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Quantifying Financial Distress to Stop Hospital Bankruptcy, Closure

Using more than profitability and cash flow ratios to inform a turnaround strategy is key to stalling the trend toward hospital bankruptcy and closure, an expert said.

By Jacqueline LaPointe

- More healthcare organizations will face financial troubles, and possibly a hospital bankruptcy or closure, in the coming years as the healthcare industry undergoes major changes. Changes that will result in lower reimbursement rates, more competition from hospital giants, and lower patient volumes.

While forward-thinking hospitals with market power and value-based care capabilities may be able to adapt to the evolving healthcare landscape, many more will find themselves in financial distress.

To find out just how bad the outlook was for hospitals in his state, James Langabeer, II, PhD, MBA, analyzed 310 Texas hospitals using data from the American Hospital Association’s (AHA) Annual Survey Database from 2012 to 2015.

Just over 16 percent of acute care hospitals in Texas were under moderate or several financial distress in 2015, and the number of hospitals facing distress seems to be growing based on Z-scores, found the Professor of Healthcare Management and Informatics at the University of Texas Health Science Center at Houston, who published the findings in Hospital Topics.

Chart shows that the percentage of distressed hospitals continues to increase.

Source: Hospital Topics

The Z-score is a weighted composite score of four types of ratios, Langabeer and his research team explained. The score accounts for financial leverage, profitability, liquidity, and capital structure, which can all be found on hospital balance sheets and income statements.

READ MORE: Overcoming Rural Hospital Revenue Cycle Management Challenges

The model developed by NYU Professor of Finance Edward I. Altman in the 60’s has predicted the potential for bankruptcy and closure in over ten industries, including healthcare.

Scores closer to zero indicate poor financial condition, while scores over three indicate a strong financial position.

Z-scores revealed that the number of hospitals in Texas that are at risk to file bankruptcy or even close is increasing. And Langabeer pointed out that this trend is not isolated to the Southern state.

In fact, new data from the AHA uncovered that approximately one-quarter of hospitals operated with a negative total margin in 2016. The proportion of hospitals running their business with a negative margin significantly increased since 2010.

The data shows that hospitals are facing significant financial challenges. These hardships will likely result in an uptick in hospital bankruptcies in the near future and closures over the long-term.

READ MORE: Preparing the Healthcare Revenue Cycle for Value-Based Care

“We need to be doing something different because the trend is changing. We have more distressed hospitals today than we did four years ago,” Langabeer recently stressed to RevCycleIntelligence.com.

Determining a hospital’s financial distress level

Quantifying a hospital’s finance distress level is the first step to changing the trend toward hospital bankruptcies and closures, Langabeer stated. But looking at just a couple profitability metrics won’t do the trick if hospital CFOs are really serious about improving their organization’s bottom line.

“Any CFO of a hospital will be looking at their balance sheet, how much cash they have on hand, and how much equity that they have. But they don’t usually look at it together,” he said.

Typical profitability or cash flow ratios do not create the “big picture necessary to foresee declining financial health,” he added in the study.

But every CFO can calculate their hospital’s Z-score using financial leverage, profitability, liquidity, and capital structure numbers found on the organization’s balance sheet, he advised. The formula is:

Image shows the formula to calculate a Z-score, a value that can help hospitals determine their level of financial distress.

Source: Hospital Topics

READ MORE: How Hospital Merger and Acquisition Activity is Changing Healthcare

The variable X1 represents net working capital (e.g., current assets less current liabilities) ÷ total assets. The variable X2 represents retained earnings ÷ total assets. Variable X3 is earnings before income taxes ÷ total assets. X4 represents the book value of equity ÷ book value of debt,” the study elaborated.

Hospitals with scores less than 1.8 points are at immediate risk of bankruptcy, while scores between 1.81 and 3 points represent a grey zone where hospitals are at risk financial distress. Z-scores greater than 3 points indicate good financial conditions.

“I encourage all CFOs to look at that number and see if it's trending up or down,” Langabeer said. “The score probably won’t be a surprise. Most CFOs know if they're running a distressed organization, but they may not use those terms. This is a way to quantify it and put it in terms to show how close you are to eventual closure.”

Hospital CFOs should determine their organization’s Z-score on a monthly basis and track it over 24 to 36 months to ensure the hospital is going in the right direction. Financial leaders can then use the scores as a basis for change, Langabeer emphasized.

Developing a turnaround strategy

A hospital’s Z-scores should be the foundation of the organization’s strategy for bringing themselves out of financial distress, the healthcare professor explained.

Failing to use the scores as a basis for change will result in a bankruptcy and likely a future hospital closure. However, neglecting to use the scores to incite a complete financial turnaround strategy could also be the final nail in the coffin for distressed hospitals.

“I don't think that most people know how to really think about turn arounds. When CEOs, CFOs, and administrators are in this position, they’re in crisis mode. They tend to think about ways to cut costs – getting rid of some employees, shedding some costs, and looking at everything to tighten the belt,” Langabeer remarked.

“That's a normal response, but it’s very short-term,” he stressed. “You can only do so much because you’ve gone through years of being lean anyway and you’re still distressed.”

Hospitals that are in the severely distressed category and the grey zone, which means the organization is almost severely distressed, need to start doing business differently to get themselves into a comfortable financial position over the next 12 months.

“Some of it can be financial. Maybe restructuring or tackling debt or making accounts payable 45 days instead of 30 days,” he elaborated.

James Langabeer, II, PhD, MBA, Prof of Healthcare Management and Informatics, University of Texas Health Science Center, discusses hospital financial distress.
James Langabeer, II, PhD, MBA, Prof of Healthcare Management and Informatics, University of Texas Health Science Center at Houston Source: University of Texas Health Science Center at Houston

“But fundamentally CFOs needs to get involved with figuring out how to manage their business differently. How do we restructure our service lines? How do we partner with different facilities? How do we get better referral networks from rural, urban, or whatever the opposite of where you're sitting is? We’re finding CFOs needs to become much more strategic, and not just on the financial side, but also on the business side of things.”

Hospital CFOs should be asking their organization what they need to be doing to improve their financial position. For example, distressed hospitals should be considering ways to improve market visibility and market share.

Improving revenue mix by offering additional outpatient services should help, Langabeer and his research team added in the study. Treating more patients with higher acuity levels can also open new, more complex service lines for hospitals, which tend to carry higher reimbursement rates.

Considering an acquisition or affiliation is another strategy distressed hospitals should consider. Partnering with a health system, network, or integrated delivery system can bring immediate financial relief through new technologies, support, and capital, as well as revenue growth through the health system’s better financial position and brand.

While doing more is vital to the hospital’s financial turnaround strategy, so is doing less. Specifically, hospital CFOs should also be asking their organization what they should stop doing to improve the hospital’s bottom line.

For example, hospitals should not be offering certain service lines if they are not turning a profit or meeting a community need. Hospitals also do not need to be operating in certain locations, Langabeer explained.

The bottom line is that hospital CFOs need to be thinking more strategically and less tactically to truly prevent the impending onslaught of hospital bankruptcies and closures, he emphasized. And that also applies to hospital leaders who do not think their organization is at risk.

“About 85 percent of hospitals would say right now that they're not distressed based on these numbers. But I don't believe that that is a sign that we are OK,” he said. “It indicates that we need to be constantly thinking about other things to add value and now is the time to do it.”

Healthcare reform efforts are going to herald in an era of value-based care and payment. The efforts are also going to introduce a new way of operating a hospital.

“We're going to have lower reimbursement rates overall. We may have higher reimbursements in some service areas if we do bundled payments, but that all requires people working together, building collaborative networks, and focusing on markets,” he stated. “Hospitals need an understanding of where healthcare reform is going and what payers are trying to do.”

The transition away from fee-for-service will also bring a plethora of unknowns, creating potential challenges for even the most financially sound hospitals.

“There's a lot of unknown with pay-per-performance or value-based purchasing, especially in terms of getting hospitals data that they don't have,” he said. “This is a shift in the way we've managed hospitals and now it's a form of differentiation in terms of strategy. Can we differentiate by proving and showing value in certain services lines above and beyond what others in our region might be doing?”

With so many unknowns and changes, value-based care and other recent healthcare reforms should be an opportunity for all hospital leaders to examine their financial standing and develop turnaround strategies.

“I would say to everybody else who is not currently distressed to use this as an opportunity to think about where you are today and what you need to be doing over the next five years,” Langabeer concluded. “Maybe it's not the next 12 months, like a distressed hospital would have to think, but this should still be an impetus for change.”

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