In recent years, nonprofit hospitals and health systems in the United States have been facing operational and economic challenges. To maintain stability, these healthcare organizations often rely on financial reserves. Financial reserves, which include liquid cash resources and unrestricted investments, have served as a lifeline for nonprofit hospitals during the COVID-19 pandemic and other operational disruptions.
A report prepared for the American Hospital Association (AHA) by Kaufman Hall highlights the significance of financial reserves in minimizing operational disruption and financial distress for nonprofit hospitals. The report examines the primary functions within the financial structure of nonprofit hospitals, the functions’ role in generating financial reserves, and the influence of financial reserves on a hospital’s credit rating and debt capacity.
Nonprofit Hospitals’ Financial Structure
The financial structure of nonprofit hospitals and health systems includes three primary functions: the operating function, the finance function, and the investment function.
The operating function manages the portfolio of clinical services and strategic initiatives that define the organization’s charitable mission. Since the positive margins generated by the operating function are rarely enough to support hospital needs, the finance function forms internal and external capital.
The finance function builds cash reserves and secures external financing to support the capital spending needs of hospitals. Hospitals may invest some of their cash reserves to generate returns that can protect against potential disruptions to cash flow, known as the “investment function.”
Financial Reserves
Financial reserves are all liquid cash resources and unrestricted investments held in the finance and investment functions. The reserves are meant to act as emergency funds for hospitals and must be viewed relative to a hospital’s daily operating expenses. Days of cash on hand are a common metric used to measure financial reserves.
In the first few months of the COVID-19 pandemic, cash flow was almost nonexistent for many hospitals. Financial reserves help hospitals maintain staffing and operations and fund personal protective equipment costs.
Financial reserves can also be used as a buffer against natural disasters, cyberattacks, a payer’s inability to reimburse hospitals for care already delivered, and increased labor costs.
Financial Reserves and Credit Ratings
Financial reserves can influence a hospital’s credit rating, impacting a facility’s ability to receive municipal debt to fund large capital projects, such as building a new cancer treatment center. Municipal debt can include general obligation bonds backed by the issuing municipal authority or revenue-backed municipal bonds backed by the borrowing organization’s ability to make payments through the revenue it generates.
Credit agencies use days of cash on hand as a factor to determine a hospital’s credit rating because it indicates how long the organization could withstand severe disruption to its operations and cash flow.
Financial reserves and related funds also help define a hospital’s debt capacity or the amount of debt a facility can assume without jeopardizing its current credit rating. A higher level of financial reserves and investment income concerning existing debt obligations will increase an organization’s debt capacity and create a safety net if it has to borrow money to minimize poor operating or investment performance.
Challenges Facing Nonprofit Hospitals
According to Kaufman Hall, nonprofit facilities had negative operating margins by the end of 2022, and this pattern is anticipated to continue in 2023. The financial structure of nonprofit health systems suffered in all three areas last year, and there will still be economic challenges in 2023.
“The current situation demonstrates why financial reserves are so important: many not-for-profit hospitals and health systems will have to rely on them to cover losses until they can reach a point where operations and markets have stabilized or they have been able to adjust their business to a new, lower margin environment,” the report stated.
The COVID-19 pandemic has highlighted the need for nonprofit hospitals to have sufficient financial reserves to withstand operational disruptions. However, the question has been raised if enough nonprofit hospitals and health systems have built sufficient reserves to support them through ongoing challenges.
