COVID-19 requires intensified due diligence to understand its impact on the financial performance of health systems

Analyzing a health system’s financial performance is critical when making business decisions for the organization, but performing such an analysis is far from being straightforward for 2020 and 2021.

In 2020, health systems reallocated resources in response to the increase in COVID-19 cases that they otherwise would have utilized for day-to-day operations. As a result, financial statements for 2020 may include one-time items directly or indirectly related to COVID-19 that do not reflect either the health system’s historical performance or its future performance. Moreover, despite the deployment of COVID-19 vaccinations during the first and second quarters of 2021, the pandemic has no clear end in sight, and recovery from it remains elusive for some sectors of healthcare.

Due diligence required to assess COVID-19’s impact

Analysis of a healthcare entity’s financial performance under COVID-19 requires exceptional due diligence, whether it is performed for a buyer, an investor, or a lender. In-depth analysis is required to understand the pandemic’s direct impact on the organization and what line items should be normalized to make them comparable to historical periods and estimate projections. Thus, when developing a budget or long-term forecast or performing a service-line analysis, the organization’s management team should thoroughly review all one-time items on the financial statements that they would not ordinarily expect to find.

The following are key items on the financial statements that are likely to be directly impacted by COVID-19 and therefore warrant additional due diligence.

Net revenue

Net revenue is driven by patient volume, reimbursement and other sources of revenue. Since the surge of COVID-19 cases, health systems have seen a dramatic shift in the admission trends among service lines. Elective procedures, a core component of hospital and health system revenue, were suspended as certain departments were forced to temporarily shut down. Understanding the exact time period that these service lines remained closed is imperative to determine the impact on volume. If necessary, a normalization adjustment should be applied to account for lost volume based on historical admissions during the same period. Although most sectors are still expected to recover in 2021, despite the recent spike resulting from the COVID-19 Delta variant, certain hard-hit sectors such as skilled nursing facilities are likely to take longer to recover. And some may never see a return to historical levels of occupancy.

The rise in numbers of COVID-19 patients combined with the temporary suspension of elective procedures also precipitated a dramatic shift in the payer mix of many health systems, which has had a material impact on the organizations’ payment levels. The increased usage of telehealth services also may have adversely affected many organizations’ total payments. Healthcare organizations should diligently track payment trends and understand the extent to which public and private payers have adjusted payments due to the COVID-19 pandemic, as these developments could have a material impact on a revenue forecast.

Operating expenses

Salaries, wages and benefits remain the largest expense line item for most health systems. This expense line item may need several adjustments, including the following, for example:

• One-time severance payments
• Upward adjustments for furloughed employees
• Deferred payroll taxes

Management teams also should observe trends in contract labor expenses. Supplies expenses are typically the second largest expense line items and fluctuate in line with volume. Any adjustment to supplies expenses should correspond to the change in volume.

In particular, expenses for personal protective equipment or ventilators directly associated with COVID-19 treatments should be evaluated and treated as nonrecurring in the forecast period.

Other expenses that may require heightened due diligence include:

• Rent expenses
• Professional fees
• Advertising
• Travel and entertainment

Specifically, any rent abatements or permanent reduction in space due to the COVID-19 pandemic should be considered in rent-expense adjustments. And the COVID-19 pandemic may also have forced organizations to reduce advertising and travel expenses. As such, careful attention should be given to trends in other expense line items to determine whether the change should be considered a one-time expense and whether these expenses will return to historical levels.

Earnings

Earnings before interest, taxes, depreciation and amortization (EBITDA) continues to remain the key earnings metric from an investor perspective. The normalization adjustments previously discussed to revenue and operating expenses would ensure the organization does not understate or overstate EBITDA, thereby providing a better view of the earnings potential. Industry analysts have already redefined these financial metrics as EBITDAC, which refers to EBITDA adjusted for COVID-19.

Balance sheet items

Similar to the income statements, the balance sheet also may not provide an accurate picture of the organization’s financial strength. Government stimulus packages may mislead liquidity and leverage positions. If the health system received any Paycheck Protection Program (PPP) loans,  it is important to assess how likely it is that they will be forgiven.

Cash and debt balances need to be adjusted appropriately and further due diligence is required to understand accounts receivables, bad debts and payables trends compared with the historical levels to determine accurate working capital needs.

It also is important to ensure the organization’s tangible and intangible assets have been tested for impairment, with the findings clearly documented in writing.^a

Other considerations

For buyers, it is important to understand net operating loss (NOL) provisions to assist in structuring a deal as an asset or stock purchase. The Tax Cuts and Jobs Act of 2017 (TCJA) eliminated NOL carrybacks and permitted NOLs to be carried forward indefinitely. However, the Coronavirus Aid, Relief, and Economic Security Act (CARES Act) liberalized the ability to carry back tax losses by allowing the NOLs from a tax year beginning in 2018, 2019, or 2020 to be carried back five years. Further, if PPP loans are eligible for forgiveness, then potential tax implications should be considered.

Providers and investors also should investigate changing reimbursement policies for telehealth visits. The usage of telehealth services increased in 2020 and this trend is likely to continue post-pandemic. Although the rates Medicare pays for telehealth and in-person services have been the same during the pandemic, this provision may expire at the end of the public health emergency, which has seen multiple extensions with the ongoing pandemic. It remains to be seen whether Congress will move to expand access to telehealth in Medicare post-pandemic.

Exceptional times require exceptional measures

COVID-19 has presented health systems with an unprecedented challenge in assessing the financial performance of their organizations. When making business decisions, health system management teams require a clear picture of the effect of the pandemic on their organizations’ financial well-being. Raising the bar on due diligence efforts by closely reviewing every item within the organization’s financial statements that COVID-19 may have affected is, therefore, imperative.

Footnote

a. Lodhavia, T., “Asset impairment issues for hospitals to consider in the wake of COVID-19,” HFMA, May 29, 2020.