Cash flow management is one of the most important aspects of running a construction business. Failing to stay on top of your finances can spell disaster for your company, and this rings particularly true in an industry as complex as construction.
Construction projects follow a hierarchical payment chain. Under this system, contractors and subcontractors typically do not get paid until they have completed all or part of their deliverables. This puts material suppliers in an interesting spot. Your clients need the materials to complete the work, but they don’t have the money to pay you yet.
One way to accommodate this unique setup is to extend trade credit to your clients. The use of trade credit is a popular funding agreement in the industry, and it has advantages both for the suppliers’ side and the clients’ side.
However, selling materials on trade credit also requires managing your accounts receivables efficiently. You can outsource credit control and hire experts to manage your portfolios, or you can also develop internal talents to manage your credit in-house. Either option has risks and benefits, so you should pick the method that best fits your needs.
- Understanding trade credit in construction
- What are the risks that come with trade credit?
- Should you outsource your credit risk management processes?
- Benefits and risks of in-house credit management
- Benefits and risks of outsourced credit management
- How do you decide if you should outsource credit control or not?
- Best practices for trade credit management
Understanding trade credit in construction
Before deciding between in-house versus outsourced credit management, you must first understand what trade credit is and how it works.
Trade credit is a form of transaction between two businesses. Unlike other typical business transactions, immediate payment is not required when buying or selling materials through trade credit. A deadline for payment is instead set at a later date.
The payment deadline is based on the terms agreed upon by the parties. Net terms are ideally discussed early in the transaction, and these terms typically can range anywhere between 30 to 90 days.
Note that trade credit is just one of the many available forms of construction funding. Other financing methods include traditional bank loans, credit lines, and invoice factoring, but trade credit is considered to be one of the more attractive methods for contractors and subcontractors.
As a material supplier, you are likely to attract more clients if you offer trade credit instead of only asking for immediate payment.
What are the risks that come with trade credit?
Despite its advantages, trade credit also comes with small and big risks such as the following:
Perhaps one of the most common issues that suppliers must face is payment delays. Late payments have been a long-running problem in the construction sector, and you should know how to deal with them regardless of how you sell materials to your clients.
Keep in mind that late payments can cause a major blow to your cash flow if not managed properly. Say, for instance, that you rely on one major client to sustain your business operations. If this one client fails to pay up on time and you do not have a backup plan, you will have to scramble for cash just so you can keep your business going.
Late payments are one thing; non-payments are a completely different issue. When clients pay late, it could be because they were just waiting to get paid by their respective clients. Unfortunately, clients can sometimes be delinquent and completely ignore their payment obligations.
You can protect yourself from non-payment by being proactive, not only in vetting your trade credit clients but also in preserving your lien rights. The last thing you want to happen is to lose all your supplies for nothing.
As mentioned earlier, trade credit is a very attractive funding method for contractors and subcontractors. The more clients you attract through trade credit, the bigger your business grows. However, this also makes you more prone to credit mismanagement.
When you start selling materials on trade credit, you should develop the right processes and policies that will help ensure that you get paid. Without the proper procedures in place, you might end up mismanaging your accounts receivables and your entire cash flow.
Should you outsource your credit risk management processes?
There is no correct answer as to which is better between in-house and outsourced credit control. How you control and manage credit completely depends on your needs and capacities.
Most smaller companies start by managing their trade credit in-house. A smaller clientele is arguably more manageable, but the bigger your business grows, the more complex your portfolios can be.
However, having a big client base does not necessarily mean that you should outsource credit control. There are advantages and disadvantages that come with both in-house management and outsourcing, and you should assess which of the benefits and risks are worth dealing with.
Benefits and risks of in-house credit management
Benefits of in-house credit management
- Direct control of credit portfoliosWhen you manage your credit in-house, you have direct control over all your credit portfolios. Having direct control over your client’s accounts comes with many other advantages. If, for example, you are concerned about security and confidentiality, you are in a better position to protect your data and track which parties can have access to them.
Other than protecting your data, you can also afford to become more flexible when you manage your credit in-house. For instance, you can extend special considerations to your loyal clients, and you can also renegotiate the terms of your agreements as you deem fit.
- Direct customer relationsIn-house credit management means working with your clients without any third party involved. This means you get to know your clients better, and you get to build solid business relationships with them. You can also build your reputation in the industry and establish direct communication lines by being your client’s direct contact.
When you have unmediated relationships with your clients, you can also avoid major communication gaps from happening. Sometimes communication lines fall through, and this causes payment disputes. You can avoid payment disputes by being in constant communication with your clients.
- No added feesManaging your trade credit in-house can be cheaper because you do not have to pay an external party to do the job. If your credit management processes and policies are effective and efficient, choosing to outsource the job can be an unnecessary expense.
However, in-house credit management is not always the cheaper option. Sometimes spending extra to get expert help can be the more cost-effective option in the long run. Consider the capacities of your credit team and the amount of work that they are expected to do. If you are overstretching your resources to manage your trade credit, outsourcing may be the ideal option.
Risks of in-house credit management
- Demanding and time-consumingIn-house credit control can be demanding and time-consuming, especially when you have a large clientele and a small staff. Your credit team may be just one or two people and they might also have other responsibilities for the company. This setup may not be good for your business in the long term, especially if your credit team starts losing focus on their other tasks.
When you manage your trade credit through a small and overworked credit team, you risk the possibility of mismanaging your trade credit and cash flow altogether. Be wary of this scenario and consider outsourcing your credit management processes instead.
- Limited capabilitiesYour resources can be generally limited when you manage your credit in-house. For instance, you need to use software and other management tools at your disposal or spend on more sophisticated technologies that third-party credit experts already use.
Managing credit risks on your own also means relying on your own expertise and knowledge. The members of your credit team need to be highly knowledgeable, so you need to provide proper training. Otherwise, they may not do their jobs properly and end up damaging your cash flow.
- Costly in certain waysIn-house credit management may require you to invest money not only in proper staff training but also in advanced software. It can therefore be costly compared to outsourcing your credit management needs.
The extra cost can also manifest in other ways, especially if your credit team is overstretched with work. For example, sales representatives who are also responsible for recovering late payments may not generate new sales as they will be too focused on their other responsibilities.
Benefits and risks of outsourced credit management
Benefits of outsourced credit management
- Improved efficiencyWhen you outsource all your credit management work, you give yourself more time to focus on your actual business operations. You do not run the risk of overstretching your resources, and you do not get distracted by the pressure of recovering late payments from delinquent clients.
The improved efficiency will be beneficial for your company, though it does not mean that you can afford to drop the ball on managing your cash flow. You still need to protect the health of your cash flow at all costs while growing your business.
- Accessible expert adviceWorking with a third-party credit controller means having access to their knowledge expertise. Credit management is all they do, and they have gained the relevant skills and experience from working with various other construction clients.
Because good third-party credit managers are industry experts, you can trust that they are reliable and that they will be able to manage your trade credit properly. They need to do well as their business also depends upon their quality of service and overall reputation.
- Automated processesWith third-party credit managers, payments and other credit processes can be automated. You do not have to make the collection calls or set up deadline reminders – they can handle these tasks for you, so you do not have to stress about them.
Third-party credit controllers can also submit monthly reports for you to review, and you can use different key performance indices to assess how efficient they are in collecting payments. The credit management process can become way more efficient when you are working with parties who know what they are doing.
Risks of outsourced credit management
- No direct controlOne of the downsides of going with a third-party credit controller is the lack of direct control over your clients’ credit portfolios. It may be difficult for you to know when to intervene or when to renegotiate payment deadlines and terms. You may even lose loyal clients for failing to adjust your terms to accommodate their needs.
Note, however, that the lack of direct control is not necessarily disadvantageous. You simply need to work together with your third-party credit manager and your clients to avoid any potential communication gaps and issues.
- Increased risk of miscommunicationThe third-party credit controllers are the ones who manage your trade credit, so they also have direct contact with your clients. Because there are multiple parties involved – your clients, your credit manager, and you — there is a higher risk for miscommunication to occur.
It is important to avoid communication gaps with your clients, especially when you are outsourcing credit controllers. Communication gaps can lead to payment disputes, and these disputes may result in bigger issues with legal ramifications.
- Reduced internal expertiseAnother downside of outsourcing credit control is not having internal experts in managing your credit and cash flow. Having in-house credit management experts allows you to monitor the work of your credit controllers and ultimately protect your cash flow.
Also, keep in mind that third-party credit management companies can be extremely busy, and you might go down their priority list. Since you are not always the priority, it may be best to still have an internal expert that is familiar with your trade credit policies.
How do you decide if you should outsource credit control or not?
When deciding between in-house or outsourced credit control, you should consider the following factors:
- Human resourcesHow big is your credit team? Do they have other responsibilities outside managing your trade credit? If credit management work is a burden to your staff and is slowing down other processes at work, it may be best to get help from third-party experts.
- Client baseHow many trade credit clients do you have? How many of them miss their payment deadlines frequently? A small client base can be difficult to manage in-house if they are all delinquents when it comes to paying on time. A large client base can be manageable for a small credit team if they have all been vetted properly during the application stage.
- Long-term plansDo you plan to develop a well-trained in-house credit staff? Or do you plan to grow other aspects of your business? If you prefer having in-house credit risk experts, it is best to improve your current in-house credit management practices. If you choose to focus on your business’ core operations, you can outsource credit management help and let experts manage your trade credit.
Best practices for trade credit management
Build a robust trade credit policy
Whether you are outsourcing credit control or managing it in-house, you still need to build and implement a robust trade credit policy. Your trade credit policy will guide you in approving or rejecting potential trade credit clients. It should also inform your decisions in setting credit limits and payment terms.
Ideally, you want to sell materials on credit only to clients who have good credit scores and payment track records. On the flip side, you can also sell materials to clients who have bad credit scores while setting a low credit limit. Your credit policy will help determine how best to increase your sales without facing unmanageable financial risks.
Be proactive in protecting your lien rights
Since late payments and non-payments are common in construction, you are strongly advised to be proactive when protecting your payment rights. One of the best ways to be proactive is to always serve a preliminary notice for every project.
Not all states require serving a preliminary notice at the beginning of a project. When required, failing to serve a preliminary notice can kill your right to filing a mechanics lien. But even if serving a preliminary notice is not required in your state, you should still consider serving one. Handing preliminary notices to property owners opens communication lines and helps avoid potential payment disputes.
Use relevant KPIs to monitor your credit management performance
Using key performance indices or KPIs is a good way to quantify how effective your credit management practices are. It doesn’t matter whether you outsource your credit management work or you do it on your own – you still want to know if there are any weaknesses in your processes that you need to improve.
Some of the KPIs that you can use is the day sales outstanding or DSO and the Collection Effective Index or CEI. The DSO lets you know the average number of days it takes you to collect payment from your clients, while the CEI tells you how effective your payment collection practices are.