Is Your Hospital Truly Profitable?
Economic value added can be applied to the entire organisation
or its individual departments
is essentially the surplus left after making an appropriate charge for
the capital employed in the
- Dr Deepali Junnarkar Roy
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
- 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.
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.
The writer is Joint MS in Inlaks & Budhrani Hospital, Pune