November 2018

by Steve Winn, Marek Brothers Systems

Sir Donald Munger: Tell me, Commander, how far does your expertise extend into the field of diamonds?

James Bond: Well, hardest substance found in nature, they cut glass, suggests marriage, I suppose it replaced the dog as the girl’s best friend. That’ about it.

M: Refreshing to hear that there is one subject you’re not an expert on!

In this scene from “Diamonds are Forever,” M revels in James Bond’s lack of expertise on diamonds. Lucky for 007, his job did not depend upon his skills as a gemologist. As subcontractors, our jobs probably don’t either, but they do depend upon our skills in evaluating our general contractor customers.

Sometime in the 1930s, Robert Shipley established the Gemological Institute of America to provide formal training to jewelers and created the 4Cs of diamond quality as the best practices for evaluating diamonds according to standard factors.

These 4Cs are Color, Clarity, Cut, and Carat Weight. Using these factors, any diamond can be compared and properly valued on an objective standard allowing anyone from the hopeful romantic suitor to the apologetic husband currently residing in the doghouse to purchase a worthy stone with confidence that the price paid was in line with the market value.

Similarly, though it’s unclear who came up with it first, the credit industry developed its own 4Cs for evaluating potential customers for credit privileges. It would be prudent to stop here and define “credit,” because I lost count a long time ago of how many times a general contractor, when asked to complete a credit application, incredulously exclaimed, “Credit application?! You’re working for me. I should be checking you out!” “Yes, you should,” I respond, but that is a topic for later in this article. So we define credit as anytime we provide goods or services and do not receive payment before we leave. If we have to go back to the office and send out an invoice, that’s “credit.”

The 4Cs of the credit world are: Character, Capacity, Capital, and Conditions. The short definitions of these are:

• Character: The willingness to pay its debts.
• Capacity: The ability of a business to operate successfully.
• Capital: The ability of a business to pay its debts.
• Conditions: The global, national, local economic conditions, as well as those of the industry in which the business is operating.

There are other Cs that have been added over time, such as Collateral and [Insurance] Coverage, but generally speaking, the original 4Cs work well in separating the diamonds from the “not diamonds” from whom we might need some form of security. Any of these factors can be the most important factor to a creditor. It all depends upon what you’re selling and when.

I began my career in traditional credit, which is more cut and dried than what we see in the construction industry. The customer places an order, receives the product, and must pay within a fixed number of days or the debt is “past due.” With construction credit, we find a whole other level of complexity.

In the construction world, we sign subcontracts that have “contingent pay” terms. Their obligation to pay us is triggered when their customer pays them. Sometimes the operative word is “if.” We get paid if they get paid. In reality, we have based our right to get paid on whether our customer can do a good enough job so it can get paid by its customer. Who does that?! The only other group I can think of that uses contingent pay is the personal injury lawyer. Many of those like to go by the names like “The Hammer” or other tools (but why never “The Screw?”), but I digress. Safe to say, contingent pay terms put us in a unique group and we need to understand the various facets of these gems we call customers and how the 4Cs of Credit Evaluation are shaped by the uniqueness of our industry.

As said earlier, all of the 4Cs are important, however the priority of the 4Cs vary by industry and company credit policy. For the construction industry, each of these carries an additional C, which stands for “Customer.” Our customer’s customer to be exact. Much like contracts contain flow-down provisions, when our customer has a crappy customer, expect flush down economics ….

Here is how we rank them at our company, an interior finishes subcontractor:

1. Capital: Gotta’ have it. Capital is the blood that feeds the muscles (i.e. operations) so they can work and get stronger. A lack of capital doesn’t mean the muscles don’t get fed, but that blood (i.e. money) will be pulled from other areas (i.e. accounts payable), which is why it’s ranked No. 1. Sure we have laws mandating prompt payment and protecting construction payments as trust funds, but isn’t the best fight the one you avoid? Beware the cash-poor customers for they will treat your money like it is their money. Beyond the capital on your customer’s balance sheet, knowing the owner’s source of funds (or if there is a payment bond in place) for this project will help in evaluating the level of risk. Inclusions are dark spots inside a diamond that devalue it and dark spots on the balance sheet devalue our customers.

1. Conditions: We rank this No. 1 because the economic conditions in the world, our country, our community, and our respective industries affect us and they affect our customers. Sometimes to the good, sometimes to the bad. Some industries may be trending up, some may be waning. It could be something broad like oil prices or a specific player like an Enron. We have to respond accordingly to maximize sales and minimize bad debt. Since the construction industry intersects with all others, it’s best to keep in mind that not everything that sparkles is a diamond. We need to not only understand how our customers are faring in the current economy, but how their customer is, as well.

1. Capacity: Our customer’s ability to operate its business successfully directly affects its ability to pay us, so this must rank No. 1 on our list! This factor, though common to all industries, takes on aspects peculiar to construction. Our general contractor customers agree to performance obligations with the owner of the project, and we have based expectation of payment on the ability of our customer to successfully operate its business. Its failure to meet its obligations will, at minimum, delay payment, but could cost us severely in other ways like injuries, fines, production overruns, etc. How well do they schedule and coordinate the various trades? Is the job site clean? Do they place a priority on safety? Do they manage change orders timely and pay full value? Is their back office effective at billing and collecting? What quality of subcontractors do they hire? That cheap-rate sub might not have the same performance and safety standards that we follow. Do they have a reputation for quality? The answer to each of the questions can make the difference between finding a real gem of a customer or a real jam of a situation.

1. Character: Could there be a more important factor? That’s why we rank this C as No. 1 on our list. Early in my career, my boss helped me understand this when he said, “I’d rather have a bad contract with a good contractor than a good contract with a bad contractor.” I have found this to be true time and again. A man who has both money and bad character will find a way to keep his money, right or wrong. A man who does not have money, but has good character will find a way to get you your money, if at all possible. Some ways we can evaluate character in our industry is to read their contract. It’s not a deal breaker, but much is indicated about a company by this document and how they engage negotiating it, such as their sophistication, experiences, typical sector (commercial, residential, government, etc.) in which they perform, how fair and reasonable they are and their general modus operandi. Ask other subcontractors about this contractor’s backcharge practices. What was the bid spread for this project? Are they known for underbidding to get the job and then take it out of the subcontractors later? The answers to some of these questions could mean you have a diamond in the rough to help develop or just a rough character to avoid.

We rank every one of these Cs at the top because, like evaluating the value of a diamond, each quality carries an independent impact on that diamond’s (or customer’s) true value.

The 4Cs of Construction Credit—because the world of construction can be as hard as … well … a diamond. If we fail to take time to use them in evaluating our customers, we may find ourselves trying to dodge painful hits, in which case, I recommend learning the 5 Ds of Dodgeball!

Steve Winn is the corporate credit manager for Marek Brothers Systems. His career in credit spans 31 years, with over 29 in the construction industry. He has written several articles on credit management and contract negotiation. In his spare time, he works out, volunteers, and travels to developing countries building playgrounds for children who have never seen one.

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