A Permanent Margin Reset? What CFOs Need to Know

The financial outlook for not-for-profit hospitals and health systems is once again under scrutiny.

With operating margins at risk of a permanent reset, concerns have been raised among investors as it may lead to widespread downgrades, a new report by Fitch Ratings says.

While we are not expected to face a "sector-ending incident," hospitals and health system CFOs must carefully manage their liquidity and capital spending to navigate these challenges.

What is Happening with Operating Margins?

Traditionally, healthy operating margins for hospitals have ranged from 3% or higher.

In fact, even Kaufman Hall has reported that the median calendar year-to-date operating margin index was 2.0% through the end of this past November, “still well below the 3%-4% range often cited as a sustainable operating margin for not-for-profit hospitals and health systems.”

Now, Fitch Ratings predicts that the ideal range will likely reset to 1%-2% for not-for-profit hospitals in the future. While a significant reduction, the report suggests that widespread downgrades are unlikely due to the robust balance sheets and capital spending discipline demonstrated by many health systems.

Despite this, individual hospitals may face downgrades if they are unable to defer capital investments and fail to improve operational efficiencies.

What is the Cause?

One of the critical factors contributing to the financial uncertainty ahead is the aging population Fitch says.

By 2030, the last of the baby boomer generation will reach the age of 65, leading to a larger population in need of heightened healthcare services.

This scenario may strain healthcare providers' resources, potentially impacting their profitability. The need for increased staffing and the associated costs, the report says, may offset any gains made in operational efficiencies.

Another area of concern in the report is the days' cash on hand ratio. It questions whether the current range of 200-250 days may be too high, given the ongoing struggles of the sector.

However, the data shows that the ratio has consistently remained above 200 days in nine out of the last ten years, with a median of 216 days based on 2022 financials. Despite potential improvements in profitability and investment gains, the report suggests that this metric may see little improvement.

So how can CFOs prepare?

There are a few strategies hospital and health system CFOs can use to stay ahead.

Maintain a robust balance sheet: The report highlights the importance of building and maintaining a robust balance sheet to withstand potential financial challenges. CFOs should focus on healthy liquidity cushions to protect against unforeseen circumstances and maintain financial stability.

Optimize capital spending: As the industry faces financial headwinds, CFOs should evaluate capital spending carefully. Prioritizing investments that directly contribute to operational efficiency and improved patient care will be crucial to ensure long-term success.

Plan for the aging patients: With the incoming surge of the baby boomer generation requiring increased healthcare services, CFOs must develop strategic plans to support the growing demand. This may include proactive workforce planning, optimizing processes, and leveraging technology to enhance efficiency.

Monitor days' cash on hand ratio: While the current days' cash on hand ratio range may be appropriate given the sector's challenges, CFOs should continue monitoring this metric. A robust ratio can provide a buffer during economic downturns or unforeseen circumstances, safeguarding against potential financial instability.

While moving in a positive direction, the outlook for not-for-profit hospitals and health systems presents challenges that demand careful financial planning and strategic decision-making. While the reset of operating margins and the pressure to improve profitability may not result in widespread downgrades, it is essential for CFOs to maintain strong financial foundations.