Payment terms are lengthening in nearly every industry as buyers seek to make the best use of their capital, and construction is no exception. Project owners are implementing longer payment terms, which is especially challenging for the subcontractors performing the work.
The working capital challenge for construction subcontractors is complex. It stems from multifaceted factors beyond the trend in payment terms, including traditional industry financial processes and a challenging credit/financing landscape for small- and mid-sized businesses.
Because of the traditionally long and uncertain payment waiting periods for construction subcontractors, their expenses for project work, such as payroll and materials, are outlaid long before payment is received. In addition, these waiting periods can vary greatly, making accounting difficult. Pay-when-paid and pay-if-paid clauses, as well as retention rates, can exacerbate the challenges.
Together, these factors create cash flow difficulties that can dramatically impact working capital management, leading to financial strain and—in the worst case, failure—leaving forward-thinking general contractors looking for innovative ways solve the problem.
One strategy employed by some builders entails helping their subcontractors address longstanding working capital and cash flow challenges. The arrival of supply chain finance (SCF) programs in construction, an evolving approach, brought changes to the flow of funds, enabling faster and more predictable payments.
Supply Chain Finance
SCF techniques enable buyers of goods and services to maintain and enhance their own working capital while improving the working capital of their suppliers and alleviating cash flow challenges through accelerated, predictable payments. In construction, general contractors deploying SCF programs work with third-party funders to arrange payment of approved invoices on specified dates. Participating subcontractors receive their payments at an agreed upon time—significantly earlier than they traditionally would be paid—in exchange for a modest fee added to the invoiced amount.
According to a recent whitepaper from SCF specialist Greensill, “More than $3.5 trillion of cash is locked up in working capital around the world at any one time.” Recognizing an opportunity to unlock this capital, many industries have turned to SCF to help decrease their payables and protect their operations. In fact, Citi research estimates half of all Standard & Poor’s (S&P) 500 companies use SCF to support their suppliers and optimize working capital, including Procter & Gamble Co., DowDuPont Inc., Rolls-Royce and Coca-Cola.
However, until recently, SCF was not widely used in construction, largely because lenders that fund SCF programs viewed the industry’s historically complex, opaque and inefficient payment processes as too risky. Fortunately, technology has altered that mindset.
Changing the Game
With technology that moves payment management to the cloud, processes become efficient, standardized and transparent, helping to allay SCF funders’ longstanding concerns. Construction invoices, once seen as high-risk, become fundable assets that SCF providers can be sure are free of liens and other issues.
This is a significant development in engineering and construction, where the median days sales outstanding (DSO) metric stands at 84 days—the longest among the major 17 industries studied— according to a PwC report (also known as PricewaterhouseCoopers). At the same time, regulatory and other changes to the credit and financing landscape in the wake of the 2007 through 2008 financial crisis resulted in tougher financing conditions for small- to mid-sized businesses, making working capital gaps difficult to bridge.
Recognizing the need to address these challenges for subcontractors, a number of general contractors have recently launched SCF programs, leveraging technology to ensure that participating subcontractors are paid sooner and at a predictable time.
Proponents of SCF cite various potential benefits for supplier organizations, including greatly reduced roadblocks in cash flow, lower cost access to working capital, strengthened balance sheets and ability to fund growth. Buyer organizations benefit from increased stability in their supply chain, among other improvements.
Given the ongoing challenges arising from tight margins and financial risks, construction industry participants would do well to weigh the benefits of utilizing new, technology-enabled programs to improve working capital management, allowing them to prosper while they focus on delivering value in their projects.