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Rural Hospital Flexibility Program Tracking Project

Chapter 6
Financial Condition of Critical Access Hospitals:  1996-1999

Andrew Cameron, Ph.D.
Bill Zelman, Ph.D.
Scott Stewart, BA
University of North Carolina

A new hospital designation, Critical Access Hospital (CAH), is one part of the Medicare Rural Hospital Flexibility Program. The CAH program is a nationwide limited service hospital program built on the earlier demonstration programs of Essential Access Community Hospitals (EACHs), Rural Primary Care Hospitals (RPCHs) and Medical Assistance Facilities (MAFs). RPCHs were limited-service rural hospitals that provided outpatient and short-term inpatient hospital care on a urgent or emergency basis, then released patients or transferred them to an EACH or other full-service hospital. The financial relief for rural hospitals that convert to CAH status is a return to cost-based reimbursement for their services to Medicare patients.

• The CAH program has the potential to increase CAH margins through:

• Increasing Medicare inpatient reimbursement to allowable cost levels.

• Insulating the hospital from the impact of the new outpatient prospective payment system (OPPS) (although most rural hospitals have a temporary reprieve from OPPS).

• Decreasing the effect of health care costs that outpace reimbursement.

Beginning in 1999, the Federal Office of Rural Health Policy (FORHP) began supporting a multi-year national progress assessment of the RHFP/CAH Program. The assessment is a joint effort of six research centers. The first year of this progress assessment included site visits to 24 hospitals that had converted to CAH status. Although the assessment encompasses a wide variety of aspects of the CAH program, the purpose of this paper is to report on the financial condition of the CAHs that were included in the site visits. One of the ostensible goals of the RHFP is to reduce the likelihood of closure. The financial condition of CAHs is unquestionably a crucial factor relative to the long-term viability of these hospitals.

Since the first hospital did not convert until 1999, there are not enough data to report on the post-conversion financial performance of CAHs. Rather, this report focuses on their condition leading up to conversion. This provides a baseline from which future comparisons can be made.

Methodology

The study employs two approaches to analyzing the financial data of participating hospitals: standard financial ratio analysis and the Financial Flexibility Index (FFI).  While ratio analysis is the most common approach, the FFI is used because the risk of hospital closure is of such great concern to rural hospitals.  Our ratio analysis uses the four standard categories¹ (liquidity, profitability, capital structure and activity) to compute ratios that are analyzed in terms of their trend and relationship to a median.  As by its very nature ratio analysis computes no single summary measure, our approach is to identify key trends in the data.  On the other hand, the FFI develops a single indicator upon which judgments are made.

Financial flexibility is a concept used to assess the ability of a business to survive financial shocks that would make a hospital more susceptible to failure. Although the concept of financial flexibility is not new, William Cleverley² created an index, termed the financial flexibility index, that can be thought of as a summary measure of a hospital's financial flexibility. The FFI uses a combination of 7 financial ratios and operating data measures

Financial Ratio Analysis

Profitability: Profitability ratios attempt to show how well the CAH did in achieving an excess of revenues over expenditures or providing a return.  Even for non-profit hospitals, generating revenue in excess of expenditures is important to secure the resources necessary to update plant and equipment, implement strategic plans, or respond to emergent opportunities for investment.  Losses, on the other hand, threaten liquidity, drain other investments, and may threaten the long-term viability of the organization.  The profitability ratios reported here include the operating margin, which measures the profitability from operations alone, the net margin, which measures profitability including other sources of income, and the return on total assets.

TABLE 1

Liquidity: We use the current ratio and acid test ratio as indicators of the ability of a hospital to meet its short-term obligations.  The acid test ratio is generally considered to be a more stringent measure because it recognizes only the most liquid assets as resources available for short-term debt; the current ratio assumes that inventory and accounts receivable can be liquidated sufficiently to meet short-term obligations. The definition of all ratios used in this analysis is provided in Figure 1.

Days in accounts receivable and average payment period also are used to monitor liquidity.  Respectively, they indicate the average length of time the hospital takes to collect one dollar of receivables or pay one dollar of commercial credit. Together, they provide a cursory indication of cash management performance. 

TABLE 2

Activity and Capital Structure: Activity ratios indicate the efficiency with which a firm uses its resources, typically to generate revenue.  Activity ratios can present a complicated picture because they are influenced both by revenues and the value of assets owned by the organization.  The total asset turnover ratio compares revenues to total assets.  Total assets may rise (or fall) disproportionately in a year of heavy (dis)investment in plant and equipment, or decrease steadily with annual depreciation.  Thus, it is helpful to view total asset turnover at the same time as age of plant.  The only capital structure ratio reported here is debt service coverage, which measures the ability of a firm to cover its current year interest and balance payments.

TABLE 3

The Study Universe and Sample

The data used in this financial status study come from the 24 Critical Access Hospitals the progress assessment consortium visited in the first year of the progress assessment, which goes from September 1999 to August 2000. The 24 CAHs were visited from February to June 2000. For all 24 hospitals visited, the study team requested complete sets of financial statements and Medicare cost reports for the years 1996–1999 inclusive. These financial statements—which include the Statement of Operations, Balance Sheet, Statement of Cash Flows, and Statement of Changes in Net Assets—are the primary source of data for this analysis. A secondary source of data is the Medicare cost report, which is filed (typically) annually by every U.S. hospital that participates in the Medicare program. Finally, the study team also prepared a pre-site visit data collection instrument, which asked for a subset of financial data. A financial database was created for storing this information.

The Comparison Groups

Comparison data come primarily from HCIA, Inc.’s annual Comparative Performance of U.S. Hospitals. Comparisons are made to rural hospitals and to all hospitals covered in the HCIA reports. HCIA ratios were not available for all the ratios calculated here. In those cases, the HCIA cells are left blank in the following tables of ratios.

The median for all rural hospitals for 1997 is used as the comparison value where possible.  More recent medians were not available at the time of this writing.  They will be included in subsequent reports, as appropriate.

Medians and Quartiles

This study uses data from the 16 to 17 hospitals that were site-visited for the Tracking Project.  Ratios and elements of the FFI that utilized accumulated depreciation and depreciation expense, however, were not consistently available for all hospitals.  The tables provided in this chapter provide median values for purposes of comparison and trend analysis.  Median values are the single best measure for evaluating relative performance.  Medians are less affected than averages by extreme values or skewed distributions and generally are a meaningful measure for small samples.  However, in financial ratio analysis, care must be taken when generalizing about trends not to mistake the median value of a specific indicator to consistently represent the value for a specific hospital.  Ratio analysis can present a somewhat mixed picture of a single hospital’s condition.  Assuming that the median values for each indicator in this analysis refers consistently to the same hospital or subset of hospitals may lead to error.

Results

Table 1 lists the median values of each ratio for the sample by year. Table 2 shows the proportion of all hospitals in the sample for which the ratio was not in the desired range relative to the industry median.

TABLE 4

TABLE 5

The liquidity of the hospitals in the sample was eroded over the assessment period, even though cash management remained comparable to industry performance. As measured by the current and acid test ratios, the liquidity of hospitals in the sample declined steadily from 1996 to 1999, with the sharpest decrease in the last year. By 1999, 69 percent of the hospitals for which acid test ratios were calculated were below the 1997 median for all rural hospitals. Just over half were below the median for the current ratio. At the same time, days in accounts receivable and average payment period both indicate that cash management by hospitals in the sample is fairly consistent with that of all rural hospitals. The median collection period for the sample matches the 1997 industry median of approximately 63 days and the median payment period is near 55 days.  The means to significantly improved liquidity for the sample hospitals appear to lie beyond cash management strategies.

The abilities of the hospitals in this sample to use their assets to generate revenues seems to be eroding. The median total asset turnover ratio for sample hospitals was above the 1997 median for all rural hospitals for all of the study years.  However, total asset turnover decreased from 1997 to 1999, even as age of plant increased from near ten to 13.75. With constant revenues, the total asset turnover ratio would be expected to increase as assets depreciated. Further analysis should examine this complicated relationship between revenues and assets. Many hospitals cited modernization of plant and equipment as a major problem area (see Finding from the Field: Strategic Planning and the Balanced Scorecard in Appendix 5); lack of profitability will constrain their ability to address it.

Finally, the capacity of the hospitals in the sample that had long-term debt to cover their related obligations declined substantially during the period. Debt service coverage rose slightly from 2.76 in 1996 to 3.25 in 1997, but had fallen sharply to 0.64 by 1999. Note that debt service coverage can be measured only for those hospitals that have long-term debt. Four of the sixteen hospitals in the sample in 1999 had no long-term debt. Their ability to secure debt – a decision made by lenders based largely on the hospital’s ability to service the debt – has not been assessed.

As noted above, the financial flexibility index provides some indication of a hospital’s long-term viability by predicting its ability to withstand unexpected financial shocks. The values for the financial flexibility index are the median of the individual FFIs calculated for each hospital, each year.  In his 1985 analysis, Cleverley stated that FFIs greater than 0.7 generally indicated financial stability, but that hospitals scoring below –0.1 were in poor condition. The median FFI for hospitals in the study sample increased significantly from 0.7 in 1996 to 2.14 in 1997, but had fallen sharply to –7.7 by 1999.  The range in 1999 was –58.3 to 8.52, but 75 percent of the sample had an FFI below –4.1.

From 1996 to 1999, every financial indicator examined showed an adverse trend. In 1997, the most recent year for which industry medians are available, the sample medians for nine of the ten ratios analyzed were at or compared negatively to the median for all rural hospitals. Until industry medians are available for 1998 and 1999, we cannot determine whether these trends are peculiar to the sample or the industry as a whole. This study raises questions about the long-term financial viability of the majority of the hospitals in the sample.

Chapter 7: EMS Initiatives Under the Medicare Rural Hospital Flexibility Program (Hope) 

Footnotes

¹ Zelman, WN, McCue M and Milikan A.  “Introduction to Health care Financial Management.  Boston, Blackwell Publishers, MA 1998.

² Cleverley, W. “Financial Flexibility: A Measure of Financial Position for Hospitals.” Hospital and Health Services Administration Vol. 29. 1984. pp. 23-39.

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