Materials and goods used in a construction project are usually bought on credit. Unlike in regular business transactions, the companies that supply construction goods do not always require immediate payment before delivering the materials to a construction site. Their customers buy the materials on credit and may pay the cost later within a set amount of time.
This agreement between a material supplier and another construction participant is more commonly known as trade credit. There are risks that come with extending credit to a client, so construction businesses— especially material suppliers—must know how to set the right trade credit limit and mitigate certain credit risks before they turn into major cash flow problems.
- Trade Credit Definitions
- How to assess trade credit risk?
- Issues to note when reading a credit report
- Tips for conducting a credit risk assessment
- How to set a trade credit limit?
- Questions to ask when setting a trade credit limit
- Tips for determining credit limit
- How to create a trade credit policy
- How to create a mechanics lien policy
Trade Credit Definitions
Understanding Trade Credit
In construction, trade credits are frequently extended by material suppliers. While there are risks that come with supplying materials without requiring immediate cash in return, there are also advantages to doing it.
Trade credit is one way to build good relationships with contractors and subcontractors. If you extend trade credit with reasonable payment terms, you could potentially be the preferred supplier of your clients. Extending trade credits can also be a good way to promote the materials that you offer by letting your client test the quality and reliability before paying.
Understanding Trade Credit Limit
Setting a credit limit is important because you do not want to extend an unlimited amount of credit to your customers. You need to set a cap on how much your clients can “borrow” and this cap varies per client.
Trade credit limits are different per customer depending on the risks that the customers pose. Are they the type who always pays on time? Are they in good financial shape? Do they have a good business credit rating? These are some of the questions that you should consider when setting a credit limit for your clients.
Understanding Credit Risk
Credit limits are usually set after conducting a credit risk assessment on a client. When performing this assessment, you essentially quantify and qualify how risky it is to sell materials to the client without asking for immediate payment.
There are different types of credit risks, including the following:
How to assess trade credit risk?
Run a business credit report
Material suppliers should always run a business credit report for every client before they extend trade credit. There are many available business credit agencies that offer thorough assessments of a potential client’s credit practices.
A business credit report typically includes an overview of the client’s industry, as well as specific details on their delinquencies, if any. Some agencies also offer a preliminary analysis on potential delinquencies and business failures, depending on the industry.
Credit reports also show your potential client’s credit score or rating, and you would want to consider this score when setting a client’s credit limit. Furthermore, credit reports may also include a list of trade references which you can contact to do further risk investigation.
Consult trade references
Trade references are sources that can provide more information on a client’s past payment practices. These can be other material suppliers or other lending institutions that have previously extended credit to the client in question.
Trade references can be found on a credit report, or they can also be given to you by a potential client. If a client does not give a list of trade references, you should always ask for one. Talking to trade references is a good way to understand better how reliable a potential client is, especially when it comes to honoring their payment obligations.
Study company growth and trends
Other than business credit reports and trade references, you may also look at the financial standing of a potential borrower. How long have they been in business? Are their finances going on an upward trend?
New and emerging businesses are generally a greater risk compared to established companies. Younger and smaller clients do not have a steady list of customers yet, and there is limited information that can give you insight into how reliable they are as lenders.
Established clients in good financial shape are considered low risk because they are more likely to pay off the trade credit on time.
Issues to note when reading a credit report
- Payment trendsPay attention to the credit delinquencies of a potential client, and consider it when assessing trade credit risk.
- Mechanics and other liensConsider how many mechanics liens and other encumbrances a potential customer has. A few mechanics liens may not necessarily be a deal-breaker, but a huge amount is a red flag.
- Ongoing lawsuitsLawsuits and other legal issues should also be flagged and assessed prior to approving a trade credit application or setting a trade credit limit.
Tips for conducting a credit risk assessment
Focus on the facts
When performing a credit risk assessment, you should stick to the facts and focus less on assumptions and other unreliable factors. It may be tempting to extend credit simply because you are on good terms with a customer, but you should also consider their past payment practices and how reliable they are in settling outstanding invoices.
Take advantage of technologies
New technologies are being developed every day, and some of them are specifically designed to do credit risk modeling and assessment. You can leverage these existing and emerging technological methods to aid you in making decisions regarding trade credit limits and credit risk assessments.
Review your credit risk assessment processes regularly
No single credit risk assessment process is perfect. It is important to constantly revisit your current practices and policies and study them to identify areas for improvement. Businesses evolve too, and you can further improve your policies so they better suit your company’s growth as well as the needs of your customers.
How to set a trade credit limit?
There are different methods to set and calculate the trade credit limit that you set for your clients. The following are just three of the various trade credit limit calculation methods:
Based on needs
A needs-based credit limit is calculated based on the amount that the customer is asking for. If, for instance, a customer requires $10,000 worth of materials, you can set their maximum trade credit amount exactly at $10,000, as they requested.
Based on net worth
A credit limit based on net worth is less straightforward. It is based on a certain percentage of your customer’s net worth.
Once you have assessed the client’s net worth, you may then assign a credit limit based on a specific percentage of the net worth. Trade credit limits calculated through this method are usually set at 5% to 15% of a client’s net worth.
Based on past payment and purchase patterns
Calculating a trade credit limit based on previous performance is usually applied to existing clients. You want to assess how frequently they purchase materials from you and how diligent they have been in paying on time. You can also assess their DSO to check how quickly they collect payment for their services.
Note that no single method is considered to be the best for setting a trade credit limit. There are numerous factors to examine, and there are many gray areas too. A client can have a high net worth, for instance, but they may only have one major customer. This exposes them to greater concentration risk. If their single client fails to pay up, then you also run the risk of losing money.
Questions to ask when setting a trade credit limit
In essence, you want to ask the following questions before setting a trade credit limit for a client:
- How much money is the client asking for?
- How much is the client’s tangible net worth?
- How efficient are the client’s payment practices?
While there are different ways of calculating trade credit limits, it is important that you consider multiple methods and ask the questions above. Once you have the answers, you can take the average amount and set the trade credit limit from there.
Tips for determining credit limit
- Do not rush the decisionSetting a credit limit should not be rushed because it can make or break a transaction. A client may go to a different credit provider if you do not offer them what they need, and they can also become high-risk customers if you set the limit too high. You should set a reasonable amount of time to carefully conduct your credit risk assessment before making a decision on what credit limit to set.
- Do not base your decision on assumptionsIt is also equally important to be quantitative and objective when making your decisions regarding trade credit limits. For example, you may not set a credit limit based on the assumption that a newly founded company will potentially earn lots of money when they don’t even have a credit score yet. Deciding on a credit limit based on assumptions can cause you to lose money, especially when your assumptions turn out to be false.
- Implement an effective trade credit policyYou should develop and enforce a good trade credit policy if you don’t have one yet. A good credit policy allows you to streamline your processes for conducting credit risk assessments, setting trade credit limits, outlining payment collection practices, and addressing non-payment issues. These are all necessary to make sure your business runs smoothly and you are able to mitigate credit risks.
How to create a trade credit policy
Study current internal practices
When creating a trade credit policy, the first procedural step is to look at your internal practices and ask whether you need to create a policy from scratch. Some companies already have certain aspects of credit policy in place.
For instance, a material supplier may already have a process for setting payment terms and collecting payment. If this is the case, then they do not have to craft another set of rules from scratch.
You should first review your existing practices and see what you can utilize among your existing procedures. It can be a waste of time to write a trade credit policy from scratch when you can put together existing practices.
Determine a standard set of requirements and processes
Whether you are writing a trade credit policy from scratch or you are consolidating existing practices, your credit policy should capture the requirements and processes that govern your credit practices. Ask yourself the following questions:
- What is/are the objective(s) for establishing the credit policy?
- What steps must be completed when applying for trade credit?
- What documents must be provided by the credit applicant?
- What are the payment collection (billing) procedures?
- What are the steps for dealing with late payments?
The goal of a trade credit policy is to standardize your procedures for approving or rejecting trade credit applications, setting trade credit limits, and even dealing with late payments or unpaid accounts. These items must therefore be covered and articulated when you build your trade credit policy.
Communicate the terms and conditions clearly
Keep in mind that the trade credit policy should help you communicate your rules and requirements to your potential and existing clients. It must be not only comprehensive but also well-articulated and consistent.
A well-written trade credit policy covers all the bases. It sets forth the terms and conditions for buying materials on credit from your company, and it also guides your credit managers in determining which clients to approve or not and in dealing with them if they fail to pay up. The language must be clear, concise, and understandable for the parties who will make use of the credit policy.
Note that there is no perfect credit policy that applies to every business. Every organization has different goals, and your credit policy must reflect your company’s goals for it to be effective. If, for instance, your company prefers to work with established clients only, then your credit policy will have more stringent requirements for credit applications.
How to create a mechanics lien policy
Material suppliers are specifically encouraged to enforce a mechanics lien policy on top of having a trade credit policy. Payment disputes and delays happen so frequently in construction, but parties are fortunately able to recover payment by recording a mechanics lien against the property in question.
Setting a lien policy adds security to the trade credits that you extend. An effective mechanics lien policy incorporates the following items:
Ensure preliminary notices are served
Preliminary notices are almost always required from material suppliers. In most states, including Texas, California, and Florida, serving a preliminary notice must be done in order to preserve your lien rights.
When setting your mechanics lien policy, make sure that it outlines the rules for which party is responsible for serving the preliminary notice. You should also ensure that the preliminary notice has indeed been served. Failing to serve the preliminary when required can automatically kill your lien rights.
Set a time for how long to wait before recording a mechanics lien
Another important aspect of a lien policy is the waiting time before filing a mechanics lien. You do not want to record a mechanics lien too soon that you fail to give a client the chance to settle the debt, but you also do not want to file a mechanics lien too late that you run the risk of missing the deadline.
Your mechanics lien policy should set a reasonable time for when to go ahead and record a mechanics lien. You can be flexible on the time frame as long as the mechanics lien is filed on time, but you can also be more risk-averse and set a fixed period that will keep you from missing the filing deadline.
It is best practice to track the deadlines for serving preliminary notices and filing mechanics liens for each of your clients.
Standardize a process for filing a mechanics lien
When standardizing a mechanics lien filing process, you should familiarize yourself with the lien rules in your state. Most states require that you file the mechanics lien in the county recorder’s office, while others like Iowa have an online mechanics lien registry where you can record a mechanics lien electronically.
You should also understand other protocols, including the need for notifying property owners after filing a mechanics lien or canceling a mechanics lien once it has been paid. Filing a mechanics lien can be a tedious endeavor, so be sure to streamline your mechanics lien processes in the most efficient way possible.