Tackling bad debt in construction

For context, this figure represented an increase from the 561 companies in the previous quarter, and 467 in the last quarter of 2021. Bad debt, for those that don’t already know, essentially describes outstanding balances owed that are no longer deemed recoverable and must be written off.

Further confirmation of the scale of the problem came from Begbies Traynor’s Red Flag Alert report that showed more than one in eight companies in significant trouble across the UK in the fourth quarter 2022 were in the building trade. That figure made construction the third worst-hit industry for financial stress.

A long-term challenge

Stuart Green is Professor of Construction Management at the University of Reading and Chairs the University’s Environment and Sustainability Committee. He says that although the problem of bad debt has existed for decades, every government-sponsored construction initiative since the Banwell Report in 1964 has tried to implement fairer payment practices for smaller businesses in the construction sector, including retention payments. The result? “We're still talking about it in 2023,” he says.

“The causes of bad debt and cashflow stress among construction firms are many and varied, but in short, because contractors typically work on the credit provided by material supplier, most in turn try to operate on the money paid from the clients, and they try to operate by paying some contractors as late as possible,” says Green.

Indeed, faced with the realities of a stop-go economy, and an uncertain environment where projects can be cancelled or delayed with little notice, coupled with the vagaries of the competitive tendering process, large contractors have quite rationally reorganised themselves around a competitive model of structural flexibility, Green says. “In short, they now value the ability to expand and contract painlessly in accordance with fluctuations in demand. It’s a model that has proved successful for them but does put pressure on their suppliers.”

As Green points out, by adopting this model, large construction contractors have responded to the competitive landscape within the sectors in which they operate. “Given the demand uncertainty that they're faced with, and the recent cancellation of HS2 is a case in point, they're never quite sure what the demand's going to be,” he says. As a result, larger contractors will almost always prioritise their own cashflow needs and if that means not paying suppliers, then so be it.

"Standard forms of contracts are a good idea as they provide consistency of understanding and protect against the ‘bully boys’ in the playground"

Avoiding bad debt

For many construction firms, the best way to avoid bad debt is to focus on a smaller number of clients and work more closely with them. For some, if they happen to be key suppliers or subcontractors, with expertise that the main contractor can't source from elsewhere, they get treated better – and paid on time.

“For the other 80% where the subcontractor has expertise that can be sourced easily from elsewhere then why bother?” says Green. “Pay them as late as possible. If they go broke, it's not a problem, they can source it from somewhere else.

“However, to protect themselves, standard forms of contracts are a good idea as they provide consistency of understanding and protect against the ‘bully boys’ in the playground. What Tier 1 contractors tend to do is pass the risk of non-standard onerous clauses onto the supply chain. So ultimately, it’s the SMEs who do the actual work who suffer.”

Another one of the more promising ideas was of project bank accounts, where all the money for the project would be held in an independent bank account until completion. Unfortunately for those further down the food chain, the government rejected the idea earlier this year.

However, firms aren’t powerless in the face of bad debt risk. Here are five key tips to avoiding (and dealing with) bad debt.

• Get it in writing: a properly written, bespoke contract for the work carried out can be worth its weight in gold. While legal fees are by their nature an extra business cost, putting in place a watertight contract can save a lot of hassle further down the line.
• Know your customer: it might seem basic, but establishing a strong relationship with clients can mean the difference between prompt payment and debt that goes bad. In practice, face-to-face meetings, regular check ins both when engaged in a project and – just as important – in between jobs. Getting that contact and rapport going will inevitably stand you in good stead when it comes time to pay.
• Go digital: an up-to-date customer relationship management and accounts system can greatly improve the understanding of your debt and cashflow position. Just as payments to payroll and suppliers can be sped up and automated, so too can spotting and chasing late payments from customers. Digital accounting software can act as an early warning system for your business, helping you chase debts before they go bad.
• Sector-specific insurance: Construction insurance specialist, Markel, for example offer contract reviews and a debt recovery service to all their construction policyholders.
• Learn the power of ‘No’: it’s never easy to turn down work – after all, every business exists to serve clients, collect revenue and make a profit. But there are times when a judicious refusal to work with certain clients can help avoid bad debt problems. As for red flags, common sense should apply: does the customer have a bad record for payment? Are you unsure they’re going to stay in business long enough to pay you? Are other suppliers reluctant to work with them?

Bad debt is a significant challenge for the construction sector and taking steps to avoid it can save you a lot of pain as projects progress.