Construction Financial Management
- Intro to Financial Management & Cash Flow
- Financial Statements For Construction Businesses
- Income statement
- Balance Sheet
- Cash flow statement
- Forecasting cash flow
- Managing cash flow
- Financial controls to prevent fraud
- Intro to Contractor Finance
- Where to find loans & other funding
- Financing equipment
- Invoice factoring
- Using credit cards wisely
- Calculating the true cost of financing
- Tips to manage cash flow
When a GC or property owner delays payment to their subcontractors, it’s not just annoying – it can get expensive. Allowing a contractor or project owner to pay late is the same as loaning them money. Every day that the money isn’t in your pocket, it’s costing you in a variety of ways. These are the carrying costs of slow payment in construction – the amount of money it costs you to carry someone else’s debt. You’re effectively paying your customer to hold your money.
If you’re not passing on those carrying costs, you’re losing money. You should, at the very least, be calculating your carrying costs in order to create an accurate idea of how much each project, and each customer, costs you. Better yet, you should be demanding faster payments.
Table of Contents
Construction payments take time
Days Sales Outstanding (DSO) is a measure of time it takes for invoices to get paid. The average DSO in the construction industry is 83 days. Think about that for a second. It takes nearly 3 months after invoicing for a contractor or supplier to get paid on average! If you’re getting paid in 45 days, you’re not doing too bad. But that means someone else isn’t getting paid for 120 days.
And that delay isn’t just an inconvenience. Late construction payments are actually costing you money – and quite a bit of it – in a variety of ways. Understanding how much slow construction payments cost is the first step to doing something about it.
The cost of time
There’s a concept in economics called the Time Value of Money. Don’t worry, we’re not going into a lecture here. The concept is pretty simple. If you’re familiar with the expression “time is money,” you already know what we’re talking about.
Imagine that you put a dollar bill in your pocket today, and find it in the laundry 10 years from now. Will it be worth the same in a decade as it is today? It’s still worth a dollar. But in ten years, everything will be more expensive than it is today. So that dollar will be worth less – it will have lost value over time.
The reason is something you hear about a lot in the news: Inflation. The inflation rate is basically the rate at which things get more expensive overall. Inflation is why you could buy a house for $15,000 in 1970, but you’d be lucky to find one for less than $150,000 today. In 2019, the annual US inflation rate was 2.9%.
So what does this mean for your construction business? Every day you work without getting paid, the money you’re earning becomes less valuable. If the property owner waits 90 days to pay you, you’re basically giving them a loan for that amount. But instead of earning interest on that loan, you’re paying the inflation rate.
Here’s an example. You do $10,000 worth of work on a house for Smith Contractors, and send an invoice. Smith takes 90 days to pay. How much inflation did you pay on that $10k?
- 2.9% / 365 days = 0.007% inflation per day
- 0.007% x $10,000 = $0.79 per day
- 90 days x $0.79 per day = $71.52
Seventy bucks might not sound like a lot. But imagine if that invoice is $50, $100, or $250k. The more money you have on the table, the more expensive time gets.
So, time costs money in the form of inflation. But that’s just one of the costs.
The cost of interest
You’re not just paying the inflation rate. You’re also paying interest – whether you use your own money, or someone else’s.
Lots of contractors accept slow payment as the status quo. They feel like it’s something they can’t change – like the weather, or getting older. But while you’re waiting to get paid, you still have bills to pay. Your employees need a paycheck. Trucks need gas. Suppliers are sending invoices. You can’t put your business on hold while you wait for the check to come in.
You have to get money from somewhere to pay your expenses in the meantime. Where does that money come from? It’s either coming from a loan or your savings. In either case, you’re paying interest.
Interest on loans
A loan is money that you’re borrowing from someone else – for example, a bank or credit card company. And they’re not giving you that money out of the goodness of their heart. They’re charging you interest on that loan.
If your business is financially sound, with good construction accounting practices and audited financial reports, you might be able to qualify for a bank loan – perhaps the cheapest form of construction financing available. If you’re lucky, the interest rate might be as low as 3% per year. (That’s slightly above the 2019 average inflation rate.)
If you’re using credit cards to pay your bills, and carrying a balance, you’re paying a lot more than 3%. Average business credit card rates are closer to 17% per year, or about 1.4% per month.
Interest on savings
If you’re fortunate enough to have business savings to meet your expenses while you wait for payment, there’s still a cost. Remember, you’re basically borrowing your own money to pay your employees and suppliers, while the GC or property owner holds onto the cash that you’ve already earned.
If you put that money into an interest-bearing savings account, you could earn as much as 2% per year (or 0.166% per month). But you’re not earning anything on it, since you’re using it to pay your bills. As a result, it becomes a cost to you. That’s what economists call an “opportunity cost.” If you didn’t spend that money, you could be using it on another opportunity – one that earns income.
The cost of lost profit
One of the costs of consistently waiting for slow construction payments is slower growth resulting from lost profit.
Consider this scenario: Three identical contractors work on the same type of construction project. Every project they work on is worth $10,000, with a 10% margin. However, they work for different customers, who pay at different times.
- Jones Construction gets paid in 30 days
- Smith Construction gets paid in 60 days
- Harris Construction gets paid in 90 days.
They each earn $1,000 in profit on each job. How much profit has each contractor earned at the end of a year?
At the end of January, the first project ends, and they all submit invoices to their customers. At the end of the 2nd month, Jones Construction gets paid for the first job. By the end of the 3rd month, Jones Construction gets paid for their 2nd job, while Smith Construction gets paid for their first. Harris Construction is still waiting. And so on.
Here’s what their profit looks like at the end of December:
- Jones Contractor: $11,000
- Smith Contractor: $5,000
- Harris Construction : $3,000
This is a simplified example, but you see what I mean. Faster payment means a faster turnaround time – you can use the money you earn on one job to reinvest in another. What you don’t see in the example above are all of the jobs that Contractors B and C had to turn down because their credit cards were maxed out and they didn’t have any money to take on new work.
Slow payments keep your construction business from growing.
If you’re preparing accurate construction accounting reports, you should be able to quickly identify your average monthly profit rate last year. Or take your average profit from your job profitability reports over the last 12 months.
How to calculate the cost of slow construction payments
Here’s a simple formula to calculate the monthly cost of late payments:
Inflation % + interest % + profit % = Carrying cost %
This is what that looks like in practice:
- Monthly inflation: 2.9% / 12 = 0.024%
- Monthly interest rate (credit card): 17% / 12 = 1.42%
- Potential profit rate (lost business): 5%
- Carrying cost: 6.44%
Getting paid faster: How much is early payment worth to you?
Knowing how much slow payments cost you isn’t supposed to be a depressing exercise. It’s meant to help you understand your business better, so you can be charging your customers accurately and taking steps to reduce costs. Knowing the cost of slow payment actually helps you get paid faster.
Early payment discounts
If you know that you’re paying 10% each month in carrying costs, you could offer a 5% discount to your customers for immediate payment. Or, you might consider factoring your construction invoices at a 3% per month discount rate, and get a percentage of that invoice in cash within days after you submit it.
Late payment penalties
If you have problematic customers who refuse to pay you on time, you should be passing the carrying cost on to them. If you don’t feel comfortable charging a late payment penalty, that’s understandable. Just make sure you increase your bid on the next project to incorporate the extra carrying cost that you know you’re paying.
How to speed up payment and reduce carrying cost
By now, it should be clear that, when your customers pay you late, you’re paying the price. Slow payments cost you money. And in construction, payments are slow. So what can you do?
Understanding the carrying cost of slow payment helps you to make financial decisions that save you money and speed up payments. But hopefully, understanding how much late payments cost will motivate you to adopt some good business habits that will speed up payments – and save money – naturally.
There are a number of factors that affect a construction business’s payment. Some of these are practical, like adopting electronic payments instead of waiting for the paper check in the mail. But some of the easiest ways to speed up payment are all about letting your customer know that you expect to be paid on time, and are willing to take action to ensure it.
Here are 3 simple steps to speed up payment in construction:
- Send preliminary notice on every job. A preliminary notice is a simple document, but an extremely powerful one. It tells the GC, property owner, and others at the top of the payment chain that you’re on the job. A preliminary notice sets an expectation early on. It says that you take the job – and your payment – seriously. The GC will be much more likely to put your payment application in the “pay first” stack at the end of the month.
- Exchange the right payment documents at the right time. Provide ultra-detailed pay applications and conditional lien waivers before the contract deadline. The easier it is for the GC or property owner to see the work you’ve done, and sign off on it, the faster you can get paid.
- Learn (and use) the construction laws where you work. Every state has laws that protect contractors, suppliers, and other construction businesses, ensuring that they get paid for the work they do. A mechanics lien is one of a contractor’s most powerful tools to ensure they get paid. But in order to use it, you have to protect it. Learn what the law requires in your state. And while you’re reading up on payment laws, check out your state’s Prompt Payment Act. Nearly every state has a law that sets deadlines for payments on construction projects, and charges automatic interest penalties on late payments.
Getting paid faster in construction isn’t rocket science. It’s a series of tried & trusted habits that, when you practice them regularly, can transform your construction business – and the payment practices of your customers.
Discover how a Florida contractor’s average DSO went from 60 days to 14 days after sending notices on every job.