Anyone in the building materials and supply industry knows that managing credit and debt is one of the company’s primary challenges. This is no industry secret, either. An enormous amount of materials are furnished to projects and contractors on credit, and as a result, the industry has one of the highest debt ratios (behind only banks!).
What is a debt ratio, and why is it important?
Debt Ratio is a financial ratio that indicates the percentage of a company’s assets that are provided via debt…The higher the ratio, the greater risk will be associated with the firm’s operation.
This chart comparing industry debt ratios is sobering for anyone handling credit and debt for a building materials company. Building material companies have an average debt ratio of 48.54%, which is nearly half its assets. Compare this to some other industries: Apparel 15.53%, E-Commerce 6.02%, Entertainment 29.07%, Information Services 22.20%, and so on.
High Debt Ratios Means High Risk
Everyone has heard the statistics about how easy it is to fail in business – any business. Only 47% of construction businesses continue to operate after just 4 years of business. The closure rate slows down after 4 years but doesn’t stop, and after 10 years only 35% of businesses are open.
Those in the building materials industry are particularly susceptible to insolvency and failure because of their high debt ratios. As explained in the above Wikipedia definition, the higher your debt ratios, the greater risk associated with your firm’s operation. The reason for the high risk is that the company has less room for financial error. A company with a lower debt ratio can take some bad accounts, but with a higher debt ratio, there’s just not enough cash to withstand credit blows.
The material building supply industry, therefore, is walking a tight rope. It furnishes materials on credit and is constantly leveraging its success on a calculated gamble that a certain percentage of its customers will pay their bills. With so many customers holding materials and owing the company money, however, there’s a high risk. As I’ve discussed in the past, even your great credit customers pose a significant risk.
Traditional Ways To Manage Your Risk On Outstanding Debt
There are a number of ways that building material companies mitigate their credit risk. Most have credit policies and credit managers who green light every single credit account. They require a mix of protections be put in place before supplying on the account. The protections required will vary depending on the credit worthiness of each client.
Here are some measures a company will take before shipping materials on credit.
1) Run A Credit Check
Getting each customer to fill out a credit application and then running a credit check on them is a necessary first step on every single account for your company, and it’s easy. Here is a great article from Inc. Magazine about how to run a business credit check. When reviewing these reports you want to confirm that the company actually has past credit experiences, that their credit is positive, and that their risk of default is low.
2) Getting Personal Guarantees
Some businesses will be so large and established that a personal guaranty is not required. The majority of small and mid-sized businesses, however, will pose a significant credit risk for your company even if their credit check comes back clean. For this reason you’ll want to seriously consider requiring personal guarantees from the owners before extending a certain amount of credit. Personal guarantees make your debt more collectible in the event the business runs into financial problems, but it’s not a perfect remedy. Plus, remember that getting the personal guarantee of someone with poor credit is not very useful, and so you’ll want to check the individual’s credit as well. Finally, other protections are warranted.
3) Joint Check Agreements or Letters of Credit
In some instances, the credit of the business and individual might be suspect. You want to work with these companies but you can’t put the company on the line based on their credit. In these circumstances it may be possible to explore a joint check agreement or letter of credit. A joint check agreement is an agreement with your customer’s customer (the party higher in the contracting tier) whereby they agree to put your company’s name on any checks to your customer. A letter of credit is a guarantee from a third party (usually a bank) that if your customer defaults, you can pursue payment directly from the third party.
Products That Help You Manage Credit Risk
The above-three “traditional” ways to manage credit risks are usually implemented by in-house credit departments. There are some products out there, however, that can help companies mitigate their credit risk. Credit managers have different tastes about which credit products are more valuable than others. In addition to these personal preferences, credit policies usually spell out when these additional products will be required and when the company will bear the entire risk of non-payment.
You can insure almost anything in our society, and that includes the risk that your customer might not pay. To use these products, you’ll open an account with a credit insurer. Each time you have a credit application you want insured you’d send it to the insurer and they will evaluate the customer. If they give you a green light to do business with the customer, you’ll be able to file a claim if the customer doesn’t pay. It’s as simple as that. Drawbacks include: (i) High premium costs for each account; (ii) The insurer will only green light companies with acceptable credit, leaving you unprotected for customers with bad or non-existing credit.
Check Guaranty Services
Check Guaranty Services work a little different from credit insurance services and are more commonly used by building material companies selling materials to contractors in a more retail environment. In these situations, the supplier gets payment for the materials immediately upon delivery to the customer at the company’s facility. They usually don’t know anything about the customer or anything about where the customer will use the supplies. In these instances, the customer pays by check and the building material company goes to a check guaranty service to have the check “cleared.” If the check clears with the service but bounces, the company can get paid directly from the service. Drawbacks include: (i) It’s not very useful for suppliers who supply on credit; and (ii) The high per-check cost (usually a percentage of the check amount) for the service.
Ultimate Credit Risk Mitigation With Lien Protections
Compliance with the mechanics lien laws, however, can virtually eliminate your credit risk without the drawbacks of the other credit products and precautionary measures. All of these credit precautions are important for the material building supply industry, but each have drawbacks. Further, at the end of the day, after all of these precautions are implemented there is still a significant credit risk. Compliance with the mechanics lien laws, however, can virtually eliminate your credit risk without the drawbacks of the other credit products and precautionary measures.
First, it’s important to consider how mechanics liens work and why they are so effective. This is important because a credit manager’s first instinct is to distrust any credit technique as bullet proof. Of course, that instant distrust is valuable, because there’s no such thing as a bullet proof technique, and yes, mechanics lien compliance has its vulnerabilities. It is, however, far and away more successful and guaranteed than the other products out there, and that’s because it’s so flexible in securing your debt and creating legal remedies to get you paid. Check out this article about the 17 ways a mechanics lien works to get your company paid.
Second, compliance is cheap and…with certain help…easy. Complying with the lien laws is as simple as sending your preliminary notices at the start of each project and then monitoring your deadlines to file your lien on time if you are not paid. The cost is low, and while the process of sending your notices out and managing which notices are due and when can be a nightmare, you can outsource your preliminary notice work to companies like Levelset, powered by Levelset and save tons of time and money.