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The UK construction industry is estimated to be worth £200 billion. It is a highly dispersed industry estimated to comprise over 200,000 enterprises, which range in size from large multinational construction groups, to small companies of self-employed individuals. The sector is a major employer in the UK economy and it accounts for 8.3% of employed population - 2008. For many years, the industry has been plagued by numerous problems including issues such as not completing projects on time, failure to stick to original budget, and failure to meet client's expectations. However, in the past decade, the government has introduced various policies in an effort to improve the performance in the construction industry.
Profitability of a firm is vital for the company's survival and growth. The goal of a firm therefore, is to maximise profit by utilizing its assets. Construction firms need to have a strong liquidity to withstand the protracted timescales often associated with construction projects. The main aim of this study was to specifically examine the relationship between liquidity and profitability of UK construction firms.
The results of this study supported the hypothesis that there is a negative relationship between liquidity and profitability of the UK construction firms. Moreover, fundamental analysis of profitability of UK construction companies supported the hypothesis that there is a negative correlation between the size of a UK construction firm and profitability.
The construction industry in the United Kingdom is often regarded as the guardian, or at least an indicator, of the economy. When the construction industry is fully active, it can often indicate the fact that the economy is increasing. This is driven both directly and indirectly. Firstly, the construction industry is a major employer in the United Kingdom. At its peak (during the construction boom of the early 2000s) the construction industry employed around 2.5 million. This suggests that when the construction industry is fully functional, and fully profitable, that it can (and indeed has been shown to) be a major driver of economic growth. The second means by which the construction industry drives the UK economy is through responding to a demand for new housing. The UK population is growing at an almost exponential rate, meaning that the construction industry has been impelled to respond. This emphasises the strong link between the strength of the construction industry and the economy of the United Kingdom. Certainly the government has actively courted the industry, offering incentives for the industry through PPP (Public - Private Partnerships) and PFI (Public Finance Initiatives). Both have gone someway to providing, state - issued capital for the construction industry. This has allowed construction industries to focus on providing competitive models for profitability and efficiency, and it is these models that this work will consider.
The dynamism of the construction industry is such that any work of this scope considering performance must naturally be constrained by temporal factors. The link between the construction industry and the economy is such that market fluctuations can drastically affect the wider industry. This suggests that models of operation within the industry need to be strong, particularly given the fact that many construction projects are large - scale, long - term operations. Liquidity needs to be high, especially given the fact that budgeting and timescales are often difficult to estimate, meaning that short - term capital is often required. Liquidity is therefore a vital component of the construction industry. The link between liquidity and profitability is therefore fundamentally important. This explains the rise of larger construction companies which are able to access more capital at short notice.
The purpose of this study, therefore, is to examine the link between liquidity and profitability in UK construction firms. This will provide a useful window into examining the wider case of the business models of firms. Having ascertained this, it will be possible to comment and conclude as to the optimal level of liquidity and the most successful business models in the construction industries.
Given that this is the stated goal, it is necessary to use a combination of research methods. These centre on the existing theories and literature as well as research. The theories and the literature centre on the fact that liquidity is a fundamentally vital component, as evidenced by the rise of governmental initiatives to help the construction industry. Furthermore, the relationship between equity holders and debt holders has been examined greatly in the existing literature. That said, more important than the theories is research.
Research has the capacity to provide empirical evidence to support or to undermine a theory. By examining trends in the business models in the construction industry, it is possible to show that, for example, revenue has increased in the period between 2000 and 2008. This can be used to support the existing theories that turnover in general has increased, further suggesting that liquidity is becoming increasingly important in the construction industry.
This work will therefore centre on balancing the existing theories and literatures with research. By combining the two, it is possible to gain an insight into the actualities of the business models of the construction industry. The fundamental point at issue is the link between profitability and liquidity, on which there exists much theory, and some levels of research. In terms of the construction industry, however, there has been little research conducted into the recent growth of the industry, much less on the issue of the internal organisation of the business models.
A superficial consideration of the link between profitability and liquidity would suggest that the higher the liquidity, the more capital the company would be able to access at short notice, and the potential capacity for completion of projects. An increased level of liquidity is able to act as a form of insurance for a construction company, who are able to access disposable income in order to potentially salvage projects that would have otherwise have floundered. Therefore, it may be counter - intuitive to suggest that the link between profitability and liquidity is negative, although in many respects it is the case. The reasoning behind this is complex, and requires a great deal of research, and is something that will need to be supported by large amounts of empirical evidence. It is this that will form the basis of the study considered below.
Given the fluctuating nature of the economy of the United Kingdom, particularly in more recent times, the construction industry has experienced many periods of success and many of recession. That said, certain trends appear to be consistent in the periods of growth and decline. These include the business models of leading construction companies. The underlying assumption behind this is that greater liquidity does correlate with greater profitability. This is also evidenced in the fact that construction companies are increasingly becoming bigger, nationwide entities, with large amounts of liquid assets.
This work therefore will ascertain the correlation, and resultantly the causation between the presence of high levels of liquidity and profitability in the construction industry. By conducting research into the recent trends in the industry, and using these to challenge the existing theories it will be possible to determine a conclusion into the link between liquidity and profitability in the United Kingdom construction industry.
2 OVERVIEW OF THE UK CONSTRUCTION INDUSTRY
According to the 2008 United Kingdom National Statistics Hub, the market size for the UK construction industry was estimated to be around £200 billion. Since 2000, the industry has greater share of the economy, from £69.53 billion or 7.4% of GDP value, to the present £200 billion or 8% of GDP (http://www.statistics.gov.uk/statbase) accessed 21st July 2008. However, although the construction industry is expected to benefit from numerous projects and government expenditure on infrastructure, the global financial crisis has prevented a sustained growth in the UK construction industry. The UK industry is divided into four main sectors: commercial construction, house building, infrastructure and industrial sectors in order of size.
House building: This sector has the lion share in the UK construction industry and it accounts for about 40 % of the total construction industry's output. In the UK, there is a large proportional of home owners which in 2008 stood at 70 % - a similar rate as that of the US. However, the demand for new homes is still very high and there is now a big shortfall for new houses. According to the UK Treasury's Barker review of housing supply, It is estimated that an extra 39,000 new homes need to be built each year just to keep up with the UK's population growth (http://www.hm-treasury.gov.uk/barker_review/) accessed 21st July 2008. The review also attributed lack of affordable homes as the major cause of high UK house prices. Furthermore, the report stated that if the UK was to have the same level of houses per population with that of European continent, the UK would need to build an additional 145,000 every year.
Consequently, the UK Prime Minister - Gordon Brown has promised a housing pledge, and an additional £1.5 billion funding for the UK Home and Communities Agency (HCA). The government believes this will act as a stimulus for economical reform in the present recession. Building Britain's Future consists of a series of promises across different sectors of the UK economy. The Housing Pledge and the £1.5 billion fund are broken down as follows:
- £750 million for 12,500 affordable new homes channelled through HCA approved investment partners - housing associations and private developers.
- £500 million for 7,000 new homes to stimulate the kick start stalled housing market. This will be done through high level of bids channelled through high level of bids.
- £250 million for 4,000 new homes channelled through new council homes.
- Use of public land to develop 500 new homes to attract new construction contractor players into the housing market. This will be a private public partnership and HCA and other public sector organisations would be invited to contribute in return for an equity share.
The sector for commercial construction equals to around 18% of the total output for the UK construction industry. Edward Whipp, Pre-Construction Director for EAG Construction firm states that unlike the housing construction and selling markets, the commercial sector in the UK has not been negatively affected by the current financial crisis. He further claims that the commercial area is receiving an increased number of orders from regeneration projects for large private and public sectors, and town centres (http://www.buildingtalk.com/news/eng/eng147.html) accessed 21st July 2008.
The area for building materials amounts to 13.5% of the UK construction industry. It consists of a wide range of building materials, including steel, timber, bricks, cement and tiles. The majority of these such as timber are outsourced of the UK. Also, this UK sector is undergoing a period of internalisation, with several companies forming partnerships, mergers or acquisitions with firms outside of the UK.
Although infrastructure is a total of 9% of the UK construction industry, it is the bigger construction firms that tend to dominate this sector, as the majority of government infrastructure tenders are large. For instance, the National Audit Office shows that in the last five years, over 51% of infrastructure tenders were procured by five major companies: Balfour Beatty, Alfred McAlpine, Budge, Tarmac and Fairclough (http://www.nao.org.uk/our_work_by_sector/housing,_property.aspx) accessed 21st July 2008. The industrial construction sector equals to around 6% of the total output of the UK construction industry.
2.2 Demand for Construction
The construction industry has drastically declined as a result of the economic recession. Furthermore, there is a considerable decrease in demand for domestic housing, as well as industrial, office, retail and leisure facilities. According to the governmental policy, a total of three million new homes will be built in England by 2020. This would amount to 240,000 new houses annually. In addition, the government has set aside £2 billion to modernize school buildings, under the Building Schools for the Future program.
London 2012 Olympic: Short term demand is expected to come from the construction of main London 2012 Olympic venues which will continue until the end of 2010. As the largest construction programme in the country, this will be the main contributor to the increase of construction jobs in the UK. The workforce for the three main London based projects: the Olympic Park, Olympic Village and Stratford City development is expected to be about 20,000 in 2010. (http://www.london2012.com/about/the-people-delivering-the-games/) accessed 21st July 2008.
The UK Government Comprehensive Spending Review for 2009 - 2011 has provided funding for motorway widening schemes for the MI, M6, and M25. The UK highway agency has undertaken the project to widen the M25 motorway through a letting scheme, which will cover design, build, finance and operation over 30 years. Connect Plus is the tender for the work, and is made up of a consortium of construction companies. These are: Balfour Beatty, Skanska, and Atkins and Egis Projects (http://www.contractjournal.com/Articles/2008/05/08/59050/m25-widening-q.html) accessed 21st July 2008. The contract involves the cost of £4.5 billion to develop an additional 102 kilometres capacity to the three-lane sections of the M25, which is expected to take up to eight years to complete. In addition, the Scottish Government will invest £3 billion in redevelopment of the M74.
The rail network will also receive a great amount of funding for various projects. The government has set up a £15.9 billion fund to finance the construction of the 118 Kilometre Crossrail. This will see the development of nine new underground stations in London, the renewal of numerous old ones, and major reconstructions of eleven national rail stations. The purpose is to improve transport capacity, connectivity, and services across London and the South East of the country (http://www.crossrail.co.uk/company/communications-centre/press-releases) accessed 21st July 2008. Over 14,000 people will be employed to undertake the crossrail infrastructure project, with a further 7,000 employees for its project support services. Other major redevelopment projects include the £5.5 billion Thameslink stations, Reading, Birmingham New Street, Nottingham, and Glasgow airport Rail Link.
The electricity sector is expected to steadily grow over the next three years. There are two main reasons for this. Firstly, many of the UK power stations are becoming obsolete. As a result of this, power stations need to be replaced. Lastly, there is now a greater demand for renewable sources of energy. The regeneration program will create demand from the UK government and local authority programs to regenerate inner cities, schools and hospitals.
There will also be future demand that is expected to occur after 2010 in the UK economy. This will inevitably ease the pressure from the UK banking sector, and allow home buyers to access mortgage funding. Therefore, this will lead to a greater demand for house developers. It is expected that by 2011, construction output will steadily rise up to 3% in real terms by 2013. However, growth is likely to be restricted to around 0.5% per year between 2009 and 2013.
The most serious risk facing UK construction industry is skills shortage due to an ageing population. The work force in the construction industry has grown by 20 % since 1990 but this expansion has been un-proportional across different age groups. While the number of workers aged 60 and over has doubled over this time period, the number of those aged 24 and below has fallen by 27 % and professional trades such as architecture, mechanical and civil engineering could lose 20 % of their manpower as a result of retirement in the next decade.
The Construction Industry Research and Information Association (CIRIA) state that the UK construction industry is significantly detached, and is estimated to include over 20,000 enterprises. These will range from large multinational and national construction groups, small and medium sized companies, and self-employed individuals. The majority of these ventures are classified as sole trader, with over 90% employing less than 10 people. This sector is a large employer for the UK economy, accounting for over 2.5 million employees (http://www.ciria.org/service/) accessed 21st July 2008.
The fragmentation nature and the diversity of the UK construction industry make it a highly competitive market. The growing cost of fuel and construction materials such as steel has lead to significant increases in the cost of construction. For example, the price of steel has increased by over 50 % between 2007 and 2008. Fuel has increased steadily by an average of 34 % since 2007. There have also been strong increases in the price of other construction materials such as plaster, cement and glass. In addition to slowing demand, there is a lot of pressure on the construction companies from their clients to undertake discounting.
The intense competition within the industry has resorted in a number of small firms closing their businesses and it has brought about major industry consolidations in the past few years. For example, within the past two years, Balfour Beatty has completed the acquisition of Centex Construction, GMH construction as well as Birse. In the same time, Carillion, the second largest market player has completed a US$561.6 million takeover of Mowlem and McAlpine.
Even though there are very few barriers of entry in the industry, contractors have to manage a variety of risks. Examples include: health and safety, planning, regulatory, environmental, and financial, industrial relations and project management. In the case of developing large commercial projects, constructors may be required to obtain some ownership in the form of equity. Additional to this financial burden is a contractor's technical capability, which creates a significant hurdle for a company, as well as testing its financial capabilities. As a consequence, companies are forced to consolidate or merge partnerships when bidding for tenders. It should be noted that the larger the tender, the bigger consortium of joint ventures, where resources are combined by two or more contractors. Thus, the consortium is able to produce sufficient finance and manpower to undertake major projects, along with the distribution of share tender costs, and cater for economical and performance threats. Furthermore, venture consortiums allow companies to utilize scarce resources such as skilled and specialist personnel, equipment, finance and local knowledge. They also allow participants to meet often-stringent pre-qualification requirements.
Joint ventures are temporary arrangements formed by two or more firms to enable them to pool resources in order to participate in a particular construction project. For example, in the bidding for the government Highways Agency tender for the expansion of M25, the tender was won by Connect Plus - a consortium of the following construction firms: Balfour Beatty (40 %), Skanska (40 %), WS Atkins (10 %) and Egis Projects (10 %)., a group including Balfour, Skanska, WS Atkins Plc and Egis Projects. Other consortiums that were taking part in the bid and had been short listed were M25 Flow consortium, - made up by Vinci SA, Henderson Group Plc's, John Laing unit, Carillion Plc, Costain Group Plc, Mouchel Group Plc and Jacobs Engineering Group Inc. and another consortium made up of Ferrovial Amey, Agroman units and Laing O'Rourke Plc (http://www.bloomberg.com/apps/news?pid=20601102&sid=aKZvBcayoNqo&refer) accessed 21st July 2008.
Therefore, it would appear impossible for single firms to win major construction contracts in an uneven environment. Collaborative projects can last up to ten years depending on the nature of construction. These ventures also allow smaller firms with local knowledge to partner with larger multinational corporations to bid for substantial projects. Therefore, the venturing offering system makes the UK construction industry highly competitive.
The intensity of competition for tender in the UK construction industry caused the UK Office for Fair Trading (OFT) to issue a Statement of Objections against 112 construction companies in April 2008. This was considered as one of the largest investigations conducted under the UK Competition Act. It alleges that the firms have carried out bid rigging activities. In an effort to gain higher prices for projects, it states that construction firms are conspiring with competitors during a sensitive process. This practice is known as cover pricing. Furthermore, the Objections highlight that various construction companies have participated in pre-tendering actions. Here, the successful bidder pays compensation to the unsuccessful bidder, and disguises this fraudulent activity by creating false invoices (http://www.oft.gov.uk/news/press/2008/52-08) accessed 21st July 2008.
2.4 Private Finance Initiative
The Private Finance Initiative (PFI) is the dominant government way of financing public infrastructure in the UK. These include projects such as roads, airports, hospitals, schools and prisons. The procurement of large ventures involves consortiums of numerous construction firms that utilize their resources to bid for the project. After which, the winning bidder consortium is contracted to design and develop the new project. In cases where construction may last an average of 30 years, the consortium would also be required to manage the project. Here, after completion of the project, it remains the property of the developers and leased on mortgage repayment to the concerned public body, for example, the NHS. Consequently, the building consortium must take responsibility to raise the funds needed to build the venture.
The use of PFI is rather controversial and it can be very expensive for the public. For example the Edinburgh Royal Infirmary NHS was financed by PFI at a cost of £180 million but it will cost £900 million to repay. Understandably, UK trade unions are totally opposed to PFI and they claim that private construction companies are making excessive profits from PFI scheme. However, PFI is a great benefit to the construction companies involved in the scheme. According to lobbyists, UK construction PFI has enabled construction firms such as Carillion to make between three and ten times as much money as they would do on traditional contracts.
Regardless of negative debate, PFI has immensely altered the landscape of the UK construction industry. This is evident in 2003, (only a year after PFI became widely available to UK constructors) where figures from the European Construction Industry Federation (ECIF) demonstrated that the industry had grown by over 8%. In contrast to this, both Germany and France indicated a decrease by 2.5% and 0.7% respectively (Macalister, 2003). PFI constructors assume the risk that a venture may fail or over-run. Thus, this insecurity is priced, and added to the total cost of the project. Nevertheless, the UK Association of Chartered Certified Accountants has commented that the risk cost is often overstated.
2.5 Trends in profits margins
It is known that company profits in the UK construction industry are unstable. However, in the period between of 1998 to 2007, profits have increased, and steadily grown. This is mainly as a result of government expenditure on infrastructure, and demand for commercial construction. A clear example is the fast-developing domestic housing market, and the financial district of London Canary Wharf.
The UK construction industry functions at significantly low profit margins around 2% or 3%. The average profit margin is lower than any other from all sectors of the economy, with the exceptions of retail and wholesale trades. In 2004, the average industry profits margins for the UK construction industry (calculated as profits from a proportion of total sales turnover) stood at 1.9%. However, the level has since improved to 2.4%, when last recorded in 2007 and 2008.
3 LITERATURE REVIEW AND DERIVATION OF HYPOTHESES
3.1 Performance in Construction industry
There are many reports available that examine the performance of the construction industry in both Europe and the United States. Some reports claim that the industry faces numerous problems, such as incompletion of projects within timeframes, adhering to original budgets, and failure to meet client expectations (Rosenbaum et al., 2002); (CIB, 2000); (OFPP, 1998); (Egan, 1998); (Post, 1998); and (Herbsman & Ellis, 1992). Nonetheless, in the last decade, various governments have coordinated various schemes in order to improve the overall performance of the construction industry. These include introduction of key performance indicators, public private partnerships (PPP), public finance initiatives (PFI), and lean construction.
Kashiwagi et al., (2007) conducted a 10 year (1997 to 2007) research project in order to study the performance of the construction industry from the perspective of risk minimisation. They devised what they termed 'construction industry structure model' - a quadrant diagram similar to the Boston Matrix - that depicts the best value as the lowest bid using performance and competition (Table 1).
The matrix depicts the relationship between price-based - high competition, low performance (quadrant I), best value - high competition, high performance (quadrant II), negotiated bid - low competition high performance (quadrant III) and non-performing - low competition, low performance (quadrant IV). The authors postulated that construction firms that are in Quadrants II and III are hired for their expertise. The model also suggests that when using the low-bidders, clients tend to hire project managers and inspectors in order to minimise non-performance risk through management and inspection. This type of practice in the construction industry has been identified as inefficient and results in poor performance (Luffy, 2004).
However, unfortunately, the majority of construction industry firms are low bidders. Hence, a high performance contractor is forced to lower their price in order to attain projects. For effective competition, high performance contractors are therefore obliged to sacrifice quality and optimum performance for poorer quality and lower performance (Kashiwagi et al., 2007). Contrary to this, were all competitors to practice quality and high performance equally, compromise of performance could be avoided. However, as contractors are required to meet minimum standards, the majority of them practice this method.
Inevitably, this process raises the risks of non-performance for constructors while the client attempts to minimise risk through management and inspection. This results in profit-maximisation. This is because constructors are not rewarded for higher levels of performance (Kashiwagi et al., 2007).
According to Kashiwagi et al., (2007), the construction industry is faced by three types of clients: 'the outsourcing performance based client, the partnering client, and price-based client who directs the contractor on what to do'. Firstly, the outsourcing client passes the risk to the contractor, and the partnering client shares this risk with the constructor, and the retention of risk is by the price-based client. This client manages, instructs, controls and examines the entire contraction (Kashiwagi et al., 2007). Kashiwagi et al., (2007) assume that in a risk minimising model, the three types of clients will cause construction firms to send their high performance teams to the outsourcing client in order to minimise the risk. The intermediate performance team will then be assigned to the partnering client to share the risk. Hence, the poorer performing and inexperienced team will be dealt by a price-based client in order to compensate for the low profit margin.
In 2000, the UK government introduced a framework of Key Performance Indicators (KPI) in an effort to improve UK construction performance. This framework is utilized by construction firms to validate their performance against the entire industry, using a set of agreed industry specific KPIs. The KPI framework is composed of seven main categories: Time, Cots, Quality, Client Satisfaction, Client Changes, Business Performance, and Health and Safety (KPI report for minister of construction http://www.berr.gov.uk/files/file16441.pdf) accessed 21st July 2008. Table 2 displays the various key performance indicators in the business performance section of the KPI framework. The KPI model demonstrates that the inability of a contractor to generate profit contributes significantly towards project cost and time over-runs.
3.2 Profitability and liquidity of UK Construction Firms
Profitability of a firm is vital for the company's survival and growth and it is considered as the financial proxy and measure of performance. Wright (1970) defined Profitability as a function of three factors; i) sales volume or turnover, ii) capital investment to support sales volume and iii) the margin of profit earned. Profitability measures may be used as selection criteria to estimate the economic worth of construction companies. Therefore, the profitability functions should be sufficiently complete to distinguish the best construction firms. There are two main perspectives by which the profitability of a construction firm can be approached as goals to be maximised: profit and liquidity. (Pearson and Miller, 1981), suggest that the profit function expressed as income minus costs gives a net economic effect of input and output items.
Although profitability can be measured in various ways, there are two main measures. The first one is earnings before interest, and tax (EBIT) as a percentage of total revenue (turnover). This have been operated in studies that relate to the construction (Akintoye and Skitmore, 1991); (Grossmann, 2003); (Lea and Lansley, 1975a); (Lea and Lansley, 1975b) and (Lenard and Heathcote, 1990). The other measure is return on equity (Asenso et al., 1987) and (Wright, 1970). Moreover, Wright (1970) "has specifically termed ROI, or total assets less current liabilities, 'profitability', as it seems most accurately to encapsulate the level of financial achievement against the long-term funds committed to the business".
The use of these measures as proxies of profitability however has been criticized. One of the arguments against the use of profit as a percentage of turnover is that companies may achieve high profitability only on account of a high net asset. Thus, the use of profit as percentage of turnover in the construction industry may not be appropriate. Some researchers argue that the use of ROI is not appropriate because the method of subcontracting in the industry "may not encourage firms to increase their net assets despite increases in workload" (Fellows & Langford, 1980).
Asenso et al., (1987) state that the effects of the size of a firm on profitability have been under-researched in the construction industry. However, these studies have demonstrated mixed results. A clear example of this is that while (Hall and Weiss, 1967); (Akintoye and Skitmore , 1991) and (Samuel and Smith, 1968) reported a strong correlation between profitability and the size of the firm, others such as (Singh and Whittington, 1968); (Lea and Lansley, 1975a) and (Asenso et al., 1987), have failed to find any positive correlation between the two.
Lea and Lansley (1975a) studied the effect of recession on 23 construction firms over a period of two years - 1974 and 1975. They concluded that in order to survive during this period, construction companies should employ a strategy of cost reduction in relation to overheads rather than the target of profit margins. In addition, their findings suggested that there is no evidence to support the claim that profitability depended on the size of the firm. Furthermore, it was highlighted that capital was as accessible to smaller firms as it was to larger ones. This was because management of smaller firms was just as efficient as the bigger ones. The results of the study found that the firms that were researched displayed an average of 2.5% profitability during the period. There were several instances where the authors identified a contractor's difficulty to make profit. The bidding process in the construction industry was chiefly mentioned as the cause for low mark up values. Hence, firms bid a lower figure to increase their opportunity of winning the bid.
Asenso et al., (1987) studied a total of forty-one construction companies over the ten year period of 1975-1984, divided into groups of four, based on their net assets. They found that there was no apparent correlation between firm size and its profitability. However, they were able to identify a general inverse relationship between the two. This showed that profitability tended to decline with the size of the firm. Furthermore, it was commented that larger companies had shown stable profitability over the research period.
Fellows and Langford (1980) found that in order to survive the recession, some construction firms may have deliberately generated low profits in the short run, by 'buying work'. This strategy was also common practice when firms sought further contracts from the same client. Therefore, although profits may rise in the long run, the strategy does carry an increased risk of underestimation of production costs. This would result in huge failure for the firm. Having said this however, the process has been acknowledged as another factor that directs very low profitability in the construction industry. Also, the bidding process may contribute to greater competition within the industry.
Also, the aspect of liquidity plays a crucial role for all types of companies. It is considered as the balance between current assets and current liabilities. It is important to maintain this balance, as an excessive amount of current assets may cause moderate returns on investment. On the other hand, very little current assets may result in a company's inability to finance day-to-day operations (Ghosh and Maji, 2003). In order to achieve efficient management of liquidity, plan and control of current assets and liabilities will enable the company to meet short-term obligations, and avoid over investment in available assets (Eljelly, 2004).
The goal of a firm is to maximise profit by utilizing its assets but lack of liquidity may result in bankruptcy. Therefore, the manager of a firm must act in a way as to trade off between liquidity and profit. Factors that affect liquidity include account payables, larger inventory and trade credit (Long et al., (1993), and Deloof and Jegers, (1996)). These factors may be an inexpensive and flexible source of financing for the firm.
Eljelly, (2004) studied the empirical relationship between profitability and liquidity (current ratio and cash conversion cycle) of Saudi Arabia construction firms. The study found that the size of Construction Company was negatively correlated to its liquidity and that there was great variation of liquidity among different companies in the construction industry. In addition, Deloof, (2003) while studying profitability of Belgium firms observed a strong negative correlation between operating profit and the number of day's accounts receivable, inventories and accounts payable.
Interestingly, in its KPI report for the construction industry, the government acknowledged that clients of the construction industry want their projects delivered: "on time, on budget, free from defects, efficiently, right first time, safely, by profitable companies" and that "clients expect continuous improvement from their construction team to achieve year-on-year: reductions in project costs and reductions in project times" (KPI Report for The Minister for Construction, 2000). It would appear therefore, that the government was aware of the issues that were affected the construction industry at the time. Since then, the government has introduced policies such as the private finance initiatives (PFI) where construction firms can partner with for example the National Health Service (NHS) to build hospitals. In such cases, the construction firm/s would build the hospital using private finance and the NHS would enter into a mortgage lease for twenty-five years repayment. This is also the preferred method to renew public schools and other infrastructures in the UK.
3.3 Sources of capital finance
Construction companies are heavy users of capital. An important question is therefore: where do construction firms get money to finance their investments? Capital is a vital source of sustainability and viability of all firms. In addition, the growth of a firm is dependent on the availability and the cost of funding. It has been shown that profitability and growth of firms can be constrained by lack of finance (Berger and Udell, 1998). While the management of a small firm may be preoccupied by the thoughts of where and how to get capital to finance their projects, management of large corporation may be preoccupied on how best to spend the generated profits. It follows that the financial decisions of small firms differ significantly from those of a large firms and therefore their capital structure and hence their profitability are expected to be different. Information asymmetry in small firms for example may tend to favour debt finance.
There are many ways in which a firm can raise its needed capital to finance its positive net present value (NPV) projects. The most common ways are loans, bank overdrafts, bonds and equity stocks.
3.3.1 Retained earnings
The use of retained earnings is one of the most cost-effective ways for a company to finance its investments. Therefore, many company managers prefer to retain end of year earnings to finance future projects, rather than issue the profit as a dividend to share holders. This type of finance is favoured by managers because it maintains internal involvement, and avoids unnecessary costs that are associated with the issue of new shares. Also, it does not require a change of control that may result from an issue of new shares. Furthermore, due to tax purposes, several shareholders (for example, high earning professionals) may benefit from generating capital profit rather than receive current income. However, retained earnings are not preferred by "widows and orphans". In turn, some companies restrict their self-financing from retained profits to pay shareholders a reasonable dividend.
3.3.2 Overdraft financing
Much like the use of a personal overdraft, banks extend overdraft-financing facilities to businesses that hold a current account. This form of financing is used as a short term facility to clear payment obligations when a company no longer has bank savings. Normally, there is an agreed overdraft limit. However, other payments such as an agreed interest rate above the bank's current rate, and an overdraft facility fee are required for the overdraft. Furthermore, the bank may require security before setting up a business overdraft. Overdraft financing may be particularly useful for small firms that generate positive cash flows, but encounter difficulties in timing of sales receipts with supplier payments.
3.3.3 Debt finance
The price for loaning finance is dependent on the interest rate on a particular debt and the given years for repayment. A loan means money that has been borrowed from family, friends, or a bank. It is usually processed in a way that repayment should be in full or instalments. It generates cash flow payments in relation to an agreed interest rate. In the UK, it is common practice to provide security in the form of a private property for a commercial bank loan. However, for entrepreneurs who do not hold assets, they may qualify for a government supported Small Firms Loan Guarantee Scheme, which protects the bank from any risk of a loan.
3.3.4 Equity finance
Equity finance involves giving up part of ownership of the business in return for money. Finance for early equity may also come from business angels. These are affluent individuals who may find a business of interest, and help to finance these start-up businesses. On the other hand, venture capitalists provide equity money to businesses that have progressed from prototype level, and now require funds to drive their project onwards. Furthermore, venture capitalists maintain involvement in the management of a firm. Once a company has generated speed and positive cash flows, the entrepreneur and any other partners may wish to liquidate their investment. This is achieved by participation in the stock market. It is at this level that the business is publicly owned. Private equity finance is also another way for businesses to raise money for investment. Private equity firms however remove the firm from the public trading markets into private hands - they are attracted to low leverage firms.
In addition, interest is not paid on equity finance, and firm managers are not obliged to pay dividends; although, equity holders do claim a share of the company's profits. Some managers decide to reinvest retained profits in the expansion of the company. Others may issue the profit to their shareholders in the form of dividends. However, irrespective of these two methods, equity investment by investors is heavily dependent on their propensity to consume. "Widows and orphans" for example, would prefer a firm that pays dividends, whereas professionals tend to invest in companies that desire growth.
It is important to consider the fact that all reported studies of profitability of construction firms were carried out before 2000. Thus, this study will explain in-depth analysis of profitability measures, in the top 162 UK firms in the industry after this period. The aim is to highlight potential causal mechanisms, and evaluate the arguments for and against the claim that: Financial reporting of profitability and liquidity as indicators of performance in the UK construction industry.
3.4 Derivation of Hypotheses
3.4.1 Effects of debt finance
Financial leverage invests in projects in order to earn a higher rate of return than the cost (interest) of a particular debt. Therefore, debt can effectively increase or decrease the profitability of a company. Moreover, it can also directly impact the liquidity of a firm. The reason for this is because a company's assets are made up of both equity and debt. In order to achieve maximum return from invested projects, both debt and equity finance are strategically employed by a company. This is known as capital structure. Leverage does increase a firm's liabilities; hence, it causes significant effect on revenue. Increased levels of financial leverage could cause financial distress for a company. This is normally due to the need to service the interest of a debt regardless of a firm's cash flow. It should be noted that debt, whether in the form of a bank loan or bond, is superior to stocks and shares in financial claim against a firm.
The theory of optimal capital structure gained a breakthrough with the work of Modigliani and Miller (1958). Modigliani and Miller's theorem specifies the conditions under which capital structure of a firm is irrelevant. The irrelevance holds for perfect capital markets where there is perfect competition and everyone is a price taker, there is equal access to all relevant information, and there are no transaction costs such as taxes or bankruptcy costs. Under such conditions, Modigliani and Miller showed that the value of the levered firm must be equal to the value of the un-levered firm.
However, Modigliani and Miller's theory cannot work within reality. In today's capital market, earnings are subject to costs in the form of taxes. A balance sheet allows exemption from tax on debt repayments; this inevitably provides a company freedom from tax. This tax shield is a major reason for why several corporations prefer debt. From this perspective, Modigliani and Miller revised their model. It now includes the effect of tax shield, and portrays the value of a levered firm is the same as that of an un-levered one plus the tax shield that is calculated by multiplying the value of the debt with the level of corporate tax. Hence, in the real world, the capital structure of a firm is no more irrelevant.
After Modigliani and Miller, others introduced the cost of bankruptcy in the model. In addition to paying loans, bonds and share holders in a bankruptcy, the firm has also to pay other agency costs in the form of legal fees, and other fees of restructuring or bankruptcy which must be deducted from the net value of the bankrupt firm (Harvey, 1995). These costs reduce the value of the firm and must be taken into consideration. However, the chance of becoming bankrupt increases with the amount of debt (as the repayment of the debt and its interest is a direct claim from the cash flow), therefore, the optimal capital structure is a trade-off between the tax advantage resulting from the tax shield of debt and the disadvantage of bankruptcy costs associated with debt.
Even today, after over half a century since Modigliani and Miller's model was introduced, the question as to how companies operate their capital structure remains a puzzle. In his presidential address to the American Finance Association, titled, "The Capital Structure Puzzle", Stewart Myers posed the following question: "How do firms choose their capital structures?" He went on to answer that "we don't know how firms choose the debt, equity, or hybrid securities they issue" (Myers, 1984). Various researches have generated many stances concerning capital structure. Also, further research has been conducted to explain how firms finance their investments, what is the most effective capital structure, how does financing connect with investment, and whether or not financing decisions affect company value. Studies have also concentrated on a number of factors that may impact capital structure. These include: bankruptcy costs, tax shield of debt, the pecking order theory, agency theory, information asymmetries, and debt as a disciplinary measure for management, firm ownership against debt/equity choice, transaction costs, and the trade off theory.
3.4.2 The trade-off theory
The trade-off theory highlights that companies select a certain target capital structure by trading their cost and benefits of leverage. Unlike other theories, the trade-off model is flexible, thus allowing space for adjustment of debt-equity ratio over time.
22.214.171.124 Conflicts between Equity holders and Debt holders
Equity holders are the owners of the firm and as such, if an investment financed by debt was to perform excessively well, it is the equity holders who capture most of that value. However, if the investment was to fail, the limited liability contract of the debt enables the debt holders to bear considerable consequences. The value captured by the equity holders from a successful investment can be more than offset the loss of equity value from a poor investment. It follows that; equity holders have incentives to invest in risky projects while the cost of this incentive is borne by the debt holders. However, if the debt holders are able to correctly anticipate the equity holders' future behaviour, it is the equity holder who bears this cost. This so called the "asset substitution effect," is an agency cost of debt financing. In their journal paper, "theory of the firm: managerial behaviour, agency costs and ownership structure", Jensen and Meckling (1976) stated that: an optimal capital structure can be obtained by trading off the agency cost of debt against the benefit of debt.
This would mean that large companies with slow growth and increased profits (cash cows) would also have further debt. This debt reduces the amount of "free cash" made available that may otherwise attract managers to invest in luxuries such as corporate jets, empire buildings, and over-payment. More importantly, it serves to increase managerial ownership of the residual claim (Jansen 1989).
Diamond's reputation model for choosing projects that assure debt repayment is known as the asset substitution effect (Diamond 1989). Diamond demonstrates that management is faced by two investment opportunities. One is considered as a safe and positive NPV project, and the other, an insecure venture. Investment in the safer project results in average returns, while the riskier one can either fail, or produce above average returns. Both of these projects require debt finance. Initially, debt investors cannot predict managerial intentions for choice of project. Returns from the secure project are sufficient to service the debt obligation; however, returns made by the insecure venture will only repay the debt if it is successful.
Due to the asset substitution effect, myopic maximisation of equity value would lead the manager to choose the risky project. Debt lenders however can only rely on a firm's default history and therefore, firms can build a good reputation with debt lenders by investing only in the safe project. The debt lenders reward such firms by offering them low cost debt. It follows that older, more established firms are more likely to invest in safe projects while small entrepreneurial firms with little reputation may choose the risky project. For this reason, older firms have more debt than young firms in the same industry.
126.96.36.199 Conflicts between Equity holders and Managers
Harris and Raviv (1990), and Stulz (1990), argue that company managers do not always act in the interest of the owners (equity holders). A clear example of this is that managers may want to retain earnings for reinvestment in future projects, even though payment in the form of dividends is a beneficial option for investors (Stulz 1990). Furthermore, even when conditions portray that liquidation of a firm is an investor's preferred option; mangers still tend to favour current existing operations (Harris and Raviv, 1990). In these instances, conflict cannot be resolved by way of contracts based on investment expenditure and cash flow. However, debt is capable of justifying the dispute as a debt contract provides debt holders control to force liquidation if cash flows are insufficient to service the debt obligation (Harris and Raviv, 1990). Hence, mangers determine an effective capital structure by trading off benefits of debt against the costs of debt. Table 3 summarizes the advantages and disadvantages of using debt in order to rectify the conflict between manager and equity holder.
Harris and Raviv (1990) trade off model claims that: debt will force the management to assume the optimal capital structure for the firm by trading off the improved liquidation decisions versus higher investigation costs. Leverage improves the liquidation decision because it makes default more likely while in absence of debt; the management is at no obligation to liquidate the firm even when the value of the assets is worth more than any opportunity cost. However, investors will choose to liquidate based on the information they have gathered regarding the firm. Liquidation is therefore expensive to debt holders because they have to spend resources on investigation on the firm when it is in default. The model claims that large firms with higher liquidation value (tangible assets) and those with low investigation costs are more leveraged and they are more likely to default. In addition, Stulz (1990) optimal capital structure model is based on trade off of the benefit of debt in preventing the management in investing in negative NPV projects against the cost of debt in preventing the management in investing in positive NPV projects. It is therefore hypothesized that:
- A: It is hypothesized that, big construction firms have high gearing compared to small construction firms.
- B: It is hypothesized that, highly geared construction firms have low profitability compared to small construction firms.
- C: Thus, big construction firms have low profitability compared to small construction firms.
Hypothesis 2: There exists a negative relationship between the Gearing of a company and its liquidity.
Hypothesis 3: There is a direct relationship between the profitability of a company and its liquidity. It is proposed that this relationship is likely to be a negative one.
4 DATA AND METHODOLOGY
4.1 Firm Selection and Data Collection
The majority of the data for this study was obtained from respective company websites and database such as Fame. The companies used for the purpose of this study were selected according to the top 500 UK companies. In order to be selected, a firm must have appeared for all years in the top 500 UK construction firms between 2000 and 2008. A total of 162 companies fell into this criterion.
A total of the top 162 UK construction firms have been selected as the sample of study as shown in table 4. Financial information relating to these companies is more readily accessible and their standard of accounting is more formalized according to the Generally Accepted Accounting Practice (GAAP) regulations. The sample however is quite inclusive in regard to size. The biggest firm in the study was Balfour Beatty Plc with 2008 total turnover of £8.261 billion while the smallest company was Redrow Homes (NW) Limited with a total turnover of £51 million.
Company annual reports were the primary source to gain financial data for specific firms. These were available from their respective websites. Additional data was obtained from the Fame databases. The data was collected for a period of 9 years, from 2000 to 2008. Notably, data for most cases was accessible, except for some instances where specific data was omitted. For these cases, data was collected up to the point of unavailability.
Recent financial scandals have put doubt on the reliance of the company financial data to infer conclusions regarding the health of a firm. Although financial reports can be manipulated to paint a favourable picture of the firm, it is generally agreed that these financial reports still constitute a reliable and meaningful source of information. Listed company financial reports must follow certain standardized reporting rules such as GAAP, which are regularly reviewed to improve transparency and to correct for any irregularities in financial reporting. Company financial reports have also to be independently audited while Financial Services Authority (FSA) scrutinizes corporate governance and financial reports to identify any kind of fraud.
Arguably, perhaps the most contentious issue regarding financial reporting is the dimension that affects the interpretations of financial reports. Specifically, one off entries of extraordinary loss or earning could distort the balance sheet of the company. Imagine a situation where the company has sold part of its operating arm. Although the earnings from such an activity would be considered as revenue, it is certain to improve the profit of such a company in that given year but might result in reduced earnings in future years as the potential earning from the discarded operations will not be forthcoming. Such one off extraordinary event is often given as small prints footnotes in the financial reports. In this study, such one off events was excluded in order to standardize the data.
This study was organized into two parts in order to identify overall trend and annual profitability of UK construction firms in relation to liquidity and other business indicators.
4.2.1 Part 1- Fundamental analysis of profitability and the size of UK construction firms
This part examined the fundamental relationship between profitability of construction firms and company turnover - the proxy for company size- between 2000 and 2008. Two analyses were made
188.8.131.52 Trends of Turnover Growth
Overall, trends that display revenue growth may help to explain the recent outlook of the UK construction industry. Annual revenue reports of firms from 2000 to 2008 were extracted in order to examine their trends. The year 2000 was used as the basis for calculation of revenue for each company, and given a value of 100%. The index value for the subsequent year Y was computed as: revenue in year Y divided by revenue in 2000 (100 %) in order to normalize the ratio as a relative measure. This computation gives fair comparisons of companies of different sizes. Large companies with more resources can increase contract volume that results in higher revenues. Direct comparison of absolute values may result in distortions.
184.108.40.206 Analysis of Profitability and Company size
In this study, we define the company size by its average revenue from 2000 to 2008 (inclusive). Other researchers have used a similar proxy in the construction industry (Akintoye and Skitmore, 1991 and Grossmann, 2003). Also, profitability was defined as the average net profit margin calculated as the profit before interest and tax divided by the difference between total assets and current liabilities as described by (Asenso et al., 1987) and (Wright (1970).
4.2.2 Part 2 - Examined the empirical relationship between profitability of the firms and their liquidity, gearing and sizes
An empirical method was devised in order to examine if there is a relationship between liquidity and profitability in UK construction companies. It was hypothesized that:
- There exists a negative correlation between profitability of a UK construction company and its size in terms of turnover
- There is a direct relationship between profitability of a company and its liquidity. This relationship is likely to be a negative one
- Big construction firms have high gearing, and hence, low profitability compared to small construction firms.
Profitability: The dependent variable used in this study was profitability of the firm and it is calculated as profit before interest and tax divided by the difference between total assets and current liabilities (Asenso et al., 1987) and (Wright (1970).
Current Ratio: The variable current ration was used as the proxy for liquidity and it is calculated by dividing current assets by current liabilities.
Size: The variable size was introduced in the model and it was measured by the log of firm's turnover as described in Michaelas et al., (1999). Large firms tend to have more stable cash flows and therefore a company's size is considered to be inversely proportional to the probability of default. In addition, Diamond (1989) observed that large established firms have better reputations with financial institutions and hence they tend to have more debt.
Gearing: The variable used for proxy for capital structure was financial gearing. This was calculated as the ratio of a company's long-term funds with fixed interest to its total capital.
The regression model of cross-sectional and time series data was estimated as follows: Profitability = f [The intercept of equation + (Coefficient of Size) (Size by revenue) + (Coefficient of Current Ratio) (Current Ratio) + (Coefficient of Leverage) (Leverage) + Error Term)]
Descriptive analysis was first used on the data sample to clarify the mean, median and standard deviation of each variable. Empirical analysis was carried out using Pearson correlation to measure the degree of correlation between different variables under consideration. This was followed by regression analysis to determined causal relationships between profitability variable, company size, liquidity and gearing using a least-squares dummy variable (LSDV) approach, as described by Michaelas et al. (1999).
5 Results and discussions
5.1 Results and discussion of Part 1
5.1.1 Analysis of Turnover Growth
Figure 1 demonstrates a divergent growth outlook. The results show that majority of the companies have experienced a positive continuous revenue growth during the 9-year time span. The revenue obtained in 2008 was on average 111% higher than in 2000. Overall, the outlook for company growth appears positive and progressive. Nevertheless, if we were to consider the impact of today's economic crisis, there are obvious troughs in the growth trends for 2008. Therefore, although this could suggest a recurring nature of the construction business, the limited duration of the research means that the data is inconclusive.
5.1.2 Correlation analysis between the size of the company and Profitability
SPSS Pearson correlation tests were carried out to determine whether there was any significant linear relationship between average profitability and average firm turnover. The overall test returned a correlation coefficient of -0.69 and a p value of 0.008 suggesting that there is a significant negative correlation between these two measures at the 1% level of statistical significance. Detailed results are summarized in Table 5.
Further analysis using scatter plots demonstrated that there were no obvious trend lines (see Figure 2). However, if looked at from a wider perspective, it appears that the variability of profitability reduces with increasing turnover. In conclusion of these analyses it seems that profitability of UK construction companies are linked to their sizes. Moreover, it appears that a company's profitability declines with company expansion.
A study conducted by Akintoye and Skitmore (1991), on UK construction firms showed that there appeared to be a positive correlation between profitability and the size of a construction firm. Their explanation was that large companies were "more efficient, better organized and have a better defined pricing policy". However, the above results contradict the results that were obtained by Akintoye and Skitmore (1991). One explanation for this contradiction could be the fact that the industry has undergone some strategic changes especially in the form of consolidations in mergers. These mergers might be financed through debt which explains why firms are highly geared. This support the hypothesis that the big construction firms are highly geared compared to small firms which have a negative effect on the firm's profitability. All these changes could explain the observed discrepancies.
The second observation that the profitability decreased with an increasing firm size is consistent with the findings of others; Asenso and Fellows (1987) and Akintoye and Skitmore (1991). The explanation to this finding has been suggested could result from the fact that as the level of market awareness among larger firms is higher than that of the small firms, the big firms would be quite similar in terms of pricing and production. It is therefore possible for small and medium sized companies to enjoy higher profit margins than their larger counterparts.
5.2 Results and discussion of Part 2
5.2.1 Descriptive Statistics
Results from the descriptive analysis