July 15, 2019
Sureties base their bonding decisions on many factors including a contractor’s character, capacity, and capital. These “three C’s” provide a foundation for sureties to form an opinion on a contractor’s past, current, and future performance. Sureties want to know that the construction companies that they work with are well-managed, profitable, and have measures in place to reduce risks. Sureties also want a level of assurance that contractors can perform the work they are contracted to do and can pay the bills.
In addition to the “three Cs,” sureties place emphasis on six key factors when making a bonding decision:
- Profitability and Job Estimates – A contractor’s gross profit percentage and net income as a percent of revenue should be comparable to industry averages. Sureties want to know that the contractor is bidding and completing jobs profitably. If the total gross profit percentage on a project is less than the original estimate, sureties will question a contractor’s ability to estimate job costs. Actual job margins at the completion of the job should be in-line with or better than the estimated margins at the start of project. Sureties want to see that expectations on job profitability are realistic and contractors are running a lean operation while controlling operating expenses. Having a profit fade (gross profits decrease over the course of a project) can be indictive of a number of management issues such as inaccurate estimating and lack of proper management oversight.
- Liquidity Ratios – Liquidity ratios (current ratio, quick ratio, and operating cash flow ratio) measure a company’s ability to pay debt obligations. Sureties look at a contractor’s liquidity ratios to determine if the company is highly leveraged and using a high percentage of its revenue to pay off debt. Contractors who operate with a low debt to equity ratio are more attractive to sureties.
- Working Capital – Having enough working capital (current assets minus current liabilities) to meet short-term expenses is necessary for a contractor to realize the expected profit margin on a job. Otherwise, the project may have to be financed, which will increase costs and reduce profits. Sureties like to see jobs come in under or on budget and that contractors are fiscally responsible. Sureties also like to see working capital that is 7% to 10% of the remaining cost to complete backlog for subcontractors and at least 5% for general contractors.
- Key Performance Indicators (KPIs) – Sureties will analyze month-over-month and year-over-year KPIs to determine if a contractor’s performance is in alignment with past periods, benchmarks on similar companies, and industry trends. Sureties want to see consistency in performance and that the contractor is operating as well as, or better than other companies in the same market.
- Billings – Overbilling or underbilling sends up red flags. If a contractor bills more than the costs incurred to date, the difference is in excess of the total gross profit earned on a project. This excess amount is known as “job borrow.” Sureties monitor job borrow closely because they see this as a sign that contractors are borrowing from one job to pay for another. Billing less than specified in a contract can indicate that unapproved change orders are included in the contract or the contractor is over estimating profit. Underbilling can also indicate that the contractor is not billing a client for work completed on the project on a timely basis. Sureties want to see that contractors are billing in accordance to the terms of a contract. They do not want to see that the failure to bill on time adversely affected cash flow.
- Financial Statements and Management Reports – Accurate and timely financial statements and management reports are essential. It is important for contractors to have their financial statements audited by a certified public accountant that specializes in construction accounting. Doing so will provide sureties with a level of assurance that the financial statements reflect the true story on the company’s financial well-being. Other reports that sureties will want to see include work-in-progress (WIP), A/R aging, and a monthly job status report on all projects (bonded and non-bonded). Contractors should send sureties these reports on a bi-monthly or quarterly basis, even if it is not required.
In addition, sureties look for a history of successful projects and work experiences, a succession plan to ensure that a contractor will stay in business if a member of its management team leaves unexpectedly, a history of solid banking relationships, and a short- and long-term business plan.
The ability for contractors to sustain or grow their business is generally contingent on a surety’s willingness to maintain or increase its bonding capacity. Without surety credit, most contractors will not be in the position to take on more projects or bid on larger jobs.
Martin C. McCarthy, CPA, CCIFP
McCarthy & Company, PC
Disclaimer: This alert is for informational purposes only and does not constitute professional advice. Information contained in this communication is not intended or written to be used as tax advice, and cannot be used by the recipient to avoid penalties that may be imposed under the Internal Revenue Code. We strongly advise you to seek professional assistance with respect to your specific issue(s).