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...

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…