“This article highlights the key aspects of the construction business, helping investors understand the factors that influence construction companies and the traits that distinguish fundamentally strong firms from weaker ones.”
Major Factors Affecting the Business of Construction Companies
1) Intense Price-Based Competition in the Construction Industry
The construction sector is highly fragmented, with numerous players—regional, national, and international—competing for projects. In India, there are hundreds of medium-to-large construction companies and countless smaller firms.
Industry Fragmentation
According to ICRA’s Rating Methodology for Construction (October 2022, Page 2):
“The construction industry in India is highly fragmented with the presence of a large number of players. The sector is dotted with more than 150 medium-to-large-sized entities, and competition is further intensified by international players.”
Due to the sheer number of companies, construction firms are typically categorized into large, medium, and small segments, a classification common across global markets.
Similarly, Japan Credit Rating Agency’s Methodology for General Construction (March 2012, Page 3) states:
“The construction industry has a multi-tiered structure, with super general contractors at the top. Each tier has its own level of competition, and companies are increasingly separated due to large disparities among the tiers.”
Minimal Service Differentiation
Within each segment, distinguishing one company from another is challenging because most firms offer similar, non-differentiable services. Large firms in India—such as L&T, Shapoorji Pallonji, Tata Projects, GMR, and GVK—can all execute major infrastructure projects like airports, dams, and power plants. Consequently, clients primarily select contractors based on the lowest bid rather than unique capabilities.
This trend is reinforced by DBRS Morningstar’s Global Methodology for Rating Companies in Construction & Property Development (November 2022, Page 4):
“The segment is competitive, with contracts largely obtained through competitive bidding.”
The Challenge of Customer Retention
Even large construction firms with proven expertise in handling complex projects struggle to retain clients due to the industry’s reliance on price-based selection. While strong client relationships may facilitate smoother project execution, they do not guarantee future contracts. Each new project requires companies to re-enter the bidding process and compete again.
As noted in Standard & Poor’s Key Credit Factors for the Engineering & Construction Industry (November 2013, Page 3):
“Good customer relationships can be a differentiator for a contractor, but they don’t guarantee future work. Clients frequently replace incumbent contractors in new bids due to price or technical considerations.”
Similarly, R&I’s Rating Methodology for the Construction Sector (August 2021, Pages 2–3) highlights that:
“For public sector projects, competitive bidding takes place in principle, and such bidding has also taken hold for private sector projects. Customer continuity is therefore not strong.”
“The construction industry’s high number of players is largely driven by low entry barriers and competition from international firms. Let’s explore both factors in detail.
2) Low Barriers to Entry in the Construction Industry
The construction sector has relatively low entry barriers, making it easy for new players to enter the market. Unlike industries requiring significant capital investment or proprietary technology, construction companies can start operations with minimal upfront costs and widely available technology.
Easy Market Entry
According to Standard & Poor’s Key Credit Factors for the Engineering & Construction Industry (November 2013, Page 3):
“Barriers to entry are relatively low in the E&C industry… A small E&C company typically faces low startup costs to enter a local market, and we view the industry’s capital requirements as low relative to other industries… Contractors often lack true proprietary technologies or designs that create barriers to entry in certain end-markets.”
Similarly, Scope Ratings GmbH’s Construction and Construction Materials Rating Methodology (Germany, January 2022, Page 3) states:
“Market fragmentation reflects low market entry barriers that are the result of initial investments being low and proprietary technologies not being needed to enter local markets.”
Limited Technological Disruption
One reason construction firms do not need proprietary technology is that technological changes in the industry are slow. Construction techniques remain stable for long periods before significant advancements occur, reducing the need for specialized innovation.
As Standard & Poor’s (November 2013, Page 4) notes:
“The pace of technological change in the E&C industry is generally slow, and technological displacement is typically not a major risk factor.”
Subcontracting Keeps Operations Asset-Light
Another factor lowering entry barriers is the prevalence of subcontracting. Instead of owning heavy machinery or maintaining a large workforce, many construction firms outsource work to subcontractors, allowing them to scale operations quickly without significant capital investment.
According to CRISIL’s Rating Criteria for the Construction Industry (February 2021, Page 11):
“Several companies operate extensively through subcontractors to increase the variable element of their cost structures.”
This asset-light approach helps new entrants compete for large projects without owning extensive resources. However, while subcontracting reduces financial risk, it can also compress profit margins due to higher outsourcing costs.
As DBRS Morningstar’s Global Methodology for Rating Companies in Construction & Property Development (November 2022, Page 5) points out:
“Using subcontractors can reduce profitability while typically reducing financial risk.”
Impact on Industry Competition
The combination of low capital requirements, slow technological change, and widespread subcontracting makes it easy for new companies to enter the construction market. This contributes to market fragmentation and intensifies competition, forcing companies to compete primarily on price rather than differentiation.
Another factor further increasing competition is the entry of international players, which we will discuss next.
3) International Competition in the Construction Industry
In recent years, many construction companies have expanded their operations beyond their home countries. This trend is evident among both Indian construction firms venturing into foreign markets and international firms entering India.
With rising competition in the Indian market, many domestic companies have sought growth opportunities abroad.
According to CRISIL’s Rating Criteria for the Construction Industry (May 2013, Page 2):
“Large construction companies have diversified into international markets, particularly in the Middle East and Africa, due to intense domestic competition.”
Similarly, construction firms in other countries, such as Malaysia, have also begun expanding internationally to counter increasing competition in their local markets.
As noted in the Malaysian Rating Corporation Berhad’s Rating Methodology for Construction Companies (October 2019, Pages 2-3):
“A highly competitive environment has led large construction companies to secure a growing share of overseas projects, in some cases exceeding 50% of their order books.”
For some countries, a shrinking domestic market has also been a key driver of international expansion. Japanese construction firms, for example, have had to seek growth abroad due to a declining home market.
Japan Credit Rating Agency’s Rating Methodology for General Construction (March 2012, Page 1) states:
“The general construction industry is inherently competitive, and Japan’s domestic market has long been in decline.”
The long-term outlook for Japan’s construction industry remains uncertain, with demographic trends and fiscal challenges contributing to a projected market contraction.
According to Rating and Investment Information, Inc. (R&I), Japan (August 2021, Page 2):
“Given Japan’s declining birth rate, aging population, and financial difficulties of central and local governments, the market is expected to contract over time.”
Global credit rating agencies have also recognized the increasing globalization of construction firms.
Standard & Poor’s Key Credit Factors for the Engineering and Construction Industry (November 2013, Page 3) notes:
“National boundaries often do not present a barrier to entry for engineering and construction companies.”
When foreign construction firms enter a new market, they often bring significant capital and advanced technology, further intensifying competition for local players.
In addition to fierce competition, the construction industry is also subject to economic cycles, which can create further challenges for companies operating in this space.
Cyclicality in the Construction Business
The construction industry is highly dependent on other sectors for its growth. The demand for residential and commercial construction is influenced by the real estate market, while industrial construction relies on corporate capital expenditure, which fluctuates with economic cycles. Similarly, infrastructure and public sector projects depend on government investment policies.
As a result, the construction sector experiences alternating periods of high and low demand, leading to cyclical trends.
ICRA’s Rating Methodology for Construction (October 2022, page 2):
“The construction sector exhibits a certain degree of cyclicality, being dependent on real estate and infrastructure development activities and overall economic growth. Additionally, the industrial segment depends on capital expenditure undertaken by other industries, which is cyclical.”
DBRS Morningstar’s Global Methodology for Construction and Property Development (November 2022, page 13):
“Property development and construction are highly cyclical.”
Due to this cyclicality—characterized by alternating boom and bust phases—construction companies experience fluctuations in revenue and profitability.
This cyclical nature intensifies competition, especially during downturns, as companies bid aggressively to sustain operations. Such pricing pressures significantly erode profit margins and lead to the shutdown of smaller firms.
Standard & Poor’s Key Credit Factors for the Engineering and Construction Industry (November 2013, page 3):
“During periods of low industry demand, lack of pricing discipline among industry players has hurt profit margins, as some contractors take on lower-margin work to keep their workforce employed and prevent revenue declines.”
Similarly, Japanese credit rating agencies have highlighted the risk of severe price-based competition, often forcing companies to take on economically unsustainable projects.
R&I’s Rating Methodology for the Construction Sector (Japan, August 2021, pages 4, 7):
“Earnings tend to swing widely because, in a deteriorating operating environment, companies can easily slip into price competition due to difficulties in differentiation.”
“Profitability fluctuates with changes in the order environment, and there is a risk of engaging in unprofitable projects.”
The downward pressure on margins in domestic markets compels many construction firms to seek opportunities abroad, intensifying competition at a global level.
Scope Ratings GmbH’s Construction and Construction Materials Rating Methodology (Germany, January 2022, page 4):
“As a result of the industry’s cyclicality, most market participants tend to extend operations outside their domiciled country.”
To mitigate the impact of intense competition and cyclical downturns, many construction firms pursue business diversification strategies.
6) Scale Matters: In Construction, the Big Get Bigger
In the construction industry, company size significantly influences business opportunities and profitability. Larger construction firms enjoy multiple competitive advantages that smaller players often struggle to match.
Eligibility to Bid on Large Projects
One of the primary advantages is eligibility. Many large-scale projects set minimum size or net worth criteria, making only large companies qualified to bid. Smaller firms are typically excluded from these opportunities and may only participate as subcontractors.
ICRA Rating Methodology – Construction (Oct 2022, p. 2–3):
“The scale of the entity in terms of revenues and net worth is an important eligibility criterion when larger projects are bid for… Smaller players’ participation is restricted to smaller projects and many work on a subcontract basis.”
Higher Margins in Large Projects
Large and complex projects tend to offer better profit margins compared to smaller, simpler assignments. This is primarily because:
- Lower Competition at the Top: High-value projects often require specialized skills, equipment, and financial strength, creating natural entry barriers that limit competition.
- Simpler Projects Attract Fierce Competition: In contrast, general building or road projects see intense price-based competition due to low entry barriers.
DBRS Morningstar – Global Construction Rating Methodology (Nov 2022, p. 4):
“Price is the key consideration for simple projects… Barriers are higher for large-scale projects that require specialized equipment and proprietary technologies.”
ICRA Rating Methodology – Construction (Oct 2022, p. 3):
“Larger entities generally bid for complex projects, which offer better margins.”
Japan Credit Rating Agency – General Construction (Mar 2012, p. 3):
“Mid-sized and smaller contractors more frequently receive orders for less-profitable condominium buildings.”
Direct vs Subcontracting Margins
Large players often secure direct contracts with clients, which typically carry higher margins compared to subcontracts awarded to smaller firms.
CARE Rating Methodology – Construction Sector (Dec 2020, p. 4):
“Orders received through direct participation are usually associated with higher margins compared to sub-contracted ones.”
Client Preference for Large, Reliable Contractors
Clients prefer awarding large, long-term, and complex projects to financially strong companies. This reduces the risk of project disruption due to contractor-related issues, such as financial distress or execution delays.
Standard & Poor’s – Key Credit Factors for Engineering & Construction (Nov 2013, p. 6):
“Clients are reluctant to award contracts to lesser-known companies… With large projects, which can extend for years, clients seek assurance they won’t need to change contractors mid-project.”
Economies of Scale and Negotiating Power
Large construction firms benefit from economies of scale in procurement and operations. Their size also gives them stronger negotiating power with suppliers and subcontractors, further boosting profitability.
Scope Ratings GmbH – Construction Rating Methodology (Jan 2022, p. 7):
“Size and market position determine market strength and the ability to benefit from economies of scale.”
6.1) Access to Working Capital Financing
In the construction industry, working capital—not fixed capital—is the lifeblood of operations. While these companies typically don’t need heavy investment in fixed assets, they require substantial working capital support, particularly in the form of non-fund-based facilities like bank guarantees (BGs).
Throughout a project’s lifecycle, bank guarantees are required at multiple stages:
- Bid security at the time of bidding,
- Performance security after winning the contract, and
- Retention money guarantees during the defect liability period post-completion.
ICRA – Construction Rating Methodology (Oct 2022, p.11):
“For construction entities with long execution cycles and defect liability periods, the BG requirement keeps adding over time.”
In addition to BGs, fund-based working capital is essential to mobilize resources—such as deploying equipment and manpower, procuring materials, and funding operations—until payments are received from clients.
CRISIL – Rating Criteria for the Construction Industry (Feb 2021, p.11):
“Construction companies have sizeable funds tied up in working capital.”
CARE – Construction Sector Rating Methodology (Dec 2020, p.2):
“Construction contracts are associated with relatively large working capital requirements (mainly non-fund-based)… Delays in payments and project execution lead to receivable and inventory buildup, increasing the working capital burden.”
Given these demands, access to sufficient working capital financing is critical for sustaining operations and enabling growth. A shortage of such funding can hinder a company’s ability to take on new projects or efficiently execute ongoing ones.
ICRA – Construction Rating Methodology (Oct 2022, p.11):
“Availability of sufficient working capital bank lines is a key credit factor. Without it, the company may not be able to pursue new projects or manage existing ones effectively.”
This is where large construction companies hold a significant advantage. Their size, track record, and financial strength make them more creditworthy in the eyes of banks and capital markets. They typically have better access to:
- Bank working capital limits
- Letters of credit
- Surety bonds
- Market-based funding
Scope Ratings GmbH – Construction Methodology (Jan 2022, p.3):
“Large construction companies often have better access to third-party capital and letters of credit, which is an advantage during difficult market conditions and competitive bidding.”
S&P – Key Credit Factors in Engineering & Construction (Nov 2013, p.3):
“Access to capital and surety bonding… is typically more available to larger companies and can be an important differentiator.”
In contrast, smaller players often face challenges in raising funds due to limited assets for collateral and a weaker financial profile.
Japan Credit Rating Agency – General Construction (Mar 2012, p.5):
“Mid-sized and smaller contractors have limited hypothecated assets, and external financing is not always easy for many of them.”
As a result, larger construction firms enjoy a clear competitive edge—not just in execution capabilities but also in financial flexibility, which enables them to secure new orders and maintain market leadership.
ICRA – Construction Rating Methodology (Oct 2022, p.3):
“The scale of a construction entity’s operations indicates its market strength, operating flexibility, and its ability to undertake large projects.”
6.2) Access to Skilled Manpower
Beyond working capital, access to and retention of skilled manpower is another critical factor in the successful execution of construction projects—particularly large and complex ones.
ICRA – Construction Rating Methodology (Oct 2022, p.6):
“Attracting and retaining skilled manpower is one of the key challenges for contractors, especially with the increasing complexity of projects.”
The construction industry is often characterized by harsh and demanding work environments, especially at project sites located in remote or underdeveloped areas. Workers are frequently required to operate under difficult conditions, with limited amenities and far from urban conveniences.
R&I – Construction Sector Rating Methodology (Aug 2021, p.4):
“The working environment surrounding skilled workers is harsh compared to other industries.”
Because of this, retaining skilled labor comes at a cost. Companies need to offer competitive compensation to retain experienced and technically capable workers. Larger construction firms, backed by stronger financials, are in a better position to pay premium wages and offer better job security—giving them a significant edge in attracting and retaining top talent.
Moreover, during periods of economic slowdown, larger players often compete more aggressively, even bidding for smaller projects typically handled by mid-sized or smaller firms. This creates a cascading pressure down the project hierarchy, intensifying competition and squeezing the margins and survival of smaller players.
R&I – Construction Sector Rating Methodology (Aug 2021, p.2):
“When demand declines, major companies often pursue projects that are normally the domain of semi-major firms to maintain their partner networks, leading to competition across the hierarchy.”
This dynamic further strengthens the market position of large construction companies, allowing them to not only retain skilled labor through tough cycles, but also expand their footprint by absorbing market share from smaller, less-resilient competitors.
As a result, scale continues to be a major strategic advantage in the construction industry—reinforcing the cycle where large players become even bigger over time.
7) Limitations of Conventional Financial Analysis for Construction Companies
Traditional financial analysis often falls short when it comes to assessing the true financial health of construction companies. This is primarily because of distinct accounting practices, project-specific variables, and high dependence on management assumptions.
Most construction firms use accounting methods such as the Percentage of Completion Method (POCM) or the Completed Contract Method (CCM). These involve estimates that may vary significantly between companies.
CRISIL – Rating Criteria for Construction Industry (Feb 2021, p.5):
“Construction companies can and do adopt varying accounting policies for income and profit recognition. Analysis of accounting policies is a critical first step in financial risk assessment.”
The financial position of a construction company is essentially a cumulative reflection of all its ongoing projects. Without a project-level review, it is difficult to determine the ground realities. From publicly available financial statements, investors often cannot assess key project risks such as land acquisition, regulatory approvals, cost overruns, or delayed execution—factors that are frequently obscured or under-disclosed.
Additionally, construction companies typically operate through multiple subsidiaries, which can complicate consolidation and open up avenues for accounting adjustments or manipulation, further weakening transparency.
One of the most significant concerns lies in revenue recognition under POCM. Revenue is recorded based on project cost incurred rather than actual billing or cash receipt. This gives rise to items like “Unbilled Revenue”, which may include work for which no invoice has been sent or for which disputes exist with clients.
ICRA – Construction Rating Methodology (Oct 2019, p.8):
“When projects get delayed, contractors submit claims for idle resources and cost overruns, while clients may lodge counterclaims. Recognising such claims as revenue before final resolution is viewed negatively.”
Moreover, revenue is only recognized after certain progress thresholds are crossed. Until that point, even ongoing work may not appear in financials. Cash inflows are tied to milestone completions and are not aligned with revenue recognition. As a result, construction companies often face lumpy and irregular cash flows, making traditional metrics such as sales growth, EBITDA margins, or receivables turnover less meaningful.
CRISIL – Rating Criteria for Construction Industry (Feb 2021, p.5):
“Revenue and cash flow could be lumpy. There may be a sharp disconnect between cash flow and accrued income. Conventional ratio analysis is often insufficient.”
Scope Ratings – Construction Rating Methodology (Jan 2022, p.9):
“Project execution risks can cause high variability in reported results.”
In typical financial analysis, leverage is assessed using long-term debt metrics. However, construction companies usually have low fixed assets and therefore, limited long-term borrowings. Instead, they rely heavily on short-term working capital loans to fund both daily operations and long-term project needs.
ICRA – Construction Rating Methodology (Oct 2022, p.13):
“Construction companies generally have limited access to long-term funds and often face asset-liability mismatches.”
Malaysian Rating Corporation Berhad – Construction Rating Methodology (Oct 2019, p.6):
“Traditional measures focusing on long-term debt have lost significance, as short-term borrowings are now used to finance even part of the asset base.”
Another complexity arises from mobilization advances—funds received from clients at the start of projects. While these advances function as a form of debt, they are project-specific and cannot be redeployed elsewhere in the business. As a result, cash balances may be misleading, giving the impression of higher liquidity than what is actually available.
ICRA – Construction Rating Methodology (Oct 2022, p.11):
“Mobilization advances (typically 10% of project value) can significantly impact financial profiles, especially if they are interest-bearing.”
S&P – Key Credit Factors for E&C Industry (Nov 2013, p.13):
“Contractors with large fixed-price projects often have sizable advances that are tied to the project and not freely usable. Total cash balance alone doesn’t represent true liquidity.”
Even commonly used metrics like Debt Service Coverage Ratio (DSCR) or Free Cash Flow (FCF) can give false comfort or misleading conclusions, especially in construction where the timing and nature of cash inflows and expenses vary drastically.
Malaysian Rating Corporation Berhad – Construction Rating Methodology (Oct 2019, p.7):
“High values in DSCR or FCF may sometimes reflect problems rather than strength. There is no direct correlation between cash flow levels and creditworthiness.”
8) Specialized Ratios for Analyzing Construction Companies
Given the unique characteristics of construction companies, conventional financial ratios often fail to capture the full picture. However, certain industry-specific ratios can offer useful insights—provided they are interpreted with caution and corroborated with multiple data points.
8.1) Order Book to Sales Ratio
This ratio compares the unexecuted order book to the company’s current annual revenue. It is commonly used to assess business visibility and future revenue potential.
A higher ratio typically indicates that the company has a substantial pipeline of projects, suggesting revenue visibility for the next few years. However, it may also reflect execution bottlenecks, where the company is unable to complete ongoing projects in time and, hence, struggles to start new ones.
CARE – Construction Sector Rating Methodology (Dec 2020, p.5):
“A very high order book to sales ratio may be a credit constraint if the company lacks the resources to fulfill its obligations or if the order book includes delayed/stuck projects.”
A lower ratio may imply a limited pipeline of future projects. While this could be due to faster project execution, it may also signal weak order inflows, possibly due to declining market competitiveness or a damaged reputation.
As per DBRS Morningstar, the typical range for this ratio is 1.5x to 2.0x for construction companies.
DBRS Morningstar – Global Methodology for Construction & Property Development (Nov 2022, p.13):
“A company’s backlog-to-revenue ratio will typically fall between 1.5:1 and 2.0:1.”
Key Caveats in Interpretation
Both components of this ratio—order book and sales—require a closer look, as both are influenced by management discretion and accounting assumptions:
- Order Book Ambiguities:
What qualifies as an order in the backlog can vary:- Is it based on receiving a Letter of Award?
- Being declared the lowest bidder?
- Securing all approvals and clearances to begin execution?
“Adjustments are made to the order book for stuck or slow-moving projects that are unlikely to generate revenue in the near term.” - Sales Recognition Ambiguities:
Revenue reporting can vary significantly based on:- The stage at which executed work is recognized.
- Whether revenue is booked only after bill acceptance by the client.
- How revenue disputes with customers are treated in the books.
Because of these variables, investors must look beyond the headline ratio. Understanding the assumptions and quality behind both the backlog and reported revenue is crucial before drawing any conclusions.
8.2) Bid Success Ratio
The Bid Success Ratio measures the proportion of bids won by a construction company out of the total number of bids it has submitted for new projects. It offers insight into the company’s competitiveness and market positioning.
Interpretation:
- A high bid success ratio may suggest:
- The company is a cost-efficient and technically competent player.
- Strong alignment with client requirements.
- However, it could also be a red flag, indicating aggressive bidding practices aimed at securing orders at any cost—possibly due to financial stress or a desire to maintain revenue growth. This may result in unviable or low-margin projects, increasing the risk of future losses.
- A low bid success ratio may point to:
- Weak technical qualifications or an uncompetitive cost structure, preventing the company from winning bids.
- Lack of scale, reputation, or financial strength relative to peers.
Investors should examine bid data and compare the company’s quotes with its competitors. A consistent pattern of winning projects with significantly lower bids may suggest aggressive pricing, which requires further scrutiny.
ICRA – Construction Rating Methodology (Oct 2022, p.6):
“The evaluation includes assessing whether the project is secured through aggressive bidding by analyzing the difference between the lowest (L1) and second-lowest (L2) bids in competitive tenders.”
8.3) Asset Turnover Ratios
Asset turnover ratios—such as Sales to Gross Block or Sales to Net Block—evaluate how effectively a construction company utilizes its fixed assets to generate revenue. These ratios help assess the company’s execution model, i.e., whether it leans toward asset-heavy in-house execution or relies more on subcontracting.
Interpretation:
- A lower asset turnover ratio may imply:
- Significant investment in equipment and machinery.
- A self-execution model, which can lead to higher profit margins when project volumes are high.
- However, in a downturn, underutilization of expensive equipment can strain financial performance.
S&P – Key Credit Factors for Engineering & Construction Industry (Nov 2013, p.9):
“Vertical integration can provide cost advantages and strategic control during high utilization periods but becomes burdensome in low-demand scenarios due to capital intensity.”
- A higher asset turnover ratio may indicate:
- Greater use of subcontractors for project execution.
- This model offers greater operational flexibility and lower fixed costs.
- However, it generally results in lower operating margins, as subcontracting tends to be costlier than in-house execution.
ICRA – Construction Rating Methodology (Feb 2013, p.2):
“While subcontracting enhances operating flexibility, it tends to reduce operating profitability.”
8.4) Evaluating Leverage Using Total Outside Liabilities (TOL)
Construction companies typically finance their operations through a combination of:
- Long-term borrowings
- Short-term working capital loans
- Mobilization advances received from clients
All these funding sources represent external obligations, meaning they must eventually be repaid or fulfilled. As such, investors should account for all of them—not just debt—when assessing a company’s leverage.
Why Total Outside Liabilities (TOL) Matter
Unlike traditional leverage ratios that consider only debt, credit rating agencies like ICRA use Total Outside Liabilities (TOL) to gain a holistic view of a construction company’s financial risk.
ICRA – Construction Sector Rating Methodology (Oct 2022, pp. 9–10):
“For construction companies, a sizeable liability is in the form of mobilization advances from clients. Hence, the TOL/TNW ratio gives a holistic view of the leverage.”
TOL includes:
- Total debt (long-term + short-term)
- Trade payables (creditors)
- Deferred tax liabilities
- Other external obligations
- Client advances (e.g., mobilization funds)
Formula:
TOL = Total Debt + Other Long-Term and Short-Term External Liabilities
TOL/TNW (Tangible Net Worth) then provides a comprehensive leverage metric.
Contingent Liabilities – A Hidden Exposure
Construction companies also carry significant off-balance-sheet risks in the form of bank guarantees. These are issued as part of:
- Project bidding
- Contract execution
- Operational performance
If the company underperforms or defaults, these guarantees can be invoked, turning them into actual liabilities.
ICRA – Construction Sector Rating Methodology (Oct 2022, p. 13):
“These bank guarantees form a sizeable part of the contractor’s contingent liabilities.”
Understanding Double Leverage Risk
In many cases, a holding company (HoldCo) or upper-tier subsidiary raises debt and infuses that capital as equity into a lower-tier project entity—like a special purpose vehicle (SPV), joint venture (JV), or associate.
While this appears as equity on the books of the SPV, it is in fact funded by debt, leading to a structural risk called double leverage.
ICRA – Construction Sector Rating Methodology (Feb 2013, p. 7):
“In cases where HoldCos raise debt to fund equity investments in SPVs, double leveraging gains importance. It reduces the developer’s effective financial commitment and increases the lender’s exposure to project risks.”
Investor Insight
To truly understand the financial position of a construction company, investors should:
- Use the TOL/TNW ratio instead of only Debt/Equity
- Consider contingent liabilities like bank guarantees
- Watch for double leverage structures that obscure real risk
This broader perspective helps avoid underestimating the financial leverage and ensures better risk assessment in this capital-intensive industry.
8.5) Importance of Cash Flow-Based Metrics for Construction Companies
In the construction industry, accrual-based performance metrics can often be misleading due to the accounting practices followed—particularly the Percentage of Completion Method (POCM). Under POCM, revenue is recognized in the profit and loss (P&L) account based on the progress of the project, rather than actual cash received.
However, in reality:
- Cash inflows are milestone-based and may lag behind the revenue recognized.
- Clients might dispute the stage of completion or the quality of work, delaying or even withholding payments.
As a result, a construction company might report high revenue and profit on paper, while facing cash flow stress due to delays or non-payments by customers.
Why Cash Flow-Based Metrics Matter
Given these discrepancies, it is critical for investors to focus on cash flow-based indicators rather than just accrual-based metrics.
One such parameter used by Standard & Poor’s is:
Free Operating Cash Flow (FOCF) to Debt Ratio
“FOCF, which accounts for changes in working capital and capital expenditures, provides a more realistic picture of a company’s cash-generating ability in relation to its debt burden.”
— Standard & Poor’s, Nov 2013, p. 12
Volatility in Cash Flows
Construction companies often experience significant year-on-year fluctuations in their cash flows. This is largely due to:
- Volatile working capital requirements
- Unexpected cost overruns on ongoing projects
“E&C companies demonstrate volatile discretionary cash flow, often due to large working capital swings and cost overruns.”
— Standard & Poor’s, Nov 2013, p. 12
“Construction companies generally have high and volatile working capital requirements during project cycles.”
— Scope Ratings GmbH, Jan 2022, p. 9
What Investors Should Monitor
Since working capital movements directly impact cash flow, investors should closely analyse trends in:
- Receivables: A rising trend may suggest client-side payment delays or disputes.
- Inventory: A buildup might indicate execution delays or stuck projects.
These components can signal deeper issues such as:
- Project execution challenges
- Weak customer financials
- Deterioration in receivables quality
Takeaway for Investors
Due to the unique challenges of assessing construction companies using traditional ratios, investors are advised to:
- Rely more on cash flow-based indicators
- Examine working capital components closely
- Identify underlying business risks through indirect metrics
This comprehensive view offers a more accurate understanding of a construction company’s financial health and operational resilience.
8.6) Pledge of Shares by Promoters
The pledging of promoter shareholding is a critical governance indicator that investors must closely evaluate while analyzing construction companies.
When promoters pledge their shares as collateral for personal loans, it may create a conflict of interest. To service their personal debt obligations, promoters may push the company to:
- Disburse higher dividends
- Increase promoter remuneration
- Or provide other forms of financial support
These actions may not align with the company’s long-term interests and could weaken its financial position.
“High levels of pledged promoter shareholding are a measure of depleting financial flexibility. This could pressure the company into prioritizing promoter interests over its own credit health.”
— ICRA, Rating Methodology – Construction, Oct 2022, p. 13
Implications of High Promoter Pledge
Excessive pledging also affects the company’s creditworthiness and access to external capital. Here’s how:
- If promoters default on their personal loans, lenders may invoke the pledged shares and sell them in the market.
- Such an event can lead to:
- Share price volatility
- Loss of promoter control
- Triggering of change-of-control clauses in loan agreements or bond covenants
- Forced debt prepayments and a liquidity crunch
“Failure to repay loans against pledged shares may lead to promoter stake sales. This can trigger change-of-control clauses and force early debt redemption, affecting liquidity and fundraising capacity.”
— ICRA, Oct 2022, p. 13
Investor Takeaway
Given the systemic risks associated with pledged shares, especially in capital-intensive and cyclical sectors like construction:
- Investors must scrutinize promoter pledge levels
- Evaluate the intent behind the pledge (personal use vs. company-related funding)
- Understand the potential impact on governance, financial flexibility, and control
This analysis provides a more comprehensive view of promoter behavior, financial risk, and long-term alignment with shareholder interests.
9) External Factors Impacting Construction Companies
The execution of projects by construction companies is heavily influenced by various external factors that are beyond their control. These factors can be broadly categorized into natural, regulatory, and socio-political influences.
Natural Factors
Construction companies often face challenges related to site accessibility or natural disasters, which can delay project timelines and escalate costs. Examples include:
- Difficult terrain or remote project sites that are difficult to access
- Natural disasters, such as floods, earthquakes, or storms, disrupting project progress
Regulatory and Socio-Political Factors
Construction projects are highly dependent on government policies, such as:
- Land acquisition processes
- Public investment in infrastructure projects
- Labour laws and regulations affecting workforce availability
- Environmental approvals required for project initiation
In many cases, construction companies and their management may not have full control over these regulatory requirements. Changes in these areas can significantly impact project timelines and costs.
Labour-Related Challenges
Due to the labour-intensive nature of construction work, changes in labour laws can significantly affect construction operations. For instance:
- In Malaysia, a crackdown on illegal migrant workers in 2004 severely impacted the construction industry, which was heavily dependent on this workforce.
“The crackdown and repatriation of illegal workers by the Malaysian government in 2004 showed how vulnerable some construction companies were to labour shortages resulting from this action.”
— Malaysian Rating Corporation Berhad, October 2019, p. 2
Such labour shortages can lead to project delays and increased costs, making labour law compliance a crucial aspect of risk management in construction projects.
Local Knowledge and Socio-Political Risks
Construction companies are also influenced by local socio-political environments, particularly in emerging markets. Issues such as land acquisition disputes, labour protests, or political instability can impede progress. Therefore, companies must possess deep local knowledge to successfully execute projects in these regions.
- Regional players often have an advantage in understanding local dynamics, while external players may struggle without local knowledge, which can lead to project failures.
“In developing countries, construction companies often suffer losses due to underestimation of project risks, malpractice of local agents or partners, or lapses in risk management practices.”
— DBRS Morningstar, November 2022, p. 12
Environmental and Legal Challenges
While construction companies’ direct environmental impact is typically limited to issues like soil and water pollution, projects that encounter environmental challenges can face severe consequences, including:
- Legal battles and regulatory hurdles that delay projects
- Environmental liabilities that restrict a company’s flexibility and damage its reputation
“Environmental liabilities and serious legal problems can severely restrict a company’s operational flexibility, leading to loss of supplier and customer trust, and impacting access to capital.”
— Malaysian Rating Corporation Berhad, October 2019, p. 8
Investor Takeaway
Given the wide array of external risks that impact construction projects, investors should:
- Assess each project individually to determine if it faces any environmental, legal, regulatory, social, or political challenges.
- Consider the socio-political landscape and local market dynamics when evaluating companies operating in emerging or volatile regions.
Understanding these external factors helps investors better gauge the long-term sustainability of construction companies.
FAQs on Construction Industry Business Analysis
Q1: What makes the construction business highly competitive?
A1: The construction business is highly competitive due to the presence of numerous local and international players. These companies compete by offering the lowest possible prices to customers. The industry has low barriers to entry, with players able to lease equipment and hire workers on contract, which allows new players to enter easily.
Q2: How does the construction industry cope with cyclicity in demand?
A2: The construction industry faces cyclicity, with periods of high and low demand driven by external industries such as real estate, manufacturing, and government infrastructure investments. To mitigate the risks of cyclical downturns, construction companies diversify their operations across geographies, sectors, and customer bases (both public and private), stabilizing their revenues and profits. However, excessive diversification can dilute their competitive advantages.
Q3: Why do large construction companies have an advantage?
A3: Large construction companies benefit from economies of scale, better access to financing, the ability to hire and retain skilled manpower, and improved negotiating power with suppliers and customers. These advantages allow them to bid for more complex and profitable projects, often leading to a cycle where “big gets bigger” in the construction business.
Q4: How do construction companies recognize revenue?
A4: Construction companies typically use methods like the Percentage of Completion Method (POCM) or the Contract Completion Method (CCM) for revenue recognition. However, due to the nature of the business and accounting practices, profit and loss statements based on accrual accounting may not accurately reflect the true operational status of the company.
Q5: What is the difference in how construction companies are financed compared to other industries?
A5: Unlike other industries that rely on long-term debt, construction companies predominantly use working capital debt and mobilization advances to fund their operations. This makes traditional financial ratios less relevant when analyzing construction companies, necessitating the use of special ratios to assess financial health.
Q6: What financial metrics should investors use to analyze construction companies?
A6: Investors should focus on the following key metrics for evaluating construction companies:
- Order Book to Sales Ratio
- Bid Success Ratio
- Asset Turnover Ratios
- Total Outside Liabilities
- Cash Flow-Based Ratios
- Working Capital Analysis
- Pledge of Promoters’ Shareholding
These specialized ratios help in understanding the company’s financial stability and business performance better than traditional ratios.
Q7: What external factors impact construction project execution?
A7: Several external factors can significantly affect the execution of construction projects. These include:
- Socio-political issues (e.g., local political instability or labor disputes)
- Regulatory challenges (e.g., land acquisition, environmental approvals)
- Environmental challenges (e.g., natural disasters or legal liabilities)
- Labor-related issues (e.g., strikes or shortages)
Lack of local knowledge can lead to project failures, particularly for international players unfamiliar with these local factors.
Q8: Why is local knowledge important for construction companies?
A8: Local knowledge is critical for navigating regulatory, legal, social, and environmental challenges that can arise during project execution. Inadequate understanding of the local environment can lead to project delays, cost overruns, or even project failures, especially for companies expanding into new regions without proper expertise.
Q9: How does diversification affect a construction company’s performance?
A9: Diversification helps construction companies stabilize their performance by spreading risk across different geographies, construction segments, and customer bases (public and private). However, excessive diversification can weaken the company’s specialization and expose it to risks outside its core competency, such as failures in real estate or BOT project development.
Q10: What should investors focus on when analyzing a construction company?
A10: Investors should consider a comprehensive set of factors, including:
- Competitive pressures from both domestic and international players
- The company’s level of diversification and its potential impact on stability
- Financial ratios that are tailored to the construction industry, such as cash flow-based analysis and working capital management
- The potential risks posed by external factors, including regulatory, environmental, and socio-political challenges.
By carefully evaluating these aspects, investors can gain a more accurate picture of the construction company’s true business strength.
