A common procurement sourcing challenge is to evaluate how financially healthy a potential supplier is. On the supplier side, there is a similar strategic issue for companies when evaluating their risk exposure as sub contractors. In this post, we explore how z-score models could help companies avoid situations like the ones many companies found themselves in after the collapse of the major UK-based construction company, Carillion. Using publicly available data from their filed accounts (as a PLC), we will outline how z-score models, a very basic accountancy concept covered by most 1st-year business students should have prevented Carillion from getting any contracts in Ireland or elsewhere in the past couple of years. The failure to perform this due diligence has resulted in significant losses to SMEs in Ireland and brings the role and moral duty of the State into sharp relief. The role of the Department of Education and its use of PPP procedures to commission public infrastructure has not been shown to be as effective as it should be.
Overview of the Carillion issues
Prior to its financial collapse in January 2018, Carillion was one of the UK’s largest construction companies boasting approximately 43,000 staff globally including 20,000 in Britain, over 450 public-sector contracts (let alone its private-sector business) and a 2016 operating income of £235.9 million. Following the company’s collapse, when facing a parliamentary liaison committee in February of this year, newly appointed Minister for the Cabinet Office David Lidington stated that an estimated £150m had been allocated sustain public services run by Carillion while alternative arrangements were put in place. The eventual May 2018 report of a Parliamentary inquiry by the Business and the Work and Pensions Select Committees stated Carillion’s collapse was a story of “recklessness, hubris and greed” while its business model was a “relentless dash for cash.” Meanwhile, a separate July 2018 report by the Public Administration and Constitutional Affairs Select Committee, blamed the UK government for outsourcing public procurement contracts based on lowest price, saying its use of contractors such as Carillion had caused public services to deteriorate.
Response to the collapse for similar tenders in procurement
In response to the fall of Carillion, the systemic ramifications of which were felt in both political and financial circles, the UK Cabinet Office unveiled plans to exclude suppliers with poor payment practices from winning major government contracts of over 5 million pounds. Poor payment practices pertaining to large public procurement contracts, extend from non-payments to late payments with the reforms posing the threat of harsh exclusionary punishments for companies that do not conform to these new standards. The government said a key part of the measures to be taken will be to make it easier for sub-contractors to report poor payment performance to the relevant authorities. Other changes include requirements for government suppliers to advertise sub-contracting opportunities on the government’s Contract Finder’s online system and provide data on their supply chains to show how small businesses are benefiting from central government spend. Finally, in a bid to enhance transparency, relevant project bank accounts will be regularly examined in the future. The government is undertaking to deliver a series of workshops on how such accounts can be used to best effect on public sector projects.
The primary aim of the Cabinet Office proposals, which began to be implemented in May of this year, is to seek to “level the playing field” for SMEs when bidding on government contracts, “This government is listening to the business community and is committed to leveling the playing field for smaller suppliers to win work in the public sector.” While doing so, the enforcement of the aforementioned measures will also hope to increase efficiencies in the area of public procurement and the distribution of government contracts by alleviating future costs to the taxpayer through avoidable liquidity issues. Particular emphasis will be placed on transitioning towards prioritising SMEs in the area of public procurement going into the future, as the Cabinet Office minister explained, “We have set a challenging aspiration that 33 per cent of procurement spend should be with small businesses by 2022 – and are doing more than ever to break down barriers for smaller firms.”
Industry reaction to the new procurement rules
The reaction to the recent proposals for companies with track records of late payments to be banned from bidding on government contracts has been mixed. They have been welcomed the Federation of Small Businesses with their chair Mike Cherry saying, “Episodes like the Carillion collapse bring into stark relief the need for stronger action that exclude businesses which cannot demonstrate a fair and responsible approach to payments from bidding for these contracts.” The proposals were also welcomed by market analyst Dun & Bradstreet with their UK managing director Ed Thorne commenting that the proposals were a “positive step in addressing what is a tough and long-standing issue”. Meanwhile, Labour opposition shadow minister for the Cabinet Office John Trickett responded to the plans by accusing the government of failing to hit its own targets of investment in SMEs, “Warm words from the government cannot disguise the fact they are dragging their feet on this issue.” He continued, “The Tories have missed their own targets when it comes to buying from smaller companies, so many will be sceptical about how much they really want to break big businesses’ grip on Whitehall.”
Political biases aside, have the UK Conservative government extracted the right lessons from the “Carillion Crash” and taken the measures necessary to prevent any similar events occurring again? It does appear as though the government have taken a focused look at the Carillion situation specifically and the definite factors which lead to its particular fall. While the construction company had signed up to the Prompt Payment Code, which advocates settling invoices within 30 days, Carillion was “notorious for being a late payer”, with terms of up to 120 days. According to the Federation of Small Businesses, “Carillion was able to use its dominant position to squeeze smaller firms to mask their own financial failings.” Could the multi-faceted approach being taken of reducing late payments, protecting sub-contractors by making it easier to report poor payers and prioritizing SMEs in the distribution of government contracts be the key to a more sustainable system of public procurement? Only time will tell.
Lessons for Irish suppliers and buyers – how z-score models can prevent future Carillion style issues
As the diagram accompanying this article demonstrates, Carillion was a firm in trouble for a very long time. Z-score models examine five financial ratios, given different weightings of importance, drawn from the balance sheet and profit & loss statement of a company’s accounts. Different approaches are used for private and public companies but they provide a z-score at the end that breaks down as follows:
- Above 3: The company is healthy and there are no apparent solvency/liquidity issues;
- Between 1.8 and 3: The company needs to be watched with extreme vigilance – it is under stress of some kind;
- Below 1.8: A 95% likelihood of failure.
Applying the rules for z-score models to the accounts of Carillion would have made it extraordinary to still award a key contract to a consortium of which it was a member. It is hard to believe a contracting authority would have done so. Suppliers must be vigilant on public contracts in the future, especially those fronted by main contractors and run some financial analysis like z-score models on the main contractors to ensure that they are solvent and liquid. The State should also consider the changes brought forward in the UK on major projects and consider how they could be applied in Ireland to ensure suppliers are paid within 30 days.