Factoring: Alternative Financing For The Construction Industry

The country’s been going through some pretty tough times, and the construction business is one of the industries that has been hardest hit.

According to numbers released August 2009 by the Bureau of Labor Statistics, employment in construction declined by 76,000 during July, a figure similar to the average for the three previous months. Between November and April, employment decreased by 117,000 jobs a month on average between November and April.

Given this challenging economic climate, there’s a strong possibility that a lot of construction business owners trying to survive will find that they need cash at some point-for example, to buy new equipment or pay the monthly charges on equipment they’ve bought or leased in the past. These payments are in addition to making payroll, paying taxes, paying suppliers and taking care of all the other costs of doing business. As those involved in construction know only too well, there are very few options for financing now.

The Downside of Traditional Lenders

One obvious funding source to consider is a traditional lender, such as a bank. Even in the best of times, banks have been reluctant to extend loans or provide other forms of financial support to companies involved in construction because of the nature of progress billings. In light of the current economy, the likelihood of banks being a viable source of financing is even more remote than usual.

This means construction business owners will look for new places to turn. Despite all this doom and gloom, there is good news for construction business owners. There is an alternative form of financing called factoring. It is well-respected, has proven itself over time and could be the perfect solution for a business owner in need of cash.

Everything You Need to Know About Factoring

In the United States, factoring became popular as a method of financing in the garment industry in the early 1900s. Since then, factoring has been used in all types of businesses, including manufacturing and service industries.

How does factoring work? A factor advances a construction business owner cash on the basis of one or more invoices. The factor buys the invoice, advancing up to 70 percent. When the invoice or group of invoices are paid, the balance not advanced is remitted to the customer, less the fee.

Factoring offers many advantages. The business owner does not have to borrow money, he makes no monthly payments and he can control his cash flow by exercising total control over how much he factors and how often. Perhaps most important is the fact that construction companies can get the money they need quickly.

What about risk? The good news is that factoring is virtually risk-free, and it is non-recourse. There is nothing to pay back-and if an invoice that has been factored is not paid, for credit reasons, the factor will take the loss. Compare this type of funding with traditional borrowing, which always carries risk-especially if the loan is based on the construction company’s assets.

An Example of How Factoring Works

An example of how factoring works: A subcontractor in the New York area was working on a large commercial development project and desperately needed an infusion of cash. My company determined that the subcontractor would be able to receive an advance, under no long-term contract and with no credit risk, as much as 70 percent of a single invoice totaling $100,000, or a sum of $70,000 that would be wired directly to his bank account. If the account failed to pay because of credit problems, then my company would take the loss.

The subcontractor agreed to pay 3 percent of the total for the first thirty days as a fee on the $100,000. In other words, he would pay $3,000 to factor a $100,000 invoice for one month. He would receive the balance of the money-$27,000, or $30,000 minus the $3,000 fee-upon receipt of the funds due toward payment of the invoice. He therefore received $70,000 plus $27,000, or a total of $97,000 for his $100,000 invoice.

Factoring can also play an important role in construction business once the economy gets back on its feet. Once again, this subcontractor provides a good example of how factoring can benefit a business looking to grow. Analysis of this subcontractor’s financial situation revealed that his gross margin was 18 percent and that his annual overhead was $150,000. The subcontractor realized that if he had access to “unlimited funds,” he could double his business from $2 million in annual sales to $4 million. But, he knew that doubling his sales would not mean doubling his overhead. In fact, he calculated that the extra $2 million in sales would only cost him an additional $50,000 in overhead expenses.

Once the subcontractor looked at the numbers, he understood how he could benefit from factoring. Without factoring, he made $360,000 gross profit on $2 million in sales. But by factoring 100 percent of his receivables, he only had to factor $2 million out of a projected $4 million in sales in order to generate a gross profit of $720,000. His annual cost for factoring was $60,000. Instead of a net pre-tax profit of $210,000 per year, the net profit increased to $460,000 per year for an increase of 119 percent, or a quarter million dollars.

Factoring could enable this subcontractor to grow his business by taking advantage of work opportunities he would have otherwise been forced to turn down. He was also able to receive volume discounts offered by suppliers, which resulted in even greater financial benefit.

For the construction business owner, factoring can be the way to stay in the race-or when the time is right, to grow dramatically. Factors do not buy retention, meaning monies withheld by the owner, until a project meets the owner’s satisfaction. They supply cash-cash that can help construction business owners finance their equipment, meet their payroll, tax and insurance needs, pay their suppliers and receive greater discounts from them.

Facts on Factoring:

When You Borrow from a Traditional Lender…

• It limits your flexibility
• A lender will secure assets equal to a minimum of three times the amount of the loan
• You can not secure additional funds without renegotiating the loan
• You must meet monthly payment obligations
• There is a loan liability on your balance sheet

When You Factor…

• You don’t borrow money
• You make no monthly payments
• You receive funds in 24 hours or less
• You control your cash flow by determining how much you need
• You increase the availability of immediate cash which can enable you to bid on more new jobs and earn additional supplier discounts

Construction Business Owner, October 2009