Most construction companies operate with very tight cash flows. On one hand, they must pay certain expenses quickly, including company operating costs, subcontractors, equipment vendors and material suppliers. On the other hand, most commercial construction clients demand payment terms—essentially, credit—meaning the construction company must give the client up to 60 days to pay an invoice if the company chooses to work with the client. You must balance these cash flow demands carefully; otherwise, you could experience financial problems.
As a finance professional, I have seen construction companies go out of business because they did not manage their cash flow correctly. In many cases, the problem was tied to slow-paying commercial clients. Basically, the company had given credit to a client who promised to pay quickly. However, the client paid slowly—or worse—he or she never paid. This development threw a wrench into the company’s ability to pay operating expenses. In some instances, it drove them out of business.
For the most part, some of these problems can be prevented or at least minimized. With a little due diligence, you can determine your commercial client’s creditworthiness and make better decisions to improve your cash flow and minimize bad debt.
Should You Give Credit to Your Clients?
Construction company owners often overlook the creditworthiness of clients before starting a project. At times, the owner is simply excited to book a large construction project and wants the revenue. Other times, the contract originated through a long-standing relationship that the owner was certain would pay on time.
Unfortunately, providing credit without due diligence is risky and could cost you your business. The best strategy is to provide credit only to clients who deserve it. Make the decision based on facts rather than emotion.
How to Determine Creditworthiness
First, keep in mind that no credit scoring method is perfect. Eliminating credit risk is impossible. However, you can reduce your risk by using these techniques.
The easiest and most reliable way to determine the commercial creditworthiness of a client is to buy a report from a credit bureau. These reports are not only cost-effective and accessible; they also usually provide valuable information because the data used to generate the reports comes directly from the accounting software of vendors who are willing to share their payment experiences. As a result, credit reports provide a critical snapshot of a potential client’s payment habits—a good indication of their actual creditworthiness.
Below are three of the best-known providers of commercial credit reports:
- Dun and Bradstreet (dnb.com)
- Experian Commercial (smartbusinessreports.com)
- Cortera (cortera.com)
How to Examine a Commercial Credit Report
Credit reports vary in length and level of detail. However, they usually answer the following questions:
- Does the client pay on time, or is the client always late?
- Is the payment trend positive or negative?
- How big are the client’s vendor credit lines?
- Does the client have any negative filings? (e.g., tax liens)
In essence, credit reports offer a glimpse into a client’s payment habits. A client will pay you as well as they pay other vendors.
First, examine the report and determine if the potential clients pay within terms or if they pay late. If they pay late, see how late their payments are. A few days beyond terms is common and should not cause major concern. But beware if they are paying more than 30 days beyond terms. For example, if a client promises to pay an invoice on net-30 terms but takes 70 days to pay, he or she would be 40 days beyond terms and should be considered a risky client.
Next, determine if the payment trend is positive or negative. Most reports qualify the trend with a score. Be cautious if clients are taking longer to pay now than they did in the past. This pattern often indicates financial distress.
You should also consider the average size of the vendor credit lines. Usually, limiting the size of your credit line to the average of the existing vendor lines for that prospective client is wise. Obviously, there is room for flexibility, so use your best judgment.
Finally, examine the number of reported vendor lines. A credit report that shows only a few trade lines is likely to be less accurate than a report that shows many lines.
Some Challenges to Keep in Mind
If your clients are also in the construction industry, you may encounter credit reports that show numerous negative filings. Unfortunately, liens and lawsuits are common in the industry, and these filings often carry negative credit connotations. Consequently, some reports may appear to be bad even though they are acceptable. Unfortunately, these types of reports are an industry issue, and there are no specific rules on how to handle these. Use your best judgment, but consider these suggestions:
- Liens related to financing activities (e.g., loans, equipment financing) are acceptable unless they are excessive in number or amounts.
- A few lawsuits—as long as they are for small amounts and are paid quickly—are acceptable.
- Many lawsuits, or a lawsuit for a large amount, indicate a problem.
- Liens related to unpaid taxes are always a serious problem.
How to Handle Large Projects That Demand Credit
If you are quoting a large project, consider using multiple credit reports to make a decision. Each credit bureau uses different sources and has proprietary credit-scoring mechanisms. However, since no single report is perfect, using reports from different credit bureaus helps you make a more balanced decision.
Running into Cash Flow Problems?
Cash flow problems can be an unintended consequence of offering credit—even to good clients. Offering credit without the financial wherewithal to wait 30 to 60 days for payment can have serious consequences if not managed correctly.
You can usually solve cash flow problems by using a line of credit or by financing your construction invoices. Both solutions can provide working capital and minimize some of the financial challenges of offering commercial credit to clients.