Too Big to Fix: Construction Conundrums
While economies worldwide are still grappling with the aftermath of a colossal financial crisis where confidence levels are on a roller coaster ride, the GCC construction market is still perceived to be a safe haven to do business. But it can equally spell disaster if breakneck revenue growth of any company is not properly aligned with prudent cash flow management.
Just look at these numbers reported by some of the largest listed construction firms. Company X, one of the market leaders in general contracting business, has doubled its projects backlog in past two years to 25bn, but the amount of money owed to it by its clients is almost 10bn. Company Y, a leader in engineering services subcontracting firm, also had its project bookings grown to staggering 15bn, but the receivables stand close to 6bn.
These disproportionate ratios has made the companies’ cash balance shrunk to alarmingly low levels, forcing them to seek bank loans, despite the massive sum raised earlier through IPOs. Since project financing through bond market is still in its infancy, banks will continue to play a major role, but they would be conservative in the wake of the 2008-9 crash. This is well reflected when you look at over 40% increase in construction loans issued by banks to reach close to AED181bn.
Things could further go wrong for contractors as highly competitive market does not permit firms to secure newly booked huge project backlogs with decent margins. Making profit these days is like finding a needle in a haystack. This assumption is substantiated by the fact that Company X reported year-on-year net profit rise of a meagre 10% despite doubling the revenue, whilst company Y posted a huge 50% drop in profit.
A similar scenario could unfold for other privately held contracting firms also, albeit on relatively smaller scale, as more and more firms are taking the illusionary path to grow simply too fast in a scenario wherein contract agreements are lopsided and majority of developers are very slow in their payments to contractors. It’s obvious that already squeezed margin of newly secured projects may not be sustainable in the long term, and will not generate adequate retained earnings for contractors to fund their operations, and could take a serious hit leading to cash crunch and loss of reputation.
The current method of measuring corporate performance is based on the earnings, earnings growth and return on equity (ROE). Going forward, companies should change the way they look at growing their business. They have to generate real economic value in terms of Economic Value Added (EVA), as opposed to mere accounting value as measured by GAAP metrics.
EVA measures a firms economic profit– it’s profit after subtracting full weighted average cost of capital, and after correcting accounting distortions. EVA will increase when costs are cut, assets are managed judiciously, and profitability grows the business over the full cost of the capital. The bottom line is: sitting on a risky business like contracting when opportunities for steep revenue growth knocks the door, it’s vital that organizations have their robust financial management in place together with adequate talent pool to successfully complete their committed project.
If companies do better, it’s better for the community as a whole. It’s certainly better than trying to fix problems which could be simply become too big to handle.