Business Matters

Capital Catch-22

By Alden Solovy

There is no magic number to guide investment

You've got to spend money to make money. That adage holds true when examining hospital capital expenditures. On average, hospitals that make consistent and generally larger capital investments have better financial performance.

"There is a historical connection between capital investment and financial success," says Frederick Hessler, managing director, Citigroup. "Those organizations with newer plants tend to have better cash flows."

To that point, Moody's Investor Service incorporated a new measure into its credit rating analysis: the capital spending ratio, which is capital spending divided by depreciation. The higher the ratio, the greater the investment in new capital. Ratios below 100 percent indicate that an organization is disinvesting--spending less in new capital than the depreciation of old capital.

Now here's the rub: You've got to have cash flow from operations, and decent debt capacity, in order to have the financial resources to make capital investments. But when investments are made, at least in the short run, cash flow can get hit. That, in turn, can hurt access to additional capital.

Here's how Moody's puts it in its recent Special Comment paper on the topic: "We believe that, in many instances, larger capital spending results in stronger competitive positions, especially when strategically invested in revenue generating projects. However, at times, a high level of capital spending can deplete financial ratios and negatively impact ratings in the near term."

Moody's also notes: "In instances where the capital spending ratio is less than 100 percent or less than the median, it may suggest pent-up demand and artificially high liquidity."

In other words, spend too much, financial ratios slip and access to capital falls. Spend too little and financial ratios may be too good, creating a false impression of success. Again, access to capital may fall.

"What gets danced around is how do you find that happy medium," says Ken Kaufman, managing partner of KaufmanHall. An analysis by his firm shows that the most successful hospitals spend roughly 8 percent of revenue on capital. "It's a very interesting--and very preliminary--result," he says. "Is there a magic metric? No, there is no magic metric."

Kaufman, Hessler and Moody's agree that capital spending will increase, at least in the short run, both to offset lower capital investment in the early part of the decade and for acquisition of high-ticket IT.

According to Hessler, in the last 10 years the nationwide average age of physical plants has increased 20 percent. Add to that capacity issues at many hospitals and, as Hessler puts it, "you've got the perfect storm of capital expenditures coming."

Yet, as cash flow gets hit from cuts in Medicare, Medicaid and private payers, investment capital may begin to dry up.

Kaufman notes that hospitals have been particularly fleet of foot in adjusting capital expenditures to their available resources. "It says something positive about leadership and governance that they can adjust spending."

And there may be no choice.

Contact Alden solovy at asolovy@healthforum.com

This article 1st appeared in the June 2005 issue of HHN Magazine.

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