When we note bad debts on our clients’ financial statements, we often hear about two classes of trade — contractors and small resellers. This month we’ll look at contractors and what you can do to reduce or eliminate bad debts from your contractor customers.
Contractors are a difficult class of trade when determining creditworthiness for several reasons. First, contracting companies come and go with the same owners under different names. Some contractors will declare bankruptcy one day and start a new company the next day, with the new company having a completely “clean” credit background.
Second, contractors use a different method for recording revenues and expenses on their financial statements than do most other classes of trade. Under this “percentage of completion” accounting method, a contracting company can look financially healthy one day and then be suddenly broke.
Third, contractors on some heavy construction jobs are often out of town firms where it is harder to get reliable “street” information about their condition.
However, with a little extra diligence by your credit manager, contractor risk can be managed effectively. Here are some suggestions to reduce your credit risk on contractor accounts:
- Application – Be sure to ask the principal’s name and any related companies. Ask if the owners have ever done work under any other business name. Try to find out if the owner has had any unsuccessful companies in the past where they have walked away from their supplier debts. If the company is solely owned, require a personal guarantee by the owner and check personal credit history.
- Financial Statements – Some quick comparisons of your major customers to these averages may help you identify potential weaknesses. However, in addition to providing the normal income statements and balance sheets to your credit manager, a contractor should also provide a schedule of completed and uncompleted projects.
In the “percentage of completion” method of accounting, costs and profits are spread over the term of a long contract based on the contractor’s estimate of total costs to complete the project. A contractor’s success depends upon his ability to estimate accurate costs on each project. By comparing the final costs (and profits) on completed jobs against the original estimates when the job was just started or bid, you can see if your contractor is accurate.
If your contractor constantly makes less money than anticipated, you could end up with a bad debt on your books. If he’s way over on some jobs and way under on others, this could be a sign of poor estimating ability and a high predictor of potential bad debt for you. If he constantly overestimates his costs and makes more money than he anticipates — great! He’ll always be profitable and you’re likely to always get paid.
The other item to consider and one that is unique to contractor financial statements is on the balance sheet. Contractors will have a “Costs in Excess of Billings on Uncompleted Contracts” asset and/or a “Billings in Excess of Costs on Uncompleted Contracts” liability.
The contractor with “Billings in Excess of Costs” has learned how to get a little extra cash up front from his clients. It means that he has billed more to date than he has completed on the project. This is good! Just be sure that he has this same amount or more in his cash accounts. If not, he’s already spent the money that will be needed in the future to complete his jobs.
A contractor with larger “Costs in Excess of Billings” is doing his customers a favor but not himself. It means he’s put more work into the project than he has billed. Why would he want to do this when money is so costly? He’s giving his customers an interest free loan!
A third item to check on the balance sheet is “Retentions Receivable.” Most long contracts call for a 5% – 10% withholding on progress payments until the end of the job to insure that the owner has recourse if the job is not completed properly. A reputable contractor should not have difficulty collecting his retentions if he is doing quality work. If it looks like retentions are being withheld long after job completion, be careful.
- Frequency of Credit Checks – Because contractors’ financial positions can change very rapidly, it is advisable to monitor their creditworthiness frequently. On any larger accounts, consider a quarterly review of their financials and credit history.
- Companies headquartered outside your area – Use extra precautions on out-of-state firms. Did they come to your area to do work because they couldn’t get enough jobs in their home territory? Is this the first time they’ve worked away from home? It’s easy to underestimate the extra costs of a long distance job.
With out-of-state firms, will there be any extra delay in receiving payment? If so, how will you be compensated for the waiting time to get paid?
- Good sources of contractor credit information – Most contractors work with a bonding company that insures their work. Bonding companies are usually reliable sources of credit information. By asking the contractor’s bonding limit and bonding fee, you can get a good idea of how the insurer rates your customer. (If you find bonding rates of 2% or more, you may have a higher risk company.)
You may find that your local credit group, such as NACM (National Association of Credit Managers) has a special contractor group which meets to trade info monthly. Send your credit manager if you have a significant number of contractor customers. Often these folks know when a particular contractor is in trouble long before it shows up on their financial statement.
