Masterclass

Masterclass Credit Management in the Construction Industry - an overview

Wayne Clark MICM, MAICD Construction is the third largest

industry in Australia for the number of people it employs and its GDP (Gross Domestic Product) contribution. However, it is the second largest industry when it comes to corporate insolvencies, with an average of 1,552 per annum. Understanding the nature of the industry is extremely important for effective credit management.

Industry overview

The Construction industry generates around $360 billion in revenue, producing approximately 9% of Australia’s GDP. It has a projected annual growth rate of 2.4% in the next five years. In 2019, over 1.15 million people were employed in construction (that’s 9.0% of all jobs in Australia). A further 118,800 jobs are projected to be added by May 2023. This means we will witness a 10% rise in employment in construction. “The Australian construction industry is expected to rebound in 2021 and grow by 2.6% in real terms, having contracted by 6.6% in 2019, with an estimated fall of 4% in 2020”. Source: BUSINESS WIRE – “Construction in Australia - States and Key Trends and Opportunities to 2025”

Of the 360,000 individual construction businesses in Australia, over 90% are small companies. Small businesses are the fuel that drives growth in the construction sector.

Industry profitability

Competitiveness in the Australian building and construction industry creates a low profit environment for all participants, particularly for tier 1 builders offering essentially undifferentiated offerings. A number of years ago Melbourne University

4,000

3,000

Insolvencies 7 Year Average 2013 to 2020

3,048

2,000

1,000

0

892

Accommodation & Food services Construction Manufacturing Other (business & personal) services Retail trade Transport, postal & warehousing

1,552

310

Avg per Yr 632

409

Source: ASIC

Industry Sector Payment Patterns

50.00%

40.00%

30.00%

20.00%

BICB Outstanding Debt Above 60+ Days by Industry Sector

10.00%

0.00%

Timber Exclusive to No SectorSteel FabricationInsulationCabinet Makers & Joinery RoofingSand/Gravel & L'scape SuppElectrical & White GoodsCarpet & Floor Coverings Wall & Floor TilesEarthworks & Road BldEquipment HirePlasterboard & FixersWindows & DoorsH'ware & PlumbConcrete/Concrete Prod Brick & Block Steel

Feb-19 Feb-20 Feb-21

and Deakin University conducted an analysis of the profitability of a sample of large commercial builders based in Victoria. The survey confirmed “that net profit margins for these companies are 2 and 3 percentage points of total revenues – wafer thin.” The table below shows profit margins in the construction industry at 2009/2010 (Source ABS).

ANZSIC subdivision Profit margin % Businesses that made a loss %

Building Construction 6.2% 30.7%

Heavy & Civil Engineering Construction 7.6% 15.7%

Construction Services 13.7% 20.9%

Total Construction 9.7% 22.5%

Credit is king in the construction industry

Everybody on a construction project is waiting for money from the top of the contracting chain, and the further down-the-chain a project participant is, the more opportunities there are to experience hiccups or abuses in the payment process. Money can slip through the cracks on construction projects in a variety of places, and, there are also many reasons why payments get delayed. Because everybody on the project is waiting for the parties above them to get paid before they are, any little inconvenience, delay, or dispute about any component of the work can impact payment for everyone on the project, whether or not that party was directly involved.

Industry regulators or licencing bodies

z Queensland Building and Construction Commission (QBCC) z NSW Fair Trading – Home Building Act 1989 and Home Building Regulations 2014. z Victorian Building Authority (VBA) z TAS Consumer, Building and Occupational Services z SA Consumer and Business Services z WA Department of Mines, Industry Regulation and

Safety z NT Building Practitioners Board z ACT Government, ACT Construction Occupation (Licensing) Act 2004

The credit function

The fundamental role of the credit manager is to provide governance of the organisation’s Credit Policy. So, it is extremely important that an organisation has a Credit Policy that clearly defines the parameters of their role. “Credit management is the process of granting credit, setting the terms on which it is granted, recovering

“Credit management is the process of granting credit, setting the terms on which it is granted, recovering this credit when it is due, and ensuring compliance with company credit policy, among other credit related functions.”

Construction’s credit-heavy system presents challenges for Finance Managers and Credit Managers who supply to the construction industry. It is extremely important that Credit Managers be aware of the risks to which construction businesses are exposed.

this credit when it is due, and ensuring compliance with company credit policy, among other credit related functions. The goal within a company in controlling credit is to improve revenues and profit by facilitating sales and reducing financial risks.”

Understanding the risks

The construction industry is heavily dependent on credit. Almost every construction industry participant supplies their work and/or materials without requiring payment prior to delivery. The value of the labour and/or materials supplied on credit can be substantial and the creditbased payment scheme extends all the way through the payment chain. Most companies both extend credit to customers and rely on credit from suppliers. It is quite common that the payment of a company’s own bills is delayed until payment is received from parties higher in the contracting chain. Construction’s creditheavy system presents challenges for Finance Managers and Credit Managers who supply to the construction industry. It is extremely important that Credit Managers be aware of the risks to which construction businesses are exposed. z Financial risk: Such as unmanaged growth, lack of sales, rising interest rates, overtrading, problems with the economy, and increases in oil and building supply prices. Chasing low margin sales is a recipe for failure. z Contractual risk: Penalties they may have to pay for not completing a job on time. z Project risk: Lack of proper project management, inadequate company policies or lack of application of such policies, miscalculation of time and resources required, and more. z Stakeholder risk: Problems of communication, misunderstanding on the deliverables or closeout of a building project, insufficiency of stakeholder funds. z Natural risks: Floods, earthquakes, pandemics, and other phenomena that damage construction sites or make access for work difficult or impossible. z Competition: Pressure to match price or delivery terms offered by a competitor, possibly putting profitability at risk or straining resources, loss of a project or opportunity to a competitor, and more.

Assessing risk

Whether onboarding new customers or, reviewing existing customers, access to meaningful data is critical. This information can be sourced in a variety of ways. Credit Reporting Agencies and Industry Trade Bureaus providing online access to current and historical trading data, Court actions, ASIC data, Licencing Regulators and Trade References from other suppliers. These information sources should enable the credit team to make an informed decision to trade or not trade. ➤

Regional Payment Patterns

20.00%

BICB Avg Debt % Outstanding Above 60+ Days by Region

15.00%

10.00%

5.00%

0.00%

Gold Sunshine Darling Central North Northern Brisbane Victoria Western 17/18 18/19 19/20 20/21 YTD VictoriaBrisbane & OtherNorthern TerritoryNorth QldCentral QldDarling DownsSunshine CoastGold CoastCoast Coast Downs Qld Qld Territory & Other Western AustAustralia NSW

NSW

It is often difficult to obtain financial reports from customers but, if they can be secured, then it is important to understand what they mean. Generally, they are historical documents, that is, they reflect what has happened in the past.

Things to consider when assessing risk

z Do they have a good payment history? z How long have they been operating? z Do they have a current contractor/builder licence (if required)? z Have they had a contractor/builder licence cancelled or suspended? z Have they been involved in any court actions? z Have they been involved in failed businesses in the past? z What is the business structure, company, partnership, sole trader, trust? z In what industry sector are they operating? z Do the owners or directors own property? z Are the directors willing to supply Director

Guarantees? z Are they willing to provide financial reports? (Note 1) z Do they meet the 5 c’s of credit test – Character,

Capacity, Capital, Collateral, Conditions?

Note 1: In Queensland QBCC imposes Net tangible asset requirements. NTA disclosure must be supported by audited financial statements. As far as I am aware QBCC is the only regulator that imposes minimum financial requirement for licencing.

Managing credit risk

z Know your customer – regular review process z Balanced payment conditions, deal with barriers to getting paid z Foster co-operation between Credit and Sales (Vital) z Work on all ageing buckets z Resolve queries quickly z Implement a short and effective collection process z Secure ‘Director Guarantees’ whenever possible z PPSR Registration z Enforce Credit Limits z Obtain security i.e., bank guarantees, in certain circumstances z Minimise the Risk of a Preferential Payment Claim i.e., PPS registration, ensure repayment agreements are not paid in round numbers i.e., $2,000, but random amounts or by specific invoices.

Reviewing financial reports

It is often difficult to obtain financial reports from customers but, if they can be secured, then it is important to understand what they mean. Generally, they are historical documents, that is, they reflect what has happened in the past. Examining the Profit & Loss Statements will show if they are making a profit or loss and give a breakdown of income and expenses. The Balance Sheet will provide information on Assets and Liabilities and also their net equity position. It is important to understand that the largest asset for a building business is usually ‘work in progress’. This asset can quickly evaporate if the business is placed into external administration.

Measuring collection efficiency

There are many opinions concerning methods for measuring the efficiency of collecting accounts receivable. Listed below are a few of the most common methods for calculating and measuring the effectiveness of your organization’s Accounts Receivables collections.

DSO – the most common way to measure the effectiveness of the organization’s collection is with the DSO (Days Sales Outstanding).

‘Thumb Rule’ Approach – the popularity of the ‘thumb rule’ approach lies perhaps in its simplicity: the current and preceding months’ sales are deducted from a given debtors’ balance, and the number of days involved in each month are noted. Any residual of the debtors’ balance is then expressed in terms of days of the respective month’s sales. Summation of the days noted represents the number of days debtors take to pay their accounts.

ADD – Average days delinquent. The average number of days the payment is made after the invoice due date.

CEI – Collector Effective Index (CEI) is similar to DSO and is measuring the effectiveness of the individual collector. It is another alternative in evaluating your company’s efficiency in its operations. This KPI will show at each collector level, the amount of money that is collected in a certain period against the total receivables due for that same period.

Understanding the current and future trading economy

It is vitally important for credit managers to be aware of the prevailing economic conditions as these will have an impact on the overall risk of doing business. The

prevailing sentiment amongst insolvency specialists is that insolvency and restructuring work across a range of industry sectors is going to ramp up in the first half of this year (2021). The following conditions support this sentiment: the cessation of Statutory relief for directors from liability for insolvent trading ceasing on December 31, 2020, together with the thresholds for issuing and enforcing statutory demands and the rolling back of stimulus measures. In general, we at BICB also hold to this view about the construction sector. Our forecast is for insolvencies to come in at around 1,161 for 2020/2021 and around 1,930 for 2021/2022.

We also took the following factors into consideration when making these forecasts: z Historic insolvency numbers (5-year average) z The removal of the JobKeeper program from 28

March 2021. z Domestic building stimulus measures. z Current and historic Building approvals. z Supplier ability to meet increased demand. z Cash-flow issues due to construction delays. z Price increases due to supply and demand pressures causing cost blow-outs. z Likelihood of lenders taking a harder line on businesses that have underperformed in recent years. z Simplified debt restructuring and liquidation processes for businesses that have under AUD $1 million in liabilities. z BICB’s current and historical payment trend data. z BICB’s monthly risk profile data.

*Wayne Clark MICM, MAICD Executive Director, Building Industry Credit Bureau Email: wayne@bicb.com.au T: 0402 244515

SOURCES:

ABS – 21.3 CONSTRUCTION INDUSTRY(a), Selected performance measures

BICB Article published 2 March 2021 www.bicb.com.au BICB Trading Data Statistics ASIC Series 1A Companies entering external administration - by industry Construction Industry Facts (Updated 2020) - Back to Basics DUBLIN--(BUSINESS WIRE)--The “Construction in Australia - States and Key Trends and Opportunities to 2025” report has been added to ResearchAndMarkets.com›s offering. The Ultimate Guide to Construction Risk Management Published Oct. 30, 2015 by Rachel Burger in Construction Management.

2,500

2,000

1,500

1,647

1,000

500

Insolvencies Construction Industry

1,511

1,354 1,515 y = 8.7879x + 1474.6

1,450

1,161 1,930

0

2015/2016 2016/2017 2017/2018 2018/2019 2019/2020 2020/2021 Forecast 2021/2022 Forecast

It is vitally important for credit managers to be aware of the prevailing economic conditions as these will have an impact on the overall risk of doing business. The prevailing sentiment amongst insolvency specialists is that insolvency and restructuring work across a range of industry sectors is going to ramp up in the first half of this year (2021).