What is construction factoring?
As a construction business owner, you know precisely how vital cash flow is. Keeping your construction business cash flow positive means everything. Even if you have a full order book, you can still get in trouble if you don’t have enough money coming in to keep your projects on track.
Most construction companies use a variety of financing methods to keep the cash flowing, and one of the options is construction factoring. Let’s take a closer look at what construction factoring is and how you might be able to use it in your business.
How Does Factoring Work?
Construction factoring might sound complicated, but the truth is, all it really means is that you sell some of your accounts receivable to a third party, known as a factor.
The factor effectively buys your invoices at a slightly discounted rate. They make their money by collecting those invoices and keeping the difference between what they pay contractors and the invoice value.
Sometimes, you can also get purchase order factoring; however, in most cases, the factor who buys your orders will charge you fees until the job is finished and the debt can be collected. This could be a problem if there are delays in getting the job done!
What Are the Benefits of Factoring?
If you have customers that you know are slow payers, and you build some extra markup into your quote to cover the cost of construction factoring, this is an excellent way to limit the time between completing the project and getting paid.
Usually, construction factoring is not based on your credit rating but rather on your customer’s credit rating. Since the company providing factoring is not going to be collecting from you, your credit does not really matter. This could be good if you have a newer business or your credit is not in great shape.
If you can get purchase order factoring, you can also use that money to buy products and services that you might not be able to get on favourable terms, which means you don’t have to use any of your cash reserves.
You also don’t have to worry about following up on invoices or collecting payments. Once you have sold the order or invoice to a factoring financier, they will do all the follow up until they get paid.
What Are the Drawbacks of Factoring?
Most factoring companies won’t provide financing for private clients and prefer to factor commercial purchase orders and invoices. However, you may be able to find one that is willing to work with private
clients, or if you work primarily for general contractors or developers, you could still factor those projects.
The cost of factoring can also vary a lot and will usually take a sizable percentage of the value of a project. So if you plan to use this kind of financing for construction projects, you should build the cost of the funding into your quote.
Unless you are preapproved to factor invoices and orders from certain companies or clients, there’s also no guarantee that you will be approved for this kind of financing. So you need to make sure that you get each customer you work for approved before you accept any orders from them.
How Much Can You Factor?
How much you can factor per invoice or order depends a lot on the factoring financier you are using and the customer whose orders or invoices you are hoping to factor.
Since the company who will be buying the order or invoice will base their decision on your client’s credit rating, if you plan to use factoring for their invoices, you should find out what will be covered before you quote any projects or accept any orders.
Do You Have to Factor Every Order or Invoice from A Customer?
No, you don’t have to factor every order you get or invoice you generate for any particular customer.
One of the nice things about factoring is that as long as your customers are approved, you can choose which projects you want to factor. If you work for a company that offers order and invoice factoring, you can also change your mind.
So if a project has taken longer than expected and it’s affecting your cash flow, you can choose to factor the invoice or even invoices for specific progress bills.
This means that you can choose to carry smaller invoices or orders for a customer and factor larger ones that you need to collect sooner.
Tips for Making the Most of Factoring
Construction factoring can be an expensive way to finance projects, so it’s best not to use it unless you need to.
Ideally, before you try factoring, you should try to negotiate better payment terms with suppliers or service providers. If customers typically pay their bills from you on a 30-day payment cycle, securing credit terms of 45 or 60 days will ensure that you get paid before you have to pay those bills.
You could also use other financial tools like taking a substantial deposit or charging clients for materials that are on site but not yet built into the work. This means they take ownership of those materials earlier, and you have the cash to pay your suppliers.
If you have to use factoring for larger projects, be sure to shop around before committing to a particular factoring service. The cost of factoring will differ from one company to the next, so you want to find out the best deal before signing any contracts.
Construction Accounting Is a Complex But Critical Part of Project Planning
Getting a large order from a great customer is exhilarating until you start wondering how you will cover the project’s upfront costs.
Construction accounting and the financial aspect of project planning is an ongoing process and one that you really need to stay on top of as your company grows. It’s not unheard of for fast-growing construction companies to fail despite a full order book simply because they outgrow their capacity to finance new projects. This leaves them open to penalties and other problems related to not delivering projects as promised.
So, if you’ve got a construction business that is growing fast but you aren’t great at financial planning, it might be time to speak to a commercial financial planning specialist. They can help you to plan for current orders, project future sales and costs based on historical data, and develop plans to finance your projects. Whether that means construction factoring or something else, having a plan in place before you need it is a very smart approach.
Always Plan Ahead
At CostCertified, we’ve found that even making seemingly minor changes – like using the right estimating software – can put your sales into overdrive.
We’ve had customers who have doubled or even tripled their year-on-year sales after they started using our estimating system. Of course, this is excellent news, but it often means you need to access more financing fast.
If you’re actively growing your business, it’s a good idea to research all your construction financing options, so you can find the right solutions and get them in place before you need them. That will leave you free to worry about other things – like how you’re going to get all that new work done on time!