Most Common Mistakes Made in Financial Budgeting/Forecasting: Part II

In an ever-changing health care environment, the accuracy and effectiveness of financial forecasts have faced increased scrutiny and inquiry from health care entity boards and management teams.

As a result, BKD has developed a 3-part series to address the most common mistakes we see in financial forecasts prepared by health care entities.

In Part II, we examine common mistakes related to maintaining consistency among forecast assumptions. Part I addressed mistakes related to the effect of complacency on the forecasting process, while Part III will cover aligning the forecast with the entity’s overall strategic mission.

For many health care entities, the budgeting and forecasting process is completed over several months as the management team gathers input from department heads and other parties. Throughout this arduous process, it is easy to get lost in the details and forget the big picture.

Furthermore, department heads may provide input without knowledge of all other assumptions, leading to a final forecast that includes assumptions inconsistent with one another.

Specifically, consider the following common forecast oversights:

Lack of a Market Assessment

In addition to simply analyzing historical volume trends for the entity, management should complete an overall market assessment of the service area. Knowing the service area’s demographic trends can help management determine volume forecasts.

For instance, many rural hospitals face decreasing populations and declining inpatient use rates. To keep patient volumes steady in this scenario, the entity would need to increase its market share.

However, the opposite also is true, as an increasing population may help an entity sustain increasing volume levels without increasing market share.

Disconnecting Revenues and Expenses

Once the market assessment and volume/revenue forecast are completed, management should ensure the expenses necessary to support any changes in revenues are included in the forecast. Staffing costs typically are the largest cost incurred by a health care entity, and these costs should be evaluated in comparison to expected revenue changes.

Management can evaluate trends in ratios compared to industry benchmark amounts, including salaries and wages as a percentage of net patient service revenue and full-time equivalent employees per adjusted occupied bed.

In addition, analyzing the fixed and variable portions of expenses becomes essential as volume changes are implemented into a forecast.

Ignoring Debt Covenants

Management should ensure required debt covenant calculations, such as debt service coverage or days cash on hand, are incorporated into the forecast.

In addition to knowing the minimum levels required, management also should incorporate a higher “target” level for any debt covenants to allow for a safety cushion. If the forecasted results approximate the required covenant level, an unexpected event — even if relatively small — could send management reeling for a response.

Ignoring Cash Flow Budgets

Often, management teams fall into a trap of preparing a forecast to address the statement of operations, but ignoring the statement of cash flows.

Although preparing a full statement of cash flows is more cumbersome, “cash is king,” and it should never be ignored when preparing a forecast. Balance sheet items could have a large effect on cash flows, such as debt service requirements (including required reserve funds), capital expenditures, pension requirements and working capital changes, among others.

In addition, for capital projects that include additional debt, it is imperative to evaluate the useful life of the asset driving Medicare reimbursement compared to the term of the related debt, as the entity may end up in a situation in which it will be making debt payments in the future with no associated Medicare reimbursement.

In summary, management should consider how its forecast compares to the trend in recent historical years. Management should be able to qualitatively and quantitatively summarize the key factors causing any major fluctuations and should consider implementing a “1-time items” summary to disclose to users of the forecast how significant nonrecurring transactions affect year-to-year trends.

While avoiding the mistakes discussed above can help improve the forecasting process, these represent only a sliver of potential oversights management teams make in the forecasting process. Refer to Part I, discussing the effect of complacency on the forecasting process, and look for Part III, discussing the alignment of the forecast with then entity’s overall strategic mission.