Working with builders and general contractors (GCs) has advantages. They are often recurring customers who place larger orders and can help grow your business. However, these customers usually ask for net-30-day payment terms. This request is a challenge because offering payment terms can lead to cash flow problems if not handled correctly. This article presents two proven strategies to manage this situation. We cover:
- Cash flow vs. 30-day payments
- Early payment discounts
- Factoring construction invoices
- Pay-when-paid issues
- Advantages of construction factoring
- Limitations
- Is this solution right for your business?
1. Net-30 accounts and cash flow
Most builders and general contractors ask for net-30-day terms (or longer) when they purchase building products for a project. This common practice helps them manage the project’s cash flow. As a supplier, you must offer terms to customers if you want to do business with them. Having net-30 accounts exposes your company to credit and cash flow risks. These risks must be managed correctly to avoid financial problems.
a) Credit Risk
Credit risk is the chance that your client does not pay their invoice on time or at all. The reason for non-payment can range from disputes to customer insolvency. At its worst, credit risk can potentially increase your bad debt. Credit risk can be lowered by using commercial credit reports from companies such as Dun and Bradstreet or Equifax.
b) Cash flow risk
Cash flow risk is the chance that having net-30 accounts impacts your working capital to the point that it affects your ability to pay suppliers on time. This problem occurs because many expenses come due before your customers pay their invoices. Consequently, you must pay these expenses out of your cash reserves.
This strategy works well as long as the cash reserve is sufficient to cover expenses. However, companies with thin cash reserves can quickly get into financial problems if they win a larger-than-expected contract or a customer misses a payment. In the following sections, we discuss two ways to manage this issue.
2. Early payment discounts
The easiest way to improve your cash flow is for customers to pay their invoices sooner. A well-known strategy is to offer customers a 2% discount (negotiable) as an early payment incentive. Customers that take the incentive pay their invoices in 10 days or less. Your customer can decline the offer and pay their invoice on their usual terms.
The best strategy is to offer the discount for early payment to only your best customers. These builders and general contractors provide steady work and always pay on time. They are the most likely to use the benefit and will appreciate the discount. Avoid the common mistake of offering the discount to customers with a bad payment history. It seldom works as intended and may backfire.
Early payment discounts are optional. Your client decides whether to take it or decline it. Unfortunately, you can never be sure if they will pay early. This issue can become more challenging during difficult economic times. Your customers may decline the early payment discount at the very time you need the funds the most.
3. Factoring construction invoices
Building materials suppliers that need to consistently improve their cash flow should consider using construction factoring. Construction factoring is a specialized form of factoring that has been customized for the construction industry. It finances your qualifying invoices from builders, GCs, and commercial clients. It provides the working capital you need to operate the business and grow.
Most factoring companies don’t lend money. Instead, they finance your company by purchasing your invoices. The advantage of this structure is that transactions are easier to underwrite and fund.
Invoices are purchased in two instalments. The first instalment is called the advance and covers around 80% of the value of the invoice. The advance is deposited in to your bank account shortly after you submit your invoices to the factor.
The remaining 20%, less the factoring fee, is deposited in to your account once your customer pays their invoice. This second instalment settles the transaction.
4. Pay-when-paid invoices
Some general contractors issue invoices with a so-called “pay-when-paid” clause. These clauses state that the general contractor will pay the supplier if and when the end customer pays. Invoices with this clause attached do not qualify for financing due to the risk of non-payment or short payment. For these invoices to qualify for financing, the purchaser’s contract must be amended to rescind this clause.
5. Advantages of construction factoring
Factoring has a number of benefits over other financing solutions. Advantages include the following.
a) Improves cash flow
The most important benefit of construction factoring is that it can improve your cash flow quickly.
b) Enables you to offer net-30 terms
Factoring allows you to offer net-30 terms to customers while minimizing the effects on your cash flow. Offering payment terms enables you to expand your customer base and sales.
c) Flexible limit
Your financing limit is flexible and is based on your sales, the credit quality of your invoices, and your delivery capabilities. This line adapts and can increase to support a growing company.
d) Simple qualification
The solution has simpler qualification requirements than other financing options of comparable size. This accessibility makes construction factoring a viable option for building supply companies that can’t qualify for bank financing.
6. Limitations of factoring
While factoring has several benefits, it also has some limitations that business owners should consider. Company owners must balance the expected benefits of the platform against these limitations.
a) Single problem solution
Construction factoring is designed to solve a single problem only. It improves cash flow if your problems are due to slow-paying clients. It does not help with other problems that could affect cash flow, such as profitability, operations issues, low sales, etc.
b) Cost
Construction factoring lines are more expensive than a conventional line of credit of similar size. Consequently, they work best for companies with high profit margins.
c) Requires customer involvement
Construction factoring lines usually require some involvement from your customers. Factoring companies often verify invoices prior to funding to ensure their accuracy. This verification may require contacting your clients. Additionally, invoices subject to a pay-when-paid clause may require your customer to sign a waiver prior to funding.
7. Is this solution right for your company?
Construction factoring may be the right solution for your company if the following are true:
a) Cash flow problems due to slow-paying invoices
Factoring helps only if your cash flow problems are due to slow-paying invoices. The solution was specifically designed to solve this problem.
b) 20% or greater profit margins
Companies should have a minimum profit margin of 20%. However, 30% or higher is preferred. This requirement is due to the cost of financing.
c) Accounts receivable is not encumbered
Factoring can be used only if your accounts receivable are not encumbered by liens or hypothèques from lenders.
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