Financial analysis of a contractor

1. Literature Review

The increase in PFI/PPP projects has been due to the governments need for additional services without the use of public sector finances. The main areas that have seen investment includes hospitals, schools, prisons, defence and roads. These are hugely important projects which typically last for twenty five years. Due to the projects importance it is imperative that the most suitable contractor is selected.

Contractor pre-qualification and bid evaluation proposals are assessed using different types criterion to evaluate their suitability. General, technical, managerial and financial criteria were highlighted by Hunt et al (1966). Hatush and Skitmore (1997) identified five main criteria for contractor selection as shown below in Figure 2.1 which will be explored in greater detail in the following sections.

PQQ’s usually involve answering a standard questionnaire but can also include a formal interview and presentation depending on the client’s requirements (Cooke and Williams, 2009). If contractors are successful at the PQQ stage they are then requested to provide a tender submission outlining their design proposal and cost. Depending on the procurement path a series of interviews may follow with the contractor finally submitting their best and final offer.

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1.1 Financial Position

The financial analysis of a contractors accounts involves assessing their past, present and expected future financial position so that any risks which they may bring to the project can be highlighted early on. In the pre-qualification and bid evaluation stages the main objective of the financial analysis is to determine the applicants with the financial capability of developing and delivering the project to the client’s requirements (Lamb & Merna, 2004). It would involve scrutiny of their accounts to determine profitability, solvency, liquidity, asset strength, and payment history.

1.1.1 Financial Stability

The financial stability of a contractor refers to their financial position and ability to effectively manage their finances and continue to meet contractual obligations without the need for assistance. Construction companies are severely affected by outer influences such as inflation and interest during a boom time and a reduction in construction activity during a recession.

This is particularly important in PFI/PPP projects as the contractor will usually have to wait for any variation payments until after the Special Purpose Vehicle (SPV) has begun receiving their unitary charges. This is commonly referred to as equivalent project relief (EPR) and means that the construction sub-contractor is not entitled to compensation or relief until the SPV is entitled to the same relief under the project agreement (Oyedele, 2009).

In the current economic climate a number of contractors are taking enormous risks by taking on projects at below cost in order to hold onto their market share. Both Whitten (2009) and Scully (2009) argue the point that below cost tendering is unsustainable and will increase the risk of contractors facing insolvency. The insolvencies are predicted to occur firstly among contractors who tender correctly but fail to win the contract and then among those who win the contract with unsustainably low bids. PFI/PPP projects however are seen as a way to ensure contractors survival during the recession as they are provided with a guaranteed source of income for between twenty to twenty five years.

1.1.2 Credit Rating

The credit rating of a construction firm is decided by individual lenders who use their own criteria when deciding whether or not to lend money, but they also rely heavily on data supplied by credit rating agencies. If a contractor has a poor credit rating they may be unable to pay their suppliers and sub-contractors during the project as agreed. DBRS (2008) reported that an engineering and construction company rating is dependent on a number of factors which include;

* Risk Management – The inability to effectively identify and manage risk severely affects a companies rating as it is then susceptible to huge losses.

* Project Complexity and Company Expertise – The agency will investigate the project complexity to decide on the probability of a time overrun as the liquidated ascertained damages are high in PFI/PPP projects.

* Financial Volatility – Construction companies are affected by cyclical changes in the economy which can severely affect their already tight margins.

* Size and Liquidity – A large contractor typically can achieve greater economies of scale and is in a more powerful position when negotiating with suppliers and sub-contractors.

1.1.3 Banking Arrangements and Financial Status

Contractors banking arrangements provide an indication of their trading position and whether they are highly geared or not. This occurs where a company has a lot of money borrowed in relation to the amount of capital already held by the borrower.

This may affect the contractors financial status as they may have fewer ways to raise capital when required as all their capital is already used. The ideal scenario for a contractor is to have a large cash reserve in their accounts so they are better able to deal with changes as they occur. According to Hatush and Skitmore (1997), the financial status of a contractor is measured using;

1.1.4 Typical Financial Requests

When submitting PQQ’s a contractor is usually asked to submit the following documents (JNT, 2009);

* Audited accounts for the last 3 financial years.

* A statement, as at the last reporting date, of any contingent liability or loss where not otherwise reported, which would require disclosure.

* A statement of any threatened litigation or other legal proceeding against the company or its senior staff.

* Details of any significant financial factors that may have an impact on the company (e.g. mergers, take-overs, rationalisation, change of ownership).

1.1.5 Selection Criteria

If a contractor is successful in their PQQ and are requested to submit a tender then there bid is evaluated against a set of criteria determined by the client, which is frequently for the most economically advantageous tender. Tendering for PFI/PPP projects is expensive and time consuming with only large contractors willing to tender for them. The risk is transferred down to the contractor also in the contract documents so this will be reflected in their tender submissions prices.

1.2 Reputation

“Reputation is perhaps one of the most important strategic resources”, (Flanagan and Shaughnessy, 2005). A contractors reputation (past business, company size and image, trade union record, industry standing and relationships, etc) helps to set it apart from its competitors when tendering for all types of projects.

Professional reputation is important for all businesses but for large PFI/PPP projects reputation in the form of past performance information often makes the difference between winning and losing a contract.

1.2.1 Past Business

When awarding contracts past project performance helps to indicate to prospective clients what the outcome is likely to be. If a contractor has been in business for an extended period they would then typically be able to show a track record from similar projects in the past (Watt et al, 2009).

Due to the current economic recession a number of construction companies are diversifying and may have a successful track record in the industry but not in a particular field and would therefore loose out to more experienced contractors.

1.2.2 Company Image and Size

A company’s image and size help to establish its “brand name” which distinguishes it from its competitors and alleviates client uncertainty which occurs in any project. A positive company image is particularly important for government contracts as it is funded by taxpayers money who will not want to see their money going to companies with a poor trade union record or environmental policy.

Quality standards such as ISO 9000 series give an indication that your service or products will meet a consistent standard. Sustainable construction is a relatively new concept that describes how we meet the needs of today, using an economical approach of our resources so that the needs of future generations are not compromised.

Health and safety and environmental management plans are hugely important when assessing a contract tender. The Department of Trade and Industry (2007) view the benefits of a good environmental management plan to include:

* Helping to reduce the effect of construction on the environment.

* Saving on costs.

* Improving the public image of the contractor.

* Helping to meet environmental law.

1.2.3 Previous Client/Contractor Relationship

The importance of previous dealings between clients and contractors cannot be overstated as a positive relationship can increase productivity and lead onto future projects. The issue partnering has been widely adopted in tendering in the last number of years as it offers the opportunity for improving the project outcome aswell as benefiting the whole supply chain (Dozzi et al., 1996). It utilizes each participant’s expertise and resources so that the required business objectives can be met or exceeded (Bennett & Jayes, 1998).

8. References

Bennett and Jayes (1998). The Seven Pillars of Partnering: A Guide to Second Generation Partnering. London: Thomas Telford.

Cooke, B. and Williams, P. (2009). Construction Planning, Programming and Control. Oxford: Blackwell Publishing.

DBRS. (2008 ). Rating Engineering and Construction. Toronto: DBRS.

Department of Trade and Enterprise (2007). Tendering for Public Contracts. Crown Copyright.

Dozzi, P. H. (1996). More Stable Owner-Contractor Relationships. Journal of Construction Enngineering and Management , Vol.122 No.1: pp.30-35.

JNT Association, (2009). Generic Prequalification Questionnaire. The JNT Association.

Oyedele, L. (2009). Construction Aspects of PFI Projects. Procurement and Constract Administration Lecture. Belfast: Queens University, Belfast.

Salama, M., Aziz, H., Sawah, H. and Samadony, A. (2006). Investigating the Criteria for Contractors Selection and Bid Evaluation in Egypt. Association of Researchers in Construction Management , 531-540.

Scully, D. (2009, December 17). Irish Construction Industry. Retrieved December 20, 2009, from irishconstruction.com: http://www.irishconstruction.com/page/2310

Shaughnessy and Flanagan (2005). The Effect of Layoffs on Firm reputation. Journal of Management , 31, 445-463.

Skitmore, M. and Hatush, Z. (1997). Criteria for Contractor Selection. Construction Management Economics , 15 (1), 19-38.

Watt, D.J., Kayis, B. and Willey, K. (2009). Identifying Key Factors in the Evaluation of Tenders for Projects and Services. International Journal of Project Management , (27) 250-260.

Whitten, N. (2009, August 17). Construction News. Retrieved December 20, 2009, from www.cnplus.co.uk: http://www.cnplus.co.uk/news/business/ceca-warns-of-firms-tendering-below-cost-trend/5206820.article