As most supplier companies can attest, payment terms are lengthening across virtually all industries as buyers look to make the best use of their working capital. That’s certainly true in construction, where the trend toward longer payment terms by project owners is especially challenging for the subcontractors who perform the work on projects. But a new breed of technology-enabled supply chain finance (SCF) programs are helping the construction industry come to grips with this problem.
The working capital challenge for construction subcontractors is multi-faceted and stems from factors beyond the trend in payment terms, including traditional industry financial processes and an increasingly unfavorable credit/financing landscape for small and medium-sized enterprises (SMEs).
Because of the traditionally long and uncertain payment waiting periods for construction subcontractors, their expenses for project work, such as payroll and materials, are outlaid long before payment is received for that work. Pay-when-paid and pay-if-paid clauses in construction further complicate payment timing challenges. This situation creates cash flow difficulties that can dramatically impact working capital management for subcontractors.
Lengthening payment cycles have far-reaching effects. Subcontractors, already facing an increasingly difficult lending environment, could be pushed toward expensive, short-term funding options to cover their working capital gap – with financing costs often then included in subcontractors’ bids for work. In addition, there’s the increased risk of subcontractor default resulting from an inability to effectively manage working capital. It’s worth noting that such risk tends to increase in periods of economic recovery or growth, as the ready availability of work can prompt subcontractors to take on more business than they can support.
So what’s the answer? One promising solution involves taking a cue from numerous other industries and turning to supply chain finance as a way to optimize working capital management for all stakeholders in the construction payment process.
Many sectors, from aerospace to consumer packaged goods, for years have leveraged SCF techniques to address many of the same issues that complicate financial management for construction subcontractors. In simple terms, SCF enables buyers of goods and services (in construction, the general contractors) to maintain or enhance their own working capital while also improving the working capital position and cash flow of their suppliers (i.e., subcontractors) through accelerated payment.
In a construction SCF program, a general contractor works with a third-party funder to arrange payment of subcontractors’ approved invoices on a specified date. Subcontractors who elect to participate receive their payments at an agreed upon time – and much earlier than they otherwise would be paid – in exchange for a modest fee. Once the owner provides funding for the invoice payments, the general contractor repays the funding source.
Fig. 1: Supply chain finance process flow
By enabling faster, predictable payments, SCF programs can be a source of cost-effective working capital that can improve cash flow and reduce financial strain for subcontractors. In addition, the use of SCF techniques in construction can strengthen subcontractor balance sheets in another way. Unlike bank loans, accelerated payments are not debt and thus won’t add to financial liabilities. This benefit can enable growth and diminish the risk of capital challenges impacting a subcontractor’s ability to complete work – and the general contractor’s ability to deliver a problem-free project on time/budget.
Subcontractors have welcomed such programs, noting a range of business benefits.
We earlier noted that SCF seems like an obvious solution to working capital challenges in construction. Why, then, has SCF not previously taken hold in the industry? The answer, in large part, is risk. The third-party funding entities that make SCF programs possible have shied away from construction due largely to the industry’s historically complex (multistep/multiparty), opaque and inefficient payment processes, and litigious nature.
Technology, however, has changed that. The development of robust payment management solutions has transformed construction payment processes in ways that allay the concerns of SCF funders. With the right technology, processes become efficient, standardized and transparent. Importantly, with this change invoices become “clean” fundable assets that SCF providers can be sure are free of liens, opening the industry to a new source of much-needed innovation – and funds.
Major players in the construction industry have begun to recognize the power of supply chain finance. Turner Construction, the largest commercial builder in the United States, launched an SCF program that is supported by technology from Oracle Construction and Engineering. In addition, national builder Alston Construction and South Florida-based construction firm KAST Construction are among the companies that have recently joined Turner in launching programs of their own. Executives from these general contractors recently spoke at Oracle Industry Connect, describing the benefits of SCF programs to their organizations and to their subcontractors.
The upward creep in payment terms and the challenging traditional finance environment show no signs of letting up. Given that, there is opportunity for forward-thinking leaders to embrace supply chain finance programs and unlock significant business and competitive benefits for all construction project participants.
This post was authored by David Kelly, who is vice president of client services for Oracle Construction and Engineering.