Sureties evaluate your business using the four C’s of surety credit: Capital, Capacity, Character and Communication. In its evaluation of your Capital the surety will take a hard look at your company’s financial strength using a variety of ratios, benchmarks and other measures. Here are nine of the more common ones for your attention:
Can you meet your short term obligations? Do current assets (primarily cash and receivables) exceed current liabilities (primarily accounts payable, payroll liabilities and current debt)? A surety will want your company’s current ratio (current assets divided by current liabilities) to be greater than 1.0.
Also, having a high portion of retention receivables can be concerning as retentions are not considered liquid until released.
Return on equity, which is net income divided by equity, is a good measure to see how effectively the company is using its invested capital. Return on assets, which is net income divided by total assets, is a good measure to see how effectively the company is using its asset base. A surety will look for consistency in these ratios. Additionally, these are good to benchmark against similar companies to see how your company uses its resources compared to others.
The higher debt load a company has, the larger the risk to its creditors, including the surety. Debt to equity equals the total liabilities divided by total equity. Generally, a ratio of 3.0 or lower is considered acceptable.
A surety can be concerned when underbillings exceed 25% of a contractor’s working capital balance or jobs that are more than half complete have significant underbillings. These can be indicative of less profitable jobs or poor billing practices by the contractor.
Line of credit
Sureties typically provide bonding capacity based on the working capital of the company, including the availability of the company’s line of credit. If the company has little available borrowings on its line, it will cause the surety concern that the contractor does not have ready access to funds should cash flow slow down.
Another item the surety will want to see is the backlog of the company. This consists of the remaining work to be performed on construction contacts in progress as well as signed contracts that have yet to start. A surety will need to see the company has enough profitable work to be able to cover its overhead but not too much as to spread the resources of the company too thin and have the surety take on too much risk.
Also, the surety will want to see the contractor is not overextended in its operations. A ratio of costs to complete of open jobs divided by equity should not exceed 10 times.
Supplemental Schedules - Closed and Open Jobs, G&A
One of the most critical items to provide your surety is the schedule of contracts. The work-in-process schedule outlines the estimated revenues and costs and provides a snapshot of where the job is at for progress and profitability. The closed job schedule gives a good comparison to see how jobs finish compared to how they were originally estimated. Sureties like to see consistency in these numbers as it gives them confidence in the contractor’s ability to estimate its jobs.
Nonfinancial Criteria, Reputation, Word on the Street
The construction industry is large; however, it tends to be a closely connected group due to the overlapping relationships of general contractors, subcontractors, project owners and services providers, including those involved in surety. Rumors of slow payment of subcontractors, problem jobs, disagreements with project owners can make their way around the industry. Sureties pay attention to this “word on the street” and will follow up to be certain they are mitigating their risk.
Equally important is providing the surety with timely financial statement information. This provides them comfort with the contractor’s ability to use its financial information to run their business and that the contractor take timely communication with its surety seriously.
Though the saying “cash is king” is cliché in the construction industry it is profoundly true. Sureties need adequate collateral to cover their risk should the contract run into trouble. The surety has substantially all of the assets available to it as well as those covered in the personal guarantee of the owners. Having adequate cash in the company decreases the likelihood the contractor will run into problems. Sureties can be concerned when all available cash is stripped from the company by the shareholders for their personal expenditures. Maintaining a good balance of cash in the company gives the surety comfort in the financial strength and corporate governance of the company.
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Brian Tunnelle, CPA, CGMA, MBA, CCIFP
Brian Tunnelle has more than two decades of experience in auditing, accounting and consulting for a wide range of companies with particular expertise in the construction industry. Brian’s areas of expertise include financial statement engagements, transaction financial due diligence, agreed upon procedures, employee benefit plan audits and general business consulting. Contact Brian at [email protected] or 714.671.2214.