The Importance of Low Risk in ConstructionSenior Director and Infrastructure Lead, EMEA, at S&P Global Ratings
Pressure on construction markets in developed countries has been growing since the global financial crisis: Slower economic growth, high market fragmentation and competition, and low barriers to entry are all contributing to thinning margins. In such an environment, the temptation for management teams to slacken their risk-management policies, aggressively underbid on projects or even begin shrouding their bad debts within the balance sheet can become all too real.
The market has seen this firsthand. In January, Carillion—once the UK’s second-largest facilities management and construction services company and a preferred government contractor, boasting a 4 billion pound ($5.3 billion) turnover—filed for compulsory liquidation. Among the ailments in its diagnosis were significant impairments on construction projects and diminishing operating margins. Further, Carillion’s extensive use of the UK government’s supply chain finance (SCF) scheme as a source of financing, which was largely undisclosed, kept its fragile financial state under wraps for even longer.
Constraining Companies’ Risk Exposure
How can companies avoid this? The answer is twofold: Companies should strive to impose sound risk management policies, while also moving away from financial reporting strategies that deliberately intend to hide debts from public view.
Understandably, construction firms require solid risk-management practices. Under our criteria, among the factors underpinning a corporate rating are comprehensive risk-management systems and practices. Based on our analysis of rated companies, poor management and governance practices frequently feature as the leading causes of weakened creditworthiness in the longer term.
To not only survive but also thrive in the most competitive markets, such as in Europe, firms require a conservative approach to project selection and, of course, continued excellence in project execution. Here, there are notable performances: Operating predominantly in continental Europe, Austria-based Strabag SE is considerably improving earnings before interest, tax, debt and amortization (EBITDA) margins—to 7.7 percent in 2016, from 5.2 percent in 2012. Spain-based Ferrovial and Germany-based Hochtief also feature among this range. Trouble can arise when this isn’t adhered to. Over the past five years, Carillion’s EBITDA margin has consistently fallen below the 6 percent to 11 percent benchmark that we consider average for the construction sector in Europe.
Construction firms should resist plastering over the cracks in their balance sheets and, instead, focus on ways to ensure their competitive advantage.
Keeping Tabs on the Capital
For any construction company, equally crucial is the sound management of working capital. This is especially true during the initial phases of multiyear projects, when the upfront costs can cause significant cash disbursement. To mitigate these risks wherever possible, companies could seek advance payments from their clients—although this is not customary practice in every regional market.
In this respect, lessons can be learned from Carillion. To ease the pressure from suppliers requesting payment in advance, Carillion used reverse factoring—an SCF scheme delivered by the UK government, which allows businesses to both lengthen their payment terms to their suppliers and to receive invoice payments early.
However, Carillion seems to have used reverse factoring as a source of financing as well as an “early payment facility” by extending the payment terms and without quantifying the extent to which it used the facility—or the impact this had on its financial statements. So, while many UK companies find the scheme useful for ensuring sound liquidity management, for Carillion it served to hide a substantial part of its debt from view. With this in mind, we believe that regulators and auditors can do more for companies to disclose details of their use of payment facilities and SCF schemes.
The Call for Transparency
In a highly competitive market, construction firms should resist plastering over the cracks in the balance sheet and, instead, focus on ways to ensure their competitive advantage is crucial. Among the most valuable priorities is ensuring a low financial leverage—a key driver of new business in the construction sector.
Given that larger projects often last several years, project owners are likely to seek assurances that the contractor will be dependable throughout the contract’s lifespan. Among the factors that can best provide this assurance are a strong balance sheet, low leverage and a solid liquidity profile to withstand unexpected occurrences, such as significant cost overruns.
Now is the time for greater transparency. With corporate governance failings and aggressive risks being the most likely causes of default, regulators and audit committees can help. Dissuading companies from aggressive accounting policies would represent a positive first step.