4 Facts About Construction Companies
High rate of interest have led to a working capital squeeze in the construction industry. This has actually exposed problems in its business world. The construction industry in the nation has, in recent times, been bogged down by lower margins, negative cash flows from operations, rising interest costs on high working capital, execution delays and also poor corporate governance.
- Low Margins-
- Negative Cash Flows-
- Rising Interest Cost-
- Commodity Prices-
The majority of the Indian construction/EPC (Engineering, Procurement & Construction) majors, operating in sectors such as water supply, urban infrastructure, irrigation, waste water management, roads, bridges and buildings, work on EBIDTA (operating profit) margins of 10 per cent or less and net profit margin of 2 to 4 per cent.
Till now, these companies have been focusing on turnover volumes rather than margins. This technique of building order books and concentrating on turnovers is a simple one. Winning large orders based on pre-qualifications and clocking high development rates in turnovers by partly sub-contracting such orders to smaller contractors has beaten the path of the construction majors, as opposed to the more difficult route of enhancing margins, ensuring timely execution or technology upgradation.
But following the tightening up of liquidity as well as raising of interest rates by the Reserve Bank of India over the past couple of years, there have actually been increasing delays in payments by clients of construction firms. That includes private as well as government or semi-government customers.
As a result, the sundry debtors-to-sales ratio has reached up to about 90-180 days for many EPC companies. Also, most clients retain 10-15 per cent of order value (equivalent to about 30-45 days of sales) as retention amount or performance security deposit till the defect liability period (which is typically 18 months of satisfactory performance after the completion of the project/order) is over.
Additionally, the raw material inventory, earnest money deposits submitted, etc, and the gross working capital cycle may work out from 180 days to 365 days of sales.
This is a very long working-capital cycle. And that explains why most of the construction majors have very huge amount of negative cash flows from the operations.
Recently the situation has dramatically changed. The doors for equity funding are fully closed for EPC companies due to lacklustre primary markets and changing investor perceptions.
With regards to debt funding, the cost of debt is rising significantly and has itself made it almost unviable. Furthermore, due to suspected fudging of accounts by EPC companies and corporate governance issues, most of the banks have become cautious in lending to EPC/construction companies.
These firms also have substantial off-balance sheet liabilities such as bank guarantees submitted to clients for several purposes, from securing advances given by the client to contract performances. In the changed macro-economic situation, the fees charged by banks for these guarantees would always rise due to increased risk perception.
As a result of all these factors, for various construction companies, interest and bank charges have risen to about 5 to 10 per cent of their sales. So even if EBIDTA margins may be in the range of 10 per cent, the net margins have gone down to insignificant levels.
Unable to service the debt repayments and interest charges, it is quite predicted that many EPC companies are now knocking on the doors of the Corporate Debt Restructuring or CDR Cell.
Recessionary trends in the global economy have helped significantly bring down prices of cement, steel, electro mechanical items, pipes and other commodities. However, this might not necessarily translate into improvements in margins for the EPC companies. The reason behind this is the pass-through clauses for price escalation/reduction of major raw materials, which has to be passed on to the clients.
As much as 90 per cent of overall order book of construction majors incorporates such pass-through clauses (based on RBI Price Indices, Star Prices, etc.).Only about 10 per cent of total order book might have fixed price contracts that lend limited scope for margin improvement on account of easing commodity prices.
