Lancaster Pollard recently developed its Small Hospital Indicators of Financial Strength (SHIFT) Index to help provide a better understanding of financial ratios and benchmarks for small hospitals. This article is the first in a series of Lancaster Pollard small hospital research findings.
Small, rural hospitals have long faced the challenge of accessing financial resources to keep up with technology and evolving community needs. Their very sizes and service areas can negatively affect the perception of their financial strength and, consequently, ability to borrow at reasonable interest rates. This perceived “detriment” of being small or rural has so pervaded the markets that few entities – hospitals or lenders - challenge the stereotype that smaller hospitals are financially weaker than larger, urban facilities.
A new index developed by Lancaster Pollard specifically for smaller, rural hospitals weighs financial ratios in combination with qualitative factors to create a new tool to better understand small hospital financial characteristics and their relationship to financial strength. The SHIFT Index has evolved from Lancaster Pollard’s interaction and work with community and rural hospitals nationwide. The firm’s extensive experience in this sub-sector and its successful efforts to solicit letters of credit, bank private placements and other private-investor support indicate that the hospitals themselves, lenders and the capital markets often misunderstand and underestimate smaller hospitals’ financial strength.
The SHIFT Index’s weighted system of qualitative and quantitative factors offers a clearer picture of individual small hospitals’ financial strengths and weaknesses. It will provide a new guide to identify areas of improvement and, hopefully, increase understanding and create better opportunities in the capital markets.
Existing rating agency medians have until now been the only real measure of small hospital financial strength. But only a fraction of small hospitals seek ratings: a pool of a few stands as the benchmark for thousands. These rating systems tend to judge smaller hospitals against the same criteria and expectations as larger hospitals, and statistically, small hospitals must outperform large hospitals to receive the same rating.
Default rates do not bear out the assumption that small rural hospitals are financially weaker than urban facilities. Nationally, 10.6 percent of urban hospitals closed between 1990 and 2000. Over the same period, 7.8 percent of rural hospitals closed, as indicated in the Inspector General’s 2003 report, “Trends in Rural Hospital Closure.” While some rural hospitals that closed cited lagging revenues or rising costs, the answers most often given were business decisions (mergers, relocation, consolidation). Of 58 rural hospitals that closed between 1998 and 2000, 12 reopened in new facilities, offsetting the number of true rural hospital closures.
The SHIFT Index follows the theory that smaller and rural hospitals should be judged on somewhat different criteria because they operate according to different criteria. Indicators such as debt service coverage and days cash on hand will always be important factors in financial strength. Yet investments and related ratios are not as relevant to smaller hospitals (which may not have large investment portfolios) and others, such as operating margin, tend to reward urban hospitals that have more higher-margin specializations. A benchmark ratio that may appear favorable for a large hospital may be unattainable for a small hospital, yet have little actual effect on the small hospital’s operations or ability to repay a loan.
The SHIFT Index evaluates overall financial strength compared to the hospital’s peers, a pool of about 2,000 small, non-critical access facilities with less than $70 million in net patient revenue. A separate SHIFT Index evaluates critical access hospitals.
Lancaster Pollard assigns a decile rating to more than a dozen financial ratios and factors for these 2,000-plus hospitals, creating a peer review that shows hospitals how they compare to others. The firm applies its extensive experience with small hospital finance to assign a weight to each factor, creating a proprietary system of evaluating hospital strength. The SHIFT Index also integrates small hospital reimbursement issues, such as Critical Access Hospital or Sole Community Provider status, adjusts ratios for operating margin and places additional emphasis on intangibles such as location, recruitment ability and competition.
By allowing hospitals to compare their unweighted ratios to those of their peers and see where their weighted ratios place them on the Index, the Index both effectively illustrates financial strength and shows hospitals where they can improve before attempting to access the capital markets. For example, it may show that if a hospital increased its ratio of day’s cash on hand by a certain percent, it could improve its Index ranking from the 60th percentile to the 70th, indicating that it improved enough to be stronger than 70 percent of its peers.
Lancaster Pollard’s immediate goal is to help smaller hospitals better assess their financial strength. Additionally, the firm will begin to use the Index as an integral part of the credit assessments it shares with the capital markets. Longer-term, Lancaster Pollard expects the index to help improve the capital markets’ understanding of smaller hospitals, which could eventually translate into access to more financial options, reduced financing costs and an increased investor interest in working with small hospitals.
Faced with the aging of the Hill-Burton hospitals, increasing technology demands, and shifting outpatient and other care trends, understanding a small hospital’s individual financial qualities and how they relate to overall financial strength is more critical than ever. The new Lancaster Pollard SHIFT Index is a tool for small hospitals to better understand and articulate their financial health, access sources of capital, and identify areas of improvement.
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