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Common Credit Problems in the Construction Supply Chain

Common Credit Problems in the Construction Supply Chain

March 25, 2021

The construction industry is unlike other businesses, especially when we look closer at its distinct credit policies and supply chain processes. Construction projects involve multiple stakeholders, and a single project can take on multiple designers, subcontractors, and material suppliers before it gets completed.

The financial aspect of managing a construction business is also unique in itself. Materials and goods are often bought on credit, which means that payments to suppliers are sent out at a later date after receiving the materials. Projects can also be funded through invoices that are yet to be settled.

Managing construction credit and cash flow is, therefore, no simple task. It requires meticulous attention to detail and ample preparation to prevent and mitigate credit management issues.

Common problems in construction credit management

There are numerous challenges that credit managers face when running a construction business, no matter where they are in the supply chain process. The following are some of the most common problems in construction credit management that are faced by contractors, subcontractors, and material suppliers:

Common Problems in Construction Credit Management

  • Late payments

    Slow and delayed payments are, unfortunately, quite common in the construction industry. This is a huge challenge among credit managers. Failure to receive payment on time can create a major bottleneck in a company’s cash flow, and it can result in bigger financial problems down the road.

  • Inefficient cash flow management

    A healthy cash flow is arguably the lifeblood of any construction business. Understanding your company’s cash flow will let you know how much cash you have on hand, and it consequently allows you to make informed business decisions. Poor cash flow management can lead your company to insolvency or the inability to shoulder your bills and other immediate needs.

  • Poor credit risk management 

    Assessing credit risks and implementing an airtight credit policy is highly important when preventing and addressing slow and late payments. Credit managers must diligently vet potential clients and assess their credit risks prior to approval. Otherwise, a company may be put in a tight spot if a majority of their clients are slow payers who are unable to settle invoices on time, if at all.

Top contractor problems in managing cash flow

  • Waiting on payment from owners 

    Not all owners are diligent in honoring their payment responsibilities, and this is a common issue among contractors when it comes to receiving payment. Owners may also dispute the contractor’s quality of work and disagree with the amount stated in an invoice, and these can lead to cash flow issues.

  • Allocating costs to various projects 

    It is common in construction to fund succeeding projects using earnings from a current project. In these circumstances, allocating the funds must be done with extreme attention to detail to avoid running into major financial issues due to insufficient cash.

  • Sending invoices late 

    When invoices are sent late, expect the payments to also come at a later date. Failing to manage your invoices properly is another common problem that has caused huge financial setbacks to many construction companies.

Why do credit issues persist in construction?

Most of the problems mentioned above are already well-known in the industry. Many construction experts might even argue that they are self-evident, especially if you understand the credit system as applied to the construction sector.

Still, many construction companies fall prey to poor credit management that leads to fatal credit problems. It is, therefore, extremely important to comprehend why credit and payment issues persist in the construction sector.

Vague contract provisions

One of the most common mistakes construction professionals make is enter into a contract filled with loopholes and vague provisions. Even worse, some construction companies do not document their client agreements at all.

Proper documentation is a lifesaver when running into major credit and payment disputes. When everything is clearly laid out in words and all stakeholders agree to transparent and unambiguous provisions, almost all issues can be settled and ironed out immediately.

To avoid or reduce credit issues, you must therefore ensure that the contracts you enter are solid and airtight, with provisions that clearly address all possible issues that could come along the course of a construction project.

Fixed contract prices

Property owners typically prefer having fixed-price contracts. These contracts impose fixed pricing that must be paid off to a contractor, with an established estimation and allocation of costs right from the very beginning of a project.

While a fixed-price contract sounds easy and straightforward, especially when both owner and contractor agree to its provisions, it can actually lead to nasty payment disputes later on. This is because a construction project is never a straightforward process. Change orders may be needed during construction, prices of materials may change significantly, and construction costs can go beyond the amount that has been initially agreed upon.

Fixed contract prices can lead to disputes that would have been avoided if better contract terms have been negotiated prior to signing the contract.

Insufficient communication

Establishing communication lines among all stakeholders is important, especially in mid to large-scale projects. When multiple contractors, subcontractors, and suppliers are involved, it becomes all the more imperative to ensure that all construction parties are up-to-date with project updates and are in constant communication with each other.

One reason why payment delays occur in construction is due to a lack of awareness. A prime contractor, for example, may drop the ball on which subcontractors they have to pay at a certain time. This issue may be solved if subcontractors are constantly communicating with the prime contractor.

The same idea applies to all other types of construction stakeholders. If pricing changes are required, for instance, contractors must always communicate with the owners first to get approval. Subcontractors should also communicate with suppliers for possible deals, and designers must communicate with owners or contractors to ensure that all issues and concerns are addressed promptly.

Inadequate capital or cash on hand

Payment issues also happen due to the most obvious reason: the client simply does not have the money to pay up. Not having sufficient cash on hand can be due to poor cash flow management or inefficient credit practices, and the issue can either be short-term or long-term.

Credit managers must learn to understand the nuances behind cash flow bottlenecks among their clients. Some clients can be suffering through a temporary cash flow backlog. A client, for instance, has made a deal with a delinquent property owner which caused them to miss a payment. This can be a one-off dent in their account, and it must be dealt with accordingly.

It is also possible that a client’s failure to provide payment can be indicative of a bigger financial issue. If a client has a chronic problem with paying on time, or if they have major weaknesses in their payment practices, more stringent measures and penalties must be imposed.

4 tips to manage construction credit issues

  1. Build robust contracts

    Building robust contracts can never be emphasized enough. A robust contract is one that is clear and unambiguous, and it must lay out all the important terms and conditions that take into account possible issues that may be encountered during the construction process. Potential issues include dealing with late payments and liquidated damages.

  2. Implement a clean and efficient credit policy

    Credit policies are just as important as contracts. When a company has a solid credit policy, its decisions for approving or rejecting potential clients are guided by data-driven insights. An effective credit policy also outlines the process for billing customers as well as addressing missed payments.

  3. Preserve your lien rights

    One of the best tools to pursue and recover payments from delinquent clients is to file a mechanics lien. In most states, a preliminary notice must first be served on certain stakeholders before a valid mechanics lien can be filed. If you want to have the option of filing a mechanics lien in case major payment disputes ensue, be sure that you preserve your lien rights by sending a valid preliminary notice.

  4. Use technology to your advantage

    From project management to invoicing to payment collection, many construction processes can be improved by leveraging the technologies available to you. Make use of computerized invoice management tools to ensure that your invoices are always sent on time. You can also use mechanics lien filing software to file a lien quickly and effectively.

Building an efficient construction payment system

  1. Understand supply chain financing

    Supply chain financing is currently one of the most popular ways to avoid slow payments and allow both suppliers and buyers to have sufficient working capital during the course of a project. In this set-up, buyers are incentivized to pay the invoice early through a funder.

  2. Ensure invoices are sent on time

    Before a client can pay you, they must first receive an invoice. Your invoices must therefore be sent on time, so clients are able to manage their finances accordingly. Constantly sending late invoices does not look professional, and it can be detrimental to your company’s cash flow in the long run.

  3. Automate payment reminders

    Some clients need reminding, and it is best if you leverage technology to send out regular payment reminders to your clients. You can send out automated emails or text messages to let clients know about approach payment deadlines or late payment warnings.

  4. Evaluate current practices regularly

    Every company must constantly seek to improve its existing processes. Regular evaluation is, therefore, important so you are able to assess if your current payment practices are effective or if there are aspects that can be further improved and optimized.

Construction cash flow challenges

Construction Cash Flow Challenges and Solutions

  1. Limited cash on hand

    Construction companies often have limited cash reserves. One way to address this challenge is to take advantage of financing options available to contractors and subcontractors. When buying materials, for example, you should take on financing deals instead of paying everything upfront.

  2. Poor invoicing and payment collection practices

    Late invoices and missed payments can be fatal to your company’s cash flow. If you are short-staffed and you do not have the resources to process and send invoices on time, consider investing in invoice management software that can allow you to send and monitor your invoices.

  3. Delinquent clients

    Sometimes the problem is not about your internal practices. To make sure that you are sufficiently armed against delinquent clients, always make sure that you serve the required preliminary notices. This way, you are able to preserve your lien rights and you can file a mechanics lien to recover your payment if needed.

Construction financing solutions

There are also other financing solutions that you can take advantage of to fund your construction projects and to make sure that you are well-equipped to settle credits and keep your finances afloat.

  • Equipment leasing financing 

    Instead of paying cash to purchase all your equipment – from heavy-duty machinery to office computers – you should consider leasing them or buying them through a third-party funder. The goal is to spread out your existing resources and not deplete your finances right from the get-go.

  • Angel investors 

    There are investors that may be willing to help fund your construction project. Take the time to look for investors that may be a good fit to fund your projects, and see if you can get a third-party to shoulder a large portion of your expenses.

  • Bank loans 

    One traditional option is to apply for bank loans. This financing option is best suited for mid to large-sized companies with established credit ratings as well as relevant assets that can be used as collateral.

Managing construction working capital

The key to preventing and mitigating construction credit issues is managing your working capital properly. Working capital is the difference between your assets and liabilities – it is the amount that you currently have after you subtract the amount that you owe from other parties.

Positive working capital means that you have disposable cash. This disposable cash can be used to pay for your immediate needs, including regularly scheduled bills and unexpected expenses for emergencies. Construction businesses typically aspire to have a positive and high amount of working capital.

This does not mean, however, that negative working capital is an indicator of a failing business. A company can have very little cash on hand because its expenses are directly funded by invoice payments. Some experts would even say that having a negative working capital can indicate high profitability and efficient cash flow management.

Whether your company aims to have high positive working capital or maintain a negative but steady working capital, it is important that you are able to convert your invoices to payment as quickly as possible. Aiming for a low day sales outstanding or DSO is one metric to gauge how efficiently you are managing your finances.

Another way to manage your working capital and mitigate credit issues is to forecast the growth and potential losses in your assets. Every time you take on a new project, you should understand how much you are going to get paid and when you are going to receive the payment. Also, make sure that you have contingency plans in case your clients do not pull through with settling the invoices.

Lastly, you should never let missed payments slide. Part of managing working capital is understanding that you need to get paid for your hard work no matter what. If payment deadlines are missed, you must have a strategy for handling those missed payments. Whether it be through automated payment reminders or through scheduled payment collection calls, you must have a process in place.

Best practices to manage construction credit issues

Best Practices to Manage Construction Credit Issues

Everything begins with the contract

Whether you are a contractor, subcontractor, or material supplier, the contracts that you enter must be robust and airtight. Payment terms must be clear, and your clients must understand the consequences of failing to pay on time. The contract must also outline the provisions for dealing with breaches and other potential issues.

Be ready to adjust your rates based on market changes

Prices of goods can change during the course of a project, and you must be ready to adjust your rates when major economic changes occur. Your client must understand this, and your contract must also allow for price adjustments to happen. Note that signing fixed-price contracts is generally not the best course to take in construction.

Streamline your invoicing and payment collection processes

If you could, you should choose to automate your invoice management system, so your invoices are always sent on time. You should also have a process for conducting payment collection calls and recovering payments from clients, and these processes must be reflected in your trade credit and lien policies.

Further reading