This article explores the current economic challenges for businesses in the construction industry in a post-covid-19, increased interest rate environment. It provides practical advice on what steps business owners can take now in order to be prepared for any upcoming economic tremors and provides rescue and restructuring options for those businesses needing further assistance.
Current Economic Challenges
The Construction industry has always been an industry that suffers a higher level of insolvencies. Historically one in five Australian corporate insolvent administrations are in the construction industry.
While demand for construction work has been significant in the last 3 years, currently there are various constraints the industry is experiencing which have been exacerbated by COVID-19 economic conditions including:
• Industry wide labour shortages due to a lack of skilled migration
• Increased demand in trades due to a boom in the construction industry
• Recent economic disasters such as bushfires and floods
• Increased government Infrastructure spending
• Supply chain issues of mission-critical resources such as timber.
• Increased price pressures on raw materials.
Supply Chain constraints
Over the last decade, there has been an increased reliance on obtaining construction materials from overseas. The disruption in supply chains, because of COVID, is having a significant impact on the supply of stock. This has caused ongoing project delays and cost increases which are resulting in budget blowouts.
Particularly, where builders have attempted to have fixed-price contracts in place to try to control their costing, raw material price increases have not always been factored in sufficiently and margins are being eroded. With margins eroded, cash flow and profitability become quickly impacted.
Interest rate increases
While supply chain pressures are slowly started to ease at the back end of 2022 and start of 2023, we are currently entering into an environment that has seen a significant increase in interest rates.
These increases will have some impact on the demand for new housing as well as the general mortgage belt. We are now seeing a slowing in housing markets across Australia, with the decrease being attributed to an increase in interest rates.
A lag between impact and insolvency?
We are slowly starting to see the impacts of COVID lockdowns that took place back in 2020. It always takes a few years for economic impactors to filter into the immediate market and cause disruptions and result in insolvencies.
Throwing back to the GFC in 2008/2009, mass corporate failures in the SME space did not start until about 2010 and they went through until around 2013. As the COVID lockdowns ease and any COVID support measures cease, we will see what impost the last few years have had on the construction industry.
Statutory Liabilities and ATO inactivity
When things get tough, tax debts are neglected. From our experience, when building and construction companies start to experience cashflow constraints, GST and PAYG withheld stops being remitted or reported. This provides companies the cash required to continue projects in the hope of returning to profitability at some later stage.
The ATO is ordinarily the most prolific debt collector in our economy. Since the onset of the COVID economic crisis in around March 2020, the ATO has sat on its hands and stopped collection activity altogether. Pre-March 2020, roughly half of the applications to wind-up companies were made by ATO, although ATO collection activity has begun to increase since around May 2022.
Unfortunately, those tax debts didn’t disappear overnight, and neither did insolvencies.
The Government's insolvency relief measures have suppressed insolvency numbers across all sectors, but if we talk about construction having the highest failure rate, for a variety of reasons, the number of subsequent failures is going to be greater.
Most commonly we find with those failures, in the subcontractor market, in particular, the ATO is always one of the major creditors.
The Federal Budget released by Labor in October 2022 announced that there will be $200 million in funding provided to the ATO over the 4 year term to assist the ATO increase tax receipts by $2.1 billion. As a result of this announcement, we now expect that collection activity will not only return to re- pandemic levels but significantly increase collection activity.
For example, the ATO has started again, since roughly May 2022 re-engaging with taxpayers to collect ATO debts, particularly company directors by issuing warning letters and director penalty notices, however formal winding-up proceedings by the ATO are still suppressed compared to pre-COVID levels.
The ATO compliance model causes significant delays between the ATO identifying non-compliance and ultimately business closure.
The ATO compliance model shows that the ATO will try to first deter non-compliance by detecting any taxpayers who do not want to comply. The ATO will then determine at some stage after attempting to re-engage with the taxpayer that the taxpayer has “decided not to comply” and use the full force of the law to recover the debt. At this point, the ATO may commence winding up proceedings to have a liquidator appointed to a company.
To make matters worse for company directors, tax liabilities, such as superannuation guarantee charge, GST and PAYG, can become a personal liability of the director if they are not reported within strict statutory time frames or if the ATO issue a director penalty notice on the Director. The ATO has chosen to commence issuing director penalty notices in an attempt to make directors personally liable for their debts at this stage rather than proceeding to wind up insolvent companies.
The economic cycle – when boom becomes bust
A boom always has to be followed by a bust. Therefore businesses, whether it be construction or otherwise, need to start getting their house in order, to make sure if the worst does come, they are going to be able to at least have a red-hot crack at surviving.
As outlined earlier some of the common indicators we see with businesses that end up being insolvent is that they do not adequately account for ATO tax debts but also fail to prepare or review cashflow projections.
What happens when you start having a decline in the boom cycle is that there is a lot more competition for certain contracts, causing price pressures.
There’s also the pressure on the business owner to maintain current staffing levels or the size of the business. In those circumstances, business owners start accepting lower margins on profits and slowly but surely, they start getting into trouble.
What should construction businesses do now to plan for a downturn?
Companies and individuals who win jobs just purely for cash flow end up, if something goes wrong, overnight looking at a loss. A small organisation usually can't absorb, a loss on a construction contract.
There are a few things business owners should do to get their house in order:
• Ensure you've got proper systems of account
It's quite common when we get involved with a smaller enterprise that their reporting systems just aren't up to scratch. And that's even more so if they've had a level of success and growth and they just haven't been able to keep up with the administrative side of the business.
If you feel like you've got any pressure at the moment you need to start talking to your financial advisor to figure out where the company currently stands and whether or not you've got the resources to endure some type of economic shock within the construction industry. Reporting and accounting systems must be adequately maintained to allow for your external accountant to be able to prepare cashflow projections and assess the Company’s expected future financial performance with reference to its historical data.
• Engaging and consulting with a trusted advisor
What we see with SME businesses that manage their operations and debts effectively and can adapt to the economic environment is they are always engaging with their external accountant or adviser. They are having regular cashflow meetings, reviewing their cashflow expectations, adjusting for increases in prices of raw goods and materials on contracts and closely monitoring expected future margins.
A larger business will usually benefit from engaging an experienced financial controller however smaller businesses should rely on their accountant to assist them in some of this decision-making.
• Putting in place arrangements with the ATO to address any historical tax debts
There's a level of leniency as far as entering into payment plans and doing deals with the ATO is concerned. Take advantage of this while you can but always ensure the arrangement can be realistically met.
• Having in place a business plan
Effectively planning is crucial. Review your business plan and revisit your goals and expectations. Do you have a buffer in place in case things go the other way? What are you going to do if prices increase? Are you able to talk to your customers to adjust contracts? This will assist you in negotiating a better positioning when unexpected circumstances do arise.
• Reducing capital
In boom times businesses tend to over-capitalise. In growth times owners are endeavouring to take advantage and increase the business, however, when things quieten down, you still need to be able to service the increased size of capital that was created during the boom time.
Working closely with your financial advisor, there may be a need to identify certain capital that can be rationalised, is no longer sufficiently performing or become obsolete.
• Being prepared
We don't have to tell builders but the construction industry is fraught with challenges other than economic pressure just from say recessions, supply chains, labour issues etc.
It’s a matter of getting on the front foot and figuring out what's happening with your business, being careful about what contracts and work you accept and being realistic about whether or not you are prepared for a shock in the industry.
Rescue and restructuring options
Finally, there are several further restructuring options available for directors to consider dealing with historical debts.
Shaw Gidley are experts in restructuring and turnaround and can provide various assistance to business owners including, but not limited to:
• Informal restructuring – we regularly assist companies considering an informal restructuring of their business and provide advice to allow you to make the best-informed decision
• Safe Harbour advice – Under “safe harbour” directors are protected from insolvent trading if they take a course of action that is reasonably likely to lead to a better outcome for the company and its creditors, compared to an appointment of an administrator or a liquidator. One of the advantages of a safe harbour is that it does not need to be disclosed to creditors that the Company entered into a safe harbour arrangement.
• Small Business Restructure or Voluntary Administration – This is a more formal mechanism than a safe harbour arrangement. Our experts will work with you to formulate a plan for the Company to offer creditors a return greater than in a liquidation scenario.
“In particular, companies with liabilities that do not exceed 1 million and have all of their tax lodgements up to date may benefit from the small business restructuring regime (“SBR”).
The SBR process has been particularly effective when compromising liabilities companies may have to the Australian Taxation Office.
The SBR process has many benefits above voluntary administration particularly because it allows a director to stay in control of the business during the restructuring process. A voluntary administration is more of a “hands-on” engagement that requires an administrator to trade the business of the company. This generally makes the SBR a more cost-effective.
At the same time, the SBR regime provides a company the same level of protection from certain creditors enforcing their claims during the restructuring process as voluntary administration.
At the end of the SBR engagement creditors vote on a proposal put forward by the company director. The proposal is accepted if 50% of eligible creditors by value that vote are in favour of the plan.
The Company then returns to the director with the restructuring practitioner overseeing the completion of the restructuring plan.
Should you require more information about any restructuring process, please contact our office.
For a free, confidential discussion, please contact our offices on 02 4908 4444 or 02 6580 0400 if you would like to obtain further information about these options.