CONCEPT TWO

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CONCEPT TWO

Analyzing and Boosting Creditworthiness

Xiao Liu 07/06/2007

Why Creditworthiness Matters

➢ Creditworthy organizations have access to credit enhancement, e.g. bond insurance

➢ Creditworthy organizations have access to both taxable and tax-exempt debt.

➢ Creditworthy organizations enjoy less restrictive bond document covenants.

➢ Creditworthy organizations experience lower costs associated with issuing their bonds.

➢ Creditworthy organizations are market consolidators.

External Factors Influencing Ratings and Access to Capital

➢ The financial effects of government efforts to reduce healthcare spending

➢ Revenue increases from commercial insurers are likely to slow

➢ Continued staffing shortages

➢ Regulatory compliance

➢ Increasing competition from physicians and for-profit companies

Organizational Determinants of Creditworthiness

Rating agencies and capital market, including institutional investors and bond insurers, conduct sophisticated and in-depth research and analysis on relevant data to evaluate the organization’s competition strength.

➢ Governance and management

➢ Market and strategic position

➢ Financial performance and debt position

◆ Debt position indicates an organization’s ability to repay debt.

◆ Financial performance determines an organization’s creditworthiness.

◆ Profitability Indicators (see then end of the document for indicator formulas)

1. Operating margin

2. Excess margin

3. Operating earnings before interest, depreciation, and amortization (DBIDA)

◆ Liquidity Indicators

1. Days cash on hand

2. Cash-to-debt ratio

3. Cushion ratio

◆ Debt Indicators

1. Debt-service coverage ratio

2. Debt-to-capitalization ratio

◆ Other

1. Average age of plant

2. Capital spending ratio

Key Reasons for Credit Rating Upgrades and Downgrades

Top five reasons for a rating upgrade

1. Improving financial performance

2. Market share gains

3. Significant economic event, such as the discontinuation of problematic business ventures

4. Growth in unrestricted liquidity

5. Favorable market characteristics

Top five reasons for a rating downgrade

1. Material escalation in debt burden

2. Decline in financial performance

3. Erosion of market share

4. Poor balance sheet management

5. Subordination of existing bond security with a debt instrument that has greater or increased security features

Conducting a Financial Credit Analysis

Use relevant national standards as benchmark to compare organization’s financial performance. Key indicators from S&P, Fitch Ratings, or Moody’s for similarly rated organizations to construct the necessary data chart.

Corporate Finance-Based Strategies for Credit Fitness

Use best practice corporate finance strategies:

1. Not-for-profit should act like GE: Organizations will be required to apply the basic principles of corporate finance.

2. Keep a close eye on the balance sheet

Hospitals should NOT follow the advice of some experts to be served by spending down cash, borrowing at a higher level, and accepting the resulting lowered bond rating, for eight reasons:

1. Hospitals should maintain a healthy respect for the capital markets.

2. Organizations need to protect long-term debt capacity.

3. Ratings are “sticky down”.

4. Pursuing the credit strategy described earlier exposes an individual hospital to significant additional credit risk.

5. Hospitals must ensure continued community true.

6. Investment performance may not stay as it is.

7. Hospitals need cash.

8. Hospitals should consider the impact on the industry’s credit platform.

Terms:

✓ Insurance bond (or investment bond): a single premium life assurance policy for the purposes of investment. Sarbanes-Oxley Act (2002).

✓ Covenants: a document specifying the rights of bond holders. In the U.S., federal and state securities and commercial laws apply to the enforcement of those documents, which are construed by courts as contracts. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document generally requiring approval by a majority (or super-majority) vote of the bond holders.

Key Creditworthiness Ratios

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Information reviewed in the rating process

✓ Organization, governance, and management: brief history, description of services, corporate legal structure, parent/subsidiary relationship and governance, board structure and members, and management biographies.

✓ Strategic/business position: Patient origin, market share, demographics, income levels, competition, payers, employers, unemployment rates, charity care, business/program/service mix, inpatient and outpatient utilization statistics, competitive costs/charges

✓ Financial status: Annual audited financial statements; financial feasibility study or management projections; sources and uses of funds statement; cash flow statement; consolidated debt-service tables and schedule; schedule of principal and interest payments for debt; capital leases and non indenture debt; pension expense

✓ Medical and nursing staff: Number, specialties, age, percentage of admissions, recruitment and retention plans and tools, nursing staff turnover and vacancy rates, salary and benefits structure of nursing staff, board certification of physicians, and union negotiation information

✓ Relevant business documents: Preliminary official statement, including Appendix A, strategic plan, capital plan, financial plan, budget for coming year, investment/debt policies, and swap documents

✓ Relevant legal documents: Master trust indenture, trust indenture, load agreements, accreditation report, and offering documents

Sources: Fitch Ratings. 2005b. Rating Process for Nonprofit Healthcare Credits. New York.

Moody’s Investors Service. 2000. An updated Approach to Rating Not-for-Profit Healthcare Organizations. New York; Standard & Poor’s. Not-for-Profit Healthcare: Inside the Rating Process. New York.

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