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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