Unit 1 Financial Management in the Construction Industry

Heriot-Watt University 1 D31CG

Unit 1

Financial Management in the Construction Industry

Learning objectives
At the end of this unit, you should be familiar with:
1. the concept of financial management in the context of construction contracts
2. the contribution of the construction industry to the world economy
3. why incidence of business failures is much higher among construction contracts or
companies than other businesses

Contents
1.1 Introduction
1.2 Importance of construction industry to the global economy
1.3 Reasons for business failures in the construction industry
1.4 Definition of some terms
1.5 Summary
1.6 Self-study questions

Recommended text for unit 1

Ross, A. and Williams, P. (2013), Financial management in construction contracting, 1
st
edition,
Wiley-Blackwell ISBN 978-4051-2506-2, Chapter 1.



1.1 Introduction

The opinion has been frequently expressed that the construction industry has a generous share of
economic problems. Each year the construction industry experiences a proportionally greater
number of bankruptcies than other industries. Frequently, in the trade journals, the national press
and elsewhere, statistics are quoted of bankruptcies and company liquidations which highlight
that a very large proportion of the total is accounted for by the construction industry. Alarming
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statements are made such as construction leads the bankruptcy league or construction
company failures largest of all. These statements are technically true but they are also
unnecessarily damaging to the public image of the industry. Construction forms the largest
industrial category (not subdivided in official statistics) and it does have a high proportion of
total failures, in fact slightly less than twice as much as any other category.

1.2 Importance of construction industry to the global economy

The construction industry is very important to the global economy mainly because of (1) its size,
(2) it provides predominantly investment goods, and (3) government is a major client.

It is one of the largest sectors of the UK economy contributing almost 90 billion to the UK
economy (or 6.7%) in value added, comprises over 280,000 businesses covering some 2.93
million jobs, which is equivalent to about 10% of total UK employment. The contracting
industry is the largest sub-sector of the construction sector, accounting for about 70% of total
value added generated by UK construction and almost 70% of the sectors jobs. Construction
products and services, although smaller in size, are also vital to the sectors performance and
generate substantial economic benefits. In 2011 some 16,000 UK-based firms alone, specialising
in architecture and quantity surveying services, accounted for about 4.2 billion in gross value
added. In the products sub-sector some 3,000 firms manufacturing metal structures and parts
generated almost 4 billion in value added in the same year.

Construction also has a much wider significance to the economy. It creates, builds and maintains
the workplaces in which businesses operate and flourish, the economic infrastructure which
keeps the nation connected, the homes in which people live and the schools and hospitals which
provide the crucial services that society needs. A modern, competitive and efficient construction
industry is essential to the UKs economic prosperity. Its contribution is also vital if the UK is to
meet its Climate Change Act commitments and wider environmental and societal obligations.

However, the construction sector has been affected disproportionately since the recession of
2008. In 2007 the construction sector accounted for 8.9% of the UKs GVA but by 2011 the
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sector contribution had decreased to 6.7%. The decline was experienced by all three sub-
sectors25. ONS data shows that in early 2012, the construction contracting industry.

Construction is an investment-goods industry, i.e. its new products are wanted, not for their own
sake, but on account of the goods or services which they can create or help to create. This is clear
in the case of factory building, where the factory is used to produce other commodities. In
another sense, too, the products of the construction industry are investment or capital goods, for
their values are high in relation to the income of the purchaser. Consequently, the products of the
construction industry are paid for out of capital, i.e. the purchasing power, which has accrued in
the past but not been used in the past. This capital may belong to the ultimate owner of the
construction industry product, or more usually, may be borrowed from elsewhere.

The importance of the public sector as a client (30 40% of construction demand) of the
industry also has far-reaching effects on the industry and the economy because government has
the means to exercise very direct control over demand on the industry and the way it is put to the
industry.

These three characteristics - size, investment-goods industry and dependence on government as a
client - provide the key to the inter-relationship between the industry and the economy. Problems
in the construction industry (business failure) can affect the economy in general. There are also
social costs of insolvencies to the owners, creditors, and employers of the firm. This is especially
so if there is direct government intervention to aid the failing firm. Therefore, it is not surprising
that considerable interest is being shown in the problems of the construction industry.

1.3 Reasons for business failures in the construction industry

Majority of construction companies are medium to small sized businesses, with many more sole
traders. They are all continually threatened with bankruptcy and the loss and distress associated
with it. When compared with other industries, the construction industry is not capital intensive,
being able to support a relatively high turnover in relation to capital employed. The interim
payments available to contractors and the delay of payments to subcontractors, suppliers and
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other creditors can considerably reduce the level of working capital required. A construction
companys investment in fixed assets largely depends on the type of work performed. Firms in
construction and road works may have a relatively high investment in fixed assets (nowadays the
majority of firms hire their plant needs from plant hire companies), whereas building contractors
have low investment (subcontracting the majority of the work). While this small dependence on
fixed assets frees cash for other assets, the companies with larger amounts of investment in such
fixed assets tend to be more financially stable.

The low level of capital employed usually enables contractors to operate with very low profit
margins (percentage return on turnover), whilst maintaining the standard return on investment. In
general, the construction industry shows a lower profit margin than most other industries,
averaging around two per cent. However, low levels of working capital and profit margin can
place a construction company in a vulnerable position. As a companys turnover expands, its
financial resources can become stretched and any unexpected fluctuations in working capital
requirements may cause problems. A proportionally small fluctuation in terms of turnover can
substantially affect the capital employed. For example, a ten day delay in interim payments, or
under-measurement of quantities by one per cent and not corrected until the final account (the
end of the contract) could drop the return on a contractors total capital employed by 25 per cent.
If this were to happen more than once, the effect may be disastrous - although the profit to
turnover ratio is unaffected.

The large number of construction firms starting-up each year means that many people become
part of the industry without having sufficient experience to ensure success. Consequently, there
is large number of business failures (i.e. free entry also implies free exit). This characteristic is
compounded by the high level of risk and uncertainty in the industry. Traditional methods of
tendering (i.e. the necessity to price the product before it is produced) and the uncertainties of
weather and ground conditions all contribute to the degree of risk.

The construction industry has other characteristics that strongly distinguish it from other sectors
of the economy. It is fragmented, very sensitive to economic cycles and highly competitive
because of the large number of firms and relative ease of entry. Given that cost is still the key
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factor for selecting the winning contractor, efficient contractors too can be put in a vulnerable
and risky position. These unique characteristics of the construction industry have contributed to
the high number of construction company failures.

The reasons for business failure in construction can be summarised as the following:

1.3.1 Low working capital requirement (often negative)

Contractors are usually paid before paying suppliers and subcontractors (i.e. the majority of
construction cost). A large percentage of the retention is offset by the retention held against
subcontractors. In addition, practices such as front end loading and over-measure enable
contractors to operate using a very small or even negative working capital. This leads to:

1. Difficulties in raising long term capital, which leads to:
Liquidity problems
High sensitivity to cash flow fluctuations, and
Too much reliance on short term credit facilities (e.g., overdrafts).

2. Unplanned expansion, which leads to:
Shortage of management resources
Shortage of operational resources, and
Increased sensitivity to cash flow fluctuations.

3. Ease of entry, which leads to:
(i) Inexperienced management, for example
Lack of efficient accounting systems (which includes forecasting, monitoring and
defining objectives)
Inexperience in identifying & winning claims and litigation
Failure to invest in future growth
Failure to control cash flow, and
Failure to encourage prompt payment by clients.
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(ii) High competition which leads to tendering at low prices and reduction in the share of the
market.

1.3.2 Sensitivity of the construction market to economic cycles

Unfortunately for the construction industry, the easiest ways for government to influence the
economic cycle are to:

Raise interest rates and restrict credit
Increase taxation, or
Cut down on spending.

The construction industry is affected directly and indirectly by these measures. In order to reduce
deficit and level of borrowing, government could act by adjusting the level of government
spending which directly affects the construction industry. During economic recessions, the
adoption of tax increases and raising of interest rates by government also go a long way to affect
the construction industry indirectly. This was sharply seen during the recent financial crisis
where the construction contribution to GDP in the UK dropped from 8.5% in 2008 to 5.9% in
2012 with total construction output dropping from 82 billion GBP to 69.5 billion during the
same period.

1.3.3 Characteristics of construction contracts

Construction contracts have unique characteristics, which distinguish them from other
businesses. These characteristics make the contracting business risky, difficult to manage and
vulnerable to bankruptcy. They include:

Each contract is large compared to total turnover.
Products of the industry are priced before production.
Contracts involve many variations and uncertainty. This can lead to claims, disputes and
litigation.
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It is difficult to measure profit of work in progress.

1.4 Definition of some terms


I nsolvency is defined in the Oxford English Dictionary as having insufficient funds to meet
debts and liabilities. Insolvency may be technical or legal. Technical insolvency is where a
company does not have time in which to realise its assets in order to pay creditors. Legal
insolvency is where a company could not pay all its creditors even if all its assets were realised.
The terminology surrounding the subject can easily lead to confusion. A few definitions may
help explanation of the issue.

Bankruptcy relates to the insolvency of an individual person i.e., any individual person owning
debts of more than a set amount (the amount may vary with time and between countries) can be
made a bankrupt if they are unable to satisfy those debts.

Liquidation also known as winding up relates to the insolvency of a company and it is the
process by which the life of a company can be brought to an end by a liquidator, usually when it
is unable to pay those debts.

Receivership relates to the insolvency of a company where a receiver is appointed to protect
assets on behalf of a secured creditor for whom those assets represent his/her security. The
appointment of a receiver does not bring the company to an end. Usually, the receiver will
continue the business for a while in order to sell it or re-organise it so that it can still trade when
receivership has been concluded, for the benefit of the creditors.


1.5 Summary
This unit introduced the concept of financial management in the context of the construction
industry and considered its benefits to the industry as a whole. It also presented reasons why
there are reports of bankruptcies in the industry more than any other sectors of the global
economy.
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1.6 Self-assessment questions
What is the meaning of bankruptcy in business terms?
What are the main reasons for the high rate of insolvency in the construction industry?
Why could many construction companies operate with a very low working capital?
Why is the construction industry considered to be very important to the general economy
in most countries?


References

Department for Business Innovation and Skills (2013), UK Construction: An economic analysis
of the sector, July 2013
Office of National Statistics UK www.ons.gov.uk