Carillion bankruptcy financial analysis

Carillion
Introduction
Carillion was a construction and facilities management company that went bankrupt in January 2018, after experiencing financial difficulties during 2017. This paper will analyze the company’s financial statements in order to examine this bankruptcy, specifically to use the techniques of financial statement analysis to ascertain what went wrong with Carillion, and how it ended up in bankruptcy.
There are three key questions that will be answered in this analysis. The first is how liquidity affected the company. Bankruptcy typically arises from a liquidity crisis, so this analysis will investigate the structure of the liquidity issues, and perhaps determine if there were signs prior to 2017 of a looming crisis, or that management’s response to the crisis was poor. The second question that needs to be answered is what the effect of bad management was on the company’s financial health. The company was continuing to acquire building contracts; its failure was not for lack of new business. The third question is to provide an analysis of the company’s performance.
By investigating these three elements, this report will utilize financial statement analysis techniques such as horizontal, vertical and ratio analyses in order to investigate the Carillion bankruptcy, as a form of financial autopsy.
Data Collection
Carillion’s financial statements are a matter of public record. The data was gathered from the Financial Times website, though there are many other public sources for this data. Background data about the bankruptcy and the various circumstances surrounding it was gathered from financial news sites. As this was a fairly high profile corporate bankruptcy, it was covered extensively in the business press, providing some insight and contextualization to the financial statements.
Data Presentation
Carillion’s balance sheets and income statements for the period 2015-2018 can be found in Appendix A.
Methodology
Carillion’s bankruptcy was analyzed using common, established techniques for financial statement analysis. Financial statements for publicly traded companies are produced in a standardized manner, which allows for comparability across years and across industries. This standardization also allows financial statement analysis techniques to be developed – means of breaking down the different components of a company’s financial statements in a standardized manner. The three major types of analysis are horizontal analysis, vertical analysis and financial ratio analysis.
Horizontal analysis is a technique whereby the performance of the company is compared against a baseline, typically the “year 1” baseline. In the case of this analysis, Jun 30, 2015 forms the baseline against which the horizontal analysis is completed. Horizontal analysis can reveal things like expenses growing faster than revenues, and this occurs because the levels are normalized at the starting point.
Vertical analysis is a means of understanding the relationship of financial statement line items to each other. The baseline for vertical analysis is different for each statement. For the income statement, the baseline is the revenue, and for the balance sheet it is total assets (i.e. the total value of the company). Vertical analysis can be valuable when comparing against other companies in the same industry, or when comparing within the same company across a number of different time periods. For example, it might show that accounts receivable as a percentage of revenue increased dramatically, which would indicate higher risk of bad debts.
Financial ratio analysis relies on the use of standardized ratios. These ratios are constructed using different line items that are common to most if not all standardized financial statements. The ratios are comparable across companies in the same industry, or within the same company over time. In theory, an analyst can construct any ratio he or she wants, but the use of standardized ratios, with standardized formulae, is one of the best means of performing financial analysis because of comparability. Ratios are typically divided into categories, such as solvency, liquidity, operating performance, investment returns and margins.
Further, there are a couple of other metrics that do not fall under the category of normal financial ratios. An important one here is the Altman z-score, which is typically used to assess bankruptcy risk. Carillion management would have been aware of the company’s z-score and thus it is worth exploring what the z-score was at different points in time, and trying to analyze management’s reaction, as this will be informative as to whether management responded appropriately to the risk that the company was facing. The Altman z-score is comprised of measures of working capital and other line items from the financial statements.
Using these different metrics allowed me to answer each of the research questions. First, liquidity is measured both by the financial ratios and by the z-score, these means being valuable in terms of determining where and when the company tipped into liquidity risk, and what its response was to that change in its business risk. The latter is a good means of explaining how the company’s management performed. In order to properly assess how management performed, it is important to know when they might have known something, and what actions they took. Both the ratios and the z-score contribute to that discussion. As to the company’s performance, all financial statement analysis seeks to understand the company’s performance, and that is precisely why the financial statement analysis was conducted.
Data Analysis
Solvency ratios are the measure of the company’s ability to stay solvent in the short-run. Once solvency ratios dip into a zone of concern, the company needs to take fairly drastic action in order to shore up the cash flow. Carillion going bankrupt is an indicator that the solvency ratios had slipped to a point of no return. Taking a look at Carillion’s solvency ratios, the findings are interesting. The rule of thumb is that the current ratio – the ratio of current assets to current liabilities should be above 1, as this allows for the company to liquidate current assets in order to meet its obligations for the coming year. Carillion had maintained a relatively stable current ratio over 1 through the end of 2016. By the middle of 2017, it had dipped to 0.74, which is a fairly dramatic decline in such a short period, but by no means past the point of no return.
The other solvency ratios, the quick ratio and the cash ratio, show a similar trend of stable levels followed by a sharp decline in the first half of 2017. The company’s financial problems were not made public until July of 2017, when it faced problems with payments for work done in the Middle East, and was spending too much money given the problems with revenue. The company started to take on debt and furthermore ended up with a pension shortfall. The inability to continue to finance its ongoing operations was not evidence at the end of June 2017, but became so in the subsequent months (Detrick, 2018).
That pensions became part of the problem indicates that the liquidity ratios could have provided some earlier warnings. Essentially, liquidity ratios look at the alignment of longer-term assets and liabilities. A key liquidity ratio is the total debt ratio. At the end of June 2016, this was at 0.77, a level at which it had stable for a couple of years. One year later, it was at 1.12, indicating a fairly rapid escalation – the company was borrowing in order to finance operations at this point. The other liquidity ratios are even more alarming, however. Where the debt ratio is relative to the size of the company, the debt-to-equity ratio reflects the company’s capital structure. Carillion’s debt-to-equity ratio was relatively stable, ranging around 3.0 for the prior few years, but then went to 5.32 by the end of 2016 and -9.42 by the end of June 2017. So the company historically had carried a capital structure that was around three-quarters debt. This level does not seem unreasonable for a company with a large fixed asset base, but would have put Carillion in a more precarious position, less able to withstand financial shocks. Normally a company has to be very stable to carry a debt-to-equity ratio that high. While construction may generally be a stable business, especially in Carillion’s major markets of the UK and Canada, the Middle East market is different, and payment is not as reliable. This proved to be the company’s undoing – as it spent money on major projects and customers failed to pay, the company saw operating losses to the point where it had eroded all the value of its equity, tipping into negative retained earnings. This meant that the value of the company’s debt was higher than the value of the company’s entire asset base – a position that is generally unsustainable, necessitating that either it raises more equity or it is generating a positive free cash flow.
Asset utilization ratios are measures of operating efficiency. These ratios can provide some context as to why a company slips into bankruptcy. In the case of Carillion, they do not. Inventory turnover remained stable throughout this period, as did days’ sales in inventory. The company was still doing business, moving inventory through its system.
If payments were an issue, it would show up under the receivables metrics, which are receivables turnover and its counterpart days’ sales in receivables. The receivables turnover rate increased over time, from 1.33 at the end of June 2015 to 1.76 two years later. The days’ sales in receivables declined during this period. In theory, this means that the company started to collect on its receivables more efficiently – on the surface these are good numbers, especially the sharp decline in 2017. However, these are not good numbers; the only reason that days’ sales in receivables declined sharply in the beginning of 2017 was a massive write-down in bad debt. This dropped the amount of outstanding receivables on the income statement, improving the receivables turn ratio, but of course the write down brutalized the income statement.
The write-down is, unsurprisingly, reflected in the profitability ratios. These measure the profitability of the company and can help identify the underlying causes of changes to the net income. Having a stable profit margin until 2017, Carillion saw a massive loss as the result of the write-down on bad debt. This is essentially work that had previously been recorded as revenue that had to be taken off – the loss shows as singular on the income statement but was building until it had to be written down. With the massive write-down, the ROA and ROE naturally took a major hit as well, on account of the loss. Companies face write-downs all the time, but the problem for Carillion is that this bad debt issue was something that was ongoing, not a one-time thing, and was impacting on the company’s ability to cover its own financial obligations.
Horizontal & Vertical Analysis
The horizontal analysis should basically confirm what the ratio analysis has already shown. The company’s financial performance took a sharp nosedive in early 2017. As its income declined, its current liabilities increased, as did its long-term debt. More telling, it’s equity decreased substantially. The write-down for bad debt saw the company’s retained earnings decline by a billion dollars, from $482 million to negative $628 million. The value of the company’s equity had been declining gradually to that point, but early 2017 proved a watershed moment where that loss wiped out all equity value that the company had.
Vertical analysis is often a powerful took for understanding operating reasons for a bankruptcy, or change in net income, because it looks at the ratio of different expenses to the revenue. For Carillion, incremental changes in operating conditions were not responsible for its financial plight. This plight came seemingly out of nowhere when the company admitted that many of its customers were simply unable to pay, to the point where it would not be able to meet obligations. That sort of underlying causal factor is obvious in the vertical analysis with the write-down line item, but that particular line item speaks for itself no matter what type of analysis
The final type of financial analysis conducted on Carillion is the Altman z-score. This metric is typically used to identify the warning signs of a company in financial distress. Given the stability of Carillion’s financials prior to 2017, it would not have been expected that the Altman z would reveal anything. However, the Altman z score at the end of 2016 was 0.96. The median is 1.8, and this means that Carillion was already in something of a state of financial distress. The Altman z at this point was impacted by a low level of working capital and retained earnings relative to assets.
The working capital is affected by the company’s high days’ sales receivable – a slow cash conversion cycle and high leverage meant that the company never had a lot of working capital on hand, something that would impact on the Altman z score. The low level of retained earnings relative to the company size is another factor worth noting – if the company is large and has built up a certain amount of size, then logically it should have a decent amount of retained earnings, simply from the profits that it has accumulated over the years. Carillion’s relative lack of retained earnings speaks to the fact that despite it being a relatively large company, it has never been an exceptionally profitable one. This reality is also reflected in its high debt load. Ultimately, Carillion was simply never a great performer and thus it was vulnerable to something like the Middle East bad debts – it didn’t have the war chest to withstand that sort of shock because it had always operated in a precarious position.
EBIT to total assets is another Altman z component that was relatively weak at the end of 2016. Again, this highlights that despite being a large company, Carillion was not making a whole lot of money even at the best of times.
By the time June 2017 rolled around the Altman z was below zero, which really meant that the company was pretty much insolvent already. However, the strong deterioration of the company’s finances showed that management response was fairly poor – it plowed ahead with its projects, and even in the 2016 annual report did not list default as a major risk factor for the company. This shows that management either did not realize the risk, or tried to downplay it in the hopes that the situation could be resolved, instead of being honest with shareholders. So management’s response to the crisis – it would have known the risks it was facing and the Altman z certainly indicated that Carillion really was not in the sort of financial position to take on those kinds of risks – was poor. It is one thing to be a highly-leveraged company with slim margins but a stable business. It is another to take that company and enter into risky deals in foreign markets. Ultimately, it was taking on bad risk and perhaps not truly understanding the nature of those risks that was Carillion’s undoing and that is very much a management problem.
Conclusion
Carillion’s bankruptcy highlights a couple of important lessons. First, there are limitations to the use of financial statements to determine financial risk. In the case of Carillion, the risk wasn’t evident on the financial statements, nor given prominent mention in the company’s annual report. Just six months before a massive write-down that devastated the company, there was nothing.
That said, it was clear from the financial statements, and the different forms of analysis, that Carillion was only of modest financial standing even prior to the massive write-down in early 2017. The reality is that Carillion was a large company with slim margins, and a stable but rather uninspiring income statement. The company was carrying a large amount of debt, which made it more vulnerable than it otherwise would have been to any issues. The Altman z score is the clearest indication that Carillion’s financial health wasn’t great, but the rapid deterioration was only due to the fact that management admitted what it probably knew for much longer – that it had money owing to it that it would never recover.
This speaks to management folly, on a couple of levels. First, the company’s financial condition, while healthy, was not so healthy that it could withstand a negative shock. Carillion would have avoided risk of such a negative shock had it stuck to its operations in the UK and Canada, but instead it pursued high profile growth projects in the Middle East. Management apparently either did not understand the risks of doing business in that market, or ignored them, because Carillion put itself in a position where its vulnerabilities could be exposed. And they were, sending the company into liquidation as a result. That is managerial incompetence, not some fluke thing that happened Further, that there was no particular indication of the pending crisis in the financial statements as of end 2016 indicates that management was trying to sweep the risk under the rug – there should have been notes at the very least to indicate the risk of bad debt that might not yet be accounted for in the statements. It is rare that a billion dollar write-down comes out of nowhere, and that again points to managerial incompetence as one of the root causes of this bankruptcy.
Appendix A: Carillion Financial Statements
Fiscal data as of Jun 30 2017 In millions of GBP
Jun 30 2015
Dec 31 2015
Jun 30 2016
Dec 31 2016
Jun 30 2017

REVENUE AND GROSS PROFIT

Total revenue
1,961
1,989
2,087
2,308
2,104

OPERATING EXPENSES

Cost of revenue total
1,809
1,801
1,917
2,127
1,935

Selling, general and admin. expenses, total
78
98
102
103
99

Depreciation/amortization
8.2
12
6.8
7
7.4

Unusual expense(income)
1.5
1
-6.8
-7.7
1,026

Total operating expense
1,859
1,885
1,984
2,214
3,219

Operating income
103
104
102
94
-1115

Other, net
-22
-23
-21
-20
-22

INCOME TAXES, MINORITY INTEREST AND EXTRA ITEMS

Net income before taxes
68
88
84
63
-1153

Provision for income taxes
8.3
7.4
12
5
-32

Net income after taxes
59
80
72
58
-1121

Minority interest
-4.5
-2.1
-3.9
-1.4
-2.4

Net income before extra. Items
55
78
68
56
-1124

Net income
55
78
68
56
-1124

Inc.avail. to common excl. extra. Items
55
78
68
56
-1124

Inc.avail. to common incl. extra. Items
55
78
68
56
-1124

EPS RECONCILIATION

Basic/primary weighted average shares
430
430
430
430
430

Basic/primary eps excl. extra items
0.13
0.18
0.16
0.13
-2.61

Basic/primary eps incl. extra items
0.13
0.18
0.16
0.13
-2.61

Dilution adjustment
0
0
0
0
--

Diluted weighted average shares
430
520
475
476
430

Diluted eps excl. extra items
0.13
0.15
0.14
0.12
-2.61

Diluted eps incl. extra items
0.13
0.15
0.14
0.12
-2.61

COMMON STOCK DIVIDENDS

DPS - common stock primary issue
0.06
0.13
0.06
0.13
0

Gross dividend - common stock
25
54
25
54
0

PRO FORMA INCOME

Interest expense, supplemental
6.4
7.7
7.6
9.9
10

SUPPLEMENTAL INCOME

Depreciation, supplemental
14
12
13
18
19

Total special items
1.5
-8.4
3.7
-7.7
1,027

NORMALISED INCOME

Normalized income before taxes
69
79
88
55
-127

Effect of special items on income taxes
0.18
-0.71
0.54
-0.61
39

Income tax excluding impact of special items
8.48
6.69
13
4.39
6.5

Normalized income after tax
61
73
75
51
-133

Normalized income avail. to common
56
70
71
49
-136

Basic normalized EPS
0.13
0.16
0.16
0.11
-0.31

Diluted normalized EPS
0.13
0.14
0.15
0.1
-0.31






Fiscal data as of Jun 30 2017 In millions of GBP
Jun 30 2015
Dec 31 2015
Jun 30 2016
Dec 31 2016
Jun 30 2017

ASSETS

Cash And Short Term Investments
422
462
376
470
390

Total Receivables, Net
1,479
1,272
1,441
1,675
1,193

Total Inventory
54
64
76
79
57

Other current assets, total
6.1
15
35
46
42

Total current assets
1,961
1,813
1,927
2,270
1,682

Property, plant & equipment, net
133
141
149
144
138

Intangibles, net
1,646
1,634
1,653
1,669
1,551

Long term investments
157
166
160
180
103

Total assets
4,036
3,870
4,021
4,433
3,669

LIABILITIES

Accounts payable
1,884
1,714
1,747
2,090
2,000

Notes payable/short-term debt
0
0
0
0
0

Current portion long-term debt/capital leases
26
34
36
97
37

Other current liabilities, total
40
24
41
31
228

Total current liabilities
1,950
1,771
1,824
2,217
2,264

Total long term debt
595
599
630
592
924

Total debt
621
632
666
689
961

Deferred income tax
15
11
12
15
19

Minority interest
24
24
29
29
30

Other liabilities, total
542
473
585
878
867

Total liabilities
3,126
2,877
3,080
3,732
4,105

SHAREHOLDERS EQUITY

Common stock
215
215
215
215
215

Additional paid-in capital
21
21
21
21
21

Retained earnings (accumulated deficit)
724
804
725
482
-628

Other equity, total
-51
-47
-21
-17
-44

Total equity
910
994
941
701
-436

Total liabilities & shareholders' equity
4,036
3,870
4,021
4,433
3,669

Total common shares outstanding
430
430
430
430
430









References

Detrick, H. (2018). What you need to know about the collapse of Carillion, a UK construction giant. Fortune. Retrieved April 11, 2018 from http://fortune.com/2018/01/15/what-you-need-to-know-about-the-collapse-of-carillion-a-u-k-construction-giant/

Investopedia (2018) Altman z-score. Investopedia. Retrieved April 11, 2018 from https://www.investopedia.com/terms/a/altman.asp