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The construction industry is credit-heavy. Almost all contractors furnish labor or materials on credit rather than requiring payment prior to delivery, despite the fact that these assets have substantial value.

This payment scheme extends throughout the payment chain; most companies extend credit and need a line of credit of their own. In many cases, the payment of a company’s own bills must be put on hold until it receives payment from the parties above it in the contracting chain. The further down the chain a project participant is, the more opportunities there are for hiccups or abuses in the payment process.

Money can slip through the cracks on construction projects in plenty of places. Also, payment can get delayed for many reasons. Because of the nature of the payment chain and the relationship among the parties, any minor inconvenience, delay or dispute about any component of the work can impact payment for everyone on the project, regardless of whether each party was directly involved.

Further, this payment environment can force companies to make difficult choices regarding which invoices to pay on time. If a company must wait for payment from parties higher on the payment chain, it may not have enough cash to float the invoices received from parties below.

Growth Can Be Dangerous
The new business opportunities presented by a growing economy are a welcome change from the recent stagnation in the construction industry. More business is generally good. However, it’s not all rosy news for construction firms. Subcontractor failure is three times more likely in a recovering economy than it is during an economic downturn, and this can put pressure on construction financial managers to be a bit more restrictive in extending credit to “risky” customers.

The easiest explanation for the increased number of construction business failures in an expanding construction economy is a cash crunch. The construction industry is cash-hungry, and subcontractors are generally expected or required to float substantial project costs. For companies that are not already swimming in cash, this payment system can be deadly if several projects are going on at one time. This presents a challenge not only for the construction company, but also for the firms that are attempting to manage extensions of credit to that company.

The stresses of the expanding economy result in riskier extensions of credit and the possibility of more write-offs. A prudent construction financial manager will take this into consideration by requiring credit checks and mandating the use of security to offset these risks.

Protections for Credit Extensions Can Be Confusing
Construction companies are in a good position to protect themselves from the possibility of non-payment. In many cases, security is built directly into the law in the form of mechanics liens or bonding requirements. The mechanics lien instrument allows contractors to secure extensions of labor or materials on credit with an interest in the improved property itself. Bond claims can provide a similar security.

However, on some projects, the available security is unclear or may not exist at all. Public-private partnerships (P3s) are rapidly gaining popularity—even to the extent that President Obama recently took steps to expand the market for P3 transportation projects. This trend makes it likely that more construction companies will be encountering P3 projects in the near future.

While there is no change in the underlying construction tasks performed on a P3 compared to any other construction project, the contractual obligations and rules and requirements regarding potential protection may be very different. For practical purposes, P3s are either private or public in nature. If the underlying project is determined to be private in nature, mechanics liens provide the available security. If the underlying project is determined to be functionally public, the security available is a bond claim.

Determining the underlying nature of the project is not the end of the road. If a mechanics lien is the appropriate remedy to secure an extension on credit, a separate question is raised: Is there a sufficient private property interest to which a mechanics lien may attach? In some instances, this project type can leave participants with no ability to secure their extensions of credit.

Financial risk-shifting clauses, changing project types, financial turbulence and high failure rates can conspire to make it difficult to manage credit in the construction industry. Wise financial managers can mitigate much of this risk by making sound and prudent credit decisions (by following a set credit policy structure) and by securing credit extensions to the fullest degree possible.

Scott Wolfe Jr. is CEO of zlien. For more information, visit www.zlien.com.

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