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“Access to external capital is a major factor in the survival of any organization, especially of organizations as heavily dependent on emerging technologies as health care providers (McLean, 2003, p.281). Explain in detail how health care organizations determine the need for, acquire, use, and pay back external capital requirements. Include, in your analysis, necessary financial ratios, as reported for Standard and Poor and/or Moody’s financial services, to maintain the S & P or Moody’s highest ratings.”
(10475)
The need for external capital arises when an organization has a project that requires large amounts of money now and promises to produce a cash flow stream in the future. The organization either does not have enough internal capital in which to fund the project, or if the organization does have sufficient internal capital, it does not wish to use this for the project.
The promised future cash-flow stream will usually be much more than the net present value of the capital required now (for-profit organization), or will be enough to sustain the project and pay back the cost of the external capital (not-for-profit organization). Another reason why an organization may wish to use external capital is in order to refinance an existing source of external capital, e.g. a loan.
Ideally, apart from the promise of future cash flows, the project will also fit the organization’s strategic goals in its pursuit of its mission. In reality, often the politics and personalities within the organization impinge on the decision to pursue a project. For the purposes of this paper it is assumed that the project has already been approved.
In determining the need to take on external capital the organization should consider what type of healthcare organization they are, the environment they do business in, the industry characteristics, and the different methods of obtaining capital and their associated costs, e.g. short-term borrowing vs. long-term borrowing, issuing shares. The optimal capital structure for the organization will be one that minimizes its weighted cost of capital, thus maximizing its value.
The choices of external capital available to a healthcare organization are no different than that for organizations in general. Just about all types of external capital sources fall under one of two categories, debt or equity. Debt instruments are usually an obligation to repay a specific amount with interest at a date specified in the future, while equity instruments are an entitlement to ownership and any dividend payments on that ownership (Allis, 2005). The major types of equity instruments are common stock and preferred stock, while the major types of debt instruments are debentures, secured bonds, and bank loans.
Common stock is “equity securities representing ownership in a corporation and provides the holder with voting rights and the right to a share of the company's residual earnings through dividends and/or capital appreciation” (The Corporate Library, 2005). In contrast, preferred stock pays dividends at a set rate (e.g. annually), and the dividends must be paid before any dividends are paid to common stock holders. However, holders of preferred stock usually do not have any voting rights (Environmental Investors Network, 2005).
Debentures are bonds or promissory notes that are secured by the general credit of the issuer, but not secured by any specific assets of the issuer. That is, an organization borrows money and promises to regularly pay interest, and at a specified time pay back the original loaned amount (Wikipedia, 2005). In contrast, secured bonds are bonds that are backed by cash flow from another asset. A bank may also loan an organization money, however the organization typically needs to provide guarantees (security of assets) in case their ability to repay the loan is compromised.
Equity instruments have the least obligation on the organization’s cash flow, especially common stock, as there is no legal requirement to an annual dividend. Not having to pay back the amount invested is an advantage, however in issuing stock the owners must dilute their total ownership of the organization. Debt instruments require no dilution of ownership, but do require a regular outflow of cash to pay interest (or interest plus principle). The advantage to the bond-holder is that if the organization fails then they are senior to stockholders in payout (Overview of the Financial System, 2005).
When making the decision on which type of external capital to pursue, the board (or owners) will consider all these advantages and disadvantages above, as well as:
Usually organizations will try and use debt rather than equity instruments in order to access external capital. This is because “going into debt is still less expensive than selling equity and sharing profits.” (Roderick, 1990). There are many theories about why organizations will choose debt or equity. Dittmar & Thakor offer that there are two explanations currently in vogue as to why an organization will choose equity over debt:
“One is that managers time equity issues during periods of overvaluation in order to exploit irrational investors, and the other is that periods of low information asymmetry happen to coincide with periods of high stock prices. We propose an alternative theory … that managers use equity to finance projects when they believe that investors’ views about project payoffs are most likely to be aligned with theirs, thus maximizing the likelihood of agreement with investors. Otherwise, they use debt.” (Dittmar & Thakor, 2005, p.2).
Once a decision has been made to acquire capital (no matter which method), then how is the capital acquired, used & paid back? If the decision is to issue bonds, the first step is to engage a specialist in bringing bonds to the market, as the lead to the financing team, and advisor to the issuer. This may be an investment banker. The investment banker will meet with senior management to discuss the project and state of the financial market, and decide on who will make up the financing team.
If the organization is not-for-profit, then they may require approval from a government organization (e.g. state CON authority in the US). The specialist will arrange the documents required to gain this approval. The specialist will also contact the appropriate bond-issuing authority and work with it to ensure that all necessary legal work and paper work is done. If the bond is to be tax-exempt, then the specialist will arrange for a bond counsel to review and make the applicable statement.
A certified public accountant may be engaged by the specialist to conduct a feasibility study. The feasibility study will describe what the funds gained by the issuer will be used for, and present a pro forma financial statement. This financial statement will be audited, and the feasibility study signed off by appropriate legal advisors to indicate that all applicable regulations are covered. The specialist will also help the issuer to produce a prospectus for the bond, which if relevant will contain the bond counsel’s statement.
The specialist will then help the issuer to go through the rating process. As part of this they will assist the organization in preparing all the necessary documents to submit to the rating agency. There are two well known international rating agencies – Moodys, and Standard & Poors. Moodys do not specify any particular financial ratios that they focus on, instead they state that their approach to rating is to “analyze fundamental factors that will drive each issuer’s long-term ability to meet debt repayments” (Moody, 2005). Standard & Poors rating agency state in their methodology document that they will look at the following key measures (all measures taken from Rating Methodology: Evaluating The Issuer):
Profitability (p. 23):
Primary Fixed-Charge Coverage Ratios (p.23, 24):
Capital Structure / Leverage and Asset Protection Ratios (p. 24)
Of all the ratios measured by Standard & Poor’s, they state that cash-flow analysis is the single most critical aspect of all credit rating decisions (Rating Methodology: Evaluating The Issuer, 2005. p. 26). The Cash Flow ratios employed by Standard & Poor’s are:
At this point the term structure of the bond can be determined and an underwriter will step in (who may also be the same investment banker who performed the specialist function). They will supervise the preparation of an initial prospectus, and circulate this to potential investors. Once the offering date nears the underwriter and the issuer will meet and set the interest rate as well as agreeing to the set proportion of par value that the underwriter will cover. All data is checked and the final prospectus is printed.
The underwriter will “make a market” through announcing their intention to maintain an inventory of the securities, and posting bid and ask prices for the foreseeable future. This will bring confidence to investors.
If the organization plans to issue stock, then the following steps are usually undertaken. The Board of Directors must approve the offer, including the conditions of sale, and ensure that any legal requirements are met. This will be documented in Board resolutions. In some cases the approval of existing shareholders is also required before any new stock is issued.
The actual requirements will be detailed in the Articles of Association / Incorporation, including any minimum amount required to be authorized in order to allow the sale to proceed. The next step is to ensure the offering is in compliance with securities laws, and to choose the route that is most cost effective for the organization. After this has been done, a legal agreement detailing the conditions of the sale must be prepared.
During the preparation phase, the organization needs to review how the stock offering may affect any future effort to access external capital. Of course the organization should endeavor to keep as many options available to itself in the future as possible. The price and number of shares to be issued needs to be decided, and any required filings with the appropriate government institution made. Finally, the company will issue stock certificates once the sale is made (All Business, 2005).
There are various strategies that a hospital can use to influence the market that they are capable of taking on more risk and are a good investment option. Generally, when competing for funds they need to ensure that they have properly prepared the information that will be required by providers of funds, clearly showing the use of the funds, the interest or return to the provider of funds, and addressing any potential risks that may affect the ability to provide promised returns to the provider of funds.
In summary, organizations determine the need for external capital according to their strategic plan and financial status. They usually have a project they wish to pursue which promises a healthy future cash flow but which requires a large capital injection in order to get going. Organizations may acquire, use and pay back external capital using a number of different methods, which may be categorized into either debt instruments or equity instruments.
Debt instruments require that the organization make regular payments from cash flow to pay back the borrowed amount plus interest. Equity instruments do not require the organization to pay back the money invested, however the owners must dilute their ownership. The method used by an organization will depend on a number of factors including their financial condition, goals, business environment, and external capital availability. When issuing bonds to access external capital, an organization may choose to have the bond rated through a well known rating agency (e.g. Moodys, Standard & Poor’s), and these agencies will require detailed information on the applying organization in order to perform ratio analysis.
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