Sunday 3 July 2016

Understanding Shipbuilders' Balance Sheets

By now, it is common knowledge that ship and oil rig builders are going through a difficult period with the low oil price resulting in customer bankruptcies, order cancellations and deferments. How are the balance sheets of ship and rig builders affected by these events? By understanding the effects of these events, you can predict how the balance sheets of ship and rig builders will look like in the coming quarters.

Before that, let us understand how a ship order "sails" through the balance sheet of a shipbuilder. When a new order is received for a ship, a deposit is usually collected. This shows up as an increase in cash on the assets side of the balance sheet. On the other hand, the cash deposit represents a commitment to deliver a ship. The same amount shows up as an increase in "excess of progress billings over work-in-progress (WIP)" (or unearned revenue) on the liabilities side. As work commences on the ship, cash is reduced to buy materials for the ship and pay workers' salaries. The company will also order some materials or services from suppliers on credit terms, leading to an increase in trade payables. It might also borrow money to pay for the materials/ services. Overall, on the assets side, cash will reduce while inventory and WIP will increase. On the liabilities side, excess of progress billings over WIP will reduce while trade payables and borrowings will increase. 

Subsequently, the company would recover the cash by progressively billing the customer for work done, which reduces the WIP but increases the trade receivables. When the customer settles the invoice, the trade receivables will reduce while cash will increase. That cash can then by used to pay off suppliers and reduce trade payables and borrowings. It is important to note that when the company bills its customer for WIP, it also includes the profit margin on the WIP. Thus, shipbuilders can progressively book a profit on the ship for the duration of the contract.

What happens when a customer goes into bankruptcy (e.g. Sete Brasil), terminates an order (e.g. Marco Polo Marine) or requests for deferment (e.g. North Atlantic Drilling (NAD))? The ship will remain as a WIP on the balance sheet, resulting in high inventory, WIP and trade receivables but low cash. Likewise, trade payables and borrowings will be at elevated levels while excess of progress billings over WIP will be low. You can compare SembMar's balance sheet as at end Dec 2014 and 2015 to see the impact.

SembMar FY15 Balance Sheet

Moving forward, if work continues on the ship with no further receipt of cash from the customer, those items mentioned above will worsen further. On the other hand, if work is stopped on the ship and there is no further order cancellation and deferment on other ships, the balance sheet will slowly improve as cash is received from the delivery from other ships.

If the company takes an impairment charge on the ship, the inventories and WIP will be reduced. In addition, the profit already booked on the ship has to be reversed out via a reduction on the revenue reserves/ retained earnings item. 

If the company manages to sell the completed ship to another buyer, the amount in inventories and WIP will be converted to trade receivables. When the buyer settles the invoice, the trade receivables will be converted to cash, which can then be used to reduce borrowings.

If the company manages to find a charter for the completed ship, the amount in inventories and WIP will be transferred to Property, Plant and Equipment (PPE). During the charter period, cash will slowly flow in from the charter but PPE will reduce progressively due to depreciation. Borrowings will not be affected significantly.

Finally, it should be highlighted that not all shipbuilders operate in the same manner. While most shipbuilders build only when they receive an order, there are others that build some ships without receiving orders. If buyers cannot be found for these build-to-stock ships, they are likely to result in a highly leveraged balance sheet for the shipbuilder. To understand why a rising oil price does not translate into better business for ship and oil rig builders, you can refer to The Missing Link Between Oil Price & O&G Profitability.

P.S. I am vested in Keppel Corp, Baker Tech and a host of other O&G companies.

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  1. Hi Chin wai,

    I noticed your recent focus on O&G sector! :-)

    Actually there is more to just balance sheet. EH a down payment or warranty received by yard is usually backed by bank guarantee. if in demand guarantee, meaning owner can even withdraw back the down payment or warranty!

    There r more things in shipbuilding contract. Shipyard nowadays normally even finance the project meaning contract can be 20 down and 80 before delivery. Meaning the 80 wip is financed by shipyard.

    Also if shops r delayed, equipment warranty that yard purchased can have their warranty expired, and this means even later owner re-activate there are hidden maintenance fees on the equipment.

    A ship postponed laying on the dock is also to cost great overhead to the yard. Some equipment vendor may even sue yard for delay or even charge shipyard for storage if they r not taking delivery of the items ordered.

    Therefore just looking at the paper balance sheet of shipbuilder tells much little.

    1. Hi Rolf,

      Yes, I'm trying to see whether there are any areas I could put some money in among all the gloom in the O&G sector.

      Thanks for filling me in on how shipbuilders operate :) I'm trying to figure out whether Keppel Corp and SembMar can restore their balance sheets.

    2. a) the 2 big builders in Sg don't provide refund guarantees from a bank, only corporate. These can only be called by the owner if there is a default by the builder - typically a delay or quality issue. Fortunately the 2 local Builders have a solid execution track record (compared to say China or even Korea). b) the vendors typically give payment terms matching the yards original contract cash flow - so in the event of delay, the yards are indeed under pressure to pay, although most of the payments are to large OEMS who also want to help the yards. Maintaining a ready rig is also not cheap, although layup costs are falling fast

    3. Hi Serendib,

      Thks for the info :)

    4. hahaha.. insider news. not suppose to divulge but I agree it's true.

      Hmm... but there r still other shipbuilders listed in Sg such as ASL, Bakertech, Triyards, Otto Marine, Ex-Jaya (b4 sold to mermaid), hence we cannot always generalised shipbuilders mean Keppel or Sembmarine. Not a good representative of the industry I think.

      Moreover r we so sure that keppel n Sembmarine will never ever give refund guarantee one day? Or even maybe some contract like the one of Sembmarine Hereema 1b contract, how well do y know the contract terms?

      It's true that big OEM always want to help the yard bcos of future biz. But as a natural paranoid, that is bcos situation is not as bad yet. In 2009 most oem helps the yard bcos OEM is still doing realtively ok.

      But if u compare the news in 2009 n the big oem of today NOV, Rolls Royce etc.. they themselves r badly hit. If situation turns bad, it will be a matter of time that it's all for ourself. after all it's about survival.

      So end of the day there is no right no wrong answer just how we look at the situation. For me, I just think things nowadays are gg abit haywire that it's better to expect the unexpected rather than think that things will remain just like the past!

      Just my views and I do respect Serendib comments very much also.

  2. I don't see a real rush to deploy cash into OG counters because of the gloom. Even if oil spikes to $100 tomorrow, the glut issue will still exist.

    1. Hi EH,

      Agree. If oil price were to spike to $100, I'll be selling out of the O&G counters :)