RELATIONSHIP BETWEEN RISK MANAGEMENT

PRACTICES AND FINANCIAL PERFORMANCE OF

CONSTRUCTION AND CONSTRUCTION RELATED

FIRMS IN PAKISTAN

MUHAMMAD SHAHZAD ANJUM

UNIVERSTI SAINS MALAYSIA

2015

-

RELATIONSHIP BETWEEN RISK MANAGEMENT

PRACTICES AND FINANCIAL PERFORMANCE OF

CONSTRUCTION AND CONSTRUCTION RELATED

FIRMS IN PAKISTAN

By

MUHAMMAD SHAHZAD ANJUM

Thesis submitted in fulfillment of the requirements for the

Degree of Doctor of Philosophy (Project Management)

February 2015

-

DEDICATION

Dedicated to

My beloved parents and loving wife

ii

ACKNOWLEDGMENT

First and foremost, I express my profound gratitude to Allah Almighty whose blessings

have enabled me to complete this task. My warmest and deepest appreciations are due to

my supervisor, Professor Dr. Abu Hassan Abu Bakar for his professional guidance,

constructive comments, continuous encouragement, frank and friendly relationship. This

thesis, in its present form, is the result of his patient readings of multiple drafts.

My special thanks are due to the respondents of survey questionnaire for their valuable

input to academic research. I also appreciate the support provided by the Librarians at

Hamzah Sendut Library, USM and resource persons in several academic, federal and

state institutions in Pakistan for their suggestions and provision of relevant materials.

Warm appreciation is also due to faculty members of School of HBP and all colleagues

who provided advice and assistance during different phases of completion of this thesis.

The general guidance on research methodology provided by Dr. Arshad Hassan is also

acknowledged.

Lastly, the completion of this gigantic task would not have been possible without the

continued support and prayers of my parents and loving wife. I express my sincere

thanks to all my family members.

Muhammad Shahzad Anjum

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TABLE OF CONTENTS

Page

ACKNOWLEDGMENT II

TABLE OF CONTENTS III

LIST OF TABLES VIII

LIST OF FIGURES IX

LIST OF ABBREVIATIONS X

LIST OF PUBLICATIONS XII

ABSTRAK XIII

ABSTRACT XV

CHAPTER 1 INTRODUCTION 1

1.1 Background of Research 1

1.2 Risk Analysis and Management 2

1.3 Managing Financial Risk in Construction Industry 5

1.4 Performance Evaluation of Construction Industry Firms 7 1.4.1 Ratio Analysis for Firm Financial Performance 7 1.4.2 Regression Analysis for Firm Performance 9 1.4.3 Risk Management Process and Practices 9

1.5 Pakistan Construction Industry: Status and Issues 10

1.6 Research Gaps 13

1.7 Research Problem 14

1.8 Research Questions 16

1.9 Research Objectives 17

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1.10 Scope of Research 18

1.11 Significance of Research 19

1.12 Limitation of Research 21

1.13 Definition of Key Terms 22 1.13.1 Risk 22 1.13.2 Risk management 22 1.13.3 Construction Related Sectors 22 1.13.4 Financial Performance 23

1.14 Thesis Organization 23

CHAPTER 2 LITERATURE REVIEW 25

2.1 Introduction 25

2.2 Risk Management in General 25

2.3 Models of Risk and Return 26

2.4 Prospect Theory of Risk Management 27

2.5 Studies on Impact of Macroeconomic Factors 28

2.6 Studies on Financial Statement Analysis 34

2.7 Studies on Financial Performance Evaluation 35

2.8 Studies on Risk Management in Construction Industry 38

2.9 Firm Performance and Risk management Practices 60

2.11 The Conceptual Frame work 65

2.12 Summary 67

CHAPTER 3 RESEARCH METHODOLOGY 68

3.1 Introduction 68

3.2 Data Description and Sources 69

3.3 Conceptual Framework and FRAME Model 71

3.4 FRAME Model Development Process 73 3.4.1 Financial Data Collection 73

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3.4.2 Mathematical Preparation of Financial Data 77 3.4.3 Formulation of Financial Performance Score (FPS) 79 3.4.4 Formulation of Economy Performance Score (EPS) 80 3.4.5 Formulation of Composite Performance Index (CPI) 83

3.5 Survey and Analysis of Risk Management Practices 85 3.5.1 Selection of Firms for the Survey 85 3.5.2 Survey Design 86 3.5.3 Questionnaire Development Process 87 3.5.4 Pilot Testing of Survey Questionnaire 89 3.5.5 Structure of Final Survey Questionnaire 92 3.5.6 Reliability Analysis of Survey Instrument 95 3.5.7 Data Collection and Response Level 96 3.5.8 Use of Likert Scale in Questionnaire 97 3.6 Statistical Analysis of Survey Data 99

3.7 Summary 104

CHAPTER 4 DATA ANALYSIS AND RESULTS 105

4.1 Introduction 105

4.2 Results of FRAME Model Components 105

4.2.1 Data Normalization for Ratio Analysis 106

4.3 Derivation of Firm Performance Score (Fps) 108

4.4 Derivation of Economy performance score (Eps) 112

4.5 Formulation of Composite Performance Index (CPI) 115

4.6 Risk Management Practices Survey 119

4.7 Results of Risk Management Survey 120

4.8 Results of Survey Question Responses 125

4.8.1 Profile of Respondents 125 4.8.2 Types of Risk Faced by High and Low Performing Firms 126 4.8.2 Methods used to Identify Financial Risk by HPs and LPs 128 4.8.3 Types of Methods Used for Risk Analysis by HPs and LPs 131 4.8.4 Qualitative Methods Used for Risk Analysis by HPs and LPs 134 4.8.5 Quantitative Methods Used for Risk Analysis by HPs and LPs 136 4.8.6 Preferences to Financial Risk Management Options by HPs and LPs 139 4.8.7 Methods Used by HPs and LPs to Transfer Financial Risk 142 4.8.8 Methods Used by HPs and LPs to Reduce Financial Risk 144 4.8.9 Methods Used by HPs and LPs to Manage Retained Risk 147 4.8.10 Methods Used by HPs and LPs to Eliminate Financial Risk 149 4.8.11 Monitoring Tools used by HPs and LPs to Control Financial Risk 151

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4.9 Descriptive Statistics of High and Low Performing Firms 154

4.10 Significance Testing of High and Low Performing Firms 157

4.10.1 Non-parametric Test (Mann-Whitney U) Test Statistics 158 4.10.2 Determining the Effect Size for Mann-Whitney U test 163 4.10.3 Parametric Test (Independent Samples t-test) 165 4.10.4 Determining the Effect Size for Independent-samples t-test 167

4.11 Summary 168

CHAPTER 5 FINDINGS AND DISCUSSION 169

5.1 Introduction 169

5.2 Relevance of Study Objectives and Methodology 170

5.3 The First Objective: Conduct Firm Performance Score Analysis 171

5.4 The Second Objective: Conduct Economy Performance Score Analysis 173

5.5 The Third Objective: Composite Performance Index Analysis 178

5.6 The Fourth Objective: Conduct Risk Management Practices Survey 179

5.6.1 Frequency of Types of Risk Faced by Firms 180 5.6.2 Methods used by Firms to Identify Risk 180 5.6.3 Use of Qualitative Methods for Risk Analysis 181 5.6.4 Use of Quantitative Methods for Risk Analysis 182 5.6.5 Preferences to Financial Risk Management Options 182 5.6.6 Methods Used to Transfer Financial Risk 183 5.6.7 Methods Used to Reduce Financial Risk 183 5.6.8 Methods Used to Retain Financial Risk 184 5.6.9 Methods Used to Eliminate Financial Risk 184 5.6.10 Monitoring Tools used to Control Financial Risk 185

5.7 Descriptive Statistics of High and Low Performing Firms 186

5.8 The Fifth Objective: Summative Industry Specific Framework 187

5.9 Significance Testing of High and Low Performing Firms 188

5.10 Summary of Risk management Survey Findings 192

5.11 Assessment of Risk management Survey Findings 194

5.12 Summary 197

CHAPTER 6 CONCLUSIONS AND RECOMMENDATIONS 198

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6.1 Introduction 198

6.2 Achievement of Research Objectives 199

6.3 Research Study Conclusions 202

6.4 Research Contribution 203

6.4.1 Contribution to Knowledge 203 6.4.2 General Policy Implications 205 6.4.3 Policy Implications for Construction Firms 207 6.4.4 Policy Implications for Construction Contractors 209 6.4.5 Policy Implications for Stakeholder Organizations 209

6.5 Recommendations for Future Research 210

REFERENCES 212

APPENDICES 232

APPENDIX A LIST OF CONSTRUCTION AND CONSTRUCTION RELATED INDUSTRY FIRMS 233

APPENDIX B CPI-BASED RANKING OF ALL FIRMS (HIGHEST TO LOWEST) 237

APPENDIX C HIGH AND LOW PERFORMING FIRMS SELECTED FOR SURVEY 240

APPENDIX D PRETESTED QUESTIONNAIRE 245

APPENDIX E SURVEY REFERENCE LETTER AND QUESTIONNAIRE ON RISK MANAGEMENT PRACTICES 249

APPENDIX F CRONBACH'S ALPHA FOR ALL ITEMS 254

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LIST OF TABLES

Table Description Page

Table 2.1 Matrix Form of Literature Review 54 Table 3.1 Composition of Selected Firms 71 Table 3.2 Data on Selected Macroeconomic Variables 83 Table 3.3 Survey Questions, Focus and Response Options 94 Table 3.4 Reliability Test for Pilot and Final Survey Instrument 96 Table 4.1 Size Factor Values (Zi) of Construction and Construction related Firms 106 Table 4.2 Normalization of Coefficients 107 Table 4.3 Fps Regression Model Summary 108 Table 4.4 ANOVA a 109 Table 4.5 Fps Model Regression Coefficients a 110 Table 4.6 Eps Regression Model Summary b 113 Table 4.7 ANOVA b 113 Table 4.8 Eps Model Regression Coefficients 114 Table 4.9 Composite Performance Index (CPI) Values for All Firms 118 Table 4.10 High Performance vs. Low Performance 119 Table 4.11 Survey Responses of High Performing Firms 121 Table 4.11 Survey Responses of High Performing Firms 122 Table 4.12 Survey Responses of Low Performing Firms 123 Table 4.12 Survey Responses of Low Performing Firms 124 Table 4.13 Designation Profile of Respondents 125 Table 4.14 Types of Risk Faced by HPs and LPs 126 Table 4.15 Methods Used for Financial Risk Identification 129 Table 4.16 Types of Methods Used for Risk Analysis 131 Table 4.17 Qualitative Methods Used for Risk Analysis 134 Table 4.18 Quantitative Methods Used for Risk Analysis 136 Table 4.19 Preferences to Financial Risk Management Options 139 Table 4.20 Methods Used to Transfer Financial Risk 142 Table 4.21 Methods Used to Reduce Financial Risk 145 Table 4.22 Methods Used to Manage Retained Risk 147 Table 4.23 Methods Used to Eliminate Financial Risk 149 Table 4.24 Monitoring Tools used to Control Financial Risk 151 Table 4.25 Descriptive Statistics for High and Low Performing Firms 155 Table 4.26A Mann-Whitney U and Wilcoxon rank-sum Test Statistics 159 Table 4.26B Mann-Whitney U and Wilcoxon rank-sum Test Statistics 160 Table 4.26C Mann-Whitney U and Wilcoxon rank-sum Test Statistics 161 Table 4.26D Mann-Whitney U and Wilcoxon rank-sum Test Statistics 162 Table 4.27 Effect Size r Values 164 Table 4.28 Group Statistics of High and Low Performing Firms 165 Table 4.29 Independent Samples t-Test 166

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LIST OF FIGURES

Page

Figure 2.1 Risk Management Lifecycle (Baker Scott, 1997) 61 Figure 2.2 Risk Management Framework (Baker Scott, 1997 62 Figure 2.3 Financial Risk Analysis, Monitoring and Evaluation (FRAME) Model 66 Figure 3.1 Development Process and Structure of Survey Questionnaire 88 Figure 4.1 Frequency of Facing Financial Risk 126 Figure 4.2 Frequency of Facing Financial Risk 127 Figure 4.3 Frequency of Facing Operational/Logistic Risk 128 Figure 4.4 Frequency of Using First Risk Identification Method 129 Figure 4.5 Frequency of Using Second Risk Identification Method 130 Figure 4.6 Frequency of Using Third Risk Identification Method 131 Figure 4.7 Frequency of Using Qualitative Methods 132 Figure 4.8 Frequency of Using Quantitative Methods 132 Figure 4.9 Frequency of Using External Experts for Risk Analysis 133 Figure 4.10 Frequency of Using Historical Data for Guidance 134 Figure 4.11 Frequency of Using Brainstorming Sessions 135 Figure 4.12 Frequency of Using Personal and Corporate Experience 135 Figure 4.13 Frequency of Using Expected Rate of Return 137 Figure 4.14 Frequency of Using Expected Net Present Value 138 Figure 4.15 Frequency of Using Breakeven Analysis 138 Figure 4.16 Preferences for Risk Transfer Option 140 Figure 4.17 Preferences for Risk Reduction Option 140 Figure 4.18 Preferences for Risk Retention Option 141 Figure 4.19 Preferences for Risk Elimination Option 141 Figure 4.20 Preferences for First Risk Transfer Method 143 Figure 4.21 Preferences for Second Risk Transfer Method 143 Figure 4.22 Preferences for Third Risk Transfer Method 144 Figure 4.23 Preferences for First Risk Reduction Method 145 Figure 4.24 Preferences for Second Risk Reduction Method 146 Figure 4.25 Preferences for Third Risk Reduction Method 146 Figure 4.26 Preferences for First Risk Retention Method 147 Figure 4.27 Preferences for Second Risk Retention Method 148 Figure 4.28 Preferences for Third Risk Retention Method 148 Figure 4.29 Preferences for First Risk Elimination Method 150 Figure 4.30 Preferences for Second Risk Elimination Method 150 Figure 4.31 Preferences for Third Risk Elimination Method 151 Figure 4.32 Preferences for First Risk Control Method 152 Figure 4.33 Preferences for Second Risk Control Method 153 Figure 4.34 Preferences for Third Risk Control Method 153

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LIST OF ABBREVIATIONS

ABBREVIATION DESCRIPTION

Fps Firm Performance Score

Eps Economy Performance Score

FRAME Financial Risk Analysis Management Evaluation

CPI Composite Performance Index

SBP State Bank of Pakistan

FBS Federal Bureau of Statistics

GoP Government of Pakistan

KSE Karachi Stock Exchange

GDP Gross Domestic Product

SPSS Statistical Package for Social Science

IFS International Financial Statistics

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LIST OF PUBLICATIONS

1. P/E Premium and Cross section of Expected Returns: An Empirical Evidence

from Pakistan Equity Market, MS Thesis, June 2009.

2. Implications of Bank Mergers and Acquisitions for Employees: Some Evidence

from Pakistan, Jinnah Business Review, Vol. 1, September 2008.

3. The Impact of Ownership Structure on the Firm Performance Evidence from

Pakistan Paper published in International Journal of Academic Research,

M.Shahzad. Anjum, A.H. Abu Bakar, Kh. Ghani. Research Part B; 2012; 4(5),

79-86.DOI: 10.7813/2075-4124.2012/B.11

4. Basing Portfolio Investment Decisions on P/E Premium and Expected Returns in

Pakistani equity Market, Accepted in International journal of Economics and

Finance, Canada

5. Macroeconomic Variables and Stock Return Volatility: An Econometric

Analysis by Shahzad Anjum, Khurram Ghani. Lambert Academic Publishing

2012.

6. Hospital Supply Chain Pharmacy Management by Syed Wasif Gillani, Syed

Azhar Syed Sulaiman, Khurram Ghani, Shahzad Anjum. Lambert Academic

Publishing 2012

1. P/E Premium and Cross section of Expected Returns in Pakistan Construction

Equity Market in 6th International conference & workshop on Built Environment

Research Publications/Conference Papers/Books

Paper Presented /Conference Attended

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in Developing Countries, University of South Australia, Adelaide, Australia 4th -

5th December 2012

Member, Project Management Institute (PMI) USA

Member, Housing Building Planning Postgraduate Student Association (HBPPSA),

HBP, USM, Malaysia

Professional Affiliations

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HUBUNGAN ANTARA AMALAN PENGURUSAN RISIKO DAN

PRESTASI KEWANGAN PEMBINAAN DAN FIRMA

BERSANGKUTAN PEMBINAAN DI PAKISTAN

ABSTRAK

Industri pembinaan memainkan peranan yang amat penting dalam mewujudkan peluang

pekerjaan kepada berjuta-juta tenaga pekerja tidak mahir dan mahir di firma

bersangkutan pembinaan di dalam ekonomi membangun. Sifat dinamik dan persekitaran

kerja yang berdaya saing dalam industri pembinaan serta risiko yang sangat terdedah

telah memaksa firma konstituen berterusan mencari strategi bagi mengurangkan kesan

buruk pelbagai jenis risiko dan meningkatkan prestasi kewangan mereka. Berdasarkan

kajian yang mendalam berkenaan model prestasi firma, kajian ini adalah bertujuan untuk

memperkenalkan model Analisis Risiko Pengurusan dan Penilaian Firma yang terkini

untuk analisis spesifik hubungan antara prestasi kewangan dan amalan pengurusan risiko

di firma bersangkutan pembinaan di Pakistan. Kajian ini telah menggunakan analisis

risiko kewangan dua tahap dan metodologi pengurusan untuk menentukan hubungan

antara prestasi kewangan firma dan amalan pengurusan risiko. Ini telah tercapai,

pertama, dengan menjalankan analisis prestasi kewangan berdasarkan analisis nisbah

menyeluruh (menggunakan data kewangan selama sembilan tahun) dan pembangunan

firma dan skor prestasi ekonomi. Dengan menggabungkan kedua-dua prestasi kewangan

ini, indeks prestasi telah digunakan untuk memilih kuartil tahap tinggi dan rendah firma

bagi melaksanakan analisis peringkat kedua. Kajian ini juga menggunakan kaedah soal

selidik untuk mengumpul maklumat spesifik industri daripada tujuh belas firma

xiv

berprestasi tinggi dan enam belas firma berprestasi rendah (menunjukkan hampir 80

peratus kadar maklum balas) untuk menentukan tahap dan sejauh mana amalan

pengurusan risiko diamalkan oleh firma berprestasi tinggi dan rendah.

Hasil konklusif mengenai kajian ini telah menentukan bahawa terdapat hubungan positif

yang signifikan antara amalan pengurusan risiko dan prestasi kewangan firma

bersangkutan pembinaan. Kajian ini, pertama seumpamanya di Pakistan dan memberi

sumbangan yang penting kepada pengetahuan mengenai hubungan antara amalan

pengurusan risiko dan prestasi kewangan firma (kawasan penyelidikan yang agak

lemah) seharusnya relevan kepada para penyelidik dan pengamal industri pembinaan

termasuklah firma yang disenaraikan, kontraktor pembinaan, badan profesional yang

relevan dan pengawal selia industri.

Memandangkan keadaan ekonomi amat berisiko dan prestasi kewangan firma

bersangkutan pembinaan bergantung pada corak pertumbuhan ekonomi negara,

penemuan daripada kajian ini telah memberikan bukti secara empirikal mengenai

kewujudan hubungan yang positif antara tahap amalan pengurusan risiko dan prestasi

kewangan firma. Oleh itu, penekanan kepada keperluan bagi firma-firma ini untuk

membangunkan dan melaksanakan proses pengurusan risiko yang lebih baik dan

meningkatkan prestasi kewangan mereka adalah dengan meminimumkan kesan buruk

daripada turun naik ekonomi dan lain-lain.

xv

RELATIONSHIP BETWEEN RISK MANAGEMENT PRACTICES

AND FINANCIAL PERFORMANCE OF CONSTRUCTION AND

CONSTRUCTION RELATED FIRMS IN PAKISTAN

ABSTRACT

Construction industry plays a vital role in creating employment opportunities for

millions of unskilled and skilled workforce in construction and Construction related

industry firms in developing economies. The dynamic nature of construction industry

and its competitive and risk prone work environment has forced the constituent firms to

continuously seek strategies to minimize the adverse effects of different types of risks

and improve their financial performance. Based on an extensive review of firm

performance models, this study is aimed to introduce an updated Firm Risk Analysis,

Management and Evaluation (FRAME) model for specific analysis of the relationship

between financial performance and risk management practices of construction and

Construction related industry firms in Pakistan. The study has used a two-stage financial

risk analysis and management methodology to ascertain the relationship between firm’s

financial performance and their risk management practices. This has been accomplished,

first, by conducting financial performance analysis based on comprehensive ratio

analysis (using financial data for nine years) and the development of firm and economy

performance scores. Combining these two, a performance index was worked out and

used to select the high and low performing quartiles of firms for the second stage of

analysis. The study then used survey approach to collect industry-specific information

xvi

from seventeen high performing and sixteen low performing firms (showing nearly 80

percent response rate) to determine the level and extent of risk management practices

adopted by high and low performing firms.

The conclusive outcome of the study has been the determination of a significant positive

relationship between risk management practices and financial performance of

construction and Construction related industry firms. This study, first of its kind in

Pakistan and an important contribution to knowledge on linkages between risk

management practices and firm financial performance (a relatively weaker research

area) should be relevant to both researchers and practitioners including construction

industry listed firms, construction contractors, relevant professional bodies and industry

regulators.

Given the highly risky economic situation and the heavy dependence of construction and

Construction related industry firm’s financial performance on the growth pattern of

national economy, the study findings provide empirical evidence on the existence of a

positive relationship between the level of risk management practices and financial

performance of firms and, thus, highlights the need for these firms to develop and

implement better risk management processes and enhance their financial performance by

minimizing the adverse consequences of economic and other fluctuations.

1

CHAPTER 1

INTRODUCTION

1.1 Background of Research

During the past two decades, investments in construction industry have been decisively

influenced by an increased share of investment funding provided by the private sector as

compared to the public sector’s financing pattern. The direct involvement of private

sector has not only increased the complexity of managing construction projects but also

promoted the diversification of risk management techniques and their implications on

firm performance. The success of any business, including the construction and

Construction related industry firms, is greatly influenced by the choices made regarding

controlling risky situations during the conduct of their operations including selection and

implementation of different projects. In general, these risks include the occurrence of

unexpected events such as natural disasters, unforeseen site conditions, material and

equipment delivery delays. As many unpleasant events are likely to occur in the

construction process, however, all stakeholders are looking for profit and each aims to

finish the job with maximum benefits and minimum risk.

The construction phase, being a crucial stage in an infrastructure project, has its own risk,

which results in a cumulative associated risk for the project (Zaini, Adnan & Haron,

2010). These risks include the occurrence of unexpected events such as natural disasters,

unforeseen site conditions, material and equipment delivery delays and equipment

2

breakdown. As there are many stakeholders involved in construction process many

unpleasant events are likely to occur but still all stakeholders are looking for profit and

each aims to finish the job with maximum benefits and minimum risk.

The construction industry generally faces both internal and external risk which not only

need to be identified but also properly managed to achieve better performance for

component firms and the expected growth targets for the industry and the economy. In

other words, risk in the construction industry can be defined as the possible occurrence of

a known or unknown event that may have a negative or positive effect on the firm itself,

the construction industry and the growth of national economy. In general, however, a

business firm must decide whether to take mitigating action or take no action and accept

the risk. Risks of medium to high magnitude will require action to be taken to minimize

an adverse impact on the business or industry. On the other hand, where the effect is

negligible, the risk can be accepted. Managing risk is rightly considered as an integral

part of good management and is fundamental to achieve good business and project

outcomes. It can, therefore, be postulated that firm’s financial performance is influenced

to a considerable extent by its adoption of risk management practices.

1.2 Risk Analysis and Management

As a consequence of rapid globalization, not only the opportunities are constantly

expanding for construction firms but the risks involved are also multiplying for the

various stakeholders and thus, necessitating the need to develop specific risk analysis

methodologies to effectively identify and manage the multitude of risks involved. Risk

3

management processes and their applications have gained significant importance in many

disciplines including finance, banking and, insurance but more particularly in the

implementation of infrastructure/construction projects worldwide.

(Valsamakis, Vivian & du Toit, 2004) refer to risk management as being the relatively

loose art and science of managing risks. The degree of risk management and the actions

taken will vary among the different organizations within an industry, depending on the

organization’s appetite for risk or the risk culture that exists in the organization. Risk

management can, therefore, be seen as process of identifying potential risk events, and

quantifying these in terms of the likelihood of occurrence and of the influences they

could have on the firm and its business opportunities. Based on this information, it is

possible to decide the strategy to be followed in addressing a specific risk that either

would eliminate the risk or would minimize the adverse affect thereof on the business.

Risk management also provides the opportunity to identify risk events occurring

elsewhere or in other countries that may be exploited for the benefit of the construction

industry in another country. The risk management process, therefore, covers not only risk

identification, but also risk assessment, risk response (action) development and risk

control strategy.

The purpose of managing risk is to change uncertainty into benefits for the organization

by constraining threats and taking advantage of opportunities (HM Treasury, 2004).

Accordingly, management of risk cannot be regarded as a linear process but rather, it

4

encompasses the balancing of a number of interwoven elements which interact with each

other and which have to be in balance with each other for effective risk management.

(Kerzner, 2001) expressed the view that risk management and monitoring are not

problem-solving techniques but should be seen as proactive techniques to obtain

objective information to prevent adverse events from occurring or towards minimizing

the negative impact thereof. The survival of any business, including the construction

industry, depends on how well risks are identified as well as managed. This can be

achieved either by eliminating the risk entirely or, at the least, reducing the adverse

impact on the business firms in the construction industry to a minimum.

(Neitlich, 2009) argued that, in the construction industry, risk management is an ongoing

process as it is critical to the sustained safety, security and, growth of the industry having

impact on the development of the economy. Due to the complexities involved, risk

management must be seen as a process that requires constant review and updating It was,

therefore, important that firms in the construction industry should not only possess the

ability to manage risk, but also the skill and foresight to recognize risk, since these

potential risks will have a strong bearing on the growth of the construction industry firms.

(Page & Meyer, 2000) stated that a risk management model is essential to reduce the

impact of risk as the model will contain full representation of a set of relationships,

including the statements defining the assumptions and interactions in the model. The

introduction and development of such a model can serve as a useful tool for the

5

construction industry to better understand the value of being able to identify risks and the

worth of being proactive in the management of these risks. Any improvement in better

risk mitigation by the firms in the construction and Construction related industry would

not only improve their performance and strengthen the industry itself but also positively

influence the growth of the national economy.

1.3 Managing Financial Risk in Construction Industry

(Mansfield, 1994) identified some major factors (finance and payment arrangements,

poor contract management, shortages in materials, inaccurate estimation, and overall

price fluctuations) that cause delays and cost overruns in different infrastructure projects

in Nigeria.

(Assaf et al., 2006) identified the causes of delay and their relative importance in large

building construction projects in Saudi Arabia. Based on the contractor’s survey, the most

important delay factors were: delays in contractor’s progress, late payment by owners

and design changes. From the view of the architects and engineers the cash problems

during construction, slow decision making process of the owner were the main causes of

delay.

(Odeyinka & Yusif, 1997) addressed the causes of delay in building projects in Nigeria.

They classified the causes of delay as project participants and extraneous factors. Client-

related delays included variation in orders, slow decision-making and cash flow

6

problems. Contractor related delays identified were: financial difficulties, material

management problems, planning and scheduling problems etc, whereas extraneous causes

of delay identified were: inclement weather, acts of nature, labour disputes and strikes.

(Al-Momani, 2000) carried out a quantitative analysis on construction delays in Jordan.

The result of his study indicated that the main causes of delay in construction of public

projects were related to designers, user changes, weather, site conditions, late deliveries,

economic conditions and increase in quantity.

Similarly, (Odeh & Battaineh, 2002) also conducted a survey aimed at identifying the

most important causes of delays in construction projects with traditional type of contracts

from the viewpoint of construction contractors and consultants. Results of the survey

indicated that contractors and consultants agreed that owner interference, inadequate

contractor experience, financing and payments, labour productivity, slow decision

making, improper planning, and subcontractors were among the top ten most important

factors.

The studies (reviewed above) indicate that although risk assessment, analysis and its

management has been used extensively in many sectors but the application of risk

management processes (covering risk identification, evaluation, mitigation, and control)

has not been practiced in the construction industry. These risks, in particular, result in

projects to be completed with time and cost overruns that affect the financial performance

of construction firm. These studies also show that the effect of delay in timely delivery of

7

construction projects is attributed to financial risk and its mitigation can be a serious

threat to any industry but particularly the construction industry.

1.4 Performance Evaluation of Construction Industry Firms

Although several models have been developed and used to evaluate firm performance but

only a few of these have incorporated economic and industry related factors. These

models have been developed during the past few decades and have taken up performance

evaluations at three (project, firm and, industry) levels. Models at the construction

industry level have been used to measure the effect of economic, political, and social

changes on the performance of the construction industry as a whole.

1.4.1 Ratio Analysis for Firm Financial Performance

Ratio analysis is among the most popular and widely used tools in evaluating financial

performance of firms in any industry. Most performance evaluation models for

construction firms have used ratio analyses based on their annual financial reports.

Financial ratios generally compare various dimensions of performance among

comparable units and within a single unit over time periods. As comparative tools, ratios

are used to measure a firm’s performance over time (trend analysis) and to compare it

with that of its competitors or industry averages (comparative analysis). The figures used

8

in calculating financial ratios primarily come from income statements and balance sheets

prepared under generally acceptable accounting practice standards.

According to (Halpin, 1985), (Newton, 1994), financial ratios are divided into four main

groups consisting of Liquidity ratios, Debt ratios, Activity ratios and, Profitability ratios

These four major financial ratio categories measure liquidity, profitability, leverage and

efficiency of firms. Although each of the above categories includes many ratios, only

some of these are considered significant. Using a single ratio is not very meaningful as it

does not reflect the comprehensive financial position of a firm. A ratio becomes

meaningful when it is compared with past ratios of the same firm or ratios of other firms

in the same industry.

As a general rule, the higher score in profitability and liquidity ratios and the lower score

in leverage ratios indicate better financial performance of a firm. (Ellis, 2006) suggested

five indicators to determine ‘Best in Class’ status of financial health of a construction

firm i.e. (1) Return on assets; (2) Return on equity; (3) Fixed asset ratio; (4) Debt to

equity, and (5) Working capital turnover. In addition, (McCall, 2006) pointed out that

working capital turnover was the most important ratio for construction contractors which

is a direct indicator of a contractor’s short term financial strength and is used to help

evaluate a contractor’s ability to fund construction projects. However, all of these ratios

are important and have to be taken into account when evaluating the financial

performance of a firm.

9

1.4.2 Regression Analysis for Firm Performance

The model used by (Kangari et al.,1992) applied multiple regression analysis to evaluate

the performance of construction companies and developed a performance grade curve to

show the relative financial position of a construction company, satisfying model

limitations. (Russell & Zhai, 1996) also applied multiple regression analysis to predict

construction companies’ failure by using economic and financial variables. Another

quantitative model based on financial ratios was developed by (Goda, 1999) with an

objective to develop standard financial ratios that reflect the performance of the

construction industry in Egypt. These standards could be used to compare the

performance of the Egyptian construction industry with the international one. According

to this study, regression analysis had provided more reliable results than that produced

using the supervised neural network.

1.4.3 Risk Management Process and Practices

Risk management can simply be considered as a centre of any company’s management

strategy. It is the process by which different companies systematically identify and

address the risks faced by their activities with the objective of achieving sustained growth

performance of the company. A few studies have been carried out to assess the extent of

formal training in risk management. One study, conducted by (Akintoye & MacLeod,

1997), used a questionnaire to survey 100 contractor and project management

firms about their risk management practices in the construction industry. Their

survey reported that 67% and 77% of the contractors and project management

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firms, respectively, did not have any formal training in risk assessment and

management techniques. Another study by (Baker, 1997) used a comprehensive

questionnaire to study risk management level in 139 British construction and oil

& gas sector companies and argued that the insight gained can aid the decision

making process and can produce a more controlled risk environment with more

profits for the companies.

1.5 Pakistan Construction Industry: Status and Issues

During the first quarter of a century after its birth in 1947, Pakistan’s construction

industry comprised of very few private constructors in Pakistan. Housing for public

sector was done by the Provincial and Central Works departments through contractors,

while the entrepreneurs constructed their residences mostly with the help of unqualified

but skilled persons. According to (Rizwan & Sarosh,2008), beginning early seventies,

large allocations were made by the Government of Pakistan to Housing Building Finance

Corporation and a number of entrepreneurs, contractors and consultants entered in the

construction industry with meagre managerial capability and insufficient technical

knowledge. This boost led to the formation of builders and developer’s associations with

the objectives of improving the state of the industry as well as to provide a platform to

showcase and address pertinent issues. Such associations, however, had to face several

problems in dealing with authorities responsible for approving building plans, sale prices,

conditions of sale, grant of house-building loans and so forth. For these and several other

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reasons, these associations largely failed to make serious efforts to improve the building

construction industry itself.

Even after some notable performances in the gigantic Indus Basin works which included

construction of large dams (Tarbela, Mangla etc), barrages and link canals and the

prestigious Pakistan Steel Mills project, the construction sector remained in a state of

depression primarily due to government’s negligence in terms of inadequate policies and

insufficient support. By the end of twentieth century, several companies (MLC Pvt. Ltd,

National Construction Ltd, Imperial Construction Company Pvt. Ltd. and Gammon

Pakistan Ltd.) that had played leading roles in national construction and infrastructure

projects, were on the verge of closure in the overall recessionary environment and paucity

of major public development projects. During this long state of depression, a vast

majority of construction related projects suffered from time delays, cost overruns, quality

non-compliance and, safety failures leading to more risky work environment.

Beginning twenty-first century, the government realized that infrastructure; housing and

building sectors were the backbone of country's economy and increased resources to

further expand the basic infrastructure in the country. The effect initiated a number of

development projects which led to increased demands for building and construction

activity in the country.

Economic Survey of Pakistan (2006-2007) indicated that Pakistan was in the midst of its

strongest economic expansion phase and its growth momentum was broad-based. The

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three major sectors (agriculture, industry and services) have provided support to strong

economic growth. The year’s real GDP growth has been powered by strong (17.2

percent) growth in construction. Brisk pace of activities in private housing, high rise

buildings along with large public sector spending on physical infrastructure and the on-

going reconstruction activities in the earthquake affected areas contributed to the sharp

increase in construction value-added. Construction with many forward and backward

linkages is also making impact on the economic growth by contributing 5.2 percent or 0.4

percentage points to this year’s real GDP growth.

According to Economic Survey of Pakistan (2013-14), the share of construction in

industrial sector is 11.48 percent and is one of the potential components of industries. Its

contribution in GDP has increased to 2.4 percent as compared to 2.2 percent last year.

The construction sector registered a growth of 11.31 percent against -1.68 percent in

2012-13. This is also highest growth level achieved since 2008-09. The increase in

growth is due to rapid execution of work on various projects, increased investment in

small scale construction and rapid implementation of development schemes and other

projects of federal and provincial governments.

The government has acknowledged in the latest Economic Survey that the strengthening

of the country's infrastructure is a basic imperative for sustaining growth momentum.

During the last two years, the government has taken various budgetary and non-

budgetary measures which are now yielding positive results. Many national and

international real estate developers have launched large construction projects in Pakistan

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which has further accelerated construction activity in the country. Pakistan now offers a

growing market for the construction industry and, according to “Pakistan Vision 2025”,

many dams and several other construction projects have been announced which has

created opportunities for both foreign and local construction and Construction related

sector firms.

1.6 Research Gaps

Many researchers have discussed risk management as a process that includes several

types of risk such as operational risk, hazardous risk, strategic risk, macroeconomic risk

and, financial risk. Out of these, it is the financial risk that has been discussed the least

and that too for industries like insurance, banking, financial services etc. Only a few

researchers have touched the financial risk in construction industry mostly limiting their

work to project financial risk and making recommendations about a project on the basis

of Net Present Value or Internal Rate of Return criteria. Whereas, the models developed

by (Kangari et al., 1992) and (Goda, 1999) have focused mainly on evaluating the

company performance using financial ratios without considering the effect of

macroeconomic and industry related factors.

On the other hand, studies conducted on level of risk management maturity have

highlighted the extent of company preferences related to different methods used to

identify, analyze and manage risk. (Baker Scott, 1997) focused on the level of company

maturity in terms of adoption of risk management practices and what other companies

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must be doing to reduce or absorb expected as well as unforeseen risks. Focusing on the

banking sector firms, (Ariffin & Kassim, 2009) analyzed the relationship between risk

management practices and financial performance of Islamic banks in Malaysia. The study

assessed the bank’s risk management practices and how that affected their financial

performance.

Given this research environment, research studies may be divided into two categories:

one group of studies has focused on financial performance analyses of companies to

assess and predict their vulnerability to financial failures with suggested guidelines to

avoid oncoming failures; the second set of studies has focused on risk management

practices of companies in one or more sectors and conducted surveys to show the level of

adoption of different aspects of a systematic risk management process. However, apart

from some important issues that need to be looked into in company financial performance

analyses (such as the number and selection of specific financial ratios and the exclusion

of macroeconomic factors in some of these analyses) one important aspect, “the

relationship between risk management practices and financial performance of firms”, has

not been brought into focus by any study especially applicable to the construction and

Construction related industry sector firms in Pakistan or elsewhere.

1.7 Research Problem

In this scenario of dearth of research studies on possible linkages between a company’s

financial performance and the level of its risk management practice, it was considered

15

important to conduct a study that focuses on this problem. It is, therefore, important to

determine how the financial performance of construction industry firms is linked to and

affected by their extent of identification, analysis and management of risk practices.

Given the above research gaps, the research problem has become obvious and it was,

therefore, considered important that a research study must be conducted for “determining

the financial performance of construction and Construction related industry firms and

how their performance is influenced by their adoption of risk management practices

during the implementation of construction projects.

This study has directed its focus on determining the relationship between financial

performance and risk management practices in the construction and Construction related

industry firms in Pakistan. It is important to note here that construction industry is

directly linked to many Construction related industry firms and a steady performance of

construction industry not only induces growth of its constituent firms but also positively

affects the firms in Construction related industries (such as cement, iron and steel, marble

and tiles, electrical and sanitary fittings with spillover effects on horticulture and

transport sectors as part of the chain reaction).

In other words, there is dearth of research studies on possible linkages between a

company’s financial performance and the level of its risk management practice. It is,

therefore, important to determine how the financial performance of construction industry

firms is linked to and affected by their extent of identification, analysis and management

16

of risk practices. While attempting to resolve the highlighted research issues and gaps,

this study has directed its focus on determining the relationship between financial

performance and risk management practices in the construction and Construction related

industry firms in Pakistan. It is important to note here that construction industry is

directly linked to many Construction related industry firms and a steady performance of

construction industry not only induces growth of its constituent firms but also positively

affects the firms in Construction related industries (such as cement, iron and steel, marble

and tiles, electrical and sanitary fittings with spillover effects on horticulture and

transport sectors as part of the chain reaction).

The present study postulates that the risk management process consists of five inter-

linked factors or steps (including risk identification, risk estimation, risk evaluation, risk

response and risk monitoring) to assess the extent of risk management practices

undertaken by sample construction and Construction related industry firms. These steps

have been explained in detail by (Baker Scott, 1997) in his study conducted in UK which

focused on the level of company maturity in terms of adoption of risk management

practices and what companies must be doing to reduce or absorb expected as well as

unforeseen risks.

1.8 Research Questions

Given this context, this research study has attempted to respond to the following

questions:

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1. What models have been developed and how different financial ratios are

used to analyze firm financial performance?

2. How key macroeconomic factors influence the financial performance of

construction and Construction related industry firms?

3. How the combined effect of financial ratios and macroeconomic factors

impacts on the financial position of construction and Construction related

industry firms.

4. Is there any relationship between financial performance and risk

management practices of construction and Construction related industry

firms?

5. How the above analyses may be combined to develop an industry-specific

conceptual model to represent the extent of relationship between financial

performance and risk management practices of construction and

Construction related industry firms.

1.9 Research Objectives

Given the above background and research questions, this study has focused on achieving

the following objectives:

1. To develop a firm performance score (Fps) for construction and Construction

related industry firms using appropriate financial ratios.

2. To develop an economy performance score (Eps) for construction and

Construction related industry firms using macroeconomic variables.

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3. To develop a composite performance index for determining the relative

financial position (ranking) of selected construction and Construction related

industry firms.

4. To determine any variations in level and extent of risk management practices

by conducting questionnaire survey of high and low performing firms.

5. To determine the extent of relationship between financial performance and

risk management practices of construction and Construction related industry

firms by combining the above analysis in a an industry-specific conceptual

model.

1.10 Scope of Research

In general, there is a dearth of literature focusing on risk management practices and their

implications on firm’s financial performance. Although there are various risk

management models available, particularly in the realm of project management, as

proposed by (Gray & Larson, 2006), the review of literature for this research undertaking

has not revealed a risk management model highlighting the above discussed relationship

between a firm’s financial performance and its level of implementation of risk

management process covering risk identification, risk analysis and, risk response. It is,

therefore, imperative to conduct a research study on construction and Construction

related industry firms in Pakistan with focus on developing a conceptual model that

shows the relationship between firm’s financial performance and its risk management

practices.

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Considering the shortcomings of existing approaches/models, and staying in conformity

with its overall scope, this two-stage research study has introduced a financial risk

analysis, management & evaluation (FRAME) model. The study, in first stage, derived a

firm performance score, an economy performance score and, combining the two, a

composite performance index to determine the firm financial performance. Using the

performance based ranking of sample firms, the study in stage two, conducted a risk

management practices survey of highest and lowest performing quartiles of firms to

determine the relationship between financial performance and level of adoption of risk

management practices by selected construction and Construction related industry firms in

Pakistan.

1.11 Significance of Research

The significance of this research study can be highlighted through its expected

contribution in many directions. First, the study is a wholesome contribution to the

existing body of knowledge on financial risk management – an area that has been least

researched especially in the context of construction and Construction related industry

firms. In this process, the study has developed a firm performance score, an economy

performance score and, combining the two, a composite performance index to select

firms showing highest and lowest financial performance. The second stage of study

conducted a survey of the selected firms and determined the relationship between firm’s

financial performance and their risk management practices. On this premise, this research

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study and its approach may be considered unique as no other similar study has been

conducted especially for construction and Construction related sector firms in Pakistan or

elsewhere.

In this process of conducting financial performance analysis (and determining economy

performance score) this research study has analyzed the impact of macroeconomic factors

such as exchange rate, interest rate and inflation rate. These are important inherent

elements that may drastically influence construction and Construction related industry

firm’s financial performance during ever changing economic conditions leading to

fluctuations in their growth with adverse consequences for the national economy.

Another significant contribution is the updating of existing firm financial performance

evaluation models and development of an industry-specific financial risk analysis,

management & evaluation (FRAME) model for conducting firm financial performance

analysis and determining its relationship to the extent of adoption of risk management

practices by the firms representing construction and Construction related industry in

Pakistan. In this process, the analysis has also collected and documented industry-specific

information on how firms identify risks and what methods, if any, are employed by them

to analyze and control these risks. The model then uses the above information to

determine the relationship between a firm’s level of risk management practice and its

financial performance.

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1.12 Limitation of Research

The scope of this research was constrained due to some limitations. First of all, from

among the various types of risk, the study mainly focuses on the financial risk.

Furthermore, in order to obtain the required information for ratio analysis, only firms

listed under the construction industry sector in Pakistan’s major stock exchange i.e.,

Karachi Stock Exchange (KSE) were selected. This number was further reduced due to

non-availability of required financial data of some firms for all study years, thus,

necessitating the inclusion of firms from the Construction related industry sectors based

on how closely their services were related to or supportive of construction industry.

Similarly, information required to conduct ratio analysis was not available for some firms

and researcher’s original plan (to work on all 17 ratios used by the State Bank of

Pakistan) had to be limited to 10-ratio financial analysis for the study. Another limitation

was the non-availability of data related to projects in the desired format and, therefore,

the use of questionnaire survey approach was adopted to collect relevant information on

risk management practices of selected (highest and lowest performing construction and

Construction related industry) firms for determining its relationship with their financial

performance.

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1.13 Definition of Key Terms

1.13.1 Risk

Following ISO standardised classification, risk is defined as “the effect of uncertainty on

achievement of objectives” (ISO 2009; en.wikipedia.org). According to (Mbeba, 2007)

cited in (Magali et al., 2014) risk is the potential that current and future events (expected

or unanticipated) may have an adverse or harmful impact on the institution’s capital,

earnings or achievement of its objectives.

1.13.2 Risk management

Risk management refers to a systematic process of identifying and analyzing of risks and

selecting the most appropriate method to treat the risk has been acknowledged to

minimize losses and at the same time increased profitability (Aris et al, 2009). In other

words, risk management is a systematic approach to identifying, measuring, monitoring

and managing the various risks faced by an institution.

1.13.3 Construction Related Sectors

Construction related Sectors refers to all sectors (and firms therein) that are considered

supportive to construction sector such as cement, iron, steel, timber and wood, marbles,

tiles and stones, electrical and sanitary works, glass, paints and varnishes, electrical

lightning, power and gas, horticulture, interior decoration, transport, light-heavy

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construction machinery, plastics, fibers, furniture, electrical appliances, and many more

as part of the chain reaction (President, Federation of Chambers of Commerce and

Industry, Pakistan, Business Recorder, December 18, 2012)

1.13.4 Financial Performance

A subjective measure of how well a firm can use assets from its primary mode of business

and generate revenues. This term is also used as a general measure of a firm's overall

financial health over a given period of time, and can be used to compare similar firms across

the same industry or to compare industries or sectors in aggregation.

1.14 Thesis Organization

This dissertation is organized into five main chapters. Chapter 1 lays down the

foundations of study and introduces the research topic, defines and elaborates the

complexity of risk management issues and methods generally adopted for its analysis and

control, highlights the research problem, the focus and scope of the study, identifies the

research questions, sets down achievable objectives of study and, explains the

significance of study along with its limitations.

Chapter 2 presents the comprehensive theoretical background of various approaches and

models developed and used by earlier researchers followed by an extensive review of

24

literature beginning with risk management as the core domain and followed by studies on

applications of financial risk analysis and other studies considered relevant to the scope

of research being undertaken.

Chapter 3 deals with data description and research methodology. It provides details of

primary and secondary data collected and analyzed for the study. It also explains

conceptual (FRAME) model, the components of financial risk analysis, management and

evaluation used to highlight the relationship between a firm’s financial performance and

the extent of risk management practices adopted. Further, it also explains the methods

and statistical analyses used to develop firm and economy performance scores and the

regression models adopted and tested to evaluate the results.

Chapter 4 presents detailed results of data analysis as per research methodology with

brief description of tabulated information.

Chapter 5 follows up on the results and presents detailed discussion of these results

summarizing the empirical findings of the study.

Chapter 6 provides the conclusions drawn from the results of the analyses followed by

discussion on implications of the study with recommendations for various stakeholders of

the construction and Construction related industry as well as some suggestions for

direction of further research on risk management practices and firm performance issues

and options.