What is Construction Finance?
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FAQs about finance options in construction
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Construction finance refers to the variety of options available to contractors, suppliers, and other construction businesses to access capital (i.e. money) when they need it. This page provides an overview of the financing options available to construction businesses looking for additional sources of cash.
Why contractors need construction finance
Cash is king, as they say in construction. A contractor’s ability to manage their cash flow will spell the difference between success and failure. Contractors typically have large up-front costs that require them to burn through cash at the beginning of a project, well before the money starts coming in. This puts a squeeze on a construction company’s cash flow from the start.
Though necessary for different reasons, contractors need to boost their cash flow whether the economy is headed for a recession, or whether they’re ramping up for a construction boom. Both scenarios can put a strain on a contractor’s cash, for reasons outside of their own control.
Why contractors don’t need construction finance
While there are good reasons why a construction businesses needs financing, paying someone else to use their cash can be like carrying a bandaid into a battlefield. Often, a contractor’s cash flow problems aren’t the result of a poorly run business. Instead, poor cash flow in construction is often caused by extremely slow payments.
Construction has one of the longest days sales outstanding (DSO) of any industry. On average, payment delays in construction stretch to nearly 3 months, putting strain on a company’s ability to cover expenses, meet payroll, and get the job done.
And long payment delays aren’t just annoying – late payments actually cost construction businesses quite a bit of money.
Before you call a bank or factoring company, it’s important to get your accounts receivables in order. Take immediate and decisive action to get your invoices paid on time.
- Download: The 3 Steps To Get Paid Faster On Every Construction Project
- Instantly Clean Up Your Aging Accounts Receivables: A Fool Proof Plan
Construction finance options
Retained Earnings
Retained earnings refers to the profit that a construction business is able to put in business savings after each successful project. Financing new projects through business savings is the ultimate goal for most small construction companies. Ultimately, it can take years, if not decades, for a contractor or supplier to build up enough retained earnings to invest in growing their business.
- Pros: Using savings has very little cost to the contractor. It’s your own money – you don’t have to pay interest or other fees to use it.
- Cons: It requires significant time, discipline, and efficient business management to build up enough business savings to draw from.
Business Loan
When a contractor takes a business loan, they receive a lump sum from the bank or other lender. The contractor pays off the principal and interest over a period of time.
The US Small Business Administration (SBA) offers a variety of loan programs that are available to construction businesses that qualify. While these loans are typically available through traditional lenders, the SBA guarantees the loan. Generally, construction companies must meet the size standards set by the SBA, which depend on the company’s annual revenue.
- Pros: A business loan typically carries a lower interest rate than many other financing options.
- Cons: The contractor generally provide good financial statements that demonstrate low risk of default, and the loan often must be backed by collateral.
Line of Credit
A line of credit is a limited pool of money that your construction business can draw from as you need it. You can withdraw and pay back money as many times as you want; interest only accrues on the amount that you withdraw. If you have a credit line of $100,000, you can withdraw any amount up to $100k. A line of credit can either be secured or unsecured.
An unsecured line of credit will always carry a higher interest rate, because it’s not guaranteed by any collateral. A credit card is the most common type of unsecured credit line.
A secured line of credit typically comes with a higher credit limit and lower interest rate, because the lender can take your asset(s) if you don’t pay back the money you withdraw.
- Pros: Provides cash flow as you need it, so you only pay interest on the amount you use.
- Cons: Typically carries a higher interest rate than a bank loan; requires good credit score and financial statements.
Equipment Financing
Banks or other lenders issue a loan that uses the equipment itself as collateral backing it up. In this way, equipment financing operates like a car loan or mortgage. For construction companies, equipment financing may be used for heavy machinery, vehicles, tools, or pretty much any operational equipment that improves their workers’ productivity.
The more you want to finance, the higher the interest rate. Because equipment depreciates, banks don’t like to lend an amount equal to the full value of the equipment. However, there are some lenders that offer to finance 100% of the equipment value. More typically, the borrower will be required to put down a percentage of cash up front.
- Pros: Typically carries a low interest rate, since it’s backed by an asset; additional income from increased productivity can pay for the loan.
- Cons: Often requires a down payment up front; requires personal or business credit score; you could lose the equipment if you miss a payment.
Invoice Factoring
Invoice factoring in construction is a process in which you sell outstanding invoices or accounts receivable. Unlike collections, factoring is only available for invoices after they are issued but before they are due. Construction factoring can provide much-needed cash flow to contractors or suppliers up front, avoiding the long delay between invoicing and payment.
Invoice factoring is not a loan. This can be a selling point for a construction company that wants to avoid putting debt on their books.
Here’s how factoring works: The moment you submit a construction invoice to your customer, you sell that invoice to a factoring company (also called a factor). The factor pays you a percentage of the invoice’s value; typically in the range of 70-90%. After your customer pays their invoice, the factoring company takes their cut and pays you the remainder. The cut that goes to the factor is known as the factoring rate. In construction, it’s usually anywhere from 1-5% per month.
- Pros: No credit score required; no monthly payments; factoring company can manage your accounts receivable and collections processes
- Cons: Can affect communication with your customers, if they are not familiar with the process.
Read more:
- Learn more pros & cons of invoice factoring
- View all articles about invoice factoring in construction
Debt issuance
Debt issuance is typically only available to very large companies with several years of audited financial statements. To issue debt, the company will work with an investment bank to issue bonds or debt to investors.
Equity offering
Also known as a stock offer, an equity offering is also generally an option only for the larges companies with a long history of good financial management. In an equity offering, the company’s owner sells stakes in their company to investors in either the private or public markets.
