Regarding Hospital Security and Financial Covenants

Posted on September 1, 2010 by Dr. David Edward Marcinko MBA MEd CMP™

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Understanding the Capital Formation Process

[By Calvin W. Wiese CPA MBA]

Almost every bond issue has security provisions. Usually the security for bond holders is described in the bond indenture. Security for credit enhancers typically is greater than that provided bond holders and is spelled out in the agreements between the credit enhancers and the hospital obligor. Covenants are promises made between the parties and are used to describe the security provisions.

Mortgages

Mortgages on properties are not common security provisions. Mortgages, reserved for poorer credits, are considered somewhat arcane. More in favor are covenants not to encumber. The idea is to ensure that no property has a superior security interest to the interests of the bond holders. This form is less restrictive and provides more flexibility to the hospital obligor. Almost all bond issues will provide either a covenant not to encumber or a mortgage on almost all property as security for the promise to make payments.

Hospital

Debt Service Covenant

Covenants based on debt service coverage are fairly common. Debt service coverage is a metric that expresses how much cash is being generated relative to the debt service of the hospital. It is, as a rule, calculated as net income available for debt services divided by annual debt service. Net income available for debt service is net income plus depreciation expense plus interest expense. Debt service is the principal and interest payments for all long-term debt. Sometimes, maximum annual debt service is used; debt service is scheduled out for each year into the future and the year with the highest amount is used. Debt service coverage is used as a trigger for various covenants. If debt service coverage falls below specified level, then provisions of covenants kick in.

The Rate Covenant

The most common covenant is the rate covenant: hospital covenants to set rates sufficiently high to ensure that debt service coverage is at least X (typically 1.10). If the specified coverage is not maintained, then the hospital promises to hire a consultant to do a study and determine what changes need to be made to achieve the specified debt service coverage.

Long Term Borrowing Covenant

Perhaps the most confusing covenants deal with additional long-term borrowing. Usually, additional long-term debt can only be borrowed when the pro-forma debt service coverage (debt service coverage including the additional long-term debt) is higher than a specified level. This limits the amount of long-term debt hospitals can borrow.

Assessment

Covenants made to bond holders are very rigid. Since there can be many bond holders, and many of them may be fairly unsophisticated, there is almost no way to get relief from them. If they are too tight, about the only means to gain relief from them is to refund the bonds. Thus, great care must be used in making covenants to bond holders. Covenants with credit enhancers can be more flexible since credit enhancers can waive covenants — if relief is needed, hospitals have the option of requesting waivers from the credit enhancers who are usually quite sophisticated and may very well find it in their interest to waive.

Conclusion

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Managing Hospital Credit Relationships

Posted on August 31, 2010 by Dr. David Edward Marcinko MBA MEd CMP™

Understanding the Capital Formation Process

By Calvin W. Wiese; CPA MBA

www.HealthcareFinancials.com

Every hospital needs to manage their credit relationships. Rating agencies and credit providers need to be targeted by hospitals for development and maintenance of credit relationships. Credit relationships are an ongoing process. They need to be fed and nurtured. Hospitals should make sure that they cultivate their relationships with credit analysts even during times when they are not seeking credit.

Capital Financing

Too often, hospitals work on credit relationships only when they need capital financing. That’s the wrong time. Relationships need to be in place before they need financing. Credit relationships should not be transaction based; rather formed and nurtured on an ongoing basis, resulting in better, more optimal transaction results. Credit relationships are fed and nurtured through communication. Communication strategies need to be multi-faceted: quarterly reporting, annual face-to-face reviews, and ad-hoc telephone conversations. Reporting needs to go beyond just what is required by the covenants. Covenanted reporting should be viewed as the minimum.

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Annual Meetings

Perhaps the most important component of nurturing credit relationships is the annual meeting. Annual meetings should be set up and conducted at the offices of the credit analysts. The meeting should review the past year and describe the plans for the future. An important component of the annual review is the financial forecast. Credibility is established by presenting a three- to five-year financial forecast each year. Variances from the forecast should be discussed and whether they are favorable or unfavorable should be explained. Candor about the good and especially the bad creates understanding and trust, which are critical components in credibility.

Uncertain Forecasts

Financial forecasts are inherently uncertain. The future is unknown, and in most cases unknowable. A financial forecast is not so much a prediction of the future, but a description of a management team’s view of the future. That view encompasses both external factors that are largely out of the control of management, and internal factors that are controllable. The forecast describes management’s strategies of dealing with that environment. As such, the financial forecast creates the context for a very profitable discussion between management and analysts. The view of the external environment can be compared and contrasted and challenged by the analysts. It is important for them to develop a comfort level with management’s view of the external environment. Given that environment, analysts can then evaluate management’s strategies for successfully leading the hospital through that environment.

Assessment

Presenting updated forecasts each year provides additional dimensions for useful dialogue. Changes in environmental views can be highlighted and discussed. Implications to hospital strategy can then be usefully identified and debated. Failures and successes in meeting the assumptions presented in prior forecasts highlight strengths and weaknesses of management in dealing with the uncertainties of its environment.

Conclusion

And so, your thoughts and comments on this ME-P are appreciated. Are the credit relationships at your healthcare institution proactive or retro-active? Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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Capital Formation for Hospitals

Posted on January 24, 2010 by Dr. David Edward Marcinko MBA MEd CMP™

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Understanding Strategic Expenditures

[By Calvin W. Wiese; MBA, CMA, CPA]

[By Dr. David E. Marcinko MBA CMP]

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.

Strategic Importance of Capital Investing

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.

Profit Driven

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.

Capital Opportunity Selection

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

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, and 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.

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Assessment

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.

CASE MODEL: CASE MODEL

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Conclusion

Your thoughts and comments on this ME-P are appreciated. Feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

Speaker: If you need a moderator or speaker for an upcoming event, Dr. David E. Marcinko; MBA – Publisher-in-Chief of the Medical Executive-Post – is available for seminar or speaking engagements. Contact: MarcinkoAdvisors@msn.com

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