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Understanding Accounts Receivable Challenges in Construction

Understanding Accounts Receivable Challenges in Construction

January 15, 2019

Accounts receivable management is a key cog in the construction industry machine. It’s crucial to understand the challenges in construction AR to be in the best poisition to secure payments on time and in full.

How much of your revenue do you write off each year? According to a payment practice study in 2016, businesses typically write off 1.5% annually and that 40% of these companies have customers who are over 90 days late on their payments. Managing the payments owed to you by clients — accounts receivable, as it’s called in the industry — is an essential cog in business operations.

Not getting timely and full payments for services rendered and products supplied can put a serious wrench of varying impact on your ability to run and grow your company. Just how much can an unpaid invoice of tens, maybe hundreds of thousands impact your business? It’s not unusual to hear about another contractor filing for bankruptcy due to clients who refuse to settle their arrears. 

Payments in Construction: A Different Accounts Receivable Beast

Managing accounts receivable in construction is a totally different beast compared to other industries. Construction job payments are not typical consumer payments or even recurring service costs. From the various modes of payments to the large contract totals and the extended time it takes to complete each project, the nature of construction accounts receivable poses different challenges for all parties involved.

Contractors should never work without pay. And on the other hand, the customer would not want to pay for the whole contract without work done. This is why retainage is typical in construction.

Add to that the fact that construction projects can get unwieldily easily. Payment issues are common as each project will involve many businesses with their own style of running finances, way of demanding and making payments, and respective degrees of openness to transactional transparency, especially for the parties at the top of the construction chain — the general contractor, the owner, and the lender.

construction collections

(In a relatively small project like a single-family home, the average number of contractors involved is 22. The number only grows the bigger the project is.)

Subcontractors, material suppliers, and equipment leasing companies face payment issues just the same. This is especially true when there is a visibility issue in the project where parties are not clear on who’s doing what and who’s paying who.

Late payments in construction are considered by many as an inevitable part of the industry. While accepting this as fact reduces the headspace delinquent accounts take, it’s also a testament that there’s a lot of room for improvement for Accounts Receivable management in construction. Getting paid faster and maintaining good accounts are definitely top-of-mind goals for all companies in construction.

Breaking down the way payments work in construction helps in seeing what must be done better and in identifying what can be done well right now.

The Construction Payment Ecosystem

It’s normal for construction companies to face challenges both in getting paid and making payments. To make money, construction companies need to offer flexibility in the way clients pay them — often in some form of credit.

As you know, construction as an industry runs heavily on credit. Full upfront payments are just not standard industry practice across all areas of construction. The IOU system is typical. Suppliers and laborers understand the system of doing their share first and then payment will follow. This payment culture runs top down, from the biggest players down to individual laborers — and the sticker price on these IOUs runs to millions of dollars.

For this reason, construction companies usually extend credit to clients while also requiring credit themselves to manage their resources effectively.

For most industries, businesses wait for payments to come in before settling their own bills and pending invoices. The same often goes for construction. This waiting game typically follows after work has been rendered and materials have been supplied. With this setup, the financial risk in construction projects increase the further away you are from the players on top of the chain where the source of money is.

construction financial risk

(By default, the financial risk increases the further the parties are from the money source.)

The red boxes represent the greatest financial risk. The further a party is from the financial source, the more exposed they are to the negative impacts of payment delays, inconsistencies, and other accounts receviable issues. Minor schedule issues can have a magnified impact on their ability to get paid on schedule. The more hands the money needs to pass through before it gets to you, the greater the risk of payment delays and similar financial issues.

This system also creates a condition where companies often have to decide whom to pay first and which invoice can be delayed. When the top of the chain delays payments, the rest suffers.

Payment-Related Risks in Construction

The parties higher up the chain have more leverage they can use to get paid faster or withstand a delay in payment. Being on top of the chain means there are fewer hands that exchange money before it gets to you but being on top also comes with its own set of challenges. One of the most impactful of these challenges is visibility into the project.

construction financial risk 2

(When claimants secure lien rights, risk is shifted to the money source and the parties close to it.)

With many companies working side by side hiring their own suppliers and subcontractors, dealing with different people with different work-styles and financial footing, those on top of the chain often struggle with keeping tabs on who’s working on the project.

These subcontractors and suppliers who are far removed from the top of the chain can secure their lien rights and file claims on the property when needed to avoid escalating accounts receivable issues. 

In most cases, the general contractor has no visibility into how their own subcontractors deal with their respective subcontractors, specifically on how contracts are structured and if everyone is getting paid when payments are released from the top.

In some states, pay-if-paid and pay-when-paid clauses allow general contractors to protect themselves from exposure to accounts receivable headaches in case subcontractors get into financial trouble in terms of paying suppliers and other subcontractors.

However, these clauses are not historically honored in California. The civil code tends to shift the greater financial risks to those who have proximity to the financial source. The policy is in place to reduce the naturally greater financial risk to those further from the money source. This is chiefly facilitated through the mechanics lien.

When contractors, subcontractors, and suppliers are diligent in the process of securing their lien rights, they are able to reduce their exposure to possible accounts receivable problems like non-payment by having the ability to put a lien against the property they worked on.

Risk Management and the Mechanics Lien

The mechanics lien now inverts the financial risk faced by the players of the project, now putting the money source and the property owner in increased financial risk in case payment issues among subcontractors and suppliers arise.

To offset this risk, the property owner and the general contractor uses lien waivers to protect their finances. It is typical that lien waivers are requested each time a payment is made on all levels of the chain. Lien waivers remove the risk of liens as progress payments and retention payments are made throughout each project.

When a party receives a payment, the lien waiver serves as a receipt which proves they have been paid a certain sum and that with the payment, they relinquish their lien rights for that specific sum. There are a lot of property owners who include no-lien clauses in their contracts, which sets the risk to lien squarely on the shoulders of the general contractor.

In this case, the general contractor needs to make sure that not only are all suppliers and subcontractors paid on every level, but that lien waivers are used to reduce their exposure to financial risk.

Your Credit Policy: The Key to Effective Accounts Receivable Management

Credit and finance professionals in construction know that there is an army of circumstances and challenges that are unique to the construction industry. Like other verticals, it’s still about minimizing risk for your company — but in construction, reducing a company’s risk exposure goes beyond traditional credit risk assessment.

Being a competent credit and finance professional in construction requires one to see different areas of the business comprehensively in the context of credit management. Helping steer the credit and finance ship toward the right direction is your credit policy.

Establishing a solid credit and lien policy

Building out a thorough credit policy is at the core of running a tight financial ship in construction. Accounts receivable management relies heavily, if not entirely, on the strength of your credit policy.

What is a credit policy?

A credit policy is a set of rules and guidelines that cover credit-financed projects. The guidelines must include the following:

credit policy

  • How you choose contracts to undertake
  • How you vet clients
  • Terms and Conditions for credit-financed projects
  • Collection process
  • Action to be taken in case of delinquent accounts

Alongside your credit policy, a necessity in construction is having a separate lien policy. In the same vein of the credit policy, your lien policy is a set of guidelines that cover how your company preserves its lien and bond rights. It also covers the rules that dictate when and how to execute lien and bond claims.

Setting the rules for credit decisions

Qualifying prospective customers are critical in credit management. Offering credit options to every prospect will result in a financial disaster. Your credit policy should include a defined set of criteria to follow when evaluating prospective clients for credit.

Cover the basics

Checking a client’s credit history and worth is a basic step that you need to cover each and every time. Do not make assumptions based on impressions or limited information. It’s a standard practice for any business in any industry to look into these credit considerations so a good potential client would be open to discussing these data points.

It’s also wise to keep in mind that credit standing is not a fixed attribute. In the course of your project, the client’s credit standing can change a little or a lot. Credit monitoring is key in minimizing your risk exposure and calibrating the credit line you extend.

Don’t rely on first credit impressions

Assessing the creditworthiness of a client goes beyond reviewing their credit history. In construction, there are a lot of factors that need to be considered, including but not limited to investigating the credit health of all other parties involved in a project, especially the top-of-the-chain parties that are closer to the financial source (lenders, GCs, owners, etc.).

Securing your lien rights

in construction, it’s fatal to not secure your lien rights. General contractors, subcontractors, equipment leasing companies, and materials suppliers all need to make sure that their lien rights are protected as their ability to file a mechanics lien is their single strongest tool in ensuring payment.

In most states, securing your lien rights start way before any issue in payment arises.

In California, all the claimants must file a Preliminary Notice (also called Preliminary 20-day Notice) within 20 days of the first day of work. This must be done for all individual contracts in a project. The Preliminary Notice protects your lien rights for private works and your bond rights for public projects. Timing and accuracy are of utmost importance here as a small error can nullify your notice and timing mistakes can seriously limit your protection via the mechanics lien. Learn more about the Preliminary 20-day Notice here.

Leveraging technology to get paid

Communication is key in any construction project. From the actual operations to making sure that everyone gets paid, transparency plays a key role in keeping everyone engaged and making everything run smoothly. On the financial side, sending invoices to request progress payments outlined in your contract is key in getting paid.

Take advantage of technology to make sure that invoices are sent, delivery receipts are secured, and clients can pay via the easiest method for them. There are a lot of invoicing software solutions that can help you streamline this step, making it painless for everyone in accounting to keep tabs on invoices sent and paid.

Following up on sluggish payments and delinquent accounts

The impact of following up in getting accounts updated and late invoices paid can’t be overstated. Anyone who works in collections know that time is money — the longer you let an invoice fester in the unpaid bin, the more difficult it’s going to get the other party to pay or even communicate with you. There is also the fact that while some companies intend to pay, they may have their own inefficiencies that can make their payments go out slower. Following up is key in making sure the slow payers are prompted to pay on time, especially when the alternative is usually getting your account lost in their records and the invoice ending up being in the red.

Take swift action

In construction, time is money. Don’t waste time waiting on a client to finally settle an unpaid invoice after you follow up. If you have secured your lien rights, you have powerful tools at your disposal. Filing a mechanics lien or bond claim on the property will be your best bet. The value of the lien can’t be overstated — check out our guide to getting paid for a step-by-step guide on how to use the lien to get paid.

In some cases, a lawsuit or going to collections could be the best option. After exhausting all your tools and reaching out to the client, it’s time to consider this last resort. Just remember that opting to go to collections will mean that the invoice is likely to get paid but on a much longer timeline and the agency will take a significant cut. Learn from this incident and incorporate the lessons in your accounts receivable management process.

Running a tight accounts receivable ship will ensure that you are always equipped to make the best step in order to get paid. There will always be accounts receivable issues like slow-paying customers or unforeseen circumstances that can lead to delays or non-payment, but effective credit management ensures that these hold-ups will not place a bottleneck on the resources needed to keep the company moving.

Just as essential in accounts receivable as sticking to your credit policy, familiarizing yourself with the laws that govern payments in California puts you in the best position to make the right decisions when acting on delinquent accounts.

The California Construction Payment Toolbox: What’s in it?

The toolbox consists of documents that secure the rights of parties in a construction project, something evert accounts receivable professional in construction must know in and out. Here is the list of documents and an overview of each one.

  • Preliminary Notice (Private & Public)
    • A notice a contractor, subcontractor, and/or suppliers (claimants) sends to the owner and/or the lender to notify them that the claimants have the right to file a lien against the property.

california preliminary notice

  • Mechanics Lien (Private only)
    • A legal claim on a property that contractors, subcontractors, and/or suppliers can exercise in case of non-payment.

mechanics lien in construction

  • Release of Mechanics Lien or Lien Waiver (Private only)
    • A document that releases a party’s right to lien. This document is often requested as part of the receipt for payment.
  • Partial Release of Mechanics Lien (Private only)
    • A document that releases a party’s right to lien for a partial portion of the total contract amount. This document is often requested as part of the receipt for a progress payment.
  • Notice of Credit or Lien Extension (Private only)
    • A document that describes payment terms and timeline agreed upon and signed by the property owner and claimant.
  • Stop Payment Notice (Private & Public)
    • Used for public contracts and private jobs where the non-paying part has no ability to settle payment, this notice creates a lien on remaining construction funds in the owner or lender’s possession.
  • Release of Stop Payment Notice (Private & Public)
    • A document served by the claimant once they have been paid after serving a stop payment notice.
  • Partial Release of Stop Payment Notice (Private & Public)
    • A document served by the claimant once they have been partially paid after serving a stop payment notice.
  • Conditional Waiver and Release on Progress Payment (Private & Public)
    • A document signed by the claimant to induce a progress payment. This relinquishes the claimant’s right to file a lien on the progress payment.
  • Unconditional Waiver and Release on Progress Payment (Private & Public)
    • A document signed by the claimant in exchange for a settled progress payment that relinquishes the claimant’s right to file a lien on the progress payment.

unconditional lien waiver and release

Conditional Waiver and Release on Final Payment (Private & Public)

  • A document signed by a claimant to induce the final payment. This relinquishes the claimant’s right to file a lien on the whole contract.

conditional lien waiver and release

Unconditional Waiver and Release upon Final Payment (Private & Public)

  • A document signed by a claimant in exchange for the settled final payment. This relinquishes the claimant’s right to file a lien on the whole contract.

Documents property owners and clients use that influence the payment timeline:

  • Notice of Completion
    • A document that owners record with the county that asserts that a construction project has been completed. The Notice of Completion triggers the time period for the recording of mechanics liens and stop payment notices.
  • Notice of Cessation
    • A document that owners record with the county that asserts that work has ceased on the project and property location. The Notice of Cessation triggers the time period for the recording of mechanics liens and stop payment notices.
  • Notice of Non-Responsibility
    • A document served by property owners to prevent claimants from recording a mechanics lien upon the property owner’s property. This applies to project where the property owner is not the project owner (e.g., tenant initiated construction projects).

Power of the Mechanics Lien

The mechanics lien is the most powerful of these tools and it lends power to the rest of the documents in the construction payment toolbox. These documents don’t intend to create hostile situations within projects and shouldn’t be used as threats. Instead, they must be valued for what they are — documents that are an expression of policy that protects all parties.  

Participation in good faith is needed from all the parties in a construction project in order for everyone to get their just due on time.

Accounts receivable management in construction is very complex and often unwieldy and convoluted but there is a battery of tools that every player on any level of the chain can use to manage risk and ensure timely payments.