C-Suite Professional

Mitigating Financial Risks in Construction: Signs of Potential Fraud or Financial Trouble

Among new construction companies, 43% have failed in the last five years. Economic downturns and pandemic concerns added to challenges, but delays, cost overruns, and poor planning are cited as the main culprits. The Bureau of Labor Statistics (BLS) shows that just 26% of construction companies make it to their 10th anniversary and just 17% live to 20.

It's hard work and takes a skilled operator to pull things together consistently to build a sustainable business in an industry that requires heavy investments in capital assets and is notorious for late payments, defaults, and cash flow problems.

What Are the Financial Risks in Construction?

Managing accounts receivable in the construction industry, guarding against fraud, contractor compliance management, and balancing tight margins are significant sources of risk.

Tight Profit Margins

The average profit margin in the construction industry is about 6%. While some have significantly higher or lower margins, there's not a lot of room for error. Mistakes in project management or unexpected challenges can erase margins quickly.

Margins are also stressed when there's competitive bidding involved as construction companies have to slim margins to win bids. Strict cost controls, active management, and efficient operations are critical to success.

Cash Flow Issues

Cash flow management presents one of the most significant challenges in construction. The gap between when you have to spend money and when you get paid can stretch for months, creating significant working capital pressure.

Progress payments help, but still lag behind your expenses, requiring companies to maintain substantial cash reserves or credit lines to bridge the gap. Additionally, retainage practices, where clients withhold 5–10% of payment until project completion, can further strain cash flow.

Accounts Receivable and Collection

Even if you have an efficient process for handling construction accounts receivables, it can take a long time to get paid, which takes an average of 83 days after an invoice is sent. One survey of construction companies reported that 100% of those surveyed reported late payments despite active attempts to collect.

Slow pays are common and add up quickly. One estimate is that slow payments cost the U.S. construction industry $280 billion in 2024, accounting for about 14% of all construction costs.

Accounts receivable in the construction industry require due diligence to avoid potential defaults and vigilance to keep cash flowing. When payments lag, it can ripple across the entire project chain, affecting suppliers and subcontractors, often forcing taking on debt or additional credit to cover the funding gap.

Mechanics liens provide some level of protection, but enforcing them typically damages any chance at ongoing work or good client relationships.

Cost Overruns

Despite best efforts, there are often unknown variables going into construction projects, where 90% of projects experience cost overruns, with an average of about 28% above projections. Price volatility in material prices, inflationary costs, and rising labor prices (and labor shortages of skilled workers) make budgeting increasingly challenging.

Add in weather delays, supply chain disruptions, and potential tariffs on needed supplies, and your overhead costs can jump rapidly.

Funding Difficulties

S&P Global says financial risks for construction companies remain elevated, seeing more downgrades than upgrades when analyzing companies. As banks tighten lending standards, and interest rates stay high, poor financial performance can hurt your ability to fund projects. This means skipping out on projects that could build your portfolio and bottom line due to a lack of funding.

Fraud in Construction

Unfortunately, fraud remains a serious concern in the construction industry. The 2024 Occupational Fraud report by the Association of Certified Fraud Examiners (ACFE) reports that corruption, bribery, fraudulent billing, payroll padding, and more are common—with a median average loss of $250,000 per incident.

Contractor Compliance

Maintaining proper licensing, insurance, and bonding represents a significant ongoing requirement. Poor contractor compliance management can result in project delays, legal issues, and financial penalties.

Companies must regularly verify contractor credentials and maintain proper documentation to protect themselves from liability. Ensuring contractors comply with project deliverables and quality is critical as well in compliance management for contractors. It's your reputation on the line.

What Is the Biggest Complaint About Contractors?

Clients complain about contractors failing to show up, doing a poor job, or not meeting deadlines. For construction companies, the biggest complaint is typically payment disputes.

These complaints often stem from poor communication and unclear expectations. Successful contractors implement robust communication systems and detailed documentation procedures to prevent misunderstandings and protect themselves from disputes.

How to Mitigate Financial Risk in Construction

Mitigating financial risk in construction requires proactive strategies, due diligence, and strong financial controls. Construction companies must assess risks before signing contracts, actively monitor financial health, and implement fraud prevention measures.

Due Diligence Before Signing Contracts

Before you sign a contract with a client or contractor, make sure they're in a good financial position to pay their bills. Reviewing a company's credit history can reveal past financial problems, late payments, or a high debt burden, which may signal risk.

Business credit reports can provide you with a snapshot of the payment history, current financial position, and projections on future financial health. Warning signs that indicate potential problems include:

• Frequent Lawsuits: A history of litigation or unpaid subcontractors could indicate financial distress.
• Erratic Payment Patterns: A business struggling to pay its bills on time may struggle to pay you.
• Declining Revenue Trends: Financial statements showing decreasing revenues or increasing losses could be red flags.
• High Debt-to-Equity Ratio: A company overly reliant on debt or credit utilization may have trouble sustaining operations.
• Negative Industry Reports: Researching industry news can help spot companies facing financial trouble or bankruptcy risks.
• Public Records: Bankruptcies, liens, and judgments can severely hinder a company's ability to pay.

All of these can impact your construction accounts receivables negatively.

Clear Contracts and Timelines

A well-structured contract helps protect your business from financial disputes and payment delays. While it may provide limited protection against defaults, it can help resolve claims more quickly. Best practices include:

• Defining clear payment terms, including progress payments and retainage policies.
• Establishing penalties for late payments or non-compliance with project timelines.
• Including a detailed scope of work, change order procedures, and dispute resolution mechanisms.

Monitoring Contractor Performance

Contractor compliance management should go beyond legal and regulatory items, including performance monitor to maintain quality standards and ensure project completion—both of which can cause significant problems for your construction company if they fall short.

Best practices include:

• Conducting frequent site visits to evaluate work progress and adherence to project specifications.
• Establishing KPIs, such as deadlines met, budget adherence, and safety compliance.
• Using construction management software to track project milestones, workforce productivity, and financial status.
• Holding regular meetings with contractors to address issues early and ensure alignment with project goals.
• Implementing systematic quality control measures to verify workmanship and material compliance with industry standards.
• Releasing payments based on verified completion of project phases to encourage accountability and minimize financial risk.

Active Account Monitoring for Changes in Financial Health

You reduce your financial risk when you do your due diligence upfront, but a lot can change during construction projects. Contractors and subcontractors that looked to be on solid footing can lose their way—causing you problems downstream. Active account management and monitoring are crucial to avoid changes in a client or contractor's financial health becoming your problem.

Construction companies should:

• Regularly review client and contractor credit reports for changes in risk profile.
• Monitor accounts receivable aging reports to detect payment delays.
• Track market trends and economic conditions that may impact project funding or financial stability.
• Consider account monitoring services to automatically flag items of concern.

Ongoing Portfolio Management to Mitigate Risk

Tracking specific accounts is important, but so is balancing risk across your entire project and credit portfolio. Every company has its own tolerance for risk, and you need to make sure that your portfolio meets your threshold. Taking on one bad client or contractor can throw your entire risk profile out of whack and expose your company to significant financial risk.

Signing up for credit portfolio scoring and risk management services can help. These best practices can also help you avoid risk:

• Balancing project sizes with a mix of small, medium, and large projects helps manage risk if one fails.
• Working with multiple clients to avoid reliance on a single source and preventing financial dependency.
• Maintaining adequate cash reserves to ensure liquidity to support bridge payment gaps.
• Using performance and payment bonds for financial protection if a contractor defaults.

How to Protect Against Contractor Fraud

Fraud prevention requires strict internal controls, background checks, and ongoing vigilance. Strategies include:

• Conducting background checks on all contractors and suppliers.
• Implementing dual-approval processes for payments and contract changes.
• Regularly auditing invoices and payroll records to detect fraudulent activity.
• Using secure digital payment systems to track financial transactions.
• Encouraging whistleblower policies and anonymous reporting for employees.

What Are Examples of Fraud Prevention Control in Construction?

Construction companies can help safeguard themselves against financial fraud by instituting a few key measures.

Monitoring Project Costs, Budget, and Contractors

Regular monitoring of your projected costs vs. actual expenses can help you spot fraud. You should investigate any variances, especially when it comes to contractor hours. Inflating hours beyond the scope required is common.

Invoice Verifications

Billing fraud makes up 38% of all fraud cases in construction projects. False, inflated, or duplicate invoices are prevalent and not-always-accidental.

Cross-check invoices with work orders, contracts, and change orders to prevent overbilling and duplicate payments.

Segregation of Duties

Different employees should handle financial transactions, approvals, and audits. This reduces the risk of fraud and a cleaner audit trail in case of disputes.

What to Do if You Are Scammed by a Contractor

If you suspect fraud, take immediate action:

• Gather Documentation: Collect contracts, invoices, payment records, and communication logs.
• Notify Authorities: Report fraud to law enforcement or relevant regulatory bodies.
• Pursue Legal Action: Consult an attorney to explore civil recovery options.
• Alert Industry Networks: Warn other businesses to prevent further fraudulent activity.

Frequently Asked Questions About Financial Risks in Construction

Should a contractor be licensed, bonded, and insured?

Always. A licensed, bonded, and insured contractor protects your business from financial liability, ensuring compliance with industry standards and regulations. You might save a few bucks using contractors who don't have the right credentials, but you're putting your reputation and business at risk.

How can I find a good licensed contractor in the United States?

Verify licenses through state licensing boards, check references, review past project performance, and ensure they carry adequate insurance and bonding. Referrals and references are your best bet, talking directly to their clients and customers to hear first-hand about how projects went.

What are typical payment terms in construction accounts receivable?

You can set terms however you want, but the most common payment terms are:

• Net 30, 60, or 90 requiring payments due within 30, 60, or 90 days of milestones or completion.
• Progress billing that requires payments at key stages of the project.
• Reserving a percentage of payment is withheld until project completion.

How can construction companies improve their accounts receivable collections?

There are a few key steps, starting with ensuring you're dealing with others who have the financial means to pay and pay their bills on time. Pulling an on-demand business credit report can help you evaluate their financial ability and payment history.

Contracts should have clear payment expectations, including lien rights where relevant. Making sure you invoice promptly and stay on top of A/R collections also makes a big difference. When things fall through the cracks, payments get delayed.

How often should contractor compliance be reviewed?

Regular contractor compliance management checks should be conducted before contract signing and throughout the project to ensure ongoing adherence to legal and financial standards.