Financial performance of companies in the construction sector

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Part 1: Introduction

The purpose of this paper is to explore the differences between two firms of the construction sector that present contrasting business models in one specific dimension during the period 2005-2011, and further analyse the determinants that shape their productivity and profitability. The selected dimension is the Turnover/Current Assets ratio, and the aim is to further explore how this ratio affects the two firms as well as their business models.

Part 2: Practical Business Context

2.1. Situation of the Construction Sector in the UK

The second half of the last decade was marked by unprecedented economic fluctuations, mainly due to the onset of the financial recession in 2008. These changes have affected severely companies’ profitability and productivity in the United Kingdom, and a number of other European countries (Myers, 2013).

Figure 1: Productivity across countries and in the UK, during 2001-2011

(Haghes and Saleheen, 2012)(p. 139)

The Construction sector in the United Kingdom, which represents 6,8% of the Gross Domestic Product (GDP), followed the same profitability and productivity patterns as the rest sectors of the British economy. The most significant reasons for this large fall in output are the reduced infrastructure requirements, due to the turbulent financial environment, and the inability of smaller firms to adjust to these changes on time, which minimised their revenue (Oulton and Barriel, 2013).

2.2. Description of selected firms and their industries

The two firms that have been selected according to the Turnover/Current Assets ratio are Seddon Property Services Limited (high ratio value), and Watson Steel Structures Limited (low ratio value).

Seddon Property Services Limited is a British Private Limited Company, engaged in the painting, decorating and pre-paint repair contractors. In April 2013 it changed its name to Novus Property Solutions Limited. It is considered a large firm in its peer group, and it has been associated with numerous diversified projects (Seddon, 2013).

According to the Annual Business Survey (ABS) of the Office for National Statistics (ONS), the firm’s industry (SIC: 43,34 – Painting and Glazing) faced the same consequences as the rest of the Construction sector. The industry’s growth peaked in 2008, followed by a sharp diminish in all financial aspects, including total turnover, purchases, and employment, resulting to a vast reduction of the industry’s size. Therefore, Seddon Ltd altered many aspects of its strategic management after 2008, in order to maintain its market share.

Watson Steel Structures Limited is a British Private Limited Company, engaged in the design, fabrication and erection of structural steelwork. Since 2011 it has been a member of Severfield-Rowen Plc. It is regarded a large specialist steelwork company, however it consists of fewer employees than the average company of its peer group, mainly due to its highly automatic work production (Watson, 2013).

According to ABS, the Steel industry (which is part of the larger sector ‘Other specialised construction activities’ – SIC 43,99) suffered severely, due to the financial recession. During 2008-2009 the industry’s total turnover was reduced by a massive 39%, and the enterprises within the industry were reduced by 10%. Even though the company continued to raise slightly its turnover, its net profit suffered losses, since at that time the company’s management involved increased risk, and acquisition of trade credit.

Part 3: Literature review of the theory on ratios

3.1. Asset Management

Asset management is the process of using efficiency, effectiveness, and efficacy in order to manage a firm’s assets, so that they add value to the firm’s purpose. Assets are categorised to current and fixed, depending on their nature and purpose. Their sum represents the firm’s total assets (Bull, 2007).

The Asset Turnover ratio indicates how efficiently total assets are used in order to generate sales (Collier, 2010). It is calculated as:

This ratio is specifically important for growth firms, as it provides a benchmark to check if they are growing revenue in proportion to assets (Holmes et al, 2008).

3.2. Liquidity and Current Assets

Current assets consist of all assets that can be readily converted to cash in order to cover liabilities and outstanding debts; thus, they are related directly to the firm’s liquidity. They include cash itself, inventory, accounts receivable, and all short-term assets used to cover day-to-day operations and ongoing expenses (Walsh, 2006). An effective way of measuring liquidity is:

This ratio indicates the revenue that can be generated in proportion to current assets. It is highly important for a firm to be able to pay its current liabilities on time, which represent the firm’s debts and short-term financial obligations (Bhattacharya, 2007).

3.3. Leverage and Current Gearing

Financial leverage indicates whether a company relies upon debt finance. Gearing is a measure of leverage, and reveals the extent to which a company utilises credit to serve its purposes. A company with high gearing might face increased difficulties in cases of downturns, as it must continue to pay its debtors (Bragg, 2007). Gearing is categorised to long and short-term. Current Gearing is short-term, and can be calculated as:

3.4. Profit Margin

Profit Margin measures how much profit the firm actually gains after delivering sales. It can be calculated as:

A high value of profit margin commonly indicates more efficient cost management (Ive and Gruneberg, 2011). However, Bull (2007) claims that profit margin can be a parochial indicator, as it does not involve the added value derived by the client, over and above the price paid.

3.5. Profitability

Profitability indicates how much profit is derived from a labour process; a high level of profitability is one of the main purposes of every profit-making firm (Bowles et al, 2005).

3.5.1. Return On Total Assets (ROTA)

ROTA indicates how effectively a company is using its assets to generate profit, before paying its contractual obligations (Holmes et al, 2008). It is expressed as:

A high value of ROTA is necessary for a company to ensure a satisfactory return on equity. Thus, it indicates how well the firm utilises its total assets to generate an operating surplus (Walsh, 2006).

3.5.2. Return On Capital Employed (ROCE)

ROCE indicates how efficiently a firm’s capital is employed (Collier, 2010). It can be calculated as:

ROCE is widely regarded one of the most important ratios relating to profitability. A higher value of ROCE indicates an efficient use of capital, as the firm is utilising its capital in order to produce higher profits (Brealey, 2011).

3.5.3. The DuPont Model

ROCE depends on Capital Employed, so it can be broken into more components (Gruneberg and Ive, 2000). The DuPont method analyses the way ROCE is affected by three factors:

  • Operating efficiency, measured by profit margin
  • Asset use efficiency, measured by total asset turnover
  • Financial leverage, measured by current gearing

As a result, ROCE can be expressed as:

The DuPont method connects different concepts, and offers a significant help to locate the specific part of the company that is underperforming (Sloman, 2006). The above equation also presents a link between ROCE and the selected ratio, which is Turnover/Current Assets. Current Assets are part of the Total Assets, therefore their management affects profitability.

Part 4: Performance analysis

This section explores the differences between the two firms’ Business Models during 2005-2011, according to their Standard Reports. Comparisons with their peer group are based on Ive and Murray (2013). The selected peer group is the specialist contractors (Tier 2 - SIC 43), as both firms are engaged in this area of industry. Both the median and the mean values were used for comparisons, in order to produce circumstantial results.

4.1. Asset Management

There are significant differences relating to asset management between the two companies. Watson Ltd had circa 494% more total assets than Seddon Ltd during 2005-2011. Even though Watson Ltd had 84,32% more turnover than Seddon Ltd, the latter generated more turnover in proportion to assets.

Figure 2

The two firms’ turnover during the examined period slightly increased. However, Watson Ltd shows a steady annual distribution, because during that period it invested on fixed assets, which increased its total assets. Contrary, Seddon Ltd retained the same amount of total assets, resulting to a marginal increase of the asset turnover ratio.

Figure 3

Compared to the peer group, Seddon Ltd presents a very effective use of its total assets, whilst Watson Ltd shows a poor performance relating to asset management, since its asset turnover ratio is even lower than the mean value.

Figure 4

4.2. Liquidity - Turnover/Current Assets

Current assets are directly related to the firm’s liquidity. Watson Ltd possessed 598% more current assets than Seddon Ltd during 2005-2011, and this need for increased liquidity is firstly explained by the expense of supplies required within the steel industry.

Furthermore, Watson Ltd was partially funded by creditors, so increased liquidity was required in order to cover the creditor liabilities. Seddon Ltd was mainly funded by its shareholders; hence, it did not have the need to maintain multiple current assets, due to its increased equity.

Figure 5

Their annual analysis shows that the Turnover/Current Assets ratio follows the same pattern as the Asset Turnover ratio. In 2010, the ratio peaked for Watson Ltd, due to the fact that during that year the company maximised its turnover.

Figure 6

The comparison with the peer group indicates the good performance of Seddon Ltd over its total assets. Contrary, Watson Ltd generates less than half revenue against its current assets in comparison to the average, because of its current liabilities.

Figure 7

4.3. Current Gearing

Watson Ltd presents a much higher value of current gearing, due to the two firms’ major differences in asset management. Current gearing is also affected by the number of employees. Watson Ltd has fewer employees, so it can use a larger proportion of its current assets to cover creditor liabilities. Thus, the firm can receive further credit. Seddon Ltd has a large number of employees, so a major part of its current liabilities is used to cover wages.

Figure 8

Seddon Ltd has a steady, but low annual performance on the current gearing ratio, whilst Watson Ltd peaked in 2006; nevertheless, from 2006 the firm progressively raised its capital employed, resulting to a general diminish of its current gearing.

Figure 9

Compared to the peer group, Watson Ltd presents a very high value of current gearing, because of its increased amount of total assets. Seddon Ltd presents a very low value, as it does not possess a wide number of assets, due to its increased equity.

It is noted that the median and the mean values are quite asymmetrical with a positive skew, meaning that the average company presents a lower current gearing than the average value.

Figure 10

4.4. Profit Margin

Watson Ltd generated more profit on average over its sales. Thus, it can be concluded that Watson Ltd performed better with regard to its cost management.

Figure 11

Seddon Ltd presents a steady profit margin distribution, as it did not alter its pricing and cost management. Watson Ltd escalated its profit margin from 2006 until 2009, due to the firm’s involvement in major projects relating to London Olympic Games in 2012. However, after 2009 the company reduced its pricing policies as part of the recession period.

Figure 12

Watson Ltd also generated increased profit against its sales in comparison with the subcontractors peer group. Seddon Ltd shows slightly less profit margin than the average, which is also indicative of its risk-averse management.

Figure 13

4.5. Profitability performance

4.5.1. ROTA

Seddon Ltd presents a higher value of ROTA, despite that Watson Ltd presents higher levels of turnover, due to differences in the possession of total assets. Moreover, Seddon Ltd utilises its total assets more efficiently, in order to generate an operating surplus.

Figure 14

Watson Ltd peaked in 2008, due to the major projects it was involved in. Nevertheless, since 2009 and hitherto, its EBIT has been significantly diminished, because of the recession. Seddon Ltd generated high levels of earnings against its reduced assets. Nonetheless, in 2011 the company increased its assets, resulting to a reduced ROTA.

Figure 15

Seddon Ltd has a double value of ROTA compared both with the median and the mean value of the peer group, as they present a rather symmetrical distribution. Watson Ltd is slightly above the average, which is not necessarily a poor EBIT performance, taking into consideration the large number of assets it possesses.

Figure 16

4.5.2. ROCE

The analysis of ROCE indicates that Watson Ltd performed better financially than Seddon Ltd during 2005-2011, since it managed its capital more efficiently in order to generate profit.

Figure 17

Seddon Ltd presents a steady distribution annually, regardless of the financial crisis, as the firm was managed without significant risks, due to its tendency to ‘make’. Watson Ltd performed greater on average, peaking in 2008. However, the company became vulnerable to outer circumstances, due to its risk-affiliate management, its increased trade credit, and its tendency to ‘buy’. As a result the firm’s ROCE fell even lower than Seddon Ltd’s ROCE in 2011.

Figure 18

The comparison with the peer group indicates that both companies have performed above the average. However, even though Watson Ltd performed better on average, its performance was marked by fluctuations, falling sharply in the beginning of the financial crisis. This instability reveals the added risk-affiliation, whilst Seddon Ltd was managed with less risk, which led to increased stability, but lower profits.

Figure 19

4.5.3. DuPont analysis

ROCE can be expressed via the DuPont Method as a derivative of three factors: profit margin, asset turnover, and current gearing. The two companies have elaborated different strategies relating to these factors, resulting to different outcomes.

Using the DuPont Method, the equation for Seddon Ltd is:

whilst the equation for Watson Ltd is:

It is concluded that Seddon Ltd presented lower profit margin and current gearing than Watson Ltd, but a higher asset turnover. The interrelations among the three ratios resulted to:

4.6 Competition

In order to estimate competition, the two firms’ market shares were compared with the top 100 companies per each peer group from FAME, for the period 2005-2011. The top companies were chosen, and not the ones closest to the chosen firms, because the latter would produce expected results. According to Boone (2008), market share can be calculated as:

Seddon Ltd’s competition consists of other large firms operating in the painting and glazing industry. The firm seeks differentiation in terms of innovation and sustainability. During the last years it has invested on staff development and training programmes, funding models, technologies, and renewable energies, whilst it developed new skills, like shared risk development. Its peer group analysis indicates that it maintains a significant market share among the industry’s top companies.

Figure 20

Watson Ltd differentiates itself from its competitors via its high specialisation of labour. At the same time, the company has internal control and comprehensive risk management processes, in order to identify and assess the potential risks to the firm’s short and long term value. However, its peer group analysis indicates that it maintains an average market share within a very demanding and concentrated industry.

Figure 21

The analysis of both firms via Porter’s Five Forces indicates that even though Watson Ltd achieved higher values of profitability on average, it has a strategic disadvantage, due to its industry’s fierce competition. Contrary, Seddon Ltd has an advantage relating to both horizontal and vertical forces, because of its industry reduced size and rivalry (Porter, 1979).

Figure 22

(Porter, 1979)

Part 5: Conclusions

The two firms elaborated different strategic management relating both to employment and the possession of assets, during 2005-2011. Seddon Property Services Limited presented increased levels of employment, but maintained decreased levels of total assets, whilst Watson Steel Structures Limited had fewer employees, but a vast number of total assets.

Their major differences in asset management are based on their liquidity requirements. Watson Ltd presented increased financial leverage, since its growth partially depended on trade credit. Therefore, the firm had increased liquidity requirements to cover its current liabilities, and avoid insolvency. On the other hand, Seddon Ltd presented better levels of equity; hence, its liquidity requirements were less, due to the fact that it was primarily funded by the shareholders. The liquidity differences between the two firms are also subject to their industries, since the steel industry requires more expensive supplies than the painting and glazing industry. As a result, Watson Ltd can be regarded as a firm that ‘buys’, whilst Seddon Ltd as a firm that ‘makes’.

Moreover, Watson Ltd’s management was risk-affiliate, which resulted to increased profits until 2008; however, the company’s profitability ratios (ROCE and ROTA) decreased significantly, due to the recession’s turbulent environment, causing more problems to its ability to cover current liabilities. On the contrary, Seddon Ltd’s management was risk-averse, and as a result the firm was more resistant to unprecedented changes, and maintained a balanced profitability pattern even during the recession; however, its levels of profitability remained steadily low.

All in all, both firms presented higher values to most ratios, compared to the mean and median values of their peer group (Tier 2), including profitability ratios. Despite their vast differences, it can be concluded that both companies were managed well, in order to serve their specific purposes and values.

Part 6: Recommendations

  • The Turnover/Current Assets ratio is important, and affects profitability from many angles. The amount of current assets can be decisive for the configuration of ROCE, as it affects the interrelations among profit margin, asset turnover, and current gearing.
  • Risk management is important, and it depends partially on the industry’s competition. Nevertheless, balance is needed, since excess risk-affiliation may lead to increased short-term profitability for the shareholders, but the firm will become vulnerable to outer changes.
  • Liquidity is crucial in order to avoid insolvency. However, excess liquidity may become a barrier to further investments.

Further Research

  • It would be of interest to compare the relations -before and after the onset of the recession- among the two firms’ managers, employees, suppliers, and clients, and how possible behavioural changes might affect productivity and profitability.

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