Carillion was in dire financial trouble. Why did the government keep awarding it contracts?

The Tories and the company's auditors have massive questions to answer.

One of the questions raised by the collapse of Carillion is how the UK government came to award major contracts to a company in such a precarious financial position.

There are clearly questions to be answered about the government’s relationship with Carillion and even more questions about the conduct of Carillion audits by KPMG. Here’s what we know.

The Tory government, like Labour before them, has been wedded to Private Finance Initiative (PFI) contracts, but surely a key requirement should have been the contractor’s ability to deliver the project.

A viable contractor should have sufficient resources and ability to absorb overruns. Such requirements do not appear to have been fulfilled by Carillion.

One of the most notable things is how little value is added by Carillion to its operations. For example, the company’s accounts for the year to 31 December 2016 show net group sales revenues of £4,395m.

Some £4,044m (92%) of this used to cover the costs of materials, various supplies and labour. Administration costs absorb £218m (5%). This leaves about 3% to cover interest payments, dividends, tax payments. Interest payments swallow up £60m (1.36%), leaving a tiny margin of less than 2% to grow or stabilise the business.

The gross margin for last decade seems to be between 2% and 5% of sales. The low margins limited Carillion’s capacity to absorb impact of inflation, contract overruns and any related financial penalties. If the outcome of contracts fluctuated by more than 2% or more then Carillion would have faced serious financial difficulties and many of its contracts would be worthless.

Despite the above background, Carillion produced optimistic cash flow forecasts and balance sheets, which could not be sustained.

On 10 July 2017, Carillion announced that: “It would be making a write down of the value of its contracts of approximately £845 million at 30 June 2017, which the Company estimated would have a net reduction of approximately £100 million – £150 million on remaining cash flow in respect of the affected contracts”

Unsurprisingly, the company’s share price fell from 192.1p on 7 July to 55.4p on 13 July last year.

By September 2017, Carillion announced an additional £200 million write down for support services contracts and said that its underlying pre-tax profits have decreased by 40%, which would have further squeezed the wafer thing margins.

Carillion had a weak capital base and thus very little capacity to absorb the assets write-down identified above.

At 31 December 2016, shareholders’ funds (or equity) as per the balance sheet were £730m and these would have been wiped by the £845m July 2017 write downs mentioned above. This meant that the company was technically insolvent and was surviving with the blessing of its bankers.

Carillion’s 2016 balance sheet had long-term debts of about £1.5bn. Given the low equity base and low profit margins, banks would have been very stringent in offering additional finance.

They may have sought assets as securities for loans, but Carillion was not in a good position to provide them. Carillion had non-current assets (plant and machinery, land and buildings, investments) of £2,163m, and £1,571m of this related to “goodwill” (generally the value of the assets of a business over and above the price paid i.e. intangible advantages).

It is a dubious asset at the best of times and of little or no value when a business’s cash flows, profits and assets are declining. The inability to offer security for loans would have made it difficult to Carillion to secure new loans.

The above raises serious questions about the business model of Carillion:

  • Why did it add so little value?
  • Were the contracts priced too low or was the company so inefficient that it simply could not unlock the value in various contracts?
  • Why was its balance sheet so inflated by worthless contracts?
  • How did auditors KPMG manage to corroborate the balance sheet values shown in the financial statements which simply evaporated?

Despite Carillion’s precarious financial position, government continued to award contracts to it.

After the July 2017 trading update (see above), Carillion secured a number of major government contracts. These included two packages for HS2 worth up to £446 million £300 million for providing support services for the UK Defence Infrastructure Organisation.

The government departments do not appear to have taken note of Carillion’s July and September trading updates, write down of assets, technical insolvency or poor cash flows.

Due diligence work, if any, carried out the governments seems deficient. Carillion had already admitted that its profit/cashflow forecasts were deficient and that it overstated its assets. Yet the government continued to award public contracts to it. The government has questions to answer.

Prem Sikka is Professor of Accounting at University of Sheffield and Emeritus Professor of Accounting at University of Essex. He tweets here.

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