Predicting bankruptcy in the heavy construction sector and analyzing the financial health of select companies

Abstract

The construction sector is one of the key sectors for gauging the macro-economic growth of a country. The performance of this sector determines the growth of multiple linked sectors such as housing, real estate etc. and affects macro economic parameters such as employment directly. For this purpose, predicting the financial health of this sector becomes critical for both the banks as well as the Government. In this project, we intended to do the same by developing a model based on data from the period of 2010 to 2017. Within the companies constituting the ‘Heavy Construction’ sector, we identified those that had undergone a ‘default event’ such as debt restructuring or default on their debt from the period of 2013- 2017. We identified predictor ratios based on past research papers which could possibly predict default rates and took the data for these ratios for the period of 2010-2012 for all companies in the heavy construction sector. After performing variable reduction by removing insignificant variables and highly correlated ratios, we ended up with 21 independent variables. After divided the data set into test and validation randomly, we ran a logistic regression using the test data set. The significant variables were Inventory/Sales (last year), Retained Earnings/Total Assets (last year), Debt to Equity (current). After cross validation, we used the regression equation to predict bankruptcy using current data for companies in the heavy construction sector. Some key observations were: Out of the companies which underwent a ‘default event’, 12 are still expected to be bankrupt going forward and 14 have actually turned healthy and not expected to go bankrupt. Also, we identified 10 new companies which weren’t flagged earlier, but are expected to go bankrupt in the future. Finally, we looked into the trends of these ratios for companies in each of the above instances. We saw that the predicted defaulters had built up inventory without being able to earn revenues from them. They were taking debt at higher costs which they were unable to pay off due to slackening revenues. This was leading to a scenario where companies were not able to retain any profits and profits if any were going towards debt servicing. The report also looks at the way in which working capital is showing an inconsistent trend, with certain defaulting companies building up high working capital by investing in inventories, while some others with near zero working capital on account of non availability of projects. The interest coverage ratio for the industry overall also is on the lower side on account of higher cost of debt due to riskiness of the industry. Finally, we closed our report by looking at a sample firm which turned around their fundamentals by repaying their debt after selling off non core assets and investing in core projects through Special Purpose Vehicles.