Why construction businesses fail

But what happens when these key controls are compromised? And how can a construction company and its stakeholders find themselves in severe difficulty – past the point when corrective action should have been taken?

It is surprising given the buoyant market and ten consecutive years of growth that the UK construction industry is expected to see the highest level of business failures for a decade in 2006, up 20 percent on the annual average.

In recent years, growth has been fuelled by significant increase in government spending on schools, transport and health, including large projects such as Heathrow Terminal 5 and rail/tube upgrades. However, this level of growth is unlikely to continue as the government is reining in public sector spending in order to reduce the budget deficit.

And these current projects have not been without difficulty, mainly due to aggressive bidding and a lack of experience of ‘end-to-end’ delivery of complex PFI projects. For example, it has been reported that Jarvis experienced problems on various education and health schemes as it continued winning contracts without ever having seen one through from end-to-end. It is also widely reported that Mowlem experienced significant issues with the Bath Spa and Dublin Port Tunnel projects.

These instances show that the construction industry is a challenging one to operate in, even for large companies. By their very nature, construction businesses offer low financial returns. They typically have an operating margin of 1-2 percent, which equates to an operating profit of €1.4-2.9 million for every €146 million of turnover, leaving very little margin for error.

Thin profit margins, fierce competition, risk of overtrading, unpredictable cash flow, regular contractual disputes, challenges with fixed price contracts, and the increasing complexity of PFI contracts adds up to a tough operating environment. If you also factor in companies that chase business outside their areas of expertise or in new geographies, and those targeting trophy contracts to boost profile and revenue growth, further pressures and challenges would seem inevitable. This applies even to those, which, on the face of it, appear to have strong balance sheets.

For example, Multiplex moved into the UK market and pursued the Wembley contract. It agreed to a fixed price contract with reportedly tight margins, even though it had a less mature relationship with the construction supply chain in the UK. UK subcontractors have become more sophisticated in recent years and Multiplex has experienced its fair share of difficulties, with its dispute with Cleveland Bridge being a high profile example.

With around a €146 million reported loss on the Wembley contract at June 2006, Multiplex is pursuing claims against various third parties as it tries to recover some of the additional costs incurred. A highly leveraged balance sheet within the construction arm of Multiplex and significant cash outflows, particularly in the UK, have drawn attention. However, the construction division is supported by a strong parent company and so is able to weather contract losses more easily than some.

Jarvis is another example. It entered the PFI arena with limited previous experience and has reportedly made losses on a significant number of contracts. It also highlights the importance of focussing on the link between profitability and cashflow. On paper, Jarvis was profitable, but in truth these profits masked the cashflow problems that Jarvis was later to experience. Strain was evident within Jarvis due to reputational damage from the Potters Bar train crash, along with adverse PR regarding delivery issues on school PFI contracts and slow payment of subcontractors. Under the surface, operational and management issues were alleged to be even more significant, with poor financial controls and loss-making, high-risk contracts increasing the cash flow burden. It was reported that negotiations with the financial stakeholders – necessary to achieve a stable platform for restructuring ¬– were complex and drawn out.

Mowlem is another example of a seemingly profitable business (despite falling margins) experiencing significant cash outflows that were causing liquidity issues. Three profit warnings were issued in the eight months to February 2005 and there was adverse publicity regarding its management and its aggressive accounting policies. However, a change in management in early 2005 led to significant improvements. It was reported that prompt action was taken to address issues by appointing professional advisors, reviewing accounting policies, and opening communication lines with banks. An asset write down of around €102 million was booked in September 2005, primarily as a result of aggressive profit recognition on contracts. Following the Carillion takeover further losses emerged, but the position now appears to have stabilised.

There are various warning signs that point to a business in trouble, including aggressive revenue recognition policies, the ability to convert operating profits to cashflow or not, cost overruns, programme delays, and poor financial reporting and systems. If some or all of these issues persist, a business will find itself in a cash crisis that can lead to business failures if not remedied quickly.

The recipe for success in this industry is strong risk management procedures, prudent accounting policies and a stable and skilled workforce. A construction business survives because of the reputation of its people and sound commercial practices, both of which take time to build but only a moment to demolish.