Rating Methodology – Construction Sector

[Issued in December 2020]

RATING METHODOLOGY –
CONSTRUCTION SECTOR

Industry Overview
The construction industry contributes around 8% to India’s Gross domestic product (GDP) and
has an important role in the development of infrastructure in the economy.
The companies operating in the sector include contractors which derive revenue from execution
of projects broadly classified under three heads - (I) Civil Infrastructure, (II) Industrial
Infrastructure and Real Estate. The civil infrastructure space includes segments such as
transportation (roads, bridges, tunnel, railway, ports, civil aviation), utilities (dams, power) and
urban development. Industrial infrastructure includes construction work associated with
manufacturing units of various industries like steel, textile, cement, chemicals, etc. The
construction work in the real estate segment pertains to construction of buildings for
commercial/residential purpose, hospitals, malls, educational institutes, etc.
The civil infrastructure projects are generally undertaken at the instance of the Government with
some projects, particularly in the transportation segment, undertaken through Public–Private–
Partnership (PPP) route. The private players may operate as both contractor as well as
developer/sponsor of such projects. The urban development projects under civil infrastructure
are primarily undertaken by the Government entities. There has been an increased focus of the
Government on the urban development front with a large budget allocation and several projects
tendered in the segment over the past two-three years. The projects in the industrial and real
estate space are initiated both by the public as well as private sectors.

Characteristics
Close linkage with the economy
The contribution of construction to GDP has been about 8% over the past several years. Growth
in infrastructure is critical for development of the economy. Focus on developing infrastructure
in the country like roads, rails, airports, power, ports, etc., in turn results in growth in
construction activity. The industry depends significantly on budgetary allocation and government
spending on infrastructure development.
 Rating Methodology – Construction Sector

Highly fragmented
Construction industry in India is highly fragmented. There are few large, organised players and a
considerable number of medium and small-sized players in the industry. These would also include
players operating as subcontractors.

High working capital intensity

Construction contracts are associated with relatively large working capital requirement (mainly
non-fund-based). The working capital requirement depends upon a host of factors like size of the
project, order mix, tenure, clientele, project advances associated with the order and credit policy
of the company. Majority of the projects are labour intensive and accordingly, construction
industry is the second-largest employer in India after agriculture. However, off-late the
construction activities across real-estate; urban development and civil space are getting
mechanized with specialized construction equipment being used for faster project execution.
The industry largely operates on a milestone-based payment mechanism for the contracts linked
to physical and financial progress on the project. Delays in receipt of dues from clients along-with
delays in project execution results in receivable and inventory build-up and increase in working
capital requirements.

Rating Methodology
Considering the size and diversity of the construction sector, CARE has developed a methodology
for the sector which attempts to analyse factors, over and above the broad corporate rating
methodology. This methodology is used to analyse entities operating in the Engineering,
Procurement and Construction (EPC) space.
CARE’s rating process begins with a review of the economic as well as industry scenario in which
the entity operates along with an assessment of the business risk factors specific to the entity.
Analysing industry factors includes analysis of demand in terms of infrastructure requirement as
well as industrial and real estate construction expected in the area catered to, level of
competition in the sector and geographies in which the entity operates, financing options and
interest rate scenario, inflationary factors affecting the input cost, etc. This is followed by an
assessment of the financial and operational risk factors and quality of management of the entity.
The various sub-elements of each risk factor are described below-

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 Rating Methodology – Construction Sector

A. Management Evaluation
CARE interacts with the management of the entity to understand the management’s vision, focus
and growth strategy. Management evaluation includes evaluation of experience of the
management in the industry, quality of accounts and nature of related party transactions, among
others.
The quality of accounts is assessed on studying the company’s accounting policies towards
revenue recognition, disclosures on contingent liabilities and extent of unbilled revenue.
For more details on management evaluation, please refer to CARE’s ‘Rating Methodology –
Manufacturing Companies’ which is available on our website www.careratings.com

B. Business/Operation Risk
Evaluation of the track record of the entity in the industry and execution capability is critical for
business risk analysis as it would determine the ability to get new orders. An assessment of the
order book indicates the revenue visibility and profitability.

Evaluation of past projects executed

Assessing the size and past track record of the entity is a key factor in assessing its future
prospects. The entity’s overall size indicates the scale of projects that it would be able to bid for,
whereas past track record indicates the competence and ability to execute projects efficiently.
Major projects executed in the past are evaluated including details with respect to the size of the
projects, type of clientele and complexity level of projects.

Order book analysis

The order book of a construction company summarizes the core business activity of the company
and is the most important exhibitor of the business profile of the company in terms of revenue
visibility. For assessing revenue visibility, slow-moving/passive orders are excluded from the
order book. Furthermore, status of requisite approvals required for project execution is also
ascertained to gauge the revenue visibility. Land acquisition, Right of Way (RoW), Environmental
/ Forest Clearances, financial closure are among common factors which impact the project
timelines affecting the status of order book.

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 Rating Methodology – Construction Sector

The construction contracts, by terms of agreement, can be classified as, lump-sum contracts,
item-rate contracts, cost-plus-percentage contracts, cost-plus-fixed fee contracts, turnkey
contracts, etc. Raw material/input prices are the major determinant of the cost of contracts along
with labour cost. Any steep rise in the input prices due to macro-economic factors and/or delays
associated with the project execution may have an adverse bearing on the profitability of the
companies in case of fixed-cost contracts. Companies having majority of contracts with in-built
escalation clauses may be viewed favourably. However, the cost escalation may be linked to
Wholesale Price Index (WPI) or any other index and any cost increase higher than the Index may
limit the benefit from the presence of escalation clause.

Diversity and credit quality of counterparty

A company which operates across various segments and geographies is more protected against
a slowdown or issues in a particular segment or geography as compared to a company with high
concentration in a particular segment or geography. Further, diversification can be seen on the
basis of total number of orders, clients, nature and size of projects undertaken, etc.
CARE also ascertains the credit profile of the clientele for whom the work order is being executed.
Client composition is important in ascertaining the liquidity associated with the work orders. The
bifurcation can be broadly in terms of central government, state government or various state
departments, private clients and Principal/Sub-Contractor. Assessment of the credit quality and
payment track record of the respective counterparty, state’s Budgetary Allocation toward
infrastructure and designated funding authority enables assessment of the cash-flow adequacy
of projects. Largely, the construction orders are obtained through participation in tenders floated
by the various Authorities (except private orders) and composition of orders based on mode of
receipt, i.e., through direct participation in bidding or sub-contracted. Order received through
direct participation is usually associated with higher margins vis-à-vis sub-contracted ones. High
proportion of sub-contracted orders may be due to lack of adequate technical/financial
qualification to participate in the tender, track record of project execution, etc. In case of
subcontracts, the credit quality of both the principal contractor and the client is assessed.

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 Rating Methodology – Construction Sector

Order book to total operating income

Order book to gross sales ratio gives an indication of the future revenue potential and visibility
for the medium-term. A very high order book to sales ratio may be a constraint from a credit
perspective, if the company does not have adequate resources to fulfil its contractual obligations
or may also be an indication of some delayed/stuck orders. On the other hand, a lower ratio
indicates lesser revenue visibility. Hence, this ratio should be at an optimum level and is looked
at in light of resources availability and execution capability.
Apart from the outstanding order book, CARE also ascertains the value of bids that the company
has participated in, the volume of orders classified as lowest bidder (L1 status) which reflect the
orders having high potential to be converted into firm orders, the order flow during the past
three years which determine the volatility of order book, etc. CARE also tries to ascertain the
reserve price, corresponding L2 (second-lowest bid) and L3 (third-lowest bid) value of the tender
award received by the company to understand the associated margin with the order and whether
the company has done aggressive bidding to enhance the order book while sacrificing on the
profitability.

Resource availability and execution capacity

The execution capacity of the company is analysed considering its equipment base, past project
execution track record, technical expertise demonstrated, manpower availability and extent of
sub-contracting. Furthermore, most construction projects require a host of clearances and
approvals at various stages which adds to the execution risk in these projects due to probable
delays.
The availability and adequacy of resources w.r.t manpower, labour contractors, construction
equipment play a prominent role in determining the ability to meet the project timelines and also
impact the profit margins of the construction companies.
CARE undertakes assessment of the work expense and sub-contracting expense vis-à-vis cost of
sales and a higher sub-contracting cost for relatively smaller firms/companies often indicates
limited execution capabilities and resource availability.
Construction entities usually do not operate on fixed asset intensive model with exceptions
constituting entities involved in projects of complex nature requiring specialised equipment.

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 Rating Methodology – Construction Sector

However, requirement of faster work execution along with increased efficiency has triggered the
development of the construction equipment industry which is gradually resulting in increased
spending on the fixed assets by the construction companies. In this context, the Fixed Asset
Turnover (FAT) ratio (Total Operating Income/Average Gross Block) throws light on the efficiency
to utilize the available fixed assets and also dependence on own v/s leased equipment. Higher
FAT ratio in construction companies may be reflection of labour-intensive work orders or high
dependence on leased equipment. Lower FAT ratio may signal inefficient/sub-optimum
utilization of the fixed assets. However, FAT ratio is compared with the peers operating in similar
segment as standalone look at the ratio itself may not give a fair view. Besides, trend of fixed
asset addition in tandem with composition of the order book is also viewed. A higher fixed asset
addition, over the years, may reflect the changing composition of the order book and require
understanding of the company’s plan on its fixed asset investment and funding.

Profitability trend
Profitability is an important indicator of the operational efficiency of the company. Profitability
levels can vary widely within the industry depending on the range of value-addition activities
carried out by the company (ranging from large-scale contractors to subcontracting companies)
as well as the competitive bidding process, leading to refined margins. The operating margin will
be higher for entities executing complex and niche projects. Entities having largely fixed-price
contracts in the order book witness volatility in margin due to adverse movement in input costs
which cannot be passed on.
Furthermore, the operating margin can be impacted on account of hiring charges and higher sub-
contracting charges for entities not having own resources in terms of machinery and labour.
Entities having own equipment will have higher operating margin and higher depreciation cost.
Also, a company’s financing capabilities can be judged on the basis of net profit margin as interest
cost is typically higher for companies finding difficulties in raising finance. Net profit margin will
be higher for companies able to procure interest-free mobilization advances or other cheaper
financing options.

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 Rating Methodology – Construction Sector

Working Capital Management

A longer collection period which is not in line with peers operating in similar segment or as per
contract terms indicates delays in payments from the clients which could lead to the entity
utilizing excess outside borrowings in order to service newer projects, leading to strain on the
debt profile. Apart from receivables, CARE also considers retention money (including retention
money not due) and unbilled revenue as part of debtors while calculating collection period so
that a realistic operating cycle is arrived at. Furthermore, information with respect to receivables
under arbitration/dispute and ageing of debtors is sought for, if required, to check whether such
debtors are realisable.
Apart from inventory of raw materials and stores, construction companies also have work-in-
progress for various contracts which have not reached billing stage. The inventory period is
analysed to see whether there are any projects which are stuck for long.
A part of the funding requirement is met through creditors and often construction entities have
back to back arrangement with sub-contractors and payment to them is made on receipt of dues
from debtors. The creditor’s period is also analysed to see whether the company is stretching
payments to its suppliers or sub-contractors due to liquidity issues.
CARE also looks at the gross current asset days to analyse the working capital requirement.

C. Financial Risk
While assessing the financial risk of the entities operating in the construction industry, CARE
analyses the revenue, profitability, cash flow, capital structure and turnover ratios. Further, off-
balance sheet exposures are also critically examined with respect to the size of the company.
Scale of operations
The scale of operation of the entity and trend of gross billing for the last few years exhibits the
stability of operations of the entity. Growing trend in gross billing indicates the ability of the
company to consistently secure orders and steadily execute them.

Capital structure and coverage indicators

CARE tries to ascertain the leveraging policy adopted by the management for the project
execution in terms of reliance on mobilization advances, external credit lines or own funding for

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 Rating Methodology – Construction Sector

working capital requirement and dependence on subcontractors. The same in turn is correlated
to the profitability.
Debt in construction entities is largely in the form of working capital borrowings to fund the
operating cycle. Term loans mainly comprise loans availed for acquiring construction equipment.
Construction entities also avail mobilisation advances from their clients towards the construction
jobs done by them. These advances are a stable source of funding for construction contractors
and may be interest free or interest bearing, depending upon the terms of the contract. However,
the entity is generally required to furnish bank guarantee against all such advances. CARE
considers such advances as part of debt for its analysis as these are backed by financial
guarantees.
Apart from bank borrowing and advances, a part of the working capital requirement is met
through creditors. Therefore, apart from debt-equity and overall gearing ratio, CARE also looks
at the ratio of Total Outside Liabilities to Tangible Networth.
To assess the ability to timely service debt, CARE looks at the coverage indicators including
interest coverage, term debt/Gross Cash Accruals (GCA), total debt/GCA, total debt/Cash flow
from operations and debt/PBILDT, and debt service coverage ratio (DSCR).
However, in construction entities, since the operating cycle is long and significant amount of
funds may be blocked in the form of inventory, debtors, unbilled revenue and retention money,
CARE also looks at the Cash DSCR. Cash availability is also adjusted for investment
commitments/support to be extended to special purpose vehicles (SPVs) sponsored by the entity
and proposed sources for funding the same. The availability of sanctioned and unutilised bank
limits is also factored in while assessing the cash flow position. CARE also looks at the trend of
monthly billing and collections to analyse the cash flow position.
Companies having a positive cash flow from operations are viewed favourably, while companies
having a negative cash flow from operations due to higher collection period or slow-moving
projects may have to resort to external sources of funding to meet its operational needs and
repayment obligations.

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 Rating Methodology – Construction Sector

Off-balance sheet exposures

Construction companies often have significant off-balance sheet items in the form of contingent
liabilities as well as other non-fund-based exposures which are required for the normal
functioning of the business. Contingent liabilities in the form of corporate guarantees are treated
as debt of the entity being rated depending upon whether the guaranteed entity is in a position
to repay its debt. The EPC companies have large requirement of non-fund-based limits such as
Bank Guarantees (BG) which can be broadly summarized as following -
• BG for submission as bid bond guarantee for participation in tenders/project bidding
• BG for submission as Performance guarantee - post confirmation of tender/project award
• BG for availing mobilization advance, as applicable
• BG for releasing the retention money deposit.
Hence, given the requirement of BG at various stages of operation, CARE analyses the utilization
of the sanctioned BG facility/availability of the BGs with the company to understand the business
growth prospect and requirement of cash margin against such BGs.
The analysis of these guarantees is also done based on the past track record of invocation of any
such guarantees. Effect is considered in calculation of potential gearing.
For more details on Financial ratios, please refer to CARE’s methodology on ‘Financial Ratios-
Non financial sector entities’ which is available on our website www.carertings.com

Liquidity Assessment and Financial Flexibility

The management’s approach and track record of maintaining sufficient liquidity cushion and
entity’s financial flexibility to access long-term funds is assessed. Liquidity cushion available with
the entity in the form of cash or cash equivalents against its upcoming obligations is analysed to
monitor any cash flow mismatches. CARE also assesses un-utilised bank lines and sanctioned
undrawn limits to analyse the liquidity cushion. Financial flexibility could also depend on other
factors such as the entity's parentage, scale of operations and its level of leverage.

Exposure to projects under Public Private Partnership (PPP) model

Many construction entities have ventured from core construction activities to investment in
projects under PPP model like Build-Operate-Transfer/Build Own Operate Transfer (BOT/BOOT),
Hybrid Annuity, real estate development, etc. The change in business model from pure play EPC

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 Rating Methodology – Construction Sector

contractors endeavoring to graduate to developers has resulted in these entities assuming

various additional risks (funding risk, legal issues, post implementation risk, throughput risk, etc.)
and increase in debt burden for these entities. The financial risk assumes higher proportions for
entities with significant exposure to their associates/special purpose vehicles (SPVs)/subsidiaries
engaged in asset developmental activities, as the asset developers, in general, may not have
adequate cushion to absorb hike in interest rates and commodity prices, and in turn, rely on their
sponsors (promoters) for any tangible and intangible support. The debt availed by the SPVs is
usually guaranteed by the sponsors or supported through sponsor undertakings. Furthermore,
funding support may be required till the project generates cash flows. The nature and extent of
support to SPVs are factored in the rating analysis.
While analysing such entities, CARE assesses the standalone profile of the entity and makes
suitable adjustments in the leverage and coverage ratios considering the execution risk
associated with the projects, guarantees extended, sponsor commitment towards the project
and cash inflow/outflow estimations for such investments.

D. Industry Risk
The construction industry is very closely linked with the economy, various macro-economic
factors affects entities in the sector. CARE analyses demand in terms of expected infrastructure
spending planned by the Government in various areas and various schemes announced to boost
infrastructure spending. The demand in industrial and real estate construction space is analysed
considering the economic activity in the country or area in which the company operates. CARE
also analyses the lending scenario towards construction sector to assess the ease of availability
of bank finance in the sector. The tight lending scenario or heightened risk perception of the
sector by the lenders leads to lower availability of the fund-based and the much-needed non-
fund-based limits which may potentially stifle growth.
The industry is highly dependent on the impact of changes in the government regulations, and
policy thrust on infrastructure spending by the centre and the states. CARE keeps track of the
overall investment scenario in sectors that affect the construction industry to assess the sector
outlook.

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 Rating Methodology – Construction Sector

Conclusion
The rating outcome is ultimately an assessment of the fundamentals and the probabilities of
change in the fundamentals of the rated entity. CARE’s Rating Committee based on its experience
and holistic judgement analyses each of the above factors and their linkages to arrive at the
overall assessment of credit quality by also taking into account the industry’s outlook. While the
methodology encompasses comprehensive, financial, commercial, economic, and management
analysis, credit rating is an overall assessment of all aspects of the issuer.

[For previous version please refer ‘Rating Methodology – Construction Sector’ issued in November 2019]

CARE Ratings Limited

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Disclaimer
CARE’s ratings are opinions on the likelihood of timely payment of the obligations under the rated instrument and are not recommendations
to sanction, renew, disburse or recall the concerned bank facilities or to buy, sell or hold any security. CARE’s ratings do not convey suitability
or price for the investor. CARE’s ratings do not constitute an audit on the rated entity. CARE has based its ratings/outlooks on information
obtained from sources believed by it to be accurate and reliable. CARE does not, however, guarantee the accuracy, adequacy or
completeness of any information and is not responsible for any errors or omissions or for the results obtained from the use of such
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partnership/proprietary concerns, the rating /outlook assigned by CARE is, inter-alia, based on the capital deployed by the
partners/proprietor and the financial strength of the firm at present. The rating/outlook may undergo change in case of withdrawal of
capital or the unsecured loans brought in by the partners/proprietor in addition to the financial performance and other relevant factors.
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not factor in any rating related trigger clauses as per the terms of the facility/instrument, which may involve acceleration of payments in
case of rating downgrades. However, if any such clauses are introduced and if triggered, the ratings may see volatility and sharp
downgrades.

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