Trade credit is one of the most popular transactions in construction. When a construction company extends trade credit, they provide services such as labor and materials before they get paid. Payment is only exchanged after services have been furnished and invoices have been sent.
Because trade credit is quite common in construction, it may seem like the most obvious option to run your business. However, extending trade credit is not something that should be done without carefully weighing its pros and cons.
Trade credit has its advantages, but it also comes with risks. If you are thinking about extending trade credit to your customers, or if you want to improve your trade credit practices, make sure that you understand how trade credit works best in the construction business.
- Extending credit in construction
- Should you extend trade credit?
- Benefits and risks of extending trade credit to clients
- How to extend trade credit in construction?
- What should you DO when extending trade credit to clients?
- What should you NOT DO when extending trade credit to clients?
- How to mitigate the risks of extending trade credit
Extending credit in construction
In construction, trade credit is most often exchanged between contractors and material suppliers.
Say, for example, that a contractor is working on a big construction project that requires a large amount of concrete. A contractor will look for a supplier that is able to provide them the concrete, and the supplier will assess the contractor’s records to determine the pricing and the payment terms.
Once the terms are agreed upon, the supplier will furnish the concrete first, and the contractor pays at a later date.
This example illustrates how trade credit can be beneficial to both parties. Because of the delayed payment, a contractor does not need to shell out a huge amount of money at once to fund a big project. Meanwhile, the supplier is able to attract more customers and increase their sales.
Should you extend trade credit?
Extending trade credit can boost your sales and put you at a competitive advantage, especially in business-to-business sectors like construction. However, credit sales also come with risks of late and non-payments, which can have adverse effects on your business.
Before you extend trade credit to customers, you may ask yourself the following questions:
Are you on top of your cash flow?
One of the reasons why trade credit is attractive to customers is because you allow them to acquire your services without paying right away. It is quite a good deal from their perspective. But from your end, extending trade credit means that you will not have access to your money until the clients pay.
This is why you should always stay on top of your cash flow when you are in a trade credit business. You should know when the money will come in, when it will go out, and how much you have left on your hands at any given time. If you fail to manage your cash properly, you might end up having a negative cash flow, which can cause serious financial problems down the road.
Do you have a trade credit policy to implement?
Extending trade credit is easier said than done, especially when you think about the practical aspects of the process. For example, if you decide to extend trade credit, you will have to decide how much your customers can borrow, when they should pay back what they owe, and what should happen in case they fail to pay up on time.
Ideally, these decisions must be guided by a trade credit policy. The credit policy is a document that standardizes your process for extending trade credit and collecting payment. A robust trade credit policy takes time to build as your values and priorities may change over time, but you should always start with developing a credit policy that you can implement.
Do you have the resources to assess each client’s credit risks?
Mid- to large-sized companies typically have a trade credit department that handles everything related to credit management, from pre-qualifying potential customers, to setting the right trade credit limits, to collecting payment. Smaller companies may have one or two people dedicated to handling all financial matters, including sales and credit.
If you decide to extend trade credit to clients, be sure that you have the resources that can implement your credit policies and manage your accounts receivables. Trade credit can be tough to manage, especially when late payments come up. If you are short on resources, you should be even more stringent in conducting credit checks and risk assessments before you sell on credit.
Benefits and risks of extending trade credit to clients
Other than asking yourself the questions listed above, you may also consult the following table to understand the pros and cons that come with extending trade credit to customers:
Benefits of extending credit to customers
- It encourages customer loyalty.
Contractors and subcontractors prefer to buy materials on credit. By buying on credit, they are able to push through with their projects without having to pay right away. This is also more beneficial for their cash flow because it allows them to get paid by their respective clients before they subsequently pay their debt.
In effect, your customers are more likely to maintain a relationship with you if you extend them trade credit. By having a loyal customer base, you are also more likely to maintain a healthy cash flow.
- It allows you to highlight the quality of your services.
When you extend trade credit to customers, the price of your products and services can take a backseat. Your clients will consider the costs of your goods, but they do not have to be your main selling point because your customers do not have to pay right away anyway.
Instead, you can focus on highlighting the quality of the materials and services that you sell. You can stand out not only by offering reasonable payment terms that are specifically tailored to a client but also by showing your customers the top quality of your services.
- It increases your sales.
Trade credit is extremely attractive to contractors and subcontractors because it is similar to a loan with 0% interest. Your customers are able to receive your services and pay at a later date, so they essentially borrow money from you at no extra cost for paying later. So when you extend trade credit to clients, you are also posed to increase your sales.
However, an increase in credit sales does not necessarily equal an increase in profit. You are selling goods and services on credit, which means that you run the risk of not getting paid at all. This is one of the reasons why extending trade credit should be done as prudent as possible.
Risks of extending trade credit to customers
- Your clients might pay after the payment deadline.
Part of extending trade credit is setting the payment terms. The payment terms typically include the payment deadline, which usually falls between 30 to 90 days after the services are delivered or after the invoices are received. Sometimes, a client will not be able to pay up within the set terms.
Late payments are one of the risks that come with extending trade credit, especially in the construction business. The hierarchical structure of construction payments increases the possibility of your customers not paying on time. If a property owner does not pay a contractor on time, and if the contractor does not have the cash to cover the payment for the materials they ordered, you will most likely not receive your money by the agreed deadline.
- You might not get paid altogether.
Other than late payments, non-payment is also fairly common in construction. Non-payment is when a client does not pay the outstanding debt at all. Clients may stop responding to your calls, or they may promise to pay after a certain date but still fail to pay up.
The best way to deal with delinquent clients is to file a mechanics lien against the property in question. Filing a mechanics lien encumbers a property, and it could get the property owner and other stakeholders to step in and settle the payment. When extending trade credit, it is best practice to also implement not only a credit policy but also a mechanics lien policy.
- You might have to spend more in trying to recover payment.
When a client does not pay their debt, you are forced to take all the necessary measures to recover your money. This can mean calling them multiple times a week, paying a visit to their office, filing a mechanics lien, or seeking the services of a third-party collections agency.
When you outsource the help of a collections agency, you will have to shell out extra cash to cover the necessary costs. You might also need to consult legal help if things escalate to lawsuits. If you take on high-risk clients or clients that have a bad credit reputation, be sure that you are able to afford the possible additional costs that could come along the way.
How to extend trade credit in construction?
If you decide to extend trade credit to customers, keep in mind the importance of striking a balance between attracting customers and managing the risks that come with them.
Extending trade credit to clients is a tricky practice. On the one hand, you cannot be too lenient and just approve anyone who applies for the sake of increasing your credit sales. On the other hand, you cannot be too strict and alienate all your potential clients.
Finding the balance is important but is not as easy as it sounds. Managing trade credit is a tough job. It means having to make tough decisions on a daily basis, and the decisions you make can have a great impact on your company’s cash flow.
To have a better grasp of what to do and what not to do when extending trade credit to clients, you can consult the table below:
What should you DO when extending trade credit to clients?
Implement a robust trade credit policy
Your credit policy should reflect the values of your company, as well as its mission and vision. Some companies prefer to be more selective in approving clients, while others prefer to approve all potential clients and just penalize them later with late payment fines.
Every company is different, but it is extremely important to standardize your credit practices, so you are able to make informed decisions.
Consult trade references
Part of trade credit management is assessing the risks that come with every client. When a potential contractor applies for trade credit, you must consult other companies that they have already worked with to understand the reputation and payment practices of this potential client.
You are strongly encouraged to ask for trade references as part of the credit application process. You should talk to a potential client’s trade references before you make any decision.
Accommodate multiple payment options
One common issue among material suppliers is not having flexible payment options for their clients. Sometimes late payments occur simply because a contractor can take more time to issue a cheque than to pay by credit card.
When you extend trade credit, you should also accommodate multiple payment options for your clients. By allowing them to pay in different ways, they have fewer excuses to not pay on time.
What should you NOT DO when extending trade credit to clients?
Fail to conduct a proper risk assessment
If you decide to sell on credit, you should always assess the risk that comes with each of your potential customers. A high-risk client is one that has a history of not paying on time. A low-risk client is one who has a good reputation among the other suppliers that they have worked with.
You need to determine the type of customer that you will be working with. Assessing their creditworthiness will help you set the right trade credit limit, the appropriate payment terms, as well as the necessary late payment fines.
Extend trade credit without a written contract
You should never enter a trade credit agreement without making it official through writing. Contracts are very important, especially if you are letting a client “borrow” your money. Without a contract, you may have no legal grounds to pursue a lawsuit against a delinquent customer.
A written contract also helps in settling disputes. Sometimes late payments happen because there are disputed items in an invoice. If a solid contract has been executed, you and your customer can use this document to settle the issue.
Fail to protect your lien rights
The best way to recover payment from a client who failed to pay up is to file a mechanics lien against the project property. However, you cannot just file a mechanics lien without following the legal requirements in the state you are in. In most states, all potential lien claimants must preserve their lien rights by serving a preliminary notice at the beginning of a project.
In states like California and Texas, failure to serve a preliminary notice can automatically nullify your lien rights. This means that you cannot file a mechanics lien to recover your payment, which significantly reduces your chances of getting paid.
How to mitigate the risks of extending trade credit
Take advantage of available technologies
These days, you can use credit risk assessment software to help you quantify the risks associated with a potential customer. There are also other pieces of technology that you can take advantage of, including invoice management software and a mechanics lien app.
Ensure your contracts are airtight
Having a robust and airtight contract can help reduce the risk of late or non-payment due to payment disputes. When a contract is detailed and well-written, all disputes can be settled by simply reading the provisions laid out in the document.
Track and manage your cash flow diligently
When you extend trade credit, you cannot afford to lose track of your cash flow. Keep in mind that an increase in credit sales means nothing if you are not able to collect the payment, and the resulting negative cash flow could cripple your entire business.
Use the right KPIs to make data-driven decisions
There are multiple KPIs that you can use to understand how your credit department is doing. You can calculate the day sales outstanding or DSO to know how quickly you collect payment from clients. You can also use the collection effectiveness index or CEI to measure how effective your collection efforts are in converting invoices to payments.
Evaluate your processes on a regular basis
Your credit policies, your payment collection practices, and your mechanics lien processes do not have to be set in stone from day one. Part of running a successful construction business is to keep doing what works and to improve what does not work. By conducting regular evaluations and assessments, you allow yourself to identify and develop the best practices that work for your company.