Carillion’s demise has been, for many people been a bit of a shock. In the annual report published in March, a “viability” statement was signed off suggesting there was no reason to believe the company would have financial difficulties in the next three years.
Nevertheless, some external sources were sceptical.
Carillion had reported average margins of about 4%, double the normal going rate for the construction industry.
While some of this could be explained by the company’s mix of business, with potentially lucrative service contracts and high-margin work in the Middle East, it seemed suspiciously high to some investors.
And high-margin work is good, as long as you actually receive payment. Industry insiders say Carillion was owed about £400m from Middle East contracts when it fell foul.
Generally, in construction, it is common knowledge that when main contractors come under pressure, their first port of call is making subcontractors wait for their money.
Late payment is endemic in construction, but Carillion was making its suppliers wait 120 days.
There was other evidence too; stories in the trade press about the woes of angry subcontractors, which enough to give keen-eyed hedge funds reason to think that cash was tight at Carillion.
Carillion had plenty of debt – about £850m at the time of its last annual report – although this had grown much larger by the time of its demise.
But that figure did not give a full picture. To help speed payment to its subcontractors, Carillion, in common with other large contractors, used a system called the Early Payment Facility.
Its suppliers could take their invoice to one of Carillion’s lenders and be paid. The bank took a fee, and Carillion no longer owed the subcontractor, but the bank.
This sum was not included in the published debt figure, but was in the accounts under a different heading – if you knew where to look.
All companies that have long-term contracts have to wrestle with the tricky question of when the profits should be recognised in the accounts.
If they abide by the actual flow of cash from the deals, then the results would be very lumpy, with big losses early on followed, hopefully, by profits in the final years.
Accounting rules allow companies to smooth the profits out, but it is a matter of judgement. If the judgement is too optimistic, profits can be booked too early.
The accounting rules are changing, with a new standard (IFRS 15) coming into force this year. It will force companies to be tougher, matching reported profits much more closely to actual cash flows.
Source: BBC News
AT THFR we have assisted numerous construction companies who are continually wrestling with cash flow whilst trying to manage their business. If you need help, feel free to arrange a consultation.