Updated: Oct 28, 2021
How to Determine the Financial Strength of Contractors
Contracting organisation financial strength is important to be determined within the tendering and selection stage to ensure the appointment of the appropriate contractor with limiting the risk of bankruptcy and project incompletion. The financial information of tenderers could be assessed through the collection of financial reports from the PQQ as indicated in PAS91.
Short term and long-term financial stability of the companies could be found by assessing their solvency and calculating the current ratio and acid test ratio as indicated in Equation 1 and Equation 2 respectively. A current ratio of 1 suggests a financially stable company but a trend over the last few years should be looked into to see the fluctuation of the ratio (Council, North Hertfordshire District, n.d.).
Moreover, an acid test ratio may provide a measurement of liquidity and the readily convertible into cash assets of the company with a ratio of 1.0 suggest a financially healthy contractor.
Furthermore, assessment of how efficiently the company’s management is utilising the resources at their disposal to generate revenue and drive profits up, as well as the comparison of significant debt is an important criterion for assessment.
The managerial aspect of a business could be assessed through the ROCE ratio and revenue/total assets as shown in Equation 3 and Equation 4 where higher ratio values indicate an effective contract winning strategy suggested to be important ratios by (Singh & Tiong, 2005) and (Council, North Hertfordshire District, n.d.). Furthermore, a multiple criteria decision-making (MCDM) technique as used by (Singh & Tiong, 2005) could be implemented to get an overall grade on the financial performance of tenderers with a focus given on ratios deemed more important to the client.
Nevertheless, it should be pointed out that a downturn in the construction industry or of the global economy could put a financially strong company into financial difficulties such as the currently unseen COVID-19 pandemic.
As recently seen when economy recovers from recession the pressure on contractors increases as material, labour and financial resources become stretched (Wakeford, 2015). Thereafter, risk is increased on the client where the project is required to be delivered on time and within budget limits. The major client risk is the insolvency of the contractor during construction period which could be financially limited by applying measures within the contracts signed as secondary options such as performance bonds and parent company guarantees (NEC4, 2017).
Parent/Holding Company Guarantees
A parent company guarantees are used to give the contractor recourse to a more substantial corporate entity that will underwrite the employer’s payment obligations under the contract which provides essential financial and legal assurance for the client if the subsidiary contractor is to go into insolvency (Meakin R, 2006).
Credit checks and financial evaluation of the parent company can be examined through the PQQ (PAS 91:2013, 2017), which could reveal the suitability of the capital and assets of the holding parent company to act as guarantee as well as legality of the guarantee contract.
The parent company is obliged to either complete the works in accordance with the contractors’ original obligations on behalf of its subsidiary company or fund the completion of the contract by others (K. Hughes , 2019), hence an advantage of guaranteed completion is present.
Secondary option X4 could be used from the NEC4 contract options as where a holding company guarantee is required with the contractor obligated to agree on the guarantee scope of works (NEC4, 2017) (Rowlinson, 2018).
Furthermore, a performance bond could be used in the contractual agreement as a form of financial security generally offered by a third party such as banks or insurance companies which give the client a binding enforceable payment guarantee up to a fixed amount of money in the situation of poor performance or project incompletion by the contractor.
Performance bond doesn’t guarantee project completion but a maximum sum payable for the damages by the contractor to the client for the breach of contract. Bond insurance rates vary depending on the creditworthiness of the contractor, with premiums often range between 2% and 3% of the amount guaranteed which is normally 10% of the contract price.
Contractors would normally pass on this premium to the client as part of their tender price submissions for the project. NEC4 secondary option X13 can be used as a condition precedent to the execution of the contract. Specified circumstances defined by the client that will be used to recall the sum of money from the bond should be clearly stated in the scope when contractors agree to the contract terms (Rowlinson, 2018) (NEC4, 2017).
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The procurement options mentioned provide satisfactory performance in the objectives of the golden triangle with both advantages and disadvantages to the construction client based on the project size and client priorities.
The continuing search for maximum value for money in construction work has, in recent years, increasingly focused attention upon the procurement process. Effective delivery of a project requires that the supply chain clearly understands the client’s needs and specific business case to deliver an economical and efficient end product.
Recent research into major projects by (Dalton, 2008) as shown in Table 1 found that 75-80% of the causes of projects failing were due to procurement, the definition of project requirements, and the client’s management capabilities.
Esurance of timely cash flow payments to contracting organisations
Negative cash flow means a company is doomed to fail. To ensure timely payment of both the main tier 1 contractor and supply chain sub-contractors under the NEC4-2017 contracts, option Y(UK) 1 could be used by setting up a project bank account (PBA).
Through this bank account all the payments of the work done on the project will be made (Rowlinson, 2018). A PBA ensures visibility and transparency of supply chain cash flow payments made by the main contractor and it has enabled the condensation of the payment cycle as Highways England managed to achieve a condensed payment period of average 18/19 days from the usual 30 to 60 days.
The client and project manager should ensure the trust deed forms for the PBA are included in the contract and are outlined in tender documentation and when the project is commissioned the contractor is responsible for opening and running the bank account. Also, due to that cash flow performance depends on the project managers cash flow management, additional training or competent managers would be effective on improving the overall performance of cashflow payments (Investopedia, 2020).
Council, North Hertfordshire District, n.d. CRITERIA USED FOR FINANCIAL EVALUATION OF CANDIDATES IN THE PROCUREMENT PROCESS. [Online] Available at: https://www.north-herts.gov.uk/
Singh, D. & Tiong, R. L. K., 2005. Evaluating the financial health of construction contractors D. Singh and R. L. K. Tiong Economic slowdown and fierce competition in the construction industry in recent years has led many construction companies to pull out of projects due to deep financial. [Online] Available at: https://www-icevirtuallibrary-com.
Wakeford, M., 2015. Construction Client Protection – Managing financial risks outside the contract. [Online] Available at: https://www.linkedin.com/pulse/construction-client-protection-managing-financial-risks-mark-wakeford/
Meakin R, C. W. C. L., 2006. Clyde & Co Firm Foundations: bonds and guarantee, s.l.: Firm Foundations Seminar.
PAS 91:2013, 2017. Construction prequalification questionnaires, s.l.: BSI.
K. Hughes , 2019. Understanding the NEC4 ECC Contract – a practical handbook, s.l.: Routledge.
Rowlinson, M., 2018. A Practical Guide to the NEC4 Engineering and Construction Contract, s.l.: John Wiley & Sons, Incorporated.