Construction contracting has huge income potential. Government infrastructure projects are most lucrative especially when the contractor lands many projects. Getting those projects off the ground, however, is a different story. That is because, like all businesses, construction contractors take a huge risk by funding their projects using cash from their reserves.
Financing is the key. Taking out construction loans for business keeps the cash within the company as well as preserves cash flow by stretching out payment terms. The construction financing industry also happens to be very diverse in its offerings.
Contractors can take out any of these 7 types of financing to fund their new projects and keep up with contractual obligations.
1. Purchase Order Financing
Purchase order financing is commonly used in e-commerce to fund huge orders. For example, an e-commerce shop receives an order for 100 bicycles. However, the shop only has 50 bicycles in stock and would need to build the remaining 500 units. For this, they will need to purchase raw materials to build the bicycles.
They send a request for materials to their supplier, but the supplier informs them that they don’t have enough credit to finance the full order. The bicycle seller then applies for PO financing from a lender to fund the remaining amount. The lender approves the application and pays the supplier for the rest of the raw materials and the bicycle seller takes delivery.
PO Financing can also be used in construction projects to acquire the needed materials. Like the example above, the contractor needs to secure a purchase order from its supplier and forward it to the lender. The lender will check the credit record of the contractor’s client, and approve the financing. The contractor purchases the materials, closes the contract and pays the lender back the money owed.
2. Business Credit Lines
Business credit lines are very practical sources of financing. It’s very flexible. More importantly, contractors with approved business lines of credit have a ready source of money they can use if they encounter cash flow problems.
Unlike traditional financing, business credit lines simply provide borrowers funds that they can partially or fully withdraw from as they see fit. If they have not used any of their credit, the lender will not compel these businesses to pay them anything. Moreover, they only pay for what they use. Borrowing will deduct the amount from the total credit line and still receive some funds for the business to use in the future.
Another advantage to a business line of credit is that it is a source of revolving capital. When you pay off what you’ve borrowed, that amount goes back to your account. So, as long as you faithfully repay your debts, you’ll always have funds accessible when you need them. It is similar to how business credit cards work but without the accompanying card.
3. Equipment Financing
Some projects may require the contractor to purchase a new set of equipment for specific tasks. Equipment financing can help contractors acquire the requisite hardware to start undertaking their part of the contract.
In equipment financing, a licensed moneylender will accept a vendor’s invoice from the borrower. This invoice shows the financer how much the borrower needs to purchase the utility. If approved, the vendor receives the funds directly from the lender. The vendor then informs the construction contractor to take delivery of the new equipment.
Equipment financing covers a variety of gear that the contractor will find useful in working on the project. These would include office supplies and equipment, computer hardware, and service vehicles in addition to heavy construction vehicles.
This form of financing also covers leases if the construction company does not see a long-term use for the equipment. If you just need money to cover the equipment costs, you can consider the better option of applying for title loans in Oklahoma or wherever you might live.
4. Accounts Receivables Financing
Construction companies rarely deal in cash payments. Instead, their agreement with their clients stipulates that the contractor will receive payment in terms. For government contracts, the government agency must pay the contractor within 30 days after the project commences and every month until the project finishes.
The 30-day gap, in the case of government projects, presents a cash flow problem for the contractor. They will need cash for their costs, but they have to wait 30 days until their first payment from the government. Accounts receivablefinancing can help fill in this gap and keep cash flowing in and out of the contractor.
Also known as invoice financing, accounts receivable financing forwards cash to the contractor that will cover its financial needs up until the first invoice is due. The invoices act as collateral against the loan, as they represent potential income that is yet to be realized under your contract. The lender will only look at the creditworthiness of your client in deciding whether or not to approve your application.
5. Contract Financing
Contracts are guarantees between two parties that they’ll consummate both their ends of the bargain. The commitment is a great asset to pledge against financing. This is because the presence of the contract assures the lender that the borrower will have a steady revenue stream that can support its financial obligations.
The contract also accelerates the approval process. This document contains everything about the project, from the expected costs to the expected revenues that the contractor will periodically receive. Lenders can quickly decide how much they can let the applicant borrow since the financing can only cover a specific percentage of the total contract.
Contract financing is commonly utilized to fund the startup costs of a project. They can be set aside to guarantee the salaries of the labor force for the duration of the contract. The money can also be used to purchase raw materials. In some cases, contractors also use these to purchase new equipment that will be assigned to the project.
6. Revenue-Based Loans
Revenue-based loans are an alternative form of financing that requires you to pledge a percentage of future income as repayment for the debt. Construction contractors can take advantage of this because a contract guarantees them a steady revenue of income throughout the validity of the contract.
When applying for revenue-based loans, borrowers present documents to the lender that shows the future income that they’ll be earning. This helps the financial institution gauge the creditworthiness of the borrower and their eligibility for this type of financing.
In the case of construction projects, contracts clearly stipulate the total contract value and the amount that the contractor invoices its client every month. The document simplifies the entire process for the lender and also raises the eligibility of the contractor.
7. SBA Loans
Small and medium enterprises have historically encountered difficulties when accessing financing. Most financial institutions find SMEs a huge lending risk because of their relatively low working capital. SMEs are also at risk of business failure within five years. The government saw through this difficulty and created the Small Business Administration Loans to bridge that gap.
SBA Loans offers at least $50,000 and up to $5 million of financing for qualified borrowers. Generally, contractors only need to satisfy the following criteria:
· They must fit the SBA’s definition of a small business.
· They must operate for profit and must be based in the United States.
· They must have operated for at least 2 years with relevant paperwork as proof.
Despite their name, SBA loans are offered by private lenders but are guaranteed by the government through the Administration. The government eases off some of the risks for the lenders, which translates to favorable repayment terms. Some loans can extend up to 25 years, but these products generally require collateral.
Key Takeaways
Construction projects will always need to seek financing. For businesses in general, it’s highly disadvantageous to pay in cash upfront. Doing so removes a significant amount from your cash reserves.
This leaves a huge hole in your cash flow, which will grow even bigger if you come across problems. This results in liquidity difficulties, especially if you don’t have many assets to convert to cash within reach.
Liquidity is the reason why businesses are encouraged to seek financing rather than pay cash. Construction loans provide the funds needed by the contractor. The company’s cash reserves remain within its reach and accessible in case a crippling financial crisis arises like the COVID-19 pandemic. Financing also stretches out repayment to several months and allows the construction business to preserve its current cash flow.
There are various types of financing available for construction projects. First, they could use their contract with their client to have a lender finance the project. They can also seek out loans against future income with accounts receivable financing, or the revenue-based loan. They can also use cryptocurrency for financing in construction.
If they need to purchase additional raw materials, they can use the contract again to have a financial institution pay for their purchase orders.
Despite their apparent advantages, financing could also burden a construction business. Construction contractors should always keep themselves informed about what types of financing are available, and what purposes can they be used for. This will be a big help in deciding later on whether or not to take a loan out in response to their circumstances.