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How to manage credit risk in the construction industry

Reading Time: 4 minutes

Construction is Australia’s third largest industry, accounting for nine per cent of our total GDP. With $360 billion in revenue generated annually, investors rightly view building and construction as a source of highly lucrative opportunities.

The pandemic led to a boom in the construction industry, but it also saw many individual businesses struggling to maintain financial equilibrium. In the three months leading up to August 2021, building and construction companies entered external administration at a 16.7 per cent higher rate than during the same period of the previous year.

The construction industry carries the kinds of risks that are part-and-parcel of all large investments, as well as some that are unique to this field. In this article, we look at why so many construction companies have faced financial difficulties in recent times and what the risks are for creditors. We also share the best tools and strategies to help you protect your business from excessive credit risk.

Credit risk challenges in the construction industry 

There are more individual firms in building and construction than in any other industry in Australia, and most of them are small businesses. The COVID-19 pandemic has created delays and shortages across the board over the past two years, and the construction sector is no exception.

While larger businesses were able to fall back on their resources during periods of low productivity, the negative impact on cash flow proved too much for many small construction firms. Unable to meet overheads and absorb the hit to their bottom line, many small builders were forced into bankruptcy.

Reliance on Subcontracting

The industry is heavily reliant on outsourcing, with subcontractors performing 80-85 per cent of all construction work in Australia – the highest rate of subcontracting for any industry in the world. The work – and therefore the capital – flows from developers to suppliers to contractors to subcontractors. The more stakeholders involved in a project, the more chances there are for payments to be delayed at various points along the chain.

Poor Project Management 

While all stakeholders on a construction project are in theory working towards the same goal, they are also distinct businesses that will ultimately put their own interests first. A contractor might choose subcontractors based on personal relationships or simply award the contract to whoever provides the lowest bid, regardless of whether they have the credentials or experience to complete the work to a high standard.

Weak financial management and subcontractor insolvency 

Perhaps the biggest issue of all is subcontractor insolvency. With so many construction firms bidding for a limited amount of work, the market is highly competitive. Builders who are desperate for work might misrepresent their financial capacity to complete a job or enter an unrealistically low bid to win a contract.

Construction projects often require the subcontractor to cover significant costs out of pocket before receiving payment. Inadequate cash flow, excessive debt, and poor financial management can lead to outstanding payments. Credit defaults can push these subcontractors into receivership before they are able to complete the job, resulting in bad debt.

Contractors may also engage in illegal phoenixing, a common problem in the construction industry. This is where the company directors liquidate the business and set up shop under a new name to avoid debts and liabilities.

The solution: due diligence and credit checks 

Fortunately, there are ways to protect yourself against bad debt. Risk cannot be eliminated altogether, but it can be significantly mitigated by performing the due diligence of credit checks to know who you are getting into business with.

CreditorWatch uses an advanced suite of tools and features to assess creditworthiness and calculate the likelihood of a company defaulting in the next 12 months. Far more comprehensive than your average credit score check, we use AI-driven automation to analyse data from an extensive and diverse database to produce an accurate, actionable assessment of credit risk.

Financial Risk Assessment 

Carrying out credit checks before you engage a contractor or subcontractor is the first line of defence against credit risk. We draw from over 50 public and private data sources, including our own customer base of over 55,000 registered businesses, to produce in-depth business credit reports. Our system identifies indicators like payment defaults, court actions, and debt collection records to let you know that you may be dealing with a high-risk entity.

Our Director Due Diligence feature goes beyond the registered business name to look into the people behind the company. This alerts you to cross-directorships and identifies cases of illegal phoenixing.

Monitoring and Alerts 

A company’s financial position can change quickly, even if they show no signs of risk during the initial credit check. Our ongoing credit monitoring feature provides you with real-time alerts of adverse behaviour. You will be notified of any suspicious activity or changes to your debtors’ financial health that could impact their ability to meet obligations.

Proactive Debtor Management

Chasing bad debts is expensive and time-consuming. DebtorLogic is an interactive trade program that analyses your Aged Trial Balance (ATB) to identify credit risks early on.

DebtorLogic analyses over 11 million trade lines from corporate ATBs, Xero and MYOB data and alerts you to deteriorating payment behaviour in your portfolio. Once a risk has been identified, you can update your credit policy and adjust your payment terms to help you get paid faster and stay ahead of bad debt.

Practice Smart Construction Lending with CreditorWatch 

The construction industry is rife with stories of financial mismanagement, irresponsible lending, and dodgy directors, but these problems aren’t unavoidable. With the advanced features on offer from CreditorWatch, there’s simply no reason for you to become another cautionary tale. Call our Customer Success Team on 1300 501 312 and find out how you can start protecting your business.