Title: Understanding project contractors and construction contracting businesses using business ratio analysis
We want you first to select what will be your core ratio for your paper, from the set of ratios given below. For each such ratio we have identified either four or six firms, as examples of firms having either relatively high or relatively low values for that ratio (as compared to benchmark average values we found for a large sample of over 1000 British construction contractors). We next require you to pick for analysis some (at least two) of the firms in the set of 4 or 6 firms given for your chosen ratio. You can pick so that all your chosen firms are examples of firms having a high, or all a low, value for your core ratio; or else you can pick so that some of your chosen firms (at least one) have high values whilst others (at least one) have low values for the core ratio.
There are seven possible core ratios for you to choose from:
1. Operating profit margin: PBIT / Turnover
2. Operating multiplier: Turnover / Total assets
3. Current gearing: Total Assets / Capital
4. Long term gearing: Capital / Shareholders Funds
5. Average labour productivity (£th): Net Value Added / Number of employees
6. Average remuneration (£th): Remuneration / Number of employees
7. Capital intensity (£th): Capital / Number of employees
There are thus 32 firms in all from which you choose. We will put on Moodle a spreadsheet called ‘Firm data' that shows a full set of profit & loss account and balance sheet variables and business ratios for these 32 firms for the years 2005 to 2011. This full set of around 60 variables and ratios extends far beyond (but includes) the seven core ratios.
Ratios (1) to (4) belong to the DuPont System. Ratios (5) to (7) belong to the Bowles System.
We will give you, by putting on Moodle: (A) a set of Benchmark Sample Average Ratios for the large sample of up to 1022 firms from which the 32 are drawn, broken down into ‘peer groups' of Tier 1 / Tier 2 and large / small firms; and (B) a set of benchmarks taken from the results of the Office for National Statistics Annual Business Inquiry (ABI) / Survey. The former gives quite a wide set of ratio values. The latter gives a smaller set of ratios, but covers a very large sample of firms indeed, allowing ratios to be shown for each SIC 4--digit part of the construction industryi. Each of these Benchmark sets show values for the years 2005 to 2011 (Ive and Murray peer groups) and from 2005 to 2007 (ABI). The ABI data provides benchmarks for very specific construction activities. If some of your firm's activities are covered within these, make good use of these benchmarks as the most representative ratios for those types of business activities.
Using the data we supply and other information you can findii we want you to tell the business ‘stories' of each of your chosen firms over the years 2005 to 2011. Your discussion and analysis will be structured around your ‘core ratio'. We want you to investigate both the reasons for and the consequences of a high or low value for your core ratio in your chosen firms. Reasons break down into immediate reasons (for example, a firm might have a high ratio of capital per employee because it has a high value of fixed assets per employee or alternatively because it has a high value of net current assets per employee) and the more underlying reasons (for example, a firm might have high fixed assets per employee because that is intrinsic to the nature of its business, such as a plant hire firm). Consequences in turn break down into immediate or proximate consequences (for example, the effect of high capital per employee on labour productivity) and ultimate consequences for profitability, that is, for Return on Capital Employed (PBIT / Capital) or Return on Shareholders Funds (PAIT / Equity).
Some firms within each set of 4 or 6 you will find to be comparable in other ways than just the core ratio values (i.e. to be broadly engaged in the same type of activity); others you will find to be engaged in contrasting activities.
The set of 32 firms contains firms engaged in the following different types of activity:
• General contractors
o Building contractors (B)
o Civil engineering contractors (C)
o Repair & maintenance contractors (R)
• Specialist contractors (limited to specific trades but including some firms in direct relationship with building owners - for example, shopfitting specialists)
• Tier 1 contractors (overlap with, but not identical to, general contractors)
• Tier 2 contractors (overlap with, but not identical to, specialist contractors)
• Plant hire firms
Remember that the primary aim of the assignment is for you to learn not about specific firms but about the underlying types of business activity they represent. We have tried to limit the firms we have given you to firms entirely or mostly engaged in one business activity. Your ‘stories' should compare both the business models (simplified as what a firm does, and how it aims to make profits doing it) and the performance of your Firm A with your Firm B, etc. and also compare each against their peer group(s) and other
benchmarks.
For each firm you need to define its activity, and offer a stylised model of how the ‘typical' firm in that activity conducts its business (its customers and how it wins work, its resources, its competitors and how it competes, its business ratios). You should also offer a description of each of your chosen firm's business strategies and business models, as you understand them; and evaluate the risks and rewards for those firms of following those strategies and models.
In the Bowles et al system the 3 core ratios are:
1. Average labour productivity (value added / number of employees)
2. Average remuneration (costs of remuneration / number of employees)
3. Capital employed per employee (Fixed Assets plus Net Current Assets / number of employees)
However, each of these ratios can be broken down into components or brought together with other ratios to create new ratios. For example, capital per employee can be broken down into: fixed capital per employee (fixed assets / number of employees); operating capitaliii (also called ‘need for working capital' and equal to net current assets used in operations, i.e. current assets excluding financial reserves minus current liabilities) per employee; and net financial assets per employee.
Bowles et al assumes working capital and net current assets is zero, so that capital employed equates to fixed assets. This is an acceptable approximation of reality in many industries, but NOT in construction contracting. To apply the Bowles system to contractors, you will have to be careful to use not ‘fixed capital' but ‘capital employed' as your denominator in measuring rate of profit.
The obvious introduction to the mathematical components of the Bowles system is chapter 10 of Bowles et al (2005), followed, for the relation of ratios to economic concepts, by chapters 11 (on competition and profit margin, and on capacity utilization and ROCE), 12 (on wage rate and unit labour cost), 13 (on technical efficiency). See also Ive & Gruneberg and Gruneberg & Ive (2000), as well as any good economics textbook for concepts of capital intensity, capital productivity and labour productivity.
In the DuPont system the 4 core ratios are:
4. Profit margin (PBIT / turnover) -- which breaks down into 4a. Gross profit margin ({turnover - cost of sales} / turnover), and 4b. Overhead cost ratio (administration expenses / turnover)
5. Operating multiplier (turnover / total assets) - which can be broken down into 5a. Turnover / fixed assets 5b. Turnover / current assets
6. Current gearing (total assets / {total assets - current liabilities}); i.e. ({capital employed + current liabilities}/ capital employed) - a large component of which may be trade creditors / total assets
7. Long--term gearing (capital employed / shareholders funds, i.e. {shareholders funds + long--term liabilities} /shareholders funds) aka Capital {Equity + Debt} / Equity. This needs to be related to the Debt and tax burden (PAIT / PBIT) to see the effect of long--term gearing on Return on Shareholders Funds relative to Return on Capital Employed.
Often understanding a firm and its business requires insight into its' position on the make / buy continuum. If a firm has a relatively low ratio of value added / turnover or of costs of remuneration / cost of sales, or remuneration / turnover then that indicates that the firm relies more heavily than the average firm in its peer group on outsourcing and using subcontractors (rather than its own employees) to do the work that becomes its turnover.
Section 1: Introduction
Effect of economic context
Whatever activities within construction contracting you choose your firms from, you will need to establish the relevant economic context for construction contracting in this period (what was happening to industry--level demand, output and employment), and the easiest and best way to do this is by using relevant government statisticsiv. The period we have asked you to examine includes years of booming construction demand and output (2005 to 2007 for demand, to 2008 for output) and years of deep recession and limited recovery (2008 to 2011). What effect did this strong economic ‘cycle' have on your chosen firms' peers and the UK construction industry as a whole?
Your peer groups for comparison should be one or more of the large samplesv of construction contractors for which you will find average ratio values in Ive and Murray (2013) ‘Trade credit in UK construction industry' (on Moodle).
Section 2: Conceptual framework and literature review
There are two main ‘systems of ratios' we expect you to use. Each system uses accounting identities (tautologies, relationships that must be true, by definition) to show how profitability can be broken down into component ratios: the Du Pont system and the Bowles system. Your discussion of concepts should include discussion of the particular ‘system of ratios' of which your core ratio is a part, and of how its ratios relate to economic concepts.
An economic view of the idea of ‘business model' is as follows:
(A) Variables that drive the firm's profit margin (for example, Porter's 5 forces model)
(B) Variables that drive the firm's need for finance (finance for assets of different types) -- measured by ratios of types of asset to total assets and total assets to turnover
(C) Variables that show how the firm sources its finance (by equity or by using different types of liability); including showing the role giving and receiving trade credit plays for the firm - measured by ratios of types of liability to total assets or to equity
(D) Variables that show what resources (capital assets and labour) the firm deploys, and what levels of resource productivity it obtains, at what cost - with resource productivity measured by turnover per employee; value added per employee; turnover--to--asset and turnover to capital ratios; value added per £ assets of £ of capital; resource structure measured by assets or capital per employee; and resource cost measured by remuneration per employee; and productivity relative to resource cost measured by profit per employee;
(E) Variables that show where the firm stands on the make--or--buy continuum
- as measured by the ratio of value added to turnover and by cost of remuneration / cost of sales;
In addition, once you have covered the essentials and if you still have time and room in the paper, it would also be relevant to explore the growth of the firm - how do its growth rates of assets compare with its growth rate of turnover and its growth rate of employment; what is its re--investment margin (retained profit / turnover) and equity
growth ratio (retained profit / equity)? If you do this, you will have to calculate the ratios yourself from the single variable data we have provided in the firm dataset.
The italicised terms above indicate the range of concepts and ratios that it might be appropriate for you to cover in your review of literature and conceptual framework.
However, you should structure and balance your discussion of concepts not so as to attempt to be comprehensive, but so as to focus upon the linkages and relationships you understand may exist between your ‘core ratio' and other ratios.
A key part of the idea of this assignment is for you to see how the ratio you do select influences and affects outcome profitability, as measured either by Return on Capital Employed (ROCE) or Return on Shareholders Funds (ROSF).
Section 3: Analysis of data
Your analysis section of the paper should contain an argument based upon models of conceptual relationships found in the theory literature and illustrated and assessed by empirical data. This data must cover not only your chosen firms, but also the peer group benchmark data provided.
Section 4: Conclusion
We expect you to conclude your paper by reflecting on what you have learnt from the assignment about business in general, construction contracting in its various forms, and specifically about your chosen firms. This should include a reasoned assessment of which if any of your chosen firms has been ‘well managed' over the period, and which firm has offered its shareholders the better mix of return and risk.
Attachment:- CM1 comp data 2015-16.rar