Contractors face widespread bonding requirements today. Not long ago, only the federal government required construction bonds; today, about a third of privately owned projects do as well. With tighter budgets governing projects everywhere, owners want stronger protections against contractor defaults. Some construction companies face the challenge of establishing a surety line from scratch, while others seek to maintain or increase their limits. Regardless, every contractor should be aware of the main areas that interest surety companies when determining bonding eligibility and capacity.
Profitability
With so many construction companies doing well today, why should a surety risk a bond for an unprofitable one? One bad year can sometimes be explained, but a construction company that loses money two years running, even if its net worth is respectable, raises a red flag in today’s surety market. Build up a sizeable reserve fund in the event of a bad year or a bad job.
One step a contractor can take to improve profitability is to decrease bonuses and control overhead costs. In turn, improved profitability increases stockholders’ equity, and the larger a company's stockholders’ equity, the easier it is to obtain bonding capacity and potentially less expensive bonds.
Net worth and working capital
Surety companies take a hard look at a bond applicant’s net worth. They generally discount assets that include risk, like aged receivables and inventory.
Sureties also look at how assets are allocated. A contractor may show a strong bottom line, but if its capital consists almost entirely of equipment and fixed assets, can it really fund a job? If such a company’s cash and credit line were to dry up, it couldn’t simply sell equipment to pay wages and other job costs, because then it couldn’t perform the job at all.
That’s why a surety company likes to see contractors with strong working capital (defined as current assets minus current liabilities). Current assets include cash, receivables under 90 days and some inventory — assets that can likely be turned into cash within a year — as opposed to property, plants, equipment and other long-term resources.
Working capital gauges a firm’s ability to finance its operations and indicates the level of protection creditors and surety companies can expect when they underwrite the firm’s operations.
In assessing a contractor’s working capital, a surety will often discount 30 to 50 percent of inventory. It won’t recognize prepaid expenses or officer or shareholder receivables.
Strong net worth combined with weak working capital is common, particularly for contractors like road builders with heavy investment in equipment. Sureties were once more flexible in bonding such firms, but most now insist on an adequate level of working capital.
While a surety looks for evidence that a contractor can complete a job, it’s also preparing for a bad outcome. If the bond is called, the surety intends to recover its losses with claims against the contractor’s assets, and it makes sure beforehand that there are assets at the ready.
Read our article about How to Get a Construction Bond.
Cash flow
Maximizing your cash on hand is a key to increasing your bonding capacity. Most surety losses are the result of a contractor’s cash-flow failure. Given cash or lending resources, most contractors can finish most jobs, even though they may take a loss. What stops them is a shortfall of cash and credit — in which case the surety must either step in and finish the contractor’s work, pay the contractor’s subs and suppliers, or both.
Cash flow isn’t just money in the bank; it’s also borrowing ability, so a strong line of credit with a bank is a plus. But keep in mind that interest-bearing debt — a fixed cost which must be serviced even if the market slows — is an unfavorable liability in a surety’s eyes.
A surety may use the following formula to calculate free cash flow:
(net income) + (depreciation, amortization and other non-cash items) – (principal payments on debt)
If this number is small and the balance sheet shows that the company is highly leveraged, the surety may reduce the bonding capacity of the contractor because of a concern about the entity’s ability to fund its debt service.
Work-in-process (WIP) calculations
Surety companies prefer to underwrite contractors who operate with accurate WIP estimates and steady work. Without accurate estimates being reflected in the company’s WIP schedule, the contractor will experience repeated gain or fade in job profitability for financial statement purposes. These gains or fades will cause the surety to question the contractor’s estimating ability, which could have a negative impact on bonding capacity.
A profit fade means the contractor recognized profit too early and must pay for it later. After a surety company bonds a contractor based on a solid financial statement, it doesn’t want to see losses showing up later. In fact, if one project manager has a habit of overly optimistic estimating, with resulting profit fading, a surety will notice his or her presence on a new project and discount the company’s bond-worthiness accordingly.
A general contractor might anticipate completing a million-dollar job for $800,000. If it incurs $400,000 in costs the first year — 50 percent of the total — it will recognize 50 percent of the total contract price as revenue, or $500,000. Accordingly, for that year, income minus costs produces a gross profit of $100,000.
However, what if next year at the job’s end the contractor’s total costs have mounted to $900,000? Its total profit on the job is now only $100,000 — which it has already recognized. The originally anticipated profit margin of $200,000 has now faded to $100,000, and the company will need to report this profit fade in the second year. Accordingly, the gross profit for year two will be zero, since 100% of the total profits on the job were recognized in the first year. In hindsight, the company should have only recognized revenue of $444,444 in the first year ($400,000 divided by $900,000 times the $1,000,000 contract amount) and the balance in year two.
Profit gains are less worrisome, and may merely register a firm’s conservative projections. But a construction company’s ability to accurately estimate work is critical, and steady WIP figures offer evidence of that strength.
A surety looks at charge rates, too. If a company charges a D8 bulldozer at $125 an hour on one job and $175 on another, a surety wonders why. The company’s WIP figure may be undervalued if it’s undercharging for equipment.
Overbillings and Underbillings
The percentage-of-completion method for recognizing income is required for most construction companies. This calculation determines whether a contractor has overbilled or underbilled on a project.
Overbilling has advantages when a job is going well. An overbilled contractor is either managing cash well — working on the owner’s capital instead of its own, saving money on interest — or building profit in the job that will show up as gain. But when a contractor is struggling, overbilling can indicate “job borrow” — using cash from one job to fund losses on another, which will show up eventually, too.
An underbilling means that a contractor has not billed the owner or general contractor enough based on the percentage of completion as reflected by the actual costs to date compared to the total estimated costs for the job. This could be a result of the billing cut- off as outlined in the contract. It may be an indicator that a job is less profitable than projected and that the gross profit could be overstated. Either way, underbillings can be a potential sign of poor cash management.
Whatever the cause, underbillings that reach 25 percent of working capital raise a warning to sureties, and the construction company should always be prepared to explain what caused them.
Read our article about Insurance and Bonding Basics.
Accounting for change orders and claims
A change order that adds $100,000 to a job can cause a contractor to recognize substantially more revenue. If the order was verbal, issued in the field in the rush to complete a job, and then the owner says it was never approved, the contractor may have recognized too much revenue, resulting in a profit fade.
Claims can raise concerns, too, particularly when a contractor approaches a new bonding agent. No surety is looking to pick up another surety’s problems.
Claims are standard in construction, of course, and surety companies look at a company’s experience over time. Still, a high number of claims going out or coming in may signal that a contractor has a history of problems with owners or suppliers.
Generally, contractors shouldn’t recognize revenue from their own claims against an owner until the claim is won. As for claims against the contractor, they represent liabilities that can reduce profit on the job.
7. Joint venture partners - When a contractor can’t find sufficient bonding, it should keep working on the issues that are holding things up. Meanwhile, it might consider a joint venture.
Some contractors can increase their effective surety limits by leveraging the strength of another firm, usually a larger one, in a joint venture. A company with untapped bonding capacity has something of value to trade with a smaller company that’s willing to pay fees or a share of profits for the opportunity to bid profitable work.
CONCLUSION
Preparing a company for bonding success is complicated — like the construction industry itself — and it requires a strong team.
Ascent Consulting has direct experience helping construction companies establish and increase their bonding capacity. If you’d like to discuss the surety environment and receive a confidential review of your own situation, please contact us here.
If you're ready to start working on your business, let's talk!
Ascent Consulting’s mission is to Build Better Construction Companies.
We are committed to delivering impressive results in the areas of
profitability, performance and growth.
No Response