For Leaders, Governors, Physicians and Hospital Executives
By Calvin Weise CPA, CMA
Some of the most important strategic decisions hospital executives make are related to capital expenditures. Almost every hospital has capital investment opportunities that are far in excess of their capital capacity. Capital investments are bets on the future. How these capital bets are placed has long-lasting implications. It is of utmost importance that hospitals bet right.
Hospitals as Business Entity
Hospitals are capital intensive businesses. Hospital buildings are unique structures that require large amounts of capital to construct and maintain. Inside these buildings are pieces of expensive equipment that have fairly short lives. Technological innovations continually drive demand for new and more expensive equipment and facilities. The ability to continually generate capital is the lifeblood of hospitals. In order to compete and succeed, it’s imperative for hospitals to continually invest in large amounts of capital equipment and expensive facilities.
Capital investment is fueled by profit. In order to continually make the necessary capital investments, hospitals must be profitable. Hospitals unable to generate sufficient profit will fail to make important capital investments, weakening their ability to compete and survive.
Hospital managers bear important responsibility in choosing which capital investments to make. There are always more capital opportunities than capital capacity. In many cases, capital opportunities not taken by hospitals create openings for others with capital capacity to fill the vacuum. By not taking such opportunities, hospitals are weakened, and their operating risk increases.
Stewardship is a term that aptly describes the responsibility borne by hospital managers in making capital investments. The New Testament parable of the talents describes this kind of stewardship. In this story, a merchant entrusted three managers with money to invest. One manager was given five units, another two, and a third one. At the end of the investment period, the two managers given five units and two units reported a 100% return. The manager given one unit reported zero return — he was fired and his unit was given to the first manager.
This is stewardship — and hospital managers are stewards of their organizations’ assets. Too often, not-for-profit hospital managers hold an erroneous view of the returns expected of them. Like the third manager in the parable, they think zero return on equity is acceptable. They understand capital investment funded by debt needs to cover the interest on the debt, but they view capital investments funded by equity as having no cost associated with the equity. From an accounting perspective, they are right. From a stewardship perspective they are dead wrong — just like the third manager in the parable.
Here’s why: as stewards, they are responsible for managing the entrusted assets. They can either put these assets at risk themselves, or they can put those assets in the market and let other managers put them at risk. If they choose to put them at risk themselves, then they have the mandate of creating as much value from putting them at risk as they would realize if they put them in the market for other managers to put at risk. They have the duty to realize returns that are equivalent to the returns they could realize in the market; otherwise, they should just put them in the market. They can either invest in hospital assets or work the assets themselves, or they can invest in financial market assets so others can work the assets. When they choose to invest in hospital assets, the required return is not zero. That’s the return they get fired for. The required return is equivalent to market returns.
Thus, when evaluating performance of hospital management teams, the minimum acceptable performance level is return on equity that is equivalent to the return that could be realized by investing the hospital assets in the market. And when evaluating a capital investment opportunity, it is important to apply a capital charge equivalent to the hospital’s weighted cost of capital — a measure that imputes an appropriate cost to the equity portion of the capital along with the stated interest rate for the debt portion of the capital structure.
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