Investors can learn several lessons from the collapse of UK’s largest construction and services company Carillion after the firm went into administration on Monday.
The firm collapsed after the UK government refused to provide guarantees for the firm’s £900m debts, prompting creditors to withdraw support.
The Carillion pension scheme was also running a deficit of £580m and will now be taken on by The Pension Protection Fund (PPF).
Carillion share price over the last year
Source: FE Analytics
As the chart above shows, Carillion’s price share has dropped almost 100 per cent over the past year, after issuing three profit warnings over a five-month period.
Below, AJ Bell investment director Russ Mould draws six lessons from the Carillion debacle he believes investors can apply to stocks from all geographies and sectors.
Beware complexity – keep it simple
Mould said investors should be aware of complexity of businesses. Carillion, he said, had managed to find synergies and overlaps between the different sectors and geographies it worked in.
He said: “The very best long-term investments develop a competitive edge – via a technological lead, a brand or market share, for example – and then deepen their core competence.”
However, Mould said Carillion was “juggling complex, long-term contracts across a range of disciplines and geographies, a feat which ultimately proved beyond it, especially once a small number of big projects went wrong”.
Be wary of companies whose history is littered with acquisitions
Another warning sign for investors is companies that have been very acquisitive, noting the complexity new companies can bring, “as deals must be integrated staff kept motivated and customer service maintained”.
Mould said M&A tends to work best when small, bolt-on deals are used to supplement existing momentum, not create it.
Carillion’s past acquisitions included Mowlem in 2006, Alfred McAlpine in 2008, Eaga in 2011 and John Laing’s facilities management business in 2014.
“These deals expanded the company’s range of services and geographical reach – to bring complexity into the company and take some cash out of it.”
Debt can be deadly if profit margins are thin
While debt is not “inherently bad”, said Mould, providing a cheap and ready source of funding, it does come attached with caveats. 
“The company’s business model must be suitable – and that means demand must be fairly predictable and margins consistent – and preferably fairly high – so that the interest can be paid without difficulty and interest cover is good,” he explained.
“Utilities and tobacco stocks can take on a lot of debt pretty comfortably,” said Mould. “Tech stocks tend to avoid it, as they need to keep investing in research so their fixed costs are high, and construction firms tend to avoid debt, too, to ensure they have a nice cash buffer in case a big project goes wrong and they are hit by cost over-runs.”
Carillion, however, did not take this precaution, according to Mould, and was further hobbled by “a huge pension deficit with disastrous consequences”.
He noted: “In 2016, it generated a stated operating profit of £146m on sales of £4.4bn for a margin of just 3.3 per cent - and that operating profit had to fund £60m of interest and pension payments, tax and £79.8m in dividends so there was little margin for error.”
Always look at how management is incentivised to behave
A further issue highlighted by Mould is executive remuneration, arguing that questions need to be asked about how bonuses and options were triggered for senior directors at the firm.
Indeed, last year, former chief executive Richard Howson received a £245,000 bonus and £346,000 in long-term performance incentives which helped to take his total package to £1.5m.
“In principle, the structure of the bonus mechanism seems sensible enough, as it was 30 per cent based on earnings per share, 20 per cent on cash conversion, 25 per cent on operational performance indicators and 25 per cent on internal leadership and staff engagement ratings,” he said.
“Yet the 2016 bonus contained telling clues for investors – the zero score for earnings per share, cash, and ratings from customers – while the use of a specific earnings per share figure (36.1p) was simply wrong, as this can lead to temptation and corner-cutting, even in this case the threshold was not reached.”
Why cash flow is more important than profit
Mould said while profits may drive short-term sentiment “it is cash that pays the bills such as salaries, interest and tax”.
He said investors must always look at the balance sheet first, the cash flow statement second and the profit & loss account third.
The balance sheet will explain how safe – or not – the firm is, while the cash flow statement can show if there are any problems, accounting issues or issues of earnings quality to address, according to Mould.
Finally, the profit & loss account will provide a short-term snapshot of trading, he added.
“One quick test is to compare and contrast growth in sales, stated profit and cash flow,” explained Mould.
“While they may grow at different rates, owing to operational gearing and investment, they should generally all show the same direction of travel.
“If they do not, investors may need to delve deeper into the company’s accounting, to ensure it is not aggressively recognising revenue or relying on asset sales and capital gains to ‘make the numbers’, as the failure of cash flow growth to tally to profit and sales growth can be a ‘red flag’,” he said.
Dividend yields that look too good to be true usually are
Lastly, investors should consider whether dividends are sustainable, said Mould, noting that Carillion’s high yields may have proved too tempting for some.
“That no doubt drew a lot of income-seekers to their doom, as the dividend was cut to zero as the profit warnings rained in and the shares collapsed,” he said.
“This reinforces the importance of looking at the net debt position – including any pension and lease liabilities – and cashflow as well as earnings cover when assessing whether a dividend is safe.”