that as a practical matter is not available to for-profit institutions); whether it can obtain governmental grants or appropriations, which were a major source of capital for not-for-profit hospitals during the Hill-Burton era from the late 1940s until the 1970s, but are available now only to government-owned hospitals (federal, state, or local); or whether it has earnings (or potential earnings). Earnings are not only an important source of capital, they are also crucial to an organization's ability to secure funds through borrowing or through selling shares.

Funds accumulated from business operations are, in principle, a source of financial capital that is available to any ongoing organization, regardless of ownership type. Such funds are created when an organization's annual cash revenues exceed its corresponding annual cash expenses. The cash revenues of investor-owned hospitals include return-on-equity payments from Medicare (and certain other third-party payers), a source of funds that is not available to the not-for-profit sector. The rationale of such separate return-on-equity payments is closely linked to cost-based reimbursement methods, which are now being phased out by Medicare. Interest expenses (that is, payments to lenders) have been a reimbursable expense, but dividend payments to investors were not so treated, either in accounting or in reimbursement rules. Yet, as is discussed later in this chapter, suppliers of equity financing the shareholders supply these funds in the expectation that they will earn an appropriate rate of return on their investments. The willingness of the investors to provide such funds depends, at minimum, on their being able to expect a return on their investment that would be equivalent to or higher than the earnings they sacrificed by supplying their funds to the hospital sector rather than, say, to the food or electronics industries. While such a return is not properly portrayed as an entitlement, it must in fact be paid if the hospital sector hopes to continue to procure funds on this basis. If investor-owned hospitals were reimbursed strictly on a cost basis, without this allowance for the cost of equity financing, then the suppliers of such funds would not earn any return and that source of funds would dry up. However, under a prospective rate-setting system, as with a charge-based system, the opportunity exists for institutions to generate funds in excess of costs.

Prior to 1982, Medicare's return-on-equity allowance for investor-owned hospitals was set at 1.5 times the rate of return earned by Medicare's Hospital Insurance Trust Fund on its investments. Legislation passed in 1982 reduced the amount of return-on-equity payments to the same rate as the trust fund. However, return on equity remains a significant source of capital, amounting to an estimated $200 million in 1984, about seven percent of Medicare capital payments to hospitals and thirty eight to forty percent of Medicare capital payments to investor-owned hospitals. With the phasing out of cost-based reimbursement, the rationale for separate return-on-equity payments to investor-owned facilities becomes much less clear. The question will undoubtedly be addressed in legislation on how Medicare should pay capital expenses in the future. In addition to recoveries of earlier expenditures through revenues for depreciation and amortization expenses, for-profit entities commonly subtract from the income they report to shareholders certain income tax expenses that did not occasion an outflow of funds during the fiscal year covered by the report.

The cash revenues of both for-profit and not-for-profit (as well as public) institutions also include funds that represent the recovery of earlier cash outlays that have been carried as "assets" on the provider's balance sheet. These recoveries—the most common of which are "depreciation and amortization". The current tax code provides one other source of working capital for for-profit organizations in the form of investment incentives, which allow companies to recover their investment costs more quickly by deferring a portion of their corporate income taxes. The percentage of taxes that are deferred (and that are therefore available as working capital) vary, depending primarily on the investment patterns of the companies. Because Humana has not been investing heavily in new facilities, its taxes paid in 1983 were at seventy seven percent of the statutory rate, and deferred taxes provided only a minor source of working capital ($7.4 million of almost $800 million of funds provided).

Although it might be expected that government-owned health care organizations would obtain financial capital from tax revenues, that not-for-profit organizations would obtain capital from philanthropy, and that for-profit organizations would obtain capital from investors, the picture is more complicated. The type of ownership of health care organizations does have important implications for the sources of capital to which they have access, but data from hospitals show that all types are heavily dependent on cash reserves and debt.

Substantial costs are incurred not only in obtaining equity and debt financing, but also in obtaining governmental or philanthropic grants and contributions. Debt requires (and equity investments usually require) that periodic payments of interest (or dividends) be made. To all sources of capital are attached certain expectations of performance; however, the expectations tied to various sources of capital differ in some very significant ways.

The much misunderstood topic of capital is key to the future for-profit/not-for-profit composition of health care. Although a level playing field is itself not an important goal for health policy, eliminating not-for-profit access to tax-exempt funding could have a devastating effect on that particular sector. Changes are needed in Medicare policies for paying for expenses, including the past practice of paying for-profit institutions a separate return-on-equity payment. Because of foreseeable changes in different sectors' access to capital, significant changes in the overall composition of health care could result inadvertently from federal policies, a factor that should be included with other capital-related policy questions to be considered.