Industry Voice

Is Your Hospital Truly Profitable?

Economic value added can be applied to the entire organisation or its individual departments

Most of us are aware of various financial ratios like return on capital employed, return on equity, net profit margin, and operating profit margin to evaluate the financial performance of the company. Many organisations that eventually were declared bankrupt showed impressive financial figures till the final outcome of insolvency. It suggests these conventional financial ratios fails to capture, evaluate and depict the correct financial position and growth.

What about your Hospital?

It is worthwhile and interesting to study the financial statement of Enron for five years before closing down in 2001. Earning Per Share (EPS) was actually increasing over five years as evident from 1st graph. EPS, net income was steadily increasing from 1996 to 2000. Then why the company was declared bankrupt and was closed down in 2001?

What was the missing link? What was not captured in traditional financial reporting and analysis? The increasing net income and earning per share misled the CEO, who was not aware of the crashing Economic Value Added (EVA), which is plotted in second graph. It showed marked decline which was not taken into consideration. In reality, Enron's EVA was markedly falling since 1998.

What is EVA?

The terminology is coined by and is registered trademark of Stern Stewart & Co. EVA is the financial performance measure of true economic profit of an enterprise. It is also one of the measures most directly linked to the capital appreciation. In other words, it means creation of shareholders' wealth over time. It tells the financial health of the organisation and is the true profit once tax and cost of capital is taken care of. EVA can be calculated as EVA = NOPAT - (TCE x WACC).

NOPAT is Net Operating Profit After Tax, TCE: Total Capital Employed, WACC: Weighted Average Cost of Capital.

Concept of EVA

Value is added only if organisation generates returns in excess of its cost of capital, which is termed as Economic Value Added. To put in a simple terms, EVA is the profit generated by the hospital over its cost of capital employed. If profit is more than capital employed, then organisation is creating wealth. A negative EVA on the other hand indicates the company is eroding capital used.

Advantages of EVA

• EVA can be applied to the entire organisation or its individual departments.
• It guides new developments and new opportunities.
• It is a financial analysis tool that helps hospital management to navigate through though economies

EVA measures real profitability of the hospital and efficiency with which capital is used.

EVA is essentially the surplus left after making an appropriate charge for the capital employed in the business. There is a cost of debt as well as cost of equity. CFO needs to know the weighted average cost of capital, which is due to cost of loan and cost of equity.

Before understanding various methods to increase EVA, it will be useful to know a very interesting and very basic concept in economics. There are two types of profits, accounting profit and economic profit. Accounting profit is total revenue minus total cost. Economic profit considers the opportunity cost as well. Economic profit once understood and brought into practice, financial decisions are made easy. An accountant measures the profit earned while an economist looks at what could have been earned. Thus, the litmus test behind any decision to raise, invest, or retain a Rupee must be to create more value than investing in an otherwise alternative investment opportunity of similar risk.

A positive EVA is the measure and reflection of a good management. A good management is one which can create value (for patients), give value (to patients and employees) and get value' (for themselves). To achieve this, management of the hospital has to deploy more and more capital to those activities wherein the amount of NOPAT generated by the activities is greater than the amount of WACC.

This is precisely the reason why pharmaceutical major Dr Reddy's Lab has been given the premium valuations by the market due to positive EVA. Nicholas Piramal, Dr Reddy's Lab, JB Chemicals use EVA model to monitor financial growth. Use of EVA in healthcare industry is quite rare. Knowledge, creativity, innovations and ideas are intangible assets of the hospital and are taken care in valuating economic growth through EVA model.

Adding Value to Your Capital Employed

• Process efficiency, six sigma, lean production concepts, evidence based clinical management, quality accreditation are definitely useful to the hospital but are not sufficient.
• EVA does not measure only economic profit, but is also a reflection of good hospital administration. A value-based healthcare delivery is in itself a good and ethical way of running a hospital. Only plush ambience will not add value to healthcare given to patients. Good medicine is good business, but good business is not necessary good medicine.
• Some strategies to make EVA positive for your hospital is to improve return on existing capital, reduce the cost of capital by adjusting the capital structure ie debt equity ratio to get maximum tax shield, investing in those departments or projects which give economic profit and not just accounting profit.
• Rapid turnover of inpatients. More day care patients.
• Hospital brand management.
• New market share— eg promotive health.
• New acquisitions which are having positive EVA.
• Reducing the bottom lines with capacity building.
• Equipment optimisation: To repair or to replace. To have best equipment rather than latest.
• Utilise idle assets.
• Avoid undue inventory in wards and OT.
• Value aligned hospitals need to empower managers at all levels to make better decisions, as if they were owners. EVA cannot be maximised by just focusing on money and machinery. Manpower management is equally important.
• EVA focused hospitals would first need to divide its activities into series of interlinked EVA centres and evaluating the opportunity cost of investment.

Conclusion

EVA is too sophisticated a tool. It is worthwhile to adopt relatively new concept in economics to judge the value added of your hospital which can be one of the real wealth creators.

deepalijunnarkar@hotmail.com
The writer is Joint MS in Inlaks & Budhrani Hospital, Pune