Best-Practice Capital Allocation and Financing

Abstract

ALLAN FINE AND J. ALEX BACCHETTI'S feature article, Capital Optimization, and Donald A. Carlson, Jr.'s feature article, Access to Capital, both address important issues that can significantly affect healthcare organizations' financial performance. The capital allocation decisions made today by an organization's senior leadership will affect financial performance far into the future. A best-practice capital allocation process ensures that organizations spend the appropriate, optimal amount of capital-not too little or too much-and that they spend it on a portfolio of initiatives that provides a positive contribution to the strategic and financial position of the organization. As described by Fine and Bacchetti, the initiatives selected must further the organization's vision and strategic direction, not simply placate the demands of squeaky-wheel constituents or carry forward historical allocation patterns. Given limited dollars for capital, overall organizational strategy and allocation of capital must be closely aligned and coordinated. An organization's ability to access the capital markets, the topic of Carlson's article, is dependent on credit ratings and overall creditworthiness. Best-practice financing or capital structure management balances long-term creditworthiness with the demand for additional debt and supports the organization's strategic plan within an appropriate credit context. Proper management of an organization's capital structure ensures access to required debt capital in the most advantageous form and at the best possible terms. For many hospitals and health systems, a carefully and creatively managed capital structure has become a competitive advantage. Over a 10-to 20-year planning horizon, the quality of an organization's capital structure can cost or save millions of dollars. THE SUPPORTING DISCIPLINE: BEST-PRACTICE FINANCIAL PLANNING Although the topics addressed in the two feature articles-how capital is accessed and how it is spent-may appear to some readers to be disparate in nature, they are in fact integrally related. The discipline that provides the glue is best-practice financial planning. In our experience, it is difficult, if not impossible, for organizations to conduct best-practice capital allocation or best-practice financing without also performing best-practice financial planning. The key principle of best-practice financial planning is this: financial performance must be sufficient to meet the cash flow requirements of the strategic plan and at the same time maintain or improve the financial integrity of the organization within an appropriate credit and risk context. Through the financial planning process, leaders ask and answer the following seven questions that are central to both capital allocation and capital structure management: 1. What are the organization's strategic capital requirements? 2. How much cash should the organization have? 3. How much debt can the organization afford? 4. What is the magnitude of the organization's capital shortfall? 5. What short- and long-term profitability targets are necessary to resolve any shortfalls? 6. What level of expense control or revenue enhancement is required to meet the profitability targets? 7. Where will the capital come from in the short and long term? Rating agencies, institutional investors, and the other capital market constituents described by Carlson expect senior executives to be able to answer such questions about debt capacity, capital constraint, and cash flow targets. Organizations with leaders who pose and answer these questions in a thorough, quantitative way through corporate finance-based financial planning will have a better chance of accessing capital over the long run and on their own terms and conditions than organizations without a disciplined process. In addition, organizations that perform corporate finance-based financial planning will be establishing a more appropriate platform for future capital allocation. …