Once found mainly in federal contracts, bonding requirements have become more widespread and require significant financial discipline. Unlike a lender, which is concerned about a borrower’s overall financial stability, a bonding company focuses a company’s ability to perform on a specific job(s). The surety wants assurance that a job is on course with project estimates as to time, costs and estimated gross margin. In the short term, a surety will view a contractor’s job status schedule more importantly than the company’s overall financial statement.
Regular job schedules normally include: original estimates; actual billings, costs and revenue recognized to date; percentage of completion; and costs and profits in excess of billings.
Whether you need to establish a bond for the first time, maintain an existing surety line or increase capacity, it’s important to understand which indicators surety underwriters monitor most closely.
1. Liquidity and working capital. A surety wants to have an assurance that a contractor can finish a job, and the best candidates are those with adequate working capital. Working capital is a measure of liquidity and is measured as current assets — cash, current receivables and some inventory — minus current liabilities. Sureties and banks carefully monitor the value and quality of a company’s working capital as this measure reflects the ability of a company to fund its operations and is a good indicator of the shorter-term financial strength of the business. Managing and improving working capital is a critical task of financial leaders in every business.
2. Cash flow. Most contractor job defaults arise from weak cash flow. To increase bonding capacity, maximize cash flow and also establish a strong line of credit with a lender.
Sureties often calculate free cash flow as net income plus depreciation and other non-cash items, minus principal payments on debt. Too low a figure — especially if the contractor is carrying high debt — will reduce bonding capacity. Financial leaders need to continuously forecast cash flow (for a prospective period of at least six to ten weeks) and take steps to improve a company’s cash situation through improved financial management, operations improvements and financing activities.
3. Work-in-process (WIP). A surety and banker wants to see steady work, accurately tracked and estimated as opposed to wide swings of gain or fade. Substantial profit fade indicates the contractor either over estimated WIP or recognized revenue too early and will face the revenue shortfall sooner or later. Substantial profit gain is not as troublesome, but still brings into question a contractor’s ability to provide accurate estimates. Financial leaders need to ensure they have in place the systems, processes and disciplines to timely and accurately compute WIP, not only for the surety and bankers, but also for the business leaders as this is critical to overall project and company profitability.
4. Over billings and under billings on WIP. Some over billing is acceptable, but too much can mean a struggling contractor is borrowing from one job to fund another. A surety knows that deficit will show up eventually. Under billings can indicate poor working capital and/or project financial management. A contractor that has not billed an owner for completed work may have overestimated project gross profit. Under billings of 25% or more of a company’s overall working capital may raise red flags to your surety and bankers. Financial leaders need to ensure they have in place the systems, processes and disciplines to timely and accurately bill for work performed and to also ensure that contract cost estimates are accurate.
5. Backlog expressed as a percentage of overhead indicates whether a contractor has enough other work on hand to pay its expenses. Financial leaders need to ensure that there is in place the processes and disciplines to accurately forecast on a prospective basis revenues for projects in process and also expected revenues for closed projects not yet started, outstanding proposals and known opportunities.
Tips for Strengthening Bonding Capacity
- Break down large jobs. A surety that balks at a large contract may be more willing to write bonds for a series of smaller jobs. Contracts can often be broken down in this way without affecting a contractor’s profits.
- A joint venture can help some contractors increase their own surety limits by leveraging the strength of another larger company.
- Find the right surety. Look for a surety whose clients include companies similar to your own, and understand which metrics and ratios it considers most important.
- Communicate. Set regular meetings and deliver a clear stream of reports. If trouble appears, speak up. The surety understands that problems occur in construction, but it wants the facts early, not as a last-minute surprise. And don’t talk just with the local agent, but get to know the home office as well.
Strengthening a contractor’s bonding capacity should be a continuous focus. Leaders of contractors need to assemble a solid team with strong financial leadership. Harvest CFO Consulting provides leaders of contracting companies the highly skilled and experienced financial leadership at the right cost.