A surety bond is a guarantee of a contractor’s performance. If a contractor fails to perform under a construction contract, the surety pays the owner for the damages (or provides some other remedy). In turn, the contractor is obligated to reimburse the surety company for these payments. It is because of this relationship that a surety bond functions like a credit guarantee.
Since the surety assumes significant financial responsibility if the contractor fails to perform, it scrutinizes the financial statements, along with the experience and the character, of the contractor. The surety, in most cases, will not provide bonding for a contractor that that they believe will not have the ability to repay.
In a survey of sureties performed by Grant Thornton, the top three criteria for obtaining credit were all financial statement-related. This is why it is important to know what the surety will look for in the financial statements and what can raise concerns during the bonding determination. Here are some financial statement items to be aware of that could attract negative attention in the mind of the surety.
Excessive Job Borrow
Overbillings, while generally considered good cash flow planning, can also raise questions when excessive. A surety will review these on a job-by-job basis. The job borrow calculation (below) considers overbillings and the total estimated gross profit of a job and is a good indication to the surety of how the contractor is managing cash flow on a job. Excessive overbillings can cause the surety to question whether the contractor will have enough cash on hand to finish a job. Job borrow that is too high in relation to cash on hand is generally a red flag for most sureties.
Job borrow = overbillings – total estimated gross profit
Property and Equipment
The surety will want to know if the contractor is properly equipped to perform the job it has been asked to bond. They will also want to know what plans are in place to acquire equipment if need be. Excessive underused equipment, especially if it is still under lease, can have a negative impact on working capital and liquidity. Also, any land carried on the balance sheet, but not used in operations, may raise questions from the surety as to its purpose (i.e. development or expansion).
Underbillings can be a major red flag to sureties. Underbillings, in the same manner as overbillings, are normally analyzed by the surety on a job-by-job basis. While some amount of underbillings are usually acceptable, excessive, chronic or significant underbillings can signal issues with collections and thus, cash flow.
Sureties will want explanations for these items, as underbillings could also signal to the surety that a contractor is attempting to hide losses. If no support or reasonable explanation can be established for these underbillings, the surety may discount them, or if underbillings are greater than twenty percent of equity (from the American Institute of Certified Public Accountants), they may eliminate them from their calculation of working capital.
Short and Long-Term Debt
Short-term debt that is heavy or excessive, especially if it is due to significant accounts receivable or underbillings, can have a negative impact on the surety’s perception of a contractor’s operations. Drawing on a line of credit because of receivables or underbillings can give the surety the impression that the business is undercapitalized. Being viewed in such a manner can cause credit to be restricted, or in some cases, cut off.
Long-term debt can also signal to the surety how well the business can stay afloat. The surety will want to have a level of comfort with the company’s ability to service long-term debt. If there is a problem in this area, the contractor will need to evaluate ways to address the issue, such as generating more revenue, cutting overhead, etc., before being questioned about it by the surety.
Significant Profit Fade
Sureties will look to see if there is any significant profit fade in open job schedules. For instance, a job that showed an estimated profit of $150,000 on Year 1 financial statements but actually ended with a profit of $80,000 on Year 2 financial statements would be considered as having significant profit fade. Again, the surety will analyze this on a job-by-job basis and will note this as a reflection on the company’s ability to control job costs, or more importantly, consider it an attempt to overstate income in the prior year, which could bring their character into question.
Addressing these issues in financial statements need not be something you do alone. Working with an accountant who has a strong construction background and a good reputation in the construction industry can be worth its weight in gold (or in this case, credit). They can help you spot the issues that may raise red flags in the surety’s review and offer suggestions for avoiding them. Having an accountant who is well known in the industry prepare your financial statements will also increase the comfort of the surety, which in turn, may make the process easier. MKS&H can help with the preparation of surety-ready financial statements, as well as other construction-related issues such as succession planning.
Having transparency in your financial statements and making a conscious effort to keep open lines of communication between you and the surety will help create a positive working relationship between you and the surety. The easier it is for the surety to understand your operations and any obstacles you may be dealing with, the easier it may be for you to obtain the credit guarantee that you need.