Construction financial processes historically have posed significant cash flow and working capital challenges for subcontractors, but a growing number of forward-looking general contractors are working to alleviate those pressures for their project partners.
The key is a combination of technology and financial innovations that alter the flow of funds in construction payments, enabling general contractors to exert greater control over when subcontractors are paid.
The longstanding challenge for subcontractors arises from the lengthy period of time between when they submit an invoice for work completed and the eventual payment of that invoice. In the intervening weeks – or even months – they still must fund expenses such as labor and materials for completed and ongoing work. Some recent statistics help quantify the challenge. According to the “2017/2018 Working Capital Study” by PricewaterhouseCoopers, the median days of sales outstanding (DSO) metric for engineering and construction was 84 days – the longest of any of the 17 major sectors studied.
For construction subcontractors, the cost of funding that working capital gap can be quite high, and financing may be difficult to obtain, particularly in light of increasingly unfavorable lending conditions for small and medium-sized enterprises (SMEs). In addition, pay-when-paid and pay-if-paid clauses in construction can compound payment timing challenges. Taken together, these factors can create cash flow difficulties that can dramatically impact working capital management for subcontractors.
On the other end of the supply chain, general contractors are constantly competing for dependable subcontractors, especially when the industry is flourishing. And the cost of a bad relationship can be high. When subcontractors fail, general contractors face a host of challenges, including project delays, costs associated with the work stoppage, complexities arising from efforts to replace the subcontractor and potential reputation damage. Such risks tend to increase in booming construction markets, as subcontractors may take on more work than they can handle, which can exacerbate cash flow struggles.
In response to this set of challenges, a growing number of general contractors – including some of the world’s largest – are turning to supply chain financing (SCF) to provide faster and more predictable payments to subcontractors using third-party funding. SCF techniques, which are widely used in a variety of industries, are now gaining ground in construction as well.
For example, Turner Construction is broadly rolling out its Accelerated Payment Program (APP) for subcontractors. Turner’s program leverages Oracle Textura payment management technology and a supply chain financing relationship to facilitate faster and more predictable payments to its participating subcontractors. The program has been well received, as it helps foster more of a partnership relationship for all of the parties down the value chain. Other general contractors offering similar programs include Alston Construction and KAST construction.
Defining Supply Chain Finance
In practice, SCF involves the use of financial techniques that help buyers to maintain or enhance their working capital position while, at the same time, enabling suppliers to improve their working capital and cash flow through accelerated payments.
In a construction SCF program, a general contractor works with a third-party funder to arrange payment of approved invoices on a specified date. Subcontractors who elect to participate receive their payments at an agreed upon time – much earlier than they otherwise would be paid – in exchange for a modest fee tied to the invoiced amount. Once the owner provides funding for the invoice payments, the general contractor repays the funding source.
Unlike traditional, bank-based small-business lending, which relies on the credit worthiness of SMEs like subcontractors, a SCF program leverages the credit position of the larger buying entities. This enables the smaller supplier companies to take advantage of rates generally well below what they could obtain on their own.
Despite the growing popularity of SCF in manufacturing, retail and the automotive sector, the complex and often-opaque nature of the construction payment process has inhibited its use within the construction industry. But that is changing as a result of technology that standardizes and automates the invoicing and payment process, increasing both efficiency and transparency and removing key risks. Such technology has made SCF a viable approach for construction industry participants, as funders have the data and confidence to know that construction invoices are investment worthy.
New Efficient Payments for Subs
All in all, SCF programs have the potential to help subcontractors access faster, more predictable payments, reducing their reliance on high-cost financing as well as improving cash flow and potentially strengthening balance sheets. Moreover, subcontractors can leverage faster payment to take advantage of their suppliers’ own early-pay discounts.
In tandem, contractors gain the benefit of stronger subcontractor relationships, competitive advantages and reduced risk of subcontractor default – which runs the risk of elevating project costs up to three times the originally forecast scope of work for a win-win on both sides.
Maximizing working capital effectiveness will be the hallmark of successful construction businesses going forward. With construction booming and finding qualified staff becoming a growing problem throughout the industry, a close working relationship between general contractors and subcontractors will become increasingly crucial for project success. As such, technology-enabled SCF programs should be considered a key tool to optimize working capital and position organizations for success across the supply chain.
