Shaun Barton, partner at Company Closure, examines the roles cash flow and other factors play in insolvency in construction businesses
Insolvency occurs when a company can no longer afford to pay its bills as they fall due, or when the value of the business’s assets is less than its liabilities. Lack of cash is one of the main causes of insolvency in construction, however, because it reduces the company’s ability to function productively.
A decline into insolvency can also happen very quickly. It’s more likely to follow the loss of a large client, for example, or after experiencing significant delays in a contract. So why is poor cash flow so serious in construction and what are the other main causes of insolvency in the industry?
Typical causes of insolvency in the construction industry
Late payments and bad debts
Construction’s inherently long payment times make it difficult for companies to plan and fund upcoming construction projects with certainty. Payment delays seriously restrict how fluidly a construction firm can operate and increase its risk of incurring bad debts.
With delays of up to 90 days or more not uncommon in construction, it isn’t surprising that smaller members of a supply chain might struggle to manage their cash effectively and decline to the point of being insolvent.
Construction Industry Scheme (CIS) and other tax liabilities
The Construction Industry Scheme requires construction firms to collect subcontractor CIS payments on behalf of HMRC and remit them at regular intervals. Failing to do so or to pay other tax liabilities promptly can lead to action by the tax body, including hefty fines and enforcement measures.
HMRC can close down companies they believe are insolvent and will take action quickly to prevent incurring further tax losses. They do run a Time to Pay (TTP) scheme, however, which can offer eligible construction firms some extra time to pay their arrears.
Tight profit margins and market competition
The low profit margins commonly associated with construction make it more challenging for smaller and medium-sized companies to grow and can be linked to financial decline over time.
There’s fierce competition to win construction projects and firms may not have the financial stability to negotiate as they would like with suppliers. The temptation to reduce bid amounts to secure a project can also lead to low profitability.
Lengthy supply chains and the ‘knock-on’ effect
Complex supply chains are another feature of the construction industry and this introduces the risk of a ripple effect throughout the chain if one member fails. If payments aren’t made on time it places all supply chain members at risk of financial decline and increases the potential for insolvency.
For example, if a main contractor goes out of business their subcontractors may not be paid for work already completed as they are unsecured creditors and lie at the bottom of the hierarchy for repayment.
What does insolvency mean for construction companies?
Insolvency doesn’t always mean that a company has to close down. Each situation is different and it depends on whether the business as a whole is viable for the future. Furthermore, there are a range of insolvency processes that can turn a business around.
In some cases, however, liquidation is the only option and this involves closing down permanently. Ways in which construction companies can avoid such serious financial issues include seeking external funding, such as invoice or asset-based finance where existing assets can be used to support cash flow.
Estimating the cash needs of future building projects and contracts, being alert to any cash shortages and acting quickly to remedy the situation, are also all key parts of avoiding insolvency.
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