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Financial risks in construction projects

Article  in  African journal of business management · December 2011

DOI: 10.5897/AJBM11.1463

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African Journal of Business Management Vol. 5(31), pp. 12325-12328,7 December, 2011
Available online at http://www.academicjournals.org/AJBM
DOI: 10.5897/AJBM11.1463
ISSN 1993-8233 ©2011 Academic Journals

Full Length Research Paper

Financial risks in construction projects

Antonio J. Monroy Antón1*, Gema Sáez Rodríguez2 and Ángel Rodríguez López3
1
Department of Finance and Marketing, Universidad Autónoma de Madrid, Spain.
2
Universidad de Alcalá, Madrid, Spain.
3
Department of Finance and Accounting, Universidad Complutense de Madrid, Spain.
Accepted 1 September, 2011

Risks in construction projects can be defined as the probability of an event that impairs the viability of
the project. This probability, perhaps, is higher than in other industries. In the construction sector, as
elsewhere, various risks that affect business can be identified. This paper aims to identify, classify and
analyze the most significant risks inherent in large engineering or construction projects, with particular
attention to the group of economic risks and developing finally a conclusion in this regard. The results
showed that construction projects are exposed to many risk sources, internal and external, being one
of the most important, the financial risks such as inflation, fluctuation of the currency, lack of solvency,
etc. Construction is a complex area involving many factors that can affect the final outcome, and being
a teamwork process whose common goal is the completion of the project, the risks are essentially due
to the uncertainty affecting the various participants in it.

Key words: Risk allocation, financial risks, construction projects, infrastructures.

INTRODUCTION

Risks in construction projects can be defined as the
probability of an event that impairs the viability of the
project. This probability is perharps, higher than in other
industries (Flanagan and Norman, 1993; Kim and Bajaj,
2000; Tah and Car, 2000), due to its inherent charac-
teristics (Bing et al., 1999; Bunni, 1997; Hayes et al.,
1986; Kangari and Riggs, 1989).
Not all risks should be associated with negative results,
because although most of the time this happens, risks
can also mean opportunities. From the moment that the
objectives of the construction project are set, time, cost
and quality represent the most important risk factors to
consider. The main problem is that these risks are not
always dealt with properly by the construction industry
(Mills, 2001; Thomson and Perry, 1992).
Risk management is a process of identifying, analysing
and responding to risks throughout the lifecycle of a pro-
ject to control, reduce or eliminate those risks (Edwards
*Corresponding author. E-mail: antonio.monroy@uam.es. Tel:
+34609588782. Fax: +34915341035.
and Bowen, 1998; El-Sayegh, 2008; Zhao and Li, 2010).
The total elimination is, in the construction sector, almost
impossible, and the objective should be to transfer them
from one party to another through contract clauses (Andi,
2006; Mak and Picken, 2000). Thus, to reduce risks, it is
very important first to identify them (Godfrey, 1996;
Hayes et al., 1986; Williams, 1995). Once this has been
done, it is possible to adopt actions to address it (Kayis
and Ahmed, 2007) and to allocate it to various parties in
order to keep it under control and to prevent possible
negative consequences (Bunni, 1997).
Risk management might also be useful in order to
maximize profits (Baker et al., 1999). However, the
benefits of risk management have not always been
understood by this sector (Flanagan and Norman, 1993;
Raftery, 1994; Ward et al., 1991).
In the construction sector, as elsewhere, various risks
that affect business can be identified. However, in this
particular area there seems to be greater risks as a result
of the involvement of multiple factors such as different
contracting parties, multiple suppliers, designers, etc., all
linked to the socio-cultural, political and economic diffe-
rences of the place where the project will be undertaken.
12326 Afr. J. Bus. Manage.
To appropriately address the risks, we must first identify
internal risks in the construction sector and in a second
stage and after analyzing them, focus on external risks,
especially in economic and financial sector. Proper risk
identification and allocation will reduce the negative
impacts, increasing efficiency and effectiveness in ma-
nagement (Abrahamson, 1984; Barnes, 1983; McCallum,
2000; Rahman and Kumaraswamy, 2002; Thompson and
Perry, 1992). There have been many classifications of
risks. Wiguna and Scott (2006) established four catego-
ries: external and site condition risks, economic and
financial risks, technical and contractual risks, and
managerial risks. In this study, risks will be classified as
external, internal and financial. This paper aims to
identify, classify and analyze the most significant risks
inherent in large engineering or construction projects,
with particular attention to the group of economic risks
and developing finally a conclusion in this regard.
INTERNAL RISKS
Internal risks in large construction projects are usually
related to the control of the management team. According
to Aleshin (2001), they have their origin within the project,
while the external risks are originated from the macro-
level. They can be divided into the following groups:
obligations of the owner, designers, contractors,
subcontractors and suppliers. In turn, these can be
subdivided into several subgroups and thus form the
overall risk structure (El-Sayegh, 2008). To reduce the
risk on the owner's obligations, they must be clearly
defined as running for their performance and a resource
statement. In case these obligations are not met,
penalties for noncompliance should be included in the
contracts (Hassanein and Afify, 2007).
The group of owner's obligations includes the following
subgroups: payments to contractors, project schedules
too tight, inappropriate intervention, design changes, lack
of scope of project definition, sudden bankruptcy and
breach of contract.
For construction contractors, payments received from
the owners represent the fundamental source of income.
So, if those owners delay payments, this means more
financial difficulties and therefore a risk of default in the
terms of the project. In some countries, the rate of late
payments by the owner has reached even 77% (Kartam
and Kartam, 2001).
The contractors, in turn, also understand that the risk of
late payment, together with the resolution of contractual
issues, is the largest that can tackle an engineering or
construction project of large dimensions. They suggest
the need for fairer contracts for them, incorporating better
payment terms and also improved methods of dispute
resolution, including mediation and arbitrage. This shows
their concern and the urgent need to improve risk
management strategies (Hassim et al., 2009). Sometimes
the project planning is too tight, and owners impose
difficult to achieve construction schedules (Dey, 2002).
Other times, the owners impose changes in project
design, thus affecting its definition. If these changes are
excessive, they bring negative consequences for the
achievement of the objectives of the project. The fact that
the owners act on the basis of time and money often
leads to poor work planning, producing precisely an
excessive duration and an increase in costs higher than
originally budgeted (Baloia and Priceb, 2003; Kaming et
al., 1997; Raftery, 1994). Morris and Hough (1987),
reviewing the different types of projects funded by the
World Bank between 1974 and 1988, found that 63% of a
total of 1,778 projects had experienced significant cost
overruns. The next group includes the risks of project
designers. The greatest risks that may occur in this
section are the design flaws and changes to be carried
out after the start of the construction phase. The design
may be incomplete, insufficient or incorrect and,
therefore, the project may not be buildable. In addition,
there may be an additional risk as the delay in the
issuance of building plans (Kartam and Kartam, 2001).
The risks associated with contractors refer to different
aspects closely related to them such as construction
accidents, quality and productivity of labor, other risks
associated with technical problems that lead to the
construction contingency and lack of qualified personnel
that shows the incompetence of contractors. In short,
many of these aspects are related. For example,
normally, when an accident happens, it affects all the
equipment, reduces productivity and employee morale,
and hinders the achievement of the target. The quality is
also affected.
In connection with the subcontractors, it is necessary to
mention that, through outsourcing, the construction
company can make profits, but that this practice, at the
same time, can be risky. Poor performance can be
obtained, which would delay the whole project, or cause a
breach of contract as a result of disputes between
subcontractors and contractor that prevent the project is
carried out. As for suppliers, the most representative risks
arising are those related to the quality of materials and
delays in the supply of material. According to contractors,
suppliers are in the third position in the risk impact
analysis (Dey, 2002; Hassim, Jaafar and Sazalli, 2009).
In addition to this series of risks, Hassanein and Afify
(2007) add three subgroups: the acquisition of
permissions, the provision of capital goods and obtaining
credits.
EXTERNAL RISKS
The external risks are not directly related to the
construction process, however, they have a high weight
in relation to the achievement of the project. They can be
classified into the following groups: political, socio-
cultural, economic, natural and other (El-Sayegh, 2008).
Within the political risks are: threats of war, strikes of

workers, changes in legislation, corruption and bribery,
delays in approvals. These risks relate to the “country
risk”. Country risk also includes cases where the host
country can not pay the debt because of their own
economic problems. Political risks affect all aspects of a
project, from site selection to completion of construction,
through operations and marketing (Wang and Chou,
2003). They are difficult to assess. When possible, they
are borne by the owners, and if it is not possible, lenders
also sometimes take risks (Maniar, 2010; Nevitt and
Fabozzi, 2000). Some authors have been more concrete
regarding political risk in construction projects of
international scope, focusing on factors such as costs -
workforce, materials and overhead costs- and income –
related to taxes, foreign currency and exchange rates-
(Ashley and Bonner, 1987; Baloia and Priceb, 2003).
Socio-cultural risks may include criminal acts or
conflicts due to cultural differences, while natural hazards
are well known (unexpected weather conditions, natural
disasters, etc.). Apart from the economic risks discussed
below, there are other external risks such as delays in
resolving contractual issues, delays in resolving disputes,
lack of equity in the bidding, local protectionism,
difficulties in insurance contracts, presence of interest
groups, resource availability, statutory regulations, etc.,
that might have a significant effect on the outcome of a
construction process.
ECONOMIC RISKS
Concerning economic risks, El-Sayegh (2008) notes that
inflation and sudden price changes represent the most
important economic risks in countries such as, for
example, the UAE. The same view is put forward for
countries such as Kuwait (Kartam and Kartam, 2001),
China (Fang et al., 2004) or Indonesia (Andi, 2006).
Just in reference to inflation, Maniar (2010) and Nevitt
and Fabozzi (2000) argue that the use of correct
forecasts of inflation is essential to meet the future cost
updated correctly, and that is the lender who has more
experience to perform these reliable predictions, even
better than the promoters of the project. The builders,
meanwhile, also see in inflation an important risk (Kartam
and Kartam, 2001).
Another economic risks to consider when planning a
large construction project is the fluctuation of the
currency, especially in the case of international projects.
Recently in many countries the construction of privately
financed infrastructures has been based on foreign
capital, thus running the risk of devaluation of local cur-
rency. International lenders rarely take that risk, preferring
to have their payments in foreign currency. In the past,
public companies or governments have accepted the
currency risk, but now, with the growing demand for
private financing, the risk of depreciation of the currency
often lies in the promoter of the project and, ultimately, on
Antón et al. 12327
consumers, because the lender is not willing to assume it
(El-Sayegh, 2008; Nevitt and Fabozzi, 2000).
Changes in interest rates are also a significant risk for
such projects. Loans with variable interest rates can be
used for long-term construction and financing, as well as
short-term needs. Forecasts of future interest rates used
to calculate the costs of the project depend on a number
of assumptions that can be fulfilled or not later. At
present, it is advisable to adjust the projects based on
variable interest rates given the uncertain economic
environment, but predictions will never be perfect (Nevitt
and Fabozzi, 2000).
Hassanein and Afify (2007) mention other various
financial risks such as lack of clarity in the allocation of
responsibilities for payment of some taxes, lack of
provisions for partial payment thus reducing the risk of
default, the improper withholding of guarantees on the
advance payment, etc. Finally, some authors consider
that the lack of financial solvency from any of the parties
(owners and contractors) is one of the greatest risks to
consider. Normally, contractors minimize their profit mar-
gins to maximize their chances of winning projects, which
is a major risk during the construction period (Hassim et
al., 2009). Financial effects of these risks are quite clear:
lower productivity, poor performance and increase in the
cost of the project (Mills, 2001).
Conclusion
Having identified and classified most of the risks inherent
to the construction and infrastructures sector it can be
said that is a complex field involving many factors that
can affect the final outcome. It could also be said that
being a teamwork process whose common goal is the
completion of the project, the risks are essentially due to
the uncertainty affecting the various participants in it. It is
also important to notice that the parties in the contract
should adopt a continuous learning approach towards
risk identification. Past projects and past events are an
opportunity from which to gain experience that might lead
to success in the future, as real-life scenarios already
seen might help to take measures in order to avoid
triggering risk events.
Another measure to reduce risks is that of their
transfer. Contractors are sometimes reluctant to forward
claims for losses in order not to harm the good relation
with the employer, which makes insurance companies´
role more important.
In the classification made, the risks are divided into
categories, the most frequently mentioned by different
authors, which require special attention. One could
consider that the most important risks are: payments to
contractors, breach of contract, poor designs and
financial risks. Among them, payments to contractors are
surely the number one, as if they are delayed or
suspended, it may cause the project gridlock. For its part,
12328 Afr. J. Bus. Manage.
the financial risks almost always result in lose of money.
It has to be kept in mind that many of the authors
mentioned in this paper analyze the financial risks of
infrastructures of countries in the Middle East and Asia.
The risks in this sector depend heavily on countries or
regions in which the projects are to be built, and it is
totally different to implement those projects in areas of
political stability such as Europe that performing them in
countries where political conflicts are usual. Therefore,
when establishing which are the most important risks in a
certain project it should be taken into account in the first
place where they intend to build. From there, the risk
analysis must be performed.
ACKNOWLEDGEMENT
This study was funded in part by the CMMP in Madrid,
Spain.
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