“The cheque is in the mail”

By Eamonn Ryan and Ntsako Khosa

The government needs to do more to stamp out late payment practices, unreasonable terms, and corporate bullying to prevent subcontractors from being burnt. Until then, bank products and facilities can improve contractors’ working capital availability. 

randsThe construction industry is suffering a cash flow crisis, as work and margins narrow.
Image credit: Financial Times

This is far from being a local issue only. The UK government is being lobbied to introduce blacklisting of late-paying contractors in the wake of the collapse of Carillion Construction a year ago, as the demise of that notorious late-payer has threatened to take down many other suppliers and subcontractors with it.

Locally, it is in everyone’s interests to promote previously disadvantaged artisans to become successful contractors and to contribute to a vibrant middle class. However, it is almost as if the main interest of municipalities was to see them fail. According to South African Forum of Civil Engineering Contractors (SAFCEC) statistics, barely one of six start-up contractors succeeds.

Late payment can bite back

There are risks related to slow or non-payment. In January, footage appeared on social media showing a contractor smashing up a new Travelodge hotel in Liverpool with a digger. He claimed he hadn’t been paid, so in revenge smashed windows, causing carnage the day before its official opening. In the footage, the digger crashes into doors and windows, sending shards of glass and door posts crashing to the ground. During the driver’s initial attempt to break through, the digger falls back down the steps. When he tries again, though, he gets into the reception area as the sound of destruction echoes around the car park. A man can be heard saying on the video: “That’s what happens when people don’t pay their wages.”

There is considerable public sympathy for the man. A GoFundMe page almost immediately raised his wages, while other people commented on social media:

  • “The man’s a legend! Standing up for the hard-working man, too many companies not paying their workers what is owed!”
  • Another added: “We have all been this guy at one point in our working lives.”

The cash flow of the construction sector is in a woeful condition for three reasons: a lack of business; tight margins (sometimes as low as 1%, and on average 2.5%) on what business still exists; and late payment terms. Those companies with plentiful working capital built up over the years are surviving but fast eating into their capital, while those less fortunate are going into insolvency. There is a genuine fear that by the time the economy turns around, the sector will be irretrievably broken, and such work as finally does come to market will go to foreign companies and workers.

How can companies ensure they survive what is expected to be a tough year for construction? This is especially difficult for SMEs and BEE companies that have not been able to build up working capital over the years and are consequently most at risk.

Ian MasseyIan Massey, director of MDA Consulting.
Image credit: Eamonn Ryan

Cash conversion

Construction can be highly profitable, says Ian Massey, director of MDA Consulting. If a business can turn over its working capital optimally six times a year with a 10% margin, it can increase its working capital by 60% in a year. In times like those — which we probably haven’t seen since the 2010 Soccer World Cup — companies should have been building up their working capital for when the cycle turns, as now. Turning over one’s working capital just three times a year because of late or slow payment at low or negative margins, rapidly eats into one’s working capital and is unsustainable even in the medium run.

“Large companies like the big six should be steadily accumulating profit, giving them a war-chest [working capital] to take on more, or bigger, projects. If you do a turnover of R30-million/year, you need working capital of R10-million to cover wages, materials (on 30-day credit), and other costs until the project is fully drawn down,” says Massey. He explains that the difficulty of working on a project-by-project basis (with no accumulated working capital) is that “it only becomes profitable when the defect liability payment is made. Furthermore, if you are losing money on a project, then it erodes your working capital immediately.”

When the big listed companies such as Aveng or Group Five lose money on a large international project, that immediately affects their capital, and they may have to raise new shareholder capital. In fact, some of these large companies are in difficulty, with business rescue and even bankruptcy a prospect.

“At the moment, nobody is making acceptable margins and at current profit levels, it is better to invest that money in the post office,” explains Massey. “Government lists construction as one of the economic engines with the capability to create many jobs. At this rate, our industry will go out of business as contractors from outside the country complete local works.”

Massey highlights another issue affecting the sector’s cash flow: the fallout of the 2010 Soccer World Cup collusion fines levied on the top-six firms, with a further R1.25-billion agreed as part of the Voluntary Reconstruction Programme. “There has been no quid pro quo from government for the business they direct the way of smaller, mentored companies. That means there has been an aggregate R2.5-billion deterioration in the working capital of these companies, and the top-six are not making the kind of money to cover these payments. I have also not seen them calling special AGMs to approach shareholders for capital — so it will show as a loss and may be a contributing factor to their insolvency.”

Massey notes that unlisted companies do not have the ability to go to shareholders for more capital and are therefore completely reliant on accumulated profits. “The case of start-up and BEE companies is therefore a major challenge, given that construction is a high-risk business. Fifty to sixty per cent of monthly project expenditure has to be funded out of working capital and is often paid out 30 days later — if they’re lucky,” says Massey.

Late payment is a major issue in the sector; one that shows no sign of improvement, “Though it can’t get worse,” says Massey. “We have to resolve this. The people who are responsible for paying contractors have a contractual responsibility to do so, a duty which has nothing to do with their internal systems.”

One means of raising working capital — that of crowd-funding — is a non-starter in South Africa, he says, because of the risks associated in South Africa and because of our financial regulations.

In 2010, a few months into a rehabilitation contract awarded to Sanyati Civil Engineering and Construction, the Free State roads department ran out of money. The main contractor, Sanyati, entered financial distress when a number of government departments failed to settle in excess of R70-million for contracts completed over a year earlier. The province later paid Sanyati’s liquidators R25-million in a court settlement. Company documents seen by amaBhungane hint that factional battles within the ANC government may have underpinned the province’s failure to pay.

Lack of financial skills

Allon Raiz, CEO of entrepreneurial support company and incubator Raizcorp, says that civil engineering contractors often share a weakness with other low-margin, high-volume businesses: a lack of financial skills, or inability to afford people with such skills. The result is poor costing of projects. “Many don’t have a good relationship with numbers, their costing is sketchy, and they frequently make less margin than they expect.”

Like many other start-up businesses, the entrepreneur is a technical person who loves what he does. Unfortunately, a business involves not just technical skills but the full panoply of proficiencies, from accounting to marketing and administration, which a single person is unlikely to share. While other advisers prescribe a minimum working capital, Raiz say this is unlikely in practice and an entrepreneur can simply aim to have “as much capital as possible”.

He urges prospective business owners to look for an investor as early as possible — because often its financial position only gets worse over time. With its poor financial skills and costing, it often occurs that a business makes a loss on its initial contracts, steadily eroding its working capital until it finally seeks an investor. By this time, their books might not justify the entry of any prudent investor.

Allon Raiz Founder of RaizcorpAllon Raiz, CEO of entrepreneurial support company and incubator Raizcorp.
Image credit: Raizcorp

Things to avoid in building a contracting business

Single-project focus: Raiz lists this as one of the most common mistakes he has witnessed by construction business start-ups. Firstly, many small construction companies spend all their time and energy on bidding for and servicing large projects. Allied to this is that single focus leads contractors to becoming simply project-based operations, making them highly susceptible to a feast-or-famine situation. When their single big project is finished, many such companies do not have a pool of smaller projects that will sustain them until the next big opportunity arrives.

“This comes about when a contractor is desperate for business, and rushes in to accept a project without reading the fine print. The contract may require the owner to be on site throughout the contract, inhibiting him from hunting for other work. When the project is complete, only then can he start to look for the next job. This unproductive gap consumes the profit made, often resulting in letting go skilled staff, so that when he gets the next tender, he is effectively starting from scratch to hire new staff. There is no accumulated core of experience. The single-project focus must be avoided by dedicating time to look for new opportunities continually, even when at work on a large project,” says Raiz.

Lack of diversity in offerings: A report published in August 2011 by two members of the University of Cape Town’s Department of Construction Economics and Management, Dr Abimbola Windapo and Prof. Keith Cattell, indicates that “the ability of a company to grow, improve turnover, and gain greater market share is linked to its ability to diversify its services and products.”

Most of the successful companies that were surveyed were “active in at least three types of product/service markets — most commonly in civil engineering contracting, general building contracting, property development and housing development.” To ensure the sustainability of their operation, a construction firm should focus not only on having a number of projects at hand, but also on diversifying the range of products and services they offer. Michael Latchigadu, trade and debtor finance head at Sasfin Bank, shares the same sentiment, stating that contractors should work towards having a good balance of work between the public and private sector.

Unclear profitability: Raiz explains that often the profits attached to a project is not as high as expected. “This is due to a lack of experience and understanding in project costing. This leads to the expected profits gradually being eaten away by unplanned-for expenses. The net effect is that profits on big projects are often nominal, if not ultimately negative.”

Overextending working capital: This is a catch-22 situation that many construction companies find themselves in when they are handling projects. Having taken on projects too large for their own resources to cope with, they find themselves both without the working capital they need to continue with the project, as well as having to subcontract various aspects of their projects to other companies — which reduces profits even further. The lack of working capital and access to finance is a major constraint on contractors at all levels of the industry. In their report, Windapo and Cattell found that the leaders of successful firms interviewed were unanimous in “acknowledging that the specific strategy responsible for their company’s development, growth, and success, was their decision to develop a strong financial base for the company.”

Developing a strong financial base — which is often described as a company having cash reserves of between one and a half and two times its monthly turnover — is not an easy feat, particularly given the low profit margins in the industry. It is made even more of a challenge in the South African context by the extreme delays in payment that are often encountered when projects are undertaken for public sector clients.

To counter this problem, Candice Pretorius, head of specialised and capital equipment finance at Sasfin Bank, advises that contractors shouldn’t tie up funding once they receive finance. “Instead of using your cash flow and tying it into long-term assets, rather keep it liquid, because a new contract might come up tomorrow and your funds are tied up. Cash is king — you need the availability in case that project comes up.”

Candice Pretorius head of specialised and capital equipment finance at Sasfin BankCandice Pretorius, head of specialised and capital equipment finance at Sasfin Bank.
Image credit: Ntsako Khosa

Financing mechanisms

Sasfin is an entrepreneurial bank that competes with other commercial banks by maintaining close relations with clients and understanding their working capital needs. It is therefore the antithesis of the traditional bank which, as the cliché goes, ‘gives clients an umbrella when it’s dry and takes it back when it rains’.

It offers debtor finance and funding according to the balance sheet of the business. “Among contractors, the upper tier [bigger contractors] don’t have issues with working capital because they have much easier access to shareholder and bank funding compared to contractors that are in the mid- and lower tiers. You find that mid- and low-tier businesses’ balance sheets don’t support borrowing because they don’t have sufficient equity nor collateral,” says Latchigadu.

Among mid- and lower-tier contractors, there are alternative lending options that look less at the business’s balance sheet and more at a specific contract and collateral in the form of plant and equipment or the company’s debtors’ book. “For instance, we could provide a contractor up to 80% of its receivables upfront — instead of it waiting 30, 60, or 90 days for payment,” he adds. That freed-up working capital can then be employed on the next project, instead of being tied up.

Michael Latchigadu trade and debtor finance head at Sasfin BankMichael Latchigadu, trade and debtor finance head at Sasfin Bank.
Image credit: Ntsako Khosa

“When we look at funding the lower tier [including SME and start-up BEE contractors], we understand that there’s two ways to look at their working capital. Firstly, it has to buy materials at the commencement of a project before the contractor is ever paid; secondly, there’s job execution, involving other expenses such as wages; then it raises an invoice and typically only after 60 days does the contractor get paid. Our offering provides support from the time of purchase of raw materials. Trade finance facilities release working capital in order to purchase raw materials, and by doing so allows the contractor to execute the job while tendering for future work. Finance is secured by the actual stock, and Sasfin controls the payment throughout the contract.

“The trade finance facility is secured by a general notarial bond lodged over the material (stock) and sureties. We also ensure payment is made directly to suppliers by requesting that the off-taker or debtor pays into our account. It’s a fully disclosed transaction. We don’t pay any cash to the contractor, but rather settle its financial obligations. This ensures money doesn’t go where it isn’t supposed to. So, when the debtor pays, we take what is owed to us and the profit goes to client,” he shares.

Sources: 


 

 

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