ASSESSING FINANCIAL VIABILITY

Practice

1. A Financial viability assessment evaluates the risk that, over the life of a proposed contract, a tenderer:

  • may not be able to deliver the goods and services which are specified in the contract; or
  • may not be able to fulfil guarantees or warranties provided for in the contract.

2. As conducting financial viability assessments imposes a cost on tenderers and the entity, assessments should be commensurate with the scale, scope and relative risk of the proposed project. The process for viability assessments should be conducted at an appropriate time in the tender process to minimise costs and time for both the entity and the tenderers.  Consequently, the timing within a procurement process and the extent of financial viability assessments should be determined on a case by case basis and not mandated on an entity-wide basis.

Assessing Project Financial Viability Risk  

3. The following factors should be considered when assessing project financial viability risk:

  • The nature of the goods or services: level of complexity
    • Projects involving a complex procurement, such as payroll services and centralised information technology services, are higher risk than simple supplies procurements. More complex, high value and relatively important projects will normally be subject to a formal risk management process. This should include consideration of the need for and scope of financial viability assessment.
  • Value of the procurement
    • Projects involving a large value procurement are generally more risky than those involving a small value procurement. However, procurement value should not be used as the sole indicator of project risk.
    • In assessing financial viability risk, the value of a procurement within a project should be considered both in the context of relative value to the entity, and in the context of relative value to the likely tenderers or potential suppliers.
  • Other factors
    • general economic factors;
    • the tightness of the labour market;
    • levels of demand for the required service;
    • understanding of profit margins in the relevant industry;
    • maturity of the relevant industry; and
    • the capacity of businesses to supply.

Risk and Financial Viability Assessment Matrix  

4. The following table outlines the key factors that characterise low, medium and high risk projects, and should be considered when assessing each separate procurement stage in a project. The level of risk of the procurement is relevant to the nature of the financial viability assessment that should be applied.

LEVEL OF RISKKEY FACTORS
Low Risk
  • Low strategic importance to entity
  • Low level of complexity
  • Minimal sensitivity
  • Low value *
  • Short-term supply
Moderate Risk
  • Moderate strategic importance to entity
  • Moderate level of complexity
  • Tight / inflexible delivery timeframe
  • Moderate level of sensitivity
  • Medium value *
  • Medium-term supply
High Risk
  • High strategic importance to entity
  • High level of complexity
  • Tight / mandatory delivery timeframe
  • High level of sensitivity
  • High value *
  • Long-term relationship and supply
*Refer to paragraph 3 (Value of the procurement)

5. In assessing risk, consideration should be given to the likelihood and consequence of a financial viability issue in the procurement and subsequent contract.  Specifically, consideration should be given to:

  • the likelihood of a financial viability risk given the nature of likely tenderers, the maturity of the industry, economic conditions, and the history of financial failure in the industry; and
  • the consequence to the entity if the supplier or contractor does experience a financial viability incident during the project or contract.  This will be heavily dependent on the importance of the good or service to the entity or its stakeholders.

Viability Assessments: Seeking Information

6. Irrespective of the level of risk, entities should ensure that tender request documentation enables the entity to complete further financial checks. For example:

The entity, or any third party authorised by the entity, may perform such security, probity and financial investigations and procedures as the entity may determine are necessary in relation to any tenderer, its employees, officers, partners, associates, subcontractors or related entities including consortium members and their officers, employees and subcontractors. Tenderers may be required to provide access to records requested by the entity or its third party representative/s in order to facilitate the necessary financial investigations.

7. The tender request documents should have a mechanism for excluding high financial viability risk tenderers, where risks cannot be appropriately managed. This may be in the form of a clause enabling the entity to exclude tenderers on the basis of their financial viability risk, or by including risk to the entity as an issue to be considered during the evaluation process, for example as part of a risk criterion or as part of a discrete evaluation criteria.

8. In designing the tender process, entities should consider what financial information will be necessary for tenderers to provide with their tender response to enable the entity to assess financial soundness. The documents required depend on the risk of the project.

Low risk

9. Where project risk is low, a financial viability assessment may not be necessary. A Tenderer’s Declaration as to financial viability may be an adequate indication of the tenderer’s financial viability.

Moderate risk

10. A Tenderer’s Declaration and a copy of the previous year’s financial statements (audited if available) should be the minimum requirements for moderate risk projects. This should enable the entity to confirm the financial soundness of the tenderer.

High risk

11. A Tenderer’s Declaration and financial statements for the previous three years should be a minimum requirement for high risk projects. If the most recent set of financial statements are more than six months old, the entity could also request the most recent part year accounts (audited if available).

12. For high risk projects, the scope for updating the financial assessment at strategic intervals during the course of the contract may be included in the requirements.

13. Entities that are planning very high risk projects may need to undertake significant and potentially intrusive measures. This should only occur where procurements within a project are of a very high value and level of complexity. In this case, specialist financial assessment should be undertaken, using a wide range of financial indicators to assess all relevant aspects of viability.

Tenderer’s Declaration

14. Generally, each tenderer should be required to submit a certified declaration on the financial viability of the tenderer, before or when submissions are lodged.

15. The declaration should attest to the financial position and financial strength of the business and specific issues that could impact on operations over the course of the proposed contract. The declaration should also address legal risks and any unmitigated risk exposures.

16. The declaration should affirm that the tenderer:

  • has sufficient financial resources to deliver the goods or services described in the tender request documentation (including fulfilling any guarantees or warranty claims);
  • is not subject to any current or impending legal action (either formal proceedings or notification of legal action) which could impact on the financial viability of the tenderer or the delivery of the goods or services; and
  • has (or will have in place) insurance cover for the purposes of, and at the levels required, for the procurement.

17. Where the tenderer is a company, the declaration should be signed by the company secretary and a director or by two directors of the company. For a company that has a sole director who is also the sole company secretary - that director. Where it is a business partnership, it should be signed by two partners and where it is a sole trading business, by the proprietor.

Options to Consider for Immature Organisations

18. There may be instances where potential tenderers for procurements are relatively young or have a short financial history.  This in turn may limit their ability to provide historical information as noted above to provide confidence regarding financial viability.  In these instances, entities could consider requesting the following information for analysis:

  • business plans;
  • bank statements for current liquidity;
  • any parent company or investor guarantee/s; and
  • financial statements of parent company or investor.

19. In these instances, especially for high risk procurements, an opportunity to discuss financial viability management with tenderer directors, financial advisers, bankers or parent company may provide additional information to allow the entity to effectively consider management of financial viability risk.

Use of Ratings Entities and Registry Organisations

20. Ratings entities can be a source of background information and financial viability information which can support a consideration of viability. In addition, regulatory registry information, including that held by the Australian Securities & Investments Commission, the Australian Business Register and various State and Territory registers can provide useful information for consideration in viability assessments.

Viability Assessments: Analysing Information

Professional financial advice

21. If a project, or any procurements associated with it, is assessed as being moderate or high risk it may be appropriate and advisable to seek a professional financial viability assessment. Such an assessment should provide independent opinion on the financial viability of the preferred tenderer and alert the entity to impending risks over the life of the project. It should include analysis of a range of financial ratios and advice on any financial management issues that should be included in the contract.

22. Regardless of whether professional advice is sought, or in-house analysis is conducted, standard reporting formats may be useful for entities that regularly conduct viability analyses. The use of templates tailored for medium and high risk procurements can help maintain comparability over time and between tender processes.

23. A common method for analysing financial reports and their meaning is to use financial ratios.  Financial ratios present representations of interaction between various components of a financial report.  The consequent ratios can be compared with industry or sector norms to provide some information to support a conclusion on potential financial viability.

24. Where an entity elects to undertake a financial viability assessment internally, the entity will need to have appropriate expertise in applying the ratios and ensuring that they are appropriate for the procurement being considered.

25. Importantly, understanding the meaning of ratio levels compared to industry or market norms and acceptable levels is essential to obtain value from ratio analysis.

26. Expertise in ratio calculation and analysis should be available from the finance area of most entities or from professional advisers.

Financial ratios used to assess financial viability

27. The following financial ratios may be useful to provide insight into a tenderer’s profitability, liquidity and financial stability. These are a subset of the large range of potential ratios that an experienced practitioner could consider in any given procurement situation.  The most appropriate financial ratios will vary with the industry, the economic conditions, and the risk of the procurement associated with the project.

28. Care should be used in applying the ratios, as standards vary between industries.

29. The application of appropriate data to a ratio (for example, consideration of what is included in “total revenue” in the ratios below) is important and needs to be determined accurately.

Trends in profitability

RatioDefinition

Net profit margin ratio (%)

Net profit divided by total revenue

Gross profit margin (%)

Gross profit divided by total revenue

Return on assets (%)

Net profit divided by total assets

30. The application of appropriate data to a ratio (for example, consideration of what is included in “total revenue” in the ratios below) is important and needs to be determined accurately.

31. A snapshot of a tenderer’s profitability can be obtained using the net profit margin ratio. For high risk procurements these ratios may be used to assess profitability trends over the period for which financial statements are obtained.

  • whether the tenderer has a track record of profitable operations, as measured by profits generated in at least two out of the three most recent financial years; and
  • whether there is an upward or downward trend in relation to the tenderer’s sales, expenses and net profit.

Trends in liquidity

RatioDefinition

Current ratio (x:1)

Current assets divided by current liabilities

Quick ratio (x:1)

Current assets less stock divided by current liabilities

These ratios provide an indication of the liquidity and cash flow. The quick ratio is a more conservative measure than the current ratio. The higher the ratio, the better the tenderer’s short-term financial strength.

Trends in financial position

RatioDefinition

Total liabilities to equity ratio (x:1)

Total liabilities divided by owners equity

Working capital ($)

Current assets less current liabilities

Interest cover ratio (x:1)

Net profit before tax plus finance expenses divided by finance expenses

These ratios provide an indication of the value of the asset base and the level of gearing underlying the business operations. The ratios should be compared to industry benchmarks.

Issues relating to financial stability that should be considered for high risk procurements include:

  • whether there is adequate capital to support the proposed procurement;
  • the maturity breakdown of the borrowings of the tenderer;
  • how non-current assets are valued in the financial statements and whether an independent valuation used or whether it was the Directors’ valuation;
  • whether there are any disclosures in the notes on commitments and contingent liabilities that could impact on the successful delivery; and
  • whether there are any post balance date event disclosures that could affect successful delivery.

35. If the entity is part of a bigger corporate group, the assessment should be extended to the group. Matters that should be addressed as part of this review include:

  • whether the entity has any related-party loans which may require repayment by the entity. If it does, the agency may want to acquire copies of the related parties’ financials or consolidated financial statements for assessment; and
  • where an entity is a subsidiary company, whether it has any parent company guarantees and if so, the nature of the guarantee.

Consideration of the Reliance on the Proposed Contract

36. In considering financial ratios and viability, consideration of the impact of the proposed contract or the impact on other individual sources of revenue (especially Government related sources of revenue) should be made.  Heavy reliance on Government income or single sources of income can increase the likelihood of a financial viability issue.

Obtain Additional Information

37. If financial viability remains a risk following analysis of information provided, entities should consider seeking additional information where consistent with tender request documentation. In such cases, consideration should be given to any additional cost to both the entity and the tenderer.

38. Consideration should be given to the need to discuss financial viability management with tenderer directors, financial advisers, bankers or parent company. This may provide additional information to allow the entity to effectively consider management of financial viability risk.

Possible Risk Mitigation Strategies

39. Entities should put in place risk mitigation strategies appropriate to the project, including strategies to address any specific risks associated with the selected tenderer.

40. Where there is sufficient financial viability risk associated with a tenderer or where the nature of the required goods or services warrants it, an entity may obtain some financial and/or performance security, to provide assurance over the performance of the tenderer. These may take the form of parent company guarantees, bank guarantees, performance guarantees, insurance bonds or letters of comfort. Where such security is sought, officials should consider any handling and security arrangements that may apply to such documents.

41. Other financial security options that entities may wish to consider include personal financial and performance guarantees from Directors and Trust beneficiaries, minimising advance payments, audit and regular financial monitoring, raising financials or credential concerns directly with the tenderers for resolution, and including contractual requirements to report in instances where a financial viability issue arises.

Parent company guarantees

42. Special purpose joint venture or subsidiary companies (subsidiaries) may be created to tender for large projects. Such entities may have little share capital or financial resources and their legal and financial liability may be quarantined from the parent company. In such cases, the tendering entity may be relying on the financial support of the parent company or another related entity, including through financial and/or performance guarantees.

43. Financial guarantees usually involve the parent company agreeing to stand behind the subsidiary’s financial capacity. A performance guarantee involves a parent company agreeing to take over provision of the services if the contractor fails to provide the services.

44. When subsidiaries submit a tender for a significant project and provide a parent company guarantee, the entity should extend the financial viability assessment to the parent company’s financial position. This would be to determine its capacity to support the procurement. Entities should take legal advice in order to ascertain how broad, how binding and how firm any parent company guarantee is.

45. Foreign companies operating in Australia often provide working capital and long term funding by way of ‘at call’ loans rather than through share equity. This provides more flexibility to the business group but it also facilitates the repatriation of funds to the offshore parent. Where at call loans exist, the financial viability assessment will need to consider whether the off-shore parent can withdraw its support and/or demand repayment of the loans currently payable.  Entities could require the parent company to provide a guarantee of financial support, which is an agreement to not demand repayment of those loans during the life of the project.  Entities should consider being named in such guarantees for high risk/high value procurements.

46. Legal advice should be obtained regarding the operation of the guarantee. This will assist in ascertaining if there are any conditions which have to be met before payment of the guarantee can be made. Conditional guarantees may require certain factors to be proven, prior to funds being released. If there is a dispute over the triggers to the payment of the guarantee, there could be significant delays in receiving the funds.

Bank guarantees

47. A bank guarantee gives the entity the right to obtain money from a bank for loss incurred as a result of the other party’s default or failure to perform.  This mechanism provides financial incentive for the service provider to perform in accordance with the contract.

48. Bank guarantees serve as a contract performance guarantee. The fact that the tenderer can provide the bank guarantee is an indicator that there is financial substance behind the tenderer (or related parties).

49. Legal advice should be obtained regarding the operation of the guarantee. This will assist in ascertaining if there are any conditions which have to be met before payment of the guarantee can be made.

50. Conditional guarantees may require certain factors to be proven, prior to funds being released. If there is a dispute over the triggers to the payment of the guarantee, there could be significant delays in receiving the funds.

51. Although a bank guarantee can assist in managing financial risk to the entity, they are likely to increase the cost to suppliers. Entities should consider the effect that such a guarantee may have on final pricing.

Insurance bonds

52. For major procurements such as those associated with construction projects, the entity may wish to consider other market forms of assurance and security. One such option is the provision of insurance bonds by suppliers, in lieu of bank guarantees. In such cases, the entity should seek expert advice to ensure that risk to the Commonwealth is not materially increased and that the benefits outweigh the costs. 

53. Entities should note that any such additional assurance requirements are likely to add costs to the supplier which may flow through to the final pricing structure.

Letters of comfort

54. Letters of comfort from the tenderer’s bankers or accountants may be requested. For low and moderate risk procurements, a letter from the tenderers’ accountant may be appropriate and adequate. Letters of comfort, however, are of little use unless the letter makes a specific statement about a particular factor.

55. In general, such letters of comfort will include disclaimers or make non-specific and general statements such as “subject to meeting the banks normal lending criteria we would be pleased to extend an appropriate facility to the company for this project”. The issuer of the letter may therefore be unlikely to take responsibility for any losses caused by reliance on the letter and very little assurance is actually provided to entities