In most cases, collecting on an invoice is not a problem, as a very high percentage of invoices are paid before they age past 90 days. Nevertheless, an entire industry of workers (i.e. credit managers) and vendors (credit monitoring, insurance, etc.) are dedicated to helping companies manage those instances when collecting an invoice is a problem. These workers and vendors are typically focused on improving two areas of the business’ collection efforts: (i) Getting invoices paid faster, in general; and (ii) Reducing those invoices that eventually become write-offs.
Gary Stockton’s excellent Small Business Brief on the Experian Business Information Services blog this week called attention to a startling statistic that “over 50 percent of 90 day late payments went uncollected by businesses” this year. Stockton explains:
5.2 percent of the value of those invoices extended more than 90 days overdue, and 2.7 percent – approximately 52 percent of the value of invoices 90 days past due – were written off as uncollectable.
This statistic was one of many insights provided by a report from Atradius’ September 2014 edition of the Payment Practices Barometer, which collects survey data about B2B receivables from suppliers in Brazil, Canada, Mexico, and the United States. This article will go through components of this Payment Practices Barometer report from the perspective of the construction financial professional, or anyone who manages credit and receivables for construction industry suppliers, equipment rental companies, subcontractors, or other participants.
Collecting on Pay Applications and Invoices is a Unique and Major Challenge For Those in the Construction Industry
When survey respondents were asked to name the greatest challenge to business profitability, over 70% pointed to challenges related to their cash flow. 31% identified cash flow specifically citing “maintaining adequate cash flow” as the greatest challenge. The remainder identified symptoms or causes of cash flow problems, with 22.5% complaining about “collecting outstanding invoices” and 20% worried about “bank lending restrictions.”
Collecting on outstanding invoices was a particular problem in the United States where respondents admitted that 42.5% of receivables were past due at the time of the survey. The report dug into why these B2B receivables were getting paid late:
- 38%: Insufficient availability of funds
- 27%: Disputes over delivered services/goods
- 28%: Complexity of payment procedure
- 29%: Problems with the invoice
- 27%: Insolvency with the buyer
There are two items from this list highlighted in red, and that’s because these two items particularly plague the construction industry.
Complexity of Payment Procedure: It’s difficult to understate how complex the payment process is in the construction industry. The layers and layers of parties are just a nagging detail of the payment process, which is also riddled with heavy paperwork needs and timing challenges. Some parties get paid on credit terms (i.e. suppliers), while others must participate in monthly payment draws subject to pay-if-paid provisions. Further, the parties are required to exchange mountains of paperwork, including confusing lien waivers.
Insolvency with the Buyer: Subcontractor default risk is explicit in the construction industry, and this is especially true in the current economic climate. Research cited in ENR, for example, expects contractor default rates to soar in the years ahead. To further complicate things, getting involved on a construction project doesn’t just put you at risk with a single contractor. To the contrary, any default by any of the tens or hundreds of contractors on the project can indirectly affect payments.
What Businesses Do To Combat Challenges and What Construction Industry Players Should Do
The Atradius report went further and inquired about what companies do to manage their credit and default risks, and here are the popular responses:
- 42%: Reserve against bad debts
- 24%: Send Dunning Letters / Payment Reminders
- 39%: Retain a collection agency
- 39%: Sell on cash terms
- 55%: Check Buyer’s Credit-Worthiness
- 55%: Monitor Buyer’s Credit Risk
- 42%: Diversify Customer Base
These are all expected responses. The playbook to combat credit and default risk is pretty mature, and managing a company’s credit risk and resulting receivables performance typically requires companies to pull one or many of these levers for results. The construction industry, however, is uniquely situated and challenged.
Sometimes, these listed items won’t apply. Selling on cash terms, for example, is very difficult in the construction business because invoices can be very large and almost always require payment “down the chain” to cover the expense. Further, checking and monitoring a buyer’s credit risk is not going to do much to insulate a party against the risk of non-direct parties elsewhere on the project. Finally, a dunning letter will do little to motivate a subcontractor to pay a bill they simply cannot pay because of a restrictive pay-if-paid clause.
In addition to many of these items not applying, the list is missing some tools available to the construction industry that is not generally available. The most obvious of these items are security rights. In specific response to the challenges and unique circumstances of the construction industry, everyone who supplies materials, equipment, or labor to a construction project has the right to secure their payment through a mechanics lien claim or bond claim. Another example is the joint check agreement.
Construction industry participants have unique credit management challenges. As per the above section, two of these unique challenges are payment procedure complications and insolvency risks.
There are industry-specific mitigation tools available to industry participants that specifically address these unique challenges. Joint check agreements, for example, offset the challenge of payment procedure complications. Security rights, like lien and bond claim rights, offset the risk of insolvency (read our Guide to Bankruptcy and Mechanics Liens).
It is foolish to not take advantage of these tools.
Get Paid Faster and Eliminate Bad Debt
Does that subheading sound good? After all, if you’re a financial professional in the construction industry in charge of receivable performance, this is your entire job. On the one hand, invoices need to get paid as fast as possible reducing the company’s overall days-sales-outstanding (DSO). On the other hand, the stuff that does age needs to get paid before it gets too old and requires a write off.
The statistic cited by Gary Stockton in his Experian Small Business Brief from the Atradius report that got our attention is that more than 50% of receivables that go over 90 days will eventually get written off. This is a shocking statistic for two very important reasons:
1. A lot of a company’s credit department and collections infrastructure is dedicated to collecting accounts that are 90 days overdue. That is a lot of collective energy, time, and expense dedicated to an effort that has a less than 50/50 chance of success; and
2. It’s really expensive to a company’s bottom line to write off so much of its receivables portfolio.
There are ways to get in front of this problem and stay in control of receivables performance…even in the construction industry. To read more on this interesting topic, check out our article: What Smart Financial Managers Know About Cash Management.