The compulsory liquidation of Carillion, the UK construction giant, has been headline news for weeks – and justifiably so. The company had a market capitalization of around £2bn in 2016 but some reports suggest its debt pile was a staggering £1bn the day before it went bust, with available cash of just £29m.
What action should procurement functions that employ companies like Carillion take to ensure that proper financial controls are in place in their supply base?
The consequences of this collapse will be most sorely felt by the more than 20,000 people employed by Carillion in the UK – over 800 of whom have already been shown the door, and the large number of small and medium-sized enterprises (SMEs) that face being paid just a tiny fraction of what they are owed for services already delivered.
Yet what will be the potential impact on the extended supply chain in the construction sector? And what action should procurement functions that employ companies like Carillion take to ensure that proper financial controls are in place in their supply base?
Potential impact on the wider supply chain
- More supply chain tiering: It’s possible we’ll see a reduction in the number of smaller companies willing to contract directly with the biggest firms, preferring instead to contract through larger SMEs and spread their risk. Such a scenario could lead to more tiering and complexity in the supply chain.
- Increased margins: The adverse publicity from Carillion could lead to higher margins for its competitors in the medium term, as clients become nervous about continuing to force margins downwards, precipitating another collapse.
- Rise in costs: Clients are likely to seek greater assurances around contract performance, which could see a rise in demand for performance bonds and an increase in the level that bonds are set, with the cost being reflected in the overall price and passed to the client.
- Splitting of work packages: A more recent trend has seen clients combining many services into very few work packages meaning only the biggest contractors, like Carillion, have the capability to tender. Clients may now choose to break work into smaller packages, opening the door for more SMEs to contract directly and spreading the risk.
Increasing financial control
During the tender process the financial stability of the bidders is often scrutinized by the client’s procurement function. Yet much of this is based on historic data and given the current economic uncertainty, offers little assurance of future viability. So, what steps can procurement and the wider client business take to ensure the contractor remains financially stable throughout the lifetime of the contract?
The Carillion collapse should serve as a warning to clients to review their working arrangements with contractors and ensure they have a suitable audit procedure that alerts them to financial difficulty sooner. This might take the form of a contractual mechanism that enables ongoing analysis of the contractor’s unpublished management accounts throughout the life of the agreement. These accounts are likely to provide a much broader picture of financial health than those in the public domain. If it’s clear that there are problems on the horizon, procurement should ensure appropriate contract mechanisms are in place to phase in a new contracting firm.
During the tender process the financial stability of the bidders is often scrutinized by the client’s procurement function. Yet much of this is based on historic data and given the current economic uncertainty, offers little assurance of future viability.
Another approach is to ensure clients include an additional cashflow test that monitors the ratio of cash plus bank facilities against current contractor liabilities. The actual value of the ratio produced is largely irrelevant. What is important is whether the ratio changes dramatically, for example by, say, 20-25%, as this could indicate a step reduction in available cash to the business or a step increase in short-term liabilities – neither of which is likely to be attractive to a client. If a quarterly balance sheet is available the calculation is straightforward to perform with committed bank facilities confirmed through a letter from the bank.
Other measures client procurement teams should include in contracts or consider for inclusion are:
- Parent company guarantees (PCG) from the ultimate parent company
- Performance bonds if PCGs are not available
- Joint and several liability clauses if the delivery vehicle is a joint venture (JV). This ensures that in the event of one party failing the other parties to the JV are jointly and severally liable and are obligated to guarantee delivery of the contract and services