Credit rating downgraded for 33% of construction companies

By Brad Walters MICM*

Around this time last year, we wrote an article in this magazine warning of the difficulties ahead for Australia’s construction industry. Our data showed that construction industry insolvencies would be on the rise and that small construction business operators were dipping into their personal finances to keep their operations afloat.

A year goes by A year later, and the future is no brighter for this embattled sector.

In January 2023, 33% of the construction entities Equifax assessed had their credit rating downgraded. Considering the credit rating of many entities in this sector is in the Highly Speculative ‘B’ range, many businesses were already in a position where they were vulnerable to adverse business, financial and economic conditions. When faced with adverse conditions over a protracted period, the headroom is often insufficient to weather the storm.

Should this trend of credit downgrades continue, we expect more construction entities over 2023 to be rated in the ‘CCC’ / High-Risk Credit Watch category. CCC-rated businesses exhibit significantly higher risk attributes, and the market typically avoids engaging with them. Where no viable alternative exists, principals and partners typically limit their exposure to these contracting entities by requiring third-party guarantees and strict contract terms.

With construction failures on the rise, financiers, insurers and other stakeholders are becoming more cautious. Equifax insolvency data for the financial year-to-date reveals construction insolvencies are up 89%. Construction insolvencies increased by 50% in the second half of 2022 compared to the first half. The construction industry has become one of the top five late-payers, and we’ve observed a higher proportion of construction businesses experiencing cash flow difficulties with many reporting net cash outflow.

Erosion of margins

As shown in Exhibit 1, eroded profit margins are a characteristic associated with entities that have had their credit rating downgraded.

For too long, construction businesses have had to cope with supply chain issues, labour shortages and adverse weather events, contributing to higher project costs and delay blowouts. This pressure can be too hard to bear in an environment where construction companies without the protections of rise and fall clauses may be unable to pass on increased costs under fixed price contracts.

Reduced cash balances

Exhibit 2 shows that weaker margins have seen companies eat into their cash balances over the last 12 months. The decrease has been swift for more vulnerable entities who relied on temporary relief mechanisms and supportive policies through Covid to improve their cash levels. This rapid downturn points to further issues on the immediate horizon.

Supply chain finance impacted

As shown in exhibit 3, entities with downgraded credit ratings have lower creditor days outstanding, which could reflect their reduced bargaining power with creditors. The slowing economy has made it harder for these businesses to continue to rely on supply chain finance from trade credit and early customer deposits, which have often been used to fund their operations.

Fewer new construction projects and reduced cash reserves have made it increasingly difficult for struggling businesses to have the resilience to weather further shocks to their cash flows. With increased interest rates and a more cautious lending environment, the question remains how these businesses with relatively small balance sheets and diminished cash reserves will fund themselves for the remainder of 2023.

Introducing a transparent & auditable risk assessment process

Despite the challenges facing the construction sector, there are still operators exhibiting sufficient financial capacity, capital, capability and resilience to weather the storm. To recognise and reward these trustworthy players, a public and private sector working group has collaborated around a new star-rating regime, which enables construction businesses to go through an independent and rigorous review process to obtain a star-rating outcome that substantiates and verifies their resilience.

The new Independent Construction Industry Rating Tool, iCIRT from Equifax provides an opportunity for more reliable players to differentiate themselves in the market and be accountable for the quality of the built assets they deliver. Higher standards drive improved public trust and market confidence, vital ingredients for an industry’s long-term viability and profitability.

More than 200 construction businesses are working through the assessment to receive a rating of between one and five stars. By expanding the line of sight and providing early visibility into who are the reputable players, dealing with trustworthy constructors is now a choice people can make. Confidence is already returning to the industry with the recent introduction of latent defects insurance, giving rated developers a way to offer 10-year protection to residential apartment buyers.

Real estate agents, financiers, insurers and industry partners are also beginning to seek out credentialed, star-rated builders and developers in a trend that may yet counterbalance some of the construction industry’s headwinds.

*Brad Walters MICM Head of Product & Rating Services Equifax www.equifax.com.au