On the surface, one health system may look as healthy as another, but certain factors may converge in the current environment to quickly erase any margin of safety that the health systems seemed to have.
Taking a look at two very similar health systems, let’s say it’s April 2020 and both systems have $2.5 billion in annual net patient revenues (NPR) and roughly 250 days of cash (and investments) on hand. In addition, both have applied for Medicare Accelerated and Advance Payments, receiving an additional 60 days cash on hand. By all appearances, these organizations are in a “Safety Zone” of financial flexibility, with approximately nine months of cash (and investments) on hand.
As you can see in the “Health Systems A and B” graphic, even though these two health systems looked the same at the beginning of the COVID-19 crisis, they end up at very different places.
So what happened? Let’s fast forward to December 2022. Nearly all the Medicare Accelerated and Advance Payments have been recouped (reducing cash on hand by 60 days), and each organization experienced losses during the time period. Health System A had losses that amounted to 15% of net revenues in 2020 and extended into 2021 and 2022. System B had losses of 25% of net revenues. System A was proactive in managing its costs and capital expenditures. It has approximately 100 days cash and reserves on hand — a big change but still providing a safety margin. System B experienced higher losses because volumes did not return as quickly as management had anticipated. They were slower to reduce costs and did not properly detect that their payer mix had greatly deteriorated due to significant COVID-19 impacts to the industries in their markets. This hurt their margins for services performed and reduced overall volumes because of patients who lost jobs and thus their employer-sponsored insurance, and delayed care. Additionally, System B had construction delays and cost overruns on a new facility, as well as higher than anticipated physician losses. This convergence of factors reduced cash and investments to essentially zero.
The example highlights how two health systems seemingly in similar financial positions pre-COVID-19 and feeling financially stable in the early weeks of the crisis can, in just a few years, be in far different positions. Could System B have assessed its financial stability during fall 2020 or early 2021 to make sure it was still in the “Safety Zone”?
“Unfortunately, many health systems may now be out of the Safety Zone without even realizing it. Being flush with cash could only be temporary.”
– Erik Shannon
Partner, Strategy and Transactions
A goal of every health system should be to stay in a “Safety Zone” of financial flexibility, i.e., having sufficient liquidity to meet short- and long-term operating needs, debt, capital investments, retirement and other obligations. Unfortunately, many health systems may now be out of the Safety Zone without even realizing it. While they have withstood some of the serious financial effects of COVID-19 thanks to economic stimulus support and other forms of federal funding, portions of that assistance may be turning back on itself. Being flush with cash could only be temporary. In addition to volumes recovering slowly, with Medicare Accelerated and Advance Payments coming due and payroll tax deferrals reversing, health systems may burn through cash much faster than they expect. Before going any further into its cash reserves, your leadership team needs to take a hard look at the system’s financial situation.
The outlook on net revenue losses
Financial distress was causing bankruptcy numbers to rise alarmingly before the pandemic, and this trend is likely to continue after the liquidity buffer provided by economic stimulus measures wears off. A wider margin of safety is needed because of this unprecedented economic time. For many health systems, short-term government assistance, additional draws on lines of credit and potentially overlooked obligations may obscure their actual liquidity position.
Are you safe?
The reality is that your organization might not be in as strong a position as it appears. To find out if you’re in the Safety Zone, you need to take an objective financial self-assessment. Your first step is answering this question — where is the distinguishing line between financial flexibility and potential insolvency? In other words, how much cash is enough?
It follows that leading into the crisis, the level of cash reserves necessary to maintain financial flexibility had to be commensurate with the revenue loss due to COVID-19.
The red line in the graph demonstrates that in order to have financial flexibility, the required level of days of cash on hand prior to the onset of COVID-19 needed to be higher to offset higher levels of reduction in annual revenue due to the pandemic’s impacts. You can determine the required necessary cash on hand for 2021 and beyond, given your anticipated losses and financial structure. Based on our research, each 5-percentage-point increase in annual loss translates into approximately a 20-day reduction of cash on hand, all else being equal.
Your position: Safety Zone vs. potential insolvency
“Based on our research, each 5-percentage-point increase in annual loss translates into approximately a 20-day reduction of cash on hand, all else equal.”
– Brian Bonaviri
Managing Director, Strategy and Transactions
When it comes to a Safety Zone, there are crucial subsets to recognize. The “Safety Zone, subsets and potential insolvency” graph demonstrates a framework for modeling how to manage financial flexibility that we have developed and use in advising clients. While the framework itself is conceptual, we have developed detailed financial models that enable organizations to understand and manage their financial flexibility.
As a health system’s cash position diminishes, its margin for error — its safety margin — decreases, and eventually it may be at risk of breaching its bond or other debt covenants. Eventually, if cash deteriorates further, the health system may fall out of the Safety Zone altogether. If you are in the safety margin, you very likely are able to meet operational and financial obligations, and to maintain compliance with bond or other debt covenants. Congratulations — you’re in the Safety Zone. Below the safety margin line is another story altogether. Though the safety margin varies by organization and market, it is the minimum buffer your organization needs to deal with unexpected events. The area below the safety margin signifies breach of bond or other debt covenants. This can trigger certain mandatory actions and requires the full attention of executive leadership and the board of directors.
“Our organization has more liquidity today than ever before. Why worry?”
As alluded to earlier, several factors have contributed to deceptive liquidity positions. One major factor is government funding. You can shed light on the reality of your situation by identifying what has been masked by this assistance. Monies from the CARES Act and the provider emergency fund are yours to keep and use. However, the liquidity boost from six months of Medicare Accelerated and Advance Payments and the payroll tax deferrals will dissipate with Medicare’s recoupment and the deadline for payroll tax payments. Your cash position may be higher than expected — especially given the economic uncertainty — but your future cash burn may be substantially greater than historical run rates.
Beyond government and HHS/CMS funding that may dry up or reverse course, additional critical factors may lead to a currently deceptive cash position and/or an increased future cash burn:
- How substantial are your debt and lease obligations? Do you have bullet or balloon payments coming due soon?
- How much availability do you have on your line of credit?
- Did you postpone capital investments to conserve cash and now have a substantial backlog of deferred maintenance that you need to finance?
- What are the magnitude and timing of your pension obligations?
- Have you seen a significant number of postponed or cancelled elective procedures?
- Have your patient demographics (e.g., underinsured, Medicaid- or Medicare-dependent) changed since COVID-19, resulting in payor mix deterioration? Do you have a deep understanding of trends and projections related to key employers/industries in your market(s)?
- To what extent are you able to flex monthly expenses? Are your expenses primarily fixed or variable? How much do you own vs. lease in terms of real estate, medical equipment, IT systems, etc.? Are your third-party vendor agreements volume-driven?
- Have you experienced increased labor costs due to the use of staffing agencies? To what extent? Is this reversible?
- Have you experienced increased supply costs due to unanticipated purchase of personal protective equipment and other COVID-19-related purchases? To what extent?
- What is the competitive landscape in which you operate? Are you the dominant healthcare provider in your service area? How are your competitors responding?
A graphical representation highlights some areas that health system leaders should consider when assessing the changing environment, and their organization’s financial position and potential future cash burn.
The convergence of financial risks and timing traps could activate a liquidity event. But as important as liquidity is, covenants can be equally essential to financial safety. Covenant calculations will be key to knowing what to expect about impacts on covenants and future obligations. Some covenant calculations require backing out of governmental funding advances. A days-cash-on-hand covenant could be tripped if a significant amount of money on the balance sheet is based on such advances.
A covenant tied to the income statement position could be violated if, regardless of the cash position, your organization exhibits substantial losses due to COVID-19. The implication is that lenders will take a closer look and might restrict movements going forward.
Putting all factors together can change how you see your cash picture. That picture might have looked good in April but may look quite different today.
Track your history to anticipate your future
Gain a greater understanding of your current situation by examining your hospital’s pre-COVID-19 financial position. Apply the pluses and minuses of operational and financial changes due to COVID-19, then your outside sources of funding. Besides days of cash on hand, focus on metrics such as revenue and volume trends year-over-year. This will help pin down the safety margin you must have and, as a result, your confidence level in the losses you can weather.
Beginning this examination now will spotlight a negative trend. In the best case, you’ll have time to act before balance sheet issues show up, liquidity constrains your options or covenants are broken. One of your actions can be using a solvency estimator tool to pinpoint the amounts and timing of your safety margin.
Take the opportunity to be certain of your Safety Zone position so you can plan accordingly.
This is the first in this fall’s series of three Safety Zone articles to help you understand your financial position and plan strategically to reach and maintain a stronger one:
Learn more: read “What boards can do to keep health systems solvent
Managing Director, Strategy and Transactions
+1 617 290 2449