Financial Due Diligence on Your Business Partners
07 May 2017
The start of the upturn in the financial cycle for the building industry is the period of highest financial risk. It is a period when:
- Staff and skills shortages start to bite
- Staff shift to new employers seeking higher pay
- Balance sheets become stretched by increasing activity and the need to finance higher levels of work in progress, accounts receivable and retentions receivable.
- Both construction companies and sub-contractors are committed to completing contracts which were negotiated months ago at tight margins and their cost structures are rising.
Property owners and their consultants have been requesting references, reviewing financial statements and conducting financial due diligence on construction companies throughout the downturn. The information building companies have been prepared to provide has varied with some allowing inspection of their financial statements and others regarding this as highly confidential and sensitive information. Bank references are invariably requested and if a bank reference is provided it gives virtually no information of any real value.
With the changing levels of activity as we start to climb the business cycle, the areas of risk move to the financial vulnerability of the sub-contractors. A lot happens between tender acceptance and time to start the job with many sub-contractors finding that their staff are moving to competitors for higher pay and they are having to replace those staff, if they can, with higher paid staff. The margins on committed jobs are often less than may now be obtainable and with rising costs, margins can be well below expectations.
The effect of these factors is that some subcontractors are or will be struggling. Some have closed their businesses, and more will need to. Some have and more will pull out of contractual commitments notwithstanding that there are legal obligations to perform.
The Required Response
It is now time for contractors to perform financial due diligence on their subcontractors in a similar way to the due diligence being performed on them. Contractors can ill afford a subcontractor walking off the job or not being able or prepared to start.
At a minimum, due diligence should include:
- Sighting IRD statements to show that for both GST and PAYE returns are being filed and payments made when due
- Credit references from trade suppliers
- Have your QS do his own calculations so you know their pricing is realistic and do not accept unrealistic prices despite the temptation.
If subcontractors don’t want you to sight their IRD statements, use an intermediary such as your accountant to view them so dollar amounts remain confidential.
Watch for other warning signs. These can include:
- Inability to provide materials due to stop credit or similar problems
- The grapevine; fellow industry companies are quick to spread stories of companies in difficulty
- Quoted prices below expected levels or below most other tenderers
- Poor quality or delayed paperwork on the project
- Loss of their key staff
For projects to run smoothly to everyone’s economic benefit there is reliance on all parties technical ability and financial strength. A missing financial link in the chain impacts everyone. Proper financial due diligence and transparency is to everyone’s benefit.