Monitor's regime will create mini "Enrons"

There is something wrong with Monitor's regime.  For a Foundation Trust to maintain adequate financial performance (as measured by Monitor's Financial Risk Rating published in its Compliance Framework), it has to carry on investing in capital to unsustainable levels.

This is best illustrated by a worked example.  Let us take a Foundation Trust.  Let us call it Smug, Cocky and Overly-Aggressive NHS Foundation Trust, or  SOFT for short.  Some change the "Overly" in SOFT's name to "Ultra" and get a new acronym.  Being a family friendly blog, we do not use such language.

SOFT is pretty typical DGH: serving a population of 350,000 people; 600-700 beds (depending on whether you count ICU beds, cots, day wards etc); 60-70,000 inpatient and day-case spells; 3,000 staff.  In terms of finances, it has an income of £200m; and an asset base of £142m - £100m in terms of land and buildings which do not depreciate; and £42m in terms of assets that need renovation, which depreciate.  This latter category - let us call it Plant & Equipment for simplicity, depreciates over 12 years - and since £42m is the net book value not the gross book value, the depreciation charge each year is £7m.  SOFT is an acute trust; but that is academic- the principles apply to mental health trusts as well.  There are those who maintain SOFT is a bit mental.

It is also assiduous about maintaining its Financial Risk Rating (see figure 1).  It tries to achieve a safe "3" by targetting the mid-point between the 3 and the 4 on each financial criterion.  The first financial criterion is "Achievement of plan" as measured by proportion of planned EBITDA actually achieved.  For this criterion, an achievement of 70% would qualify for a 3 and an achievement of 85% would qualify for a 4.  So SOFT targets 77.5% (mid-way between the thresholds for 3 and 4).  The second financial criterion is "Underlying performance" as measured by EBIDTA margin.  For this criterion, an achievement of 5% would qualify for a 3 and an achievement of 9% would qualify for a 4.  So SOFT targets 7% (mid-way between the thresholds for 3 and 4).

Figure 1: Derivation of Monitor's Financial Risk Rating (from Pg 23 of Compliance Manual)

And so on.  For the two criteria measuring "Financial efficiency," SOFT targets 4% for Return on Capital Employed, and 1.5% for Income & Expenditure Surplus margin net of dividend.  For "Liquidity"  SOFT's Director of Finance - let's call him Mr Mohs - targets 20 days.

All of this calls for a spreadsheet.  The summary of the worked model of SOFT over 10 years is presented in figure 2, and the fuller model is available here.  Please note that some further assumptions had to be made to complete the analysis, e.g., SOFT's income growth rate; other balance sheet items.  They are not critical to the analysis, and SOFT has some generic numbers.

Figure 2: SOFT Financial History - 10 year summary

Mr Mohs does not like cash accumulating on his balance sheet and authorises all excess cash to be spent on plant & equipment (line 25 on the spreadsheet); maintaining cash balances (lines 29-30, in the fuller model).  In fact, spending this excess cash on excess capital is the only thing he can do, as if he spends excess cash on operational items - it messes up his criteria for the following year, making it hard to achieve the target.

One issue that needs to surfaced is that both EBITDA margin and I&E Surplus margin cannot be independently controlled by anyone - let alone Mr Mohs, who is often a passenger in a boat he is meant to be steering.  He is a bit passive-aggressive and is prone to sulking; but I suspect that you are not reading this for a character description, so we will continue.  Mr Mohs, therefore, tries his best to trade off between the two.  And as depreciation increases over time, he works hard to increase the EBITDA margin.  You will agree that Mr Mohs has done a good job walking this tight-rope.

So, now we come to the key problem.  Under this scenario, SOFT keeps accumulating capital.  Within 10 years, its plant & equipment capital base has almost doubled from £42m to c. £75m (line 34 in the fuller spreadsheet); and as a ratio to its income, plant & equipment has gone up from c. 23% to c. 32%.

And this is where the parallel to Enron comes.  Soon SOFT and Mr Mohs run out of solid capital projects to fund; and in any case operational issues are piling up.  Slowly, the line between capital and expense begins to get blurred, and things begin to get capitalised that would/ should not be capitalised.  i.e. like Enron, balance sheet games are driving P&L performance.  And like Enron, soon SOFT would not be able to withstand a forensic balance sheet review.

And that is how Monitor's financial regime may end up creating mini "Enrons."

The problem gets much worse if Mr Mohs and SOFT target a 4 on Monitor's financial criteria.  That is the problem Cancer and Arrogance NHS Foundation Trust (CANT) face.  Given their heavy capital investment e.g., in LinAcs, and their arrogance, they have a much higher EBITDA than others, and target a 4.  I hope to return to this micro-topic of why Monitor considers EBITDA a better indication of underlying performance than EBIT at a later date in the blog.  It may be because Monitor is a bit dominated by pseudo private -equity types.  See - I am getting into that already.  We will return to CANT's problems at a later date.

I would also like to address what the solution to this problem is at a later date.  But to do that - I need your comments.  Does this chime with the way your Foundation Trust works?  And have you eroded the capital/ expense thresholds?