Nonprofit Hospitals Rely on Financial Reserves Amid Operational Challenges

Financial reserves have helped nonprofit hospitals and health systems survive amid ongoing operational and economic challenges, according to a report prepared for the American Hospital Association (AHA) by Kaufman Hall.

Nonprofit hospitals generally only have two sources of funding. They can earn revenue from operations and investments or borrow funds through debt issuance in the bond markets or other forms of borrowing. With limited funding sources, nonprofit hospitals often rely on financial reserves to maintain stability.

Nonprofit facilities ended 2022 with negative operating margins, a trend that is expected to continue in 2023, according to Kaufman Hall.

The report looked at the primary functions within the financial structure of nonprofit hospitals, the functions’ role in generating financial reserves, and the significance of financial reserves in minimizing operational disruption and financial distress.

The financial structure of nonprofit hospitals and health systems includes the operating function, finance function, and 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 include 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 cash on hand is a common metric used to measure financial reserves.

In the first few months of the COVID-19 pandemic, cash flow was almost non-existent for many hospitals. Financial reserves helped 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 unable to reimburse hospitals for care already delivered, and increased labor costs.

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 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 operation 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 in relation to 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.

All three functions of nonprofit health systems’ financial structure suffered last year, and economic headwinds remain 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.

While financial reserves have served their purpose, the question has been raised if enough nonprofit hospitals and health systems have built sufficient reserves to support them through ongoing challenges.

“When these headwinds have subsided, rebuilding these reserves should be a top priority to ensure that our not-for-profit hospitals and health systems can remain a vital resource for the communities they serve,” the report concluded.