Corbett A. Price
Andrew E. Cameron
Devin L. Price

Early-warning systems that anticipate financial distress can provide management with powerful tools to help identify and rectify problems before they reach a crisis.


At a Glance

Seven measures are indispensable to healthcare financial executives for assessing their organizations' financial well-being. Two are accrual based:

  • Cleverley's Financial Strength Index
  • Altman's modified Z score  

The rest are cash-flow based:

  • Operating cash flow ratio
  • Funds flow coverage ratio
  • Cash interest coverage ratio
  • Cash flow to total debt ratio
  • Total free cash flow ratio

How well do you know the financial condition of your organization?

Today, more than ever before, users of a hospital's financial information-whether they be investors, management, board members, community leaders, or donors-need to be informed of the organization's true financial condition. Early detection of financial distress is critically important if a hospital's executive team is to have time to take corrective action and prevent further erosion of the organization's financial health.

The problem is that hospital management and boards often seek dramatic change only after the organization has reached a crisis stage. When looking at their organizations' historical financial information, they all too often fail to see the signs of a looming financial crisis. For weak hospitals, the consequences of such inaction can be disastrous.

By being more proactive and diligent in analyzing financial measures, however, hospital leaders often can avert a crisis. In many instances, with appropriate review and analysis, a hospital's managers, investors, and board members can discern the presence of a financial problem from existing information. Indeed, audited financial statements can often present clear signals of impending disaster.

Key Measures

The question is, which kinds of measures provide the most reliable picture of a hospital's financial health? Should you use accrual-based financial statements, such as the income statement and balance sheet, or measures based on cash flow (using information from the statement of cash flows)?

There are no definitive answers to these questions. Various academics and analysts have presented data and analysis to support each position. Several examples of corporate failure exist in which accrual-based financial ratios revealed no major problems. On the other hand, reliance purely on cash-based ratios can lead to misdiagnosing as failures companies that are not bankrupt. Examples include growth companies that consume cash yet can raise more funds through debt and equity, and large companies whose operating cycles have regular periodic peaks and valleys requiring them to invest cash ahead of the anticipated peaks.

The only prudent approach is to use a balanced reporting system incorporating both types of measures. As perhaps the most effective approach, we propose using seven financial performance measures-two accrual-based and five cash-flow-based-that have been the subject of much recent research on organizational financial distress. These measures are:

  • The Financial Strength Index
  • The modified Z score
  • Operating cash flow ratio
  • Funds flow coverage ratio
  • Cash interest coverage ratio
  • Cash flow to total debt ratio
  • Total free cash flow ratio

All of these measures, detailed below, are financial ratios that can be calculated from standard financial reports-the income statement, balance sheet, and statement of cash flows. Naturally, each healthcare organization's case is different, and the values of these ratios must be viewed within the context of the organization's particular situation. Numerous contextual variables should be considered, including whether the company is mature as opposed to a startup, the particular segment of the healthcare industry, and the size of the company.

Accrual-Based Measures

The accrual-based measures are the FSI and the modified Z score. An early version of the FSI was described by William Cleverley and Andrew Cameron in Essentials of Health Care Finance, 5th ed. (Gaithersburg, Md.: Aspen Publishers, 2002). The measure was recently updated to account for changes in availability of Medicare cost report data that resulted from CMS's implementation of prospective payment systems for hospitals. The modified Z score was described by Edward Altman in "Predicting Financial Distress of Companies: Revisiting the Z-Score and ZETA Models" (working paper, July 2000, downloadable at http://pages.stern.nyu.edu/~ealtman/Zscores.pdf.

FSI. The FSI is a simple measure of overall financial health that provides an excellent starting point for analyzing a hospital's condition. It is a composite measure of four critical dimensions of financial health: profitability, liquidity, financial leverage, and physical facilities.

The FSI was designed specifically for hospitals, but it transfers well to other  industry sectors. The measure implies that firms with large profits, great liquidity, low levels of debt, and new physical facilities are in excellent financial condition, whereas those with poor profitability, low levels of liquidity, heavy debt financing, and old physical facilities are in poor financial condition

What constitutes a good FSI value? An FSI of > 3 reflects excellent financial health; 0 to 3 indicates good financial health; -2 to 0 indicates fair financial health; and < -2 is an indicator of poor financial health. Thus, if your hospital's FSI is less than 0, you should do further analysis to determine the extent of the organization's financial problems.

Modified Z score. Since the 1960s, scholars and credit analysts have worked to develop models that could reliably predict which companies would soon go bankrupt. Efforts to differentiate between failed and financially secure firms began with early use of individual ratios and then moved to Edward Altman's Z score based on multiple discriminant analysis. Altman also developed a modified Z score that does not require an explicit market valuation of the company. It is this modified version that is most applicable to not-for-profit hospitals.

If the modified Z score is > 2.90, no financial distress is predicted for the organization. If, however, the Z score is ≤ 2.90 and > 1.22, the organization faces financial distress and possible bankruptcy. A Z score of ≤ 1.21 is a predictor of bankruptcy within one year.

The implications of these scores are straightforward to interpret. If the value is ≤ 1.21, immediate and drastic action is necessary to avoid or plan for bankruptcy or closure. If the value points to financial distress, the board should recognize that the organization will likely move toward bankruptcy unless major changes are made in its operations. Often such major changes necessitate a replacement of senior management or a corporate restructuring.

Cash-Based Measures

Traditional financial statement analysis, which relies on the balance sheet and income statement, is not structured to provide a reliable view of a hospital's financial condition. Balance sheet data are insufficient for a thorough liquidity analysis because they reflect only a single point in time. And income statements contain many arbitrary noncash allocations. Too little attention is given to useful information contained in the cash flow statement.

The cash flow statement reflects changes in the other statements and focuses on what is ultimately most important for any business (and especially for distressed ones)-namely, the cash available for operations and investments. By looking closely at the following five simple ratios drawn from a cash flow statement, therefore, hospital leaders can gain a deeper insight into the viability of their organizations as ongoing concerns and avoid serious financial difficulties.

Operating cash flow ratio. Similar to, but more relevant than the more commonly used current ratio, the OCF ratio measures a hospital's ability to generate enough funds to meet current liabilities. A value below 1.0 indicates that the hospital is not generating enough cash to meet its near-term obligations (due within one year or even sooner). In such an instance, management will have to look for additional financing or divest assets to raise the necessary cash to avoid defaulting on the organization's near-term obligations.

The numerator is net cash provided by the hospital's operating activities. Depending on the organization's level of financial distress, management should monitor the hospital's cash balance and days cash on hand daily, weekly, or at the very least, monthly.

Funds flow coverage ratio. The FFC ratio indicates how well the company can meet its interest and, if applicable, tax obligations and preferred dividend payments. The FFC is valuable for predicting the risk of near-term loan default. A hospital cannot survive in the long run if it does not generate enough cash to meet its unavoidable expenditures. Some of the obligations reflected in the OCF ratio can be extended if absolutely necessary. For example, hospitals facing financial pressure can defer accounts payable expenditures. Debt and interest payments, by contrast, are contractually obligated, and nonpayment results in technical default.

The FFC ratio's numerator consists of earnings before interest and taxes plus depreciation and amortization. The denominator reflects the organization's unavoidable cash commitments-namely, interest expense plus tax-adjusted debt repayment plus, if applicable, tax-adjusted preferred dividends. (Tax-exempt organizations, of course, would eliminate the tax adjustment in the calculation.)

Cash interest coverage ratio. The cash interest coverage ratio is preferable to the more often used coverage ratio (or interest coverage ratio) because the former begins with cash flow, whereas the latter includes all sorts of noncash earnings. Cash must be used for interest payments, so a ratio that reflects cash coverage is better. The cash interest coverage ratio reflects a hospital's ability to generate cash sufficient to make the interest payments on its debt. A value less than 1.0 means the organization must take immediate steps to raise cash externally to cover its interest payments.

Cash flow to total debt ratio. Whereas the first three cash-flow ratios focus on near-term liquidity, the cash flow to total debt ratio reflects a hospital's ability to cover future debt obligations. Thus, it has a longer-term orientation than the previous ratios. It can be used to indicate a hospital's capacity for taking on additional debt. Another way this ratio can be used is by taking its reciprocal to predict about how much time the firm would need to repay all of its debt if all cash flow were directed to debt repayment (assuming no new debt and stable cash flow generation). A low value of this ratio means the company has less financial flexibility.

Total free cash flow ratio. The total free cash flow ratio is the most forward-looking of all of the measures discussed in this article. It is an indicator of the hospital's ability to meet future cash commitments, and as such, it portrays a hospital's ability not simply to survive but to thrive. Unlike the previous measures, it includes capital expenditures. Continued capital investment is necessary for any hospital to thrive in the long run. Thus, the board and management should use this ratio to ascertain the capacity of the firm to meet its long-term strategic vision and mission.

Distress Remedies

How should you respond if you find that some of these ratios suggest financial distress or a lack of long-term viability? The answer obviously depends on your organization's particular situation and the unique set of circumstances that caused it. The potential causes of and cures for financial distress obviously are too numerous to be described in this article, but some of the more common responses are listed below. In general, responses can be categorized as short- and long-term, although these categories often overlap.

Short-term responses. Obtaining additional financing through debt (such as a line of credit) or equity is a short-term response available to some hospitals, but many firms experiencing financial distress will not have this option. Other common short-term responses of hospitals to financial distress include stepping up fund-raising efforts, including those focused on increased philanthropy, and seeking local governmental or tax support. Many hospitals find short-term relief through sale of assets, such as land, divisions, buildings (perhaps through sale/leaseback arrangements), equipment, and factoring receivables.

Long-term responses. At times, extreme financial distress can force a hospital to reconsider its strategic vision and mission. Such a response typically requires a thorough market analysis and assessment of local economic conditions. Other actions that may be required that have long-term implications include bankruptcy reorganization; reconfiguration of assets and services: and joint ventures, mergers, or sale of the hospital.

Make It Routine

The seven measures described above, used in combination, provide a balanced and thorough approach to analyzing an organization's financial health. Using these financial measures, any board member, manager, or analyst can detect-long before corporate failure - whether an organization is approaching financial distress. Short of significantly fraudulent financial reports, we know of no cases of corporate failure that would not have been predicted using one or more of these measures.

To make effective use of these tools, monitoring must be routine. Tracking the seven ratios regularly and consistently is the only way to be assured of seeing the signs of impending financial distress far enough in advance to respond effectively. Keep in mind, too, that the ratios should be interpreted in the context of your organization's particular situation. These ratios sometimes reach unfavorable levels briefly because of a one-time occurrence or planned activity, giving little cause for concern. But if the ratios were to remain at unfavorable levels for an extended period, immediate corrective action would likely be needed to ensure your organization's continued viability.

Publication Date: Monday, August 01, 2005

Login Required

If you are an existing member, please log in below. Username and password are required.

Username:

Password:

Forgot User Name?
Forgot Password?







Close

If you are not an HFMA member and would like to access portions of our content for 30 days, please fill out the following.

First Name:

Last Name:

Email:

   Become an HFMA member instead