Christmas Vacation Report: Carillion’s Performance and Decline Factors

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Introduction:

Carillion PLC was the UK’s largest outsourcing company by revenue between 1999-2012 and its second-largest thereafter[footnoteRef:1]. It specialised in construction, facilities management and ongoing maintenance[footnoteRef:2]. It was situated within an industry greatly expanded during the UK’s drive to reduce public sector’s size by hiring private outsourcers to execute government contracts, which caused the government spending on outsourcing to grow from £112bn to £292bn between 1987- 2018/19[footnoteRef:3]. [1: Casse, Tom et al. “Government outsourcing What has worked and what needs reform?” Institute for Government, 20.] [2: Thomas, Daniel. “Where Did It Go Wrong for Carillion?” BBC News] [3: Casse, Tom et al. “Government outsourcing What has worked and what needs reform?” Institute for Government, 12-13.]

Being one of the largest outsourcers, Carillion, with £5.2bn in revenues in 2016 and 450 government contracts under development in 2018, entered liquidation in January 2018, becoming the largest corporate failure dealt with by the Official Receiver[footnoteRef:4]. The analysis of Carillion’s financial data indicates however that its problems were identifiable before its insolvency. [4: Neate, Rupert, and Rob Davies. “Carillion Collapse: Two Years on, ‘Government Has Learned Nothing’.” The Guardian]

Carillion’s performance and decline factors, 2008-2012:

Carillion’s early problems were visible in its balance sheets (see appendix). In 2010-2012, they showed a significant increase in non-current liabilities, with the pensions rising by £102mln and borrowings growing by £554mln in the same time period. This was due to Carillion’s purchase of Eaga in 2011, for £298mln[footnoteRef:5], and the £329mln in goodwill acquired in the process[footnoteRef:6]. That surging trend in liabilities, made 2011 a flux year, since after then Carillion’s functioning was based on expectations of future revenue needed to repay its newly-aggrandized liabilities. This can be identified as an early decline factor, as it would make the company reliant on its investment delivering future returns, which it failed to do by delivering £260mln losses in the 5 years following its acquisition[footnoteRef:7]. [5: Parliament, House of Commons, Second Joint report from the Business, Energy and Industrial Strategy and Work and Pensions Committees of Session 2017–19, “Carillion”, HC769, 8. ] [6: Ibid, 13.] [7: Ibid]

A further problem was most of Carillion’s assets being intangible and hence unable to be liquidated if Carillion struggled with debt repayment, meaning that if its intangible assets failed in delivering returns, it could not sell tangible assets to cover their due liabilities. Although total assets grew from £3153 to £3862mln between 2010-2012, most of that growth was derived from an increase in goodwill and other intangible assets, which increased by £326mln in 2011, the year of Eaga’s acquisition. Due to a large proportion of its assets being goodwill, Carillion became susceptible to impairment losses if it misjudged its acquisition’s value. As mentioned before, Eaga delivered losses after its takeover, meaning the goodwill on it was not realized. This was an early decline factor, as Carillion would have to urgently seek alternative revenue sources to meet its liabilities, compelled it to undertake riskier low-margin projects, as that would be necessary to repay its debts and made its functioning dependent on the success of these projects[footnoteRef:8]. [8: ]

Carillion’s early problems can also be spotted in its gearing ratio, which trended upwards from 49% to 78% between 2008-12, showing that Carillion’s dependence on financing through long-term debt increased, while its interest coverage ratio fell from 10.08 to 2.32 in 2010-2012. Both of these show that Carillion’s financial position became more perilous, since the profits it generated became barely sufficient to cover the costs of borrowing that formed the majority of Carillion’s finances. While temporarily Carillion could handle the extra debt burden with its cash reserves, which grew by £260mln between 2010-2012, the new liabilities would weigh down on Carillion’s performance over time, particularly with the lack of returns on the Eaga’s investment, since interest would eat into its profits.

Some profitability ratios seemingly indicated that Carillion’s financial performance was improving. For instance, the gross margin grew from 7.8% to 10.6% in 2009-2012. These ratios were misleading however, as the increase was not a result of, for instance, growing gross profits, which went up by £37mln in 2010-12, but rather a dramatic decline in revenues, which fell by £571mln. This misleading figure meant that the company was only increasing its profitability as a proportion of its revenue and that it did not increase profits it generated overall, which signalled an early decline factor, as Carillion would struggle to generate enough funds to repay liabilities.

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The slowing profitability growth was also evident in efficiency ratios, such as the asset turnover ratio, which fell from 1.63 to 0.97 between 2008-2012, suggesting that Carillion was becoming less efficient at using its assets for revenue generation, which was an early factor of decline, as it showed that Carillion struggled to increase efficiency, which could generate more profits and help with debt repayment.

Carillion’s performance and decline factors, 2013-2016:

Carillion’s problems became more evident in the later years of its operations. One of the key problems was that Carillion’s revenue, which grew by £1062mln between 2013-2016, was only coupled with a £5mln profit increase in that time frame, causing the gross margin to follow a downwards trend from 10.4 to 8 in those years. Carillion’s poor performance in increasing profits, meant that it could not create its debts and forced the company to take on more contracts with lower margins to have sufficient funds to continue operating, unlike its rivals Serco or Balfour Beatty, who instead opted to write-down their overvalued contracts, restructure and stop bidding for new ones[footnoteRef:9]. Carillion’s new undertaking of low-margin contracts would not suffice to repay its skyrocketing liabilities[footnoteRef:10], making declining profitability a clear factor for decline. [9: Vincent, Matthew. “Why Carillion Has Gone into Liquidation Rather than Administration.” Financial Times] [10: Vincent, Matthew. “Why Carillion Has Gone into Liquidation Rather than Administration.”] [bookmark: OLE_LINK1][bookmark: OLE_LINK2]Further indication of Carillion’s decline were its cash reserves, which fell by £243mln between 2012-13 and struggled to recover later, with net cash outflows in 2015-2016. The cash outflows from financing activities in 2013-2016, showed that cash was mainly used to service debt making Carillion unable to invest for the long-term financial health, sacrificed a potential source of profits that could help cover Carillion’s liabilities. Carillion’s effective necessity to use new or expected revenues to cover payment demands[footnoteRef:11], meant that with profits stagnating, its liabilities would be harder to cover. These liabilities would become a decline factor since they would become excessively large, as evidenced by the 2016 jumps in pension liabilities of £405mln and of £402mln in trade payables. 2016 was hence a flux year, as then the liabilities experienced the single largest increase and grew beyond a serviceable level. [11: Vincent, Matthew. “Why Carillion Has Gone into Liquidation Rather than Administration.” ]

Carillion’s decline was also visible in its gearing ratio trending upwards, from 0.63 to 0.84 and its interest coverage stayed between 3.43-4.08 in 2013-16. Carillion’s finances hence remained largely reliant in debt and its interest coverage remained at a relatively low level. A further decline factor was Carillion’s decision to keep paying out dividends in the years of growing liabilities and maintaining the dividend pay-out ratio at 0.17-0.18 in the same years, showing that Carillion was more preoccupied with satisfying shareholders rather than using cash to deal with Carillion’s liabilities.

This was paired with signs of creditors’ growing distrust, like the payable period falling by 23.08 days in 2013-2016, which showed that Carillion’s debts were trying to be recovered more quickly, likely due to doubts over the company’s future prospects. This was final testimony, that it was becoming fairly evident from financial statements that Carillion’s poor performance and multiple alarming decline factors meant that Carillion’s future ongoing was being placed in doubt.

Role of board of directors and auditors in decline:

Carillion’s collapse highlights the key role of board of directors, in deciding a company’s strategic direction and exercising control by, amongst others, checking the integrity of the financial statements and evaluating and manging risks[footnoteRef:12]. Carillion’s board failed to flag evident issues with the company’s risky strategy of undertaking excessive debt and attempting to repay it with future revenues, by ignoring the alarming financial statements, which were indicating Carillion’s operations were under threat of collapse. [12: Atrill, Peter, and E. J. McLaney. Financial Accounting for Decision Makers (9th Edition). Upper Saddle River: Pearson, 2019, 450.]

Carillion’s board was more focused on its task of maintaining external relations for instance with shareholders[footnoteRef:13], as shown by their decision to continue paying dividends rather than use cash for debt reduction. This illustrates that boards of directors must balance out its tasks, unlike Carillion’s, which by focusing on shareholder satisfaction, caused negligence in oversight that ended up harming shareholders. [13: Ibid]

As for auditors, whose role is composed of selecting suitable accounting policies, making reasonable and prudent estimates and judgements, presenting information suitably and understandably and applying the going-concern convention[footnoteRef:14], they too failed in their role. Carillion’s auditors, repeatedly failed see through the board’s failures by ‘failing to exercise professional scepticism’[footnoteRef:15]. This illustrates that auditors must be particularly rigorous in their assessments and must interpret financial statements critically to spot excessive risk-taking. Auditors must also provide opinions on whether the financial statements provide a true and fair view[footnoteRef:16]. KPMG’s audits by signing off Carillion’s 2014-2017 financial statements, implied they represented a ‘true and fair view’ of Carillion[footnoteRef:17], which shows their failure as they failed to spot Carillion’s declining performance and faltering business model. [14: Financial Accounting for Decision Makers, 458.] [15: Smith, Emma. “Auditors ‘in the Dock’ over Carillion as Report Calls for Big Four Break-Up.” Accountancy Age] [16: Smith, Emma. “Auditors ‘in the Dock’ over Carillion as Report Calls for Big Four Break-Up.” Accountancy Age] [17: Brooks, Richard. “Carillion Fiasco Shows Why Auditors Must Be Accountable to Parliament.” The Guardian]

Carillion’s collapse also highlights the problem with auditors’ rewards, since their clients are also their revenue source, creating a conflict of interest, as applying strict accounting standards to its clients deprives accounting firms of lucrative revenues. In Carillion’s case, KPMG received £29mln for 10 years of auditing[footnoteRef:18]. This emphasizes the need for reducing such disincentives by, for example, pooling auditors’ rewards and allocating the companies they verify randomly. [18: Smith, Emma. “Auditors ‘in the Dock’ over Carillion as Report Calls for Big Four Break-Up.” Accountancy Age]

Bibliography:

  1. Atrill, Peter, and E. J. McLaney. Financial Accounting for Decision Makers (9th Edition). Upper Saddle River: Pearson, 2019.
  2. Brooks, Richard. “Carillion Fiasco Shows Why Auditors Must Be Accountable to Parliament.” The Guardian, Guardian News and Media, 20 May 2018, www.theguardian.com/commentisfree/2018/may/20/carillion-auditors-recklessness-hubris-greed.
  3. Casse, Tom et al. “Government outsourcing What has worked and what needs reform?” Institute for Government, Institute for Government, September 2019. https://www.instituteforgovernment.org.uk/sites/default/files/publications/government-outsourcing-reform-WEB.pdf.
  4. Neate, Rupert, and Rob Davies. “Carillion Collapse: Two Years on, ‘Government Has Learned Nothing’.” The Guardian, Guardian News and Media, 15 Jan. 2020, www.theguardian.com/business/2020/jan/15/carillion-collapse-two-years-on-government-has-learned-nothing.
  5. Parliament, House of Commons, Second Joint report from the Business, Energy and Industrial Strategy and Work and Pensions Committees of Session 2017–19, “Carillion”, HC769, 16 May 2018, https://publications.parliament.uk/pa/cm201719/cmselect/cmworpen/769/769.pdf
  6. Smith, Emma. “Auditors ‘in the Dock’ over Carillion as Report Calls for Big Four Break-Up.” Accountancy Age, 24 Dec. 2018, www.accountancyage.com/2018/05/16/auditors-in-the-dock-over-carillion-as-report-calls-for-big-four-break-up/.
  7. Thomas, Daniel. “Where Did It Go Wrong for Carillion?” BBC News, BBC, 15 Jan. 2018, www.bbc.co.uk/news/business-42666275.
  8. Vincent, Matthew. “Why Carillion Has Gone into Liquidation Rather than Administration.” Financial Times, Financial Times, 15 Jan. 2018, www.ft.com/content/a4dd80be-f9f1-11e7-a492-2c9be7f3120a.
  9. http://www.annualreports.co.uk/HostedData/AnnualReports/PDF/LSE_CLLN_2016.pdf

Appendix:

  1. All uncited figures are extracted from the AC100 Christmas Report handout, which included the balance sheets, income statements and statements of cash flow of Carillion PLC in the years from 2010 to 2016 and the profitability, liquidity, gearing, efficiency and shareholder ratios from the year 2008 to 2016. A copy of the data tables from where all the figures are extracted is presented below.

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