3 primary areas of focus for effective financial planning

The year 2022 has been one of the most challenging in recent history for hospital and health system operating performance. The year-to-date median operating margin remained in negative territory at -0.3% as of the end of August, according to Kaufman Hall research. 

Given the challenges, three key areas of financial planning are critically important in today’s environment: developing dynamic projections for operating performance, establishing targets and benchmarks for performance and planning for levels of capital spending consistent with long-term strategic direction. 

1  DEVELOPING DYNAMIC PROJECTIONS FOR OPERATING PERFORMANCE 

The August numbers indicate that labor expenses have been a primary driver of operating performance deterioration, with total labor expense up 7.2% year-over-year in August 2022, and up 15.8% in a year-over-year comparison with 2020. 

At some organizations, labor shortages have created new capacity constraints, with implications for volume and revenue; 66% of respondents to a 2022 healthcare performance improvement survey reported that their organizations have run at less than full capacity because of staffing shortages. 

Many health systems are relying heavily on contract labor to cover shortages in clinical staffing. This comes at a premium that is not sustainable long term; as of this fall, contract labor costs were running at a level 500% above pre-pandemic levels.  

For financial planning purposes, management should expect higher-than-normal labor inflation over at least the next two to three years. Management should also consider current staffing shortages and the likelihood that these shortages can be alleviated in the near term. If that is not possible, management will have to factor in the cost of continued contract labor, reductions in procedural volumes and/or unit closures.  

These projected costs should reflect local market dynamics related to labor costs for both full-time equivalent and contract labor. 

Projections should be made dynamic through stress-testing — using sensitivity and scenario analyses, which are tools that can quantify risks and define a range of potential outcomes. Sensitivity analysis can be used to focus on the impact of changes to key assumptions driving the projections. Scenario-based analytics apply the results of the sensitivity analysis to create combinations of assumptions that define “alternative futures” for the organization.  

These analyses are particularly useful for understanding and identifying:

• Potential impacts to operating performance and balance sheet position 
• Headroom available with respect to the organization’s debt covenants  
• Credit rating implications 
• Operating performance inflection points that would trigger capital “off ramps” (e.g., capital related to master facility plans) 

2  ESTABLISHING TARGETS AND BENCHMARKS FOR PERFORMANCE 

As a result of today’s volatile operating environment, hospital and health system leaders have a stronger-then-ever desire to understand how their organizations are performing on a relative basis. Traditional benchmarks such as annual rating agency medians do not accurately reflect the current operating environment. Management must seek new benchmarks and reevaluate previous targets. 

With operating performance fluctuating rapidly, benchmarking should rely on data sources that update on a monthly or quarterly basis. Rating agency medians are still important, but timelier data can help finance teams adjust or normalize these medians to current conditions, especially related to operating performance and unrestricted cash. 

When reevaluating previous targets, the focus should be on longer-term performance through a multi-year planning cycle. Given operating projections, will there be opportunities to course correct over this cycle, or do previous targets need to be adjusted? Management should be cognizant of the impact new targets may have on the organization’s credit rating, but ratings should not drive strategy. The primary focus should be maintaining the organization’s path to achieving its strategic goals.  

3  PLANNING FOR LEVELS OF CAPITAL SPENDING  

As financial resources grow more constrained, so too does the ability to accommodate surprises or make investments without explicit return expectations. Thus, capital planning must become more rigorous and comprehensive. 

Capital planning needs should have clearly established goals — transformation of care delivery models or financial ROI, for example — that help determine how projects should be prioritized. When possible, projects should have predetermined off ramps if the operating environment changes. Management should also do a comprehensive assessment of the organization’s portfolio of existing assets to identify where trapped capital might be unlocked through sale or monetization for new capital needs.