Construction company balance sheets and business models
February 20, 2024
Just as you can’t judge a book by its cover or guess a packaged gift from its shape, assessing the commercial risk of trading with a construction company by the figures in its balance sheet will not reveal the whole story. You also need to understand the company’s business model and the degree of ‘subjective’ valuation it creates. Here, we take a look at what this information can tell you about a business.
Overall balance sheet structure
Funding strategy
Is funding through equity or debt, or a mix of the two? Traditionalists favour equity because the risk is locked in for the provider, whereas using leverage can mean there are a variety of ‘exit ramps’ for the lender and the opportunity to secure the debt with the company’s assets but thereby reducing the recovery prospects for other stakeholders, especially suppliers.
If leverage is significant, is the source internal through shareholders or external from third parties? Has the lending come into a UK-registered entity with normal commercial transparency, or has it been introduced through an opaque offshore structure? Are the repayment terms onerous?
‘Zombie’ companies
In theory, a company with a negative balance sheet is technically insolvent but can continue to trade if it can pay its debts. The key question is why a company is a zombie.
Consider:
- Is the deficit intentional and is there a plan to repay the debt if necessary?
- What is the impact of the hike in interest rates on the business’s viability?
- Has the deficit been caused by trading losses and why hasn’t additional equity been injected to correct it?
Our research shows that currently, 7% of all UK construction companies are zombies with a combined shortfall of £3.3bn.
Negative working capital (NWC)
Are the company’s short-term liabilities (due within a year) greater than the value of its easily realisable ‘quick’ assets such as cash, debtors and inventory? This is another recent trend, but it can reveal an excessive reliance on short-term funding such as overdraft facilities, or else a fall in activity levels but no equivalent reduction in borrowings.
9% of the UK construction industry currently has a NWC position with a combined deficit of £7.2bn.
Find out more about the current state of the UK construction industry in our recent sector report.
Valuation issues
Intangible assets
The most likely component of this heavily subjective part of a construction balance sheet is goodwill from acquisitions, where a business has been bought for a sum bigger than its net worth, usually based on its future earnings potential. What if profits and viability have deteriorated? Is this being acknowledged by suitable impairment write downs or are unrealistic values being preserved by unjustified ‘blue skies’ thinking?
Contract values
This is probably the biggest uncertainty. At any point in time, the value of an ongoing contract can be reflected in at least three items within current assets:
- work done and billed but not yet paid (debtors)
- work done but not yet certified or billed (work in progress)
- contractual deductions from payments (retentions)
Overlaying all of this may be the need to make provisions for known future losses on the contract. The longer term the contract, the greater the risk of unforeseen future losses.
One experienced consultant specialising in contract valuation has listed fourteen different questions an auditor should ask and obtain satisfactory responses before signing off on these balance sheet items, many of them calling for subjective judgments.
Trends and ratios
A key question is not just the trend for major balance sheet components such as contract value, but how they relate to movements in activity levels. Broadly speaking, if revenues are falling, current assets and liabilities shouldn’t be rising, nor should the number of trade debtor or trade creditor days outstanding be increasing. An exception could be a housebuilder, where current assets might be increasing because of a strategic decision to increase the size of its land bank.
The reasons for cash/debt level changes should also be clear. Inexplicable movements within a succession of balance sheets published by Carillion were sufficient to tip off a hedge fund manager in the US to underlying issues long before the business’s severe problems became headline news in the UK and ultimately caused its collapse.
Market considerations
The commercial health of different segments of the construction market change from time to time, so it’s important to understand the implications of a company’s different exposures. The prospects and financial health of players in these segments ebb and flow, sometimes significantly.
Right now, a heavy dependence on local authority contracts might be a red flag, given the parlous state of local government finances. Equally, involvement and heavy investment in central government infrastructure projects has been proved to be questionable, not least for some HS2 contractors. Commercial real estate, in particular offices, has been destabilised by the uncertainties of the work from home phenomenon. Some elements of the retail market were badly affected by the pandemic. Reliance on a single or a small number of major contracts is another warning sign.
Using outside experts
However experienced in the sector a management team might be, standing back to take a broader and more objective view of a risk or finding the bandwidth under day-to-day pressures to do so can be challenging, especially when the construction business concerned is a significant trading partner. There’s no shame in calling in experienced experts nor is it an unjustified cost. Getting the call right will turn them into a major net benefit.
If you are seeking professional advice for your business, Opus is here to help. You can speak to one of our Partners who can discuss options with you. We have offices nationwide and by contacting us on 020 3326 6454, you will be able to get immediate assistance from our Partner-led team.