Alternative Financing - An Alternative Remedy For The Ailing Healthcare System

Look at almost any report on a medical device market and two phrases will almost certainly occur: “Increasing cost constraints on the healthcare market…” and, “The new technology will be relatively expensive…” To paraphrase an old saying this leaves both the customers and the manufacturers of medical equipment between ‘a rock and a hard place’ with the customer struggling to afford to purchase the equipment they need and the manufacturer struggling to lower the price of their equipment sufficiently for the customer to afford it. The result of these pressures has been an explosion in co-operation between purchasers and vendors of medical equipment to find methods of payment that are acceptable to both parties. In a process akin to the Big Bang the pressures on the market have spawned a wide variety of different financing options that is both varied and complex.

The various methods of equipment acquisition can be broken down into three main types:

None of these methods of acquisition are suitable for every situation and each of them has their own advantages and disadvantages. Depreciation of the equipment and the difficulties associated with needing to upgrade technologies while still paying off interest on loan purchases have made leasing arrangements for expensive medical device capital equipment a more favourable option for purchasers.

Acquisition through leasing

The growth in leasing medical devices arose from the realisation that much of the value of a medical device arose not from its ownership, but through its use.

Fundamentally, leasing is defined as an agreement whereby the lessor (the owner of the asset), conveys to the lessee (the person who will be using it), in return for a series of regular payments, the right to use an asset for an agreed period of time. Within this concept of the customer making regular payments for the use of a medical device there are a number of different options available, the major ones being:

Financial leasing

A financing arrangement whereby a Lessee can acquire use of an asset for most of its useful life. Rental payments over the lease term are sufficient to enable the Lessor to recover the full cost of the equipment, financing charges, plus costs. This technique means that the equipment must be included in the customer's balance sheet, and amortised in accordance with the company's depreciation rules. The financial commitments take the form of long-term debt on the balance sheet, similar to a cash loan. At lease termination it also provides a Fair Market Value, fixed price or a $1 purchase option for the equipment.

Operational leasing

Essentially this is any leasing arrangement that doesn’t fall under the definitions of a financial lease. It is commonly used to acquire equipment on a short-term basis. The accounting treatment for an operating lease is straightforward for both the lessor and the lessee. The lessee has incurred an operating expense, so the lease rental payable is written off in the profit and loss account. The lessee has to disclose in the notes to the accounts the amount charged in the year and the amount of the payments to which the entity is committed at the year end. At the end of an operating lease term, the customer has the option either to purchase or renew at the product's then current Fair Market Value (FMV) or to return the equipment.

Due to the obligations associated with ownership of the equipment it is important to be aware what type of leasing arrangement is being entered into and whilst there is occasionally national legislation that helps with this definition one test that is frequently used is the 90% test. With this, if at the inception of the lease the present value of the minimum lease payments amounts to substantially all (90% or more) of the fair value of the leased asset (this normally equates to the cash price), it is presumed to be a finance lease, if not, it is an operational lease. However it is often commented that this test is over relied on in practice and it should be used as a guide and not as a rule.

Financial and operational leases are the main leasing categories but within these there are many other types in use. As Mr Kyin Lok, National Sales Manager of the Vendor Finance Division of U.S. Bancorp Equipment Finance Inc. said, “Medical equipment leasing is not that different from regular vendor leasing and finance, operational, dollar buy outs, sale leasebacks (although this is less in the medical situation) and bundle leases, where service contracts are included, are all used. In fact Medical leasing can be one of the more creative areas of the industry.”

One of the areas where the acquisition of medical devices does tend to differ from that of other types of equipment is in the area of tax. In Europe, a directive, 77/388/EEC, was established to harmonise the laws of the Member States relating to turnover taxes so that there were common systems of VAT assessment. Within this directive Annex H lists supplies of goods and services to which reduced VAT rates may be applied. Within this, medical devices are listed and therefore the amount of VAT payable on medical devices is often lower than the standard rate, but the VAT rates vary from country to country, and whilst in some countries medical devices are VAT exempt in other countries VAT is applicable but its rate is dependant upon the classification of the person the device is intended for. For example, in Italy, the visually impaired are divided into two categories: the blind or legally blind with a visual residual acuity up to 1/10 and the partially sighted with a residual visual acuity ranging from 1/10 to 3/10, and there is an application of 4% VAT, for the blind and legally blind, instead of the ordinary 20% on all devices for the disabled.

Despite the lack of uniformity in tax implementation and the accounting implications of leasing, internationally this option, as an alternative to outright purchase of medical equipment, is continuing to grow. For example, within the National Health service of the UK the use of operating leases has seen steady growth and now accounts for approximately 5% of its annual non-pay expenditure, some £500million, and most NHS trusts now have a leasing portfolio although its composition will vary dramatically from one hospital to another.

The private sector in the UK is also seeing growth, but the extent of its use varies greatly, as Mr Malcolm Granger, Director of Walm Lane Nursing Home, in London said, “Leasing is certainly an option that we have used in the past, certainly when setting up, but we have now been in business for long enough to build up substantial capital and so why bother to lease? Its faster and more efficient to purchase outright the kind of equipment we use, especially because it tends to have a long functional life.”

Leasing medical equipment is clearly not suitable for everyone and a customer needs to evaluate all the pros and cons before choosing their acquisition route as indicated in Figure 1.

This very brief introduction to this evolving sector of equipment purchase and financing will be considered in greater detail in a forthcoming Strategy Review to be published in April and a further discussion of the topic and report findings will be available in an Executive Summary to be made available on the HBS Consulting website in the next few weeks.

Author: Dr Duncan Fatz, Consultant