Bonding companies use qualitative and quantitative factors to determine the credit they will extend to a contractor. They underwrite their book of business with the assumption that there will be no claims. Issuance of a bid or performance bond is a seal of their confidence in you. When a contractor has sufficient capital and liquidity, a reputation for quality, timely work, and capacity to complete the work, a surety will extend adequate credit. Weaknesses in any of these will create real challenges.
Who are the key players in establishing your surety program?
- You, the contractor. You must complete your work on time, professionally, and with reasonable profits. You should keep cash in the business to fund future projects. You should maintain your equipment and continue to grow the equity in the business.
- CPA – You will get better surety terms when you work with a CPA who understands construction accounting. Sureties put more credence to financial reports that demonstrate a knowledge and ability to reflect the true story on the company’s financial well-being. We hear contractors express concern about the additional expense of CPA statements. A good construction-oriented CPA’s advice is worth significantly more than the cost you incur.
- Your broker – You want to work with a broker who understands construction and can work with your CPA and the surety to negotiate the bonding program that you deserve. A broker needs to understand the accounting and financial questions asked by sureties and be able to counsel the contractor and the CPA and what can be done to maximize your “bondability.”
- The surety – A surety bond is a statement of confidence in you. You want this key credit partner to believe in you and trust that you will honor your commitments. They need to be available and have the authority to approve the program that your broker will be requesting on your behalf.
What are the surety’s key considerations when offering the bond program?
- Character – they must believe in your vision and your ability to get there with integrity.
- Profitability and Job Estimates. Your gross profit percentage and net income as a percentage of revenue should meet or exceed industry averages. Inconsistent job margins will undermine the confidence of the surety (and should concern you). Unprofitable jobs raise even more alarms. Consistent, profitable work reflects a well-managed contractor who estimates and performs work effectively. If you are missing the mark, sureties will ask questions. Your broker should be able to articulate situations that can be reasonably explained and to build the confidence of the surety on lessons learned.
- Liquidity. Liquidity ratios (current, quick, and operating cash flow) measure a company’s ability to service its debt and obligations. Sureties look at a contractor’s liquidity 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. You must have adequate working capital (current assets minus current liabilities) to meet short-term expenses. Your capital needs to fund the job. Other sources of capital would erode margins. Sureties want jobs to be under or on budget and that contractors are fiscally responsible. Sureties want working capital that is 7% to 10% of the cost to complete your backlog for subcontractors and at least 5% for general contractors.
- Key Performance Indicators. Sureties are your trusted partner and will want to see both interim and year-end financial information. Their primary concerns are margins, liquidity, working capital, and consistency. Wild swings will impact bonding capacity.
- Billings. Overbilling or underbilling raise concerns. When a contractor bills more than the costs incurred to date, sureties refer to the excess amount of billings as “job borrow.” Sureties monitor job borrow closely to ensure contractors are not using revenue from one job to fund others. Underbilling can indicate failure to manage change orders, poor billing practices, slow performance, and overestimating profit. Sureties want contractors to bill promptly and in accordance with the terms of a contract. Poor billing negatively impacts cash flow.
- Financial Statements and Management Reports. Accurate, timely financial statements and management reports are essential. Surety underwriters expect CPA prepared reviews for larger contractors. CPA compilations may be accepted in certain cases. 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). Your broker can advise you on the frequency of reporting needed.
- Other Considerations. A thorough bond submission includes references, project history, succession plan, banking relationships, and the vision for the company.
Contract surety bonds can be a great tool in qualify contractors for larger projects and/or public projects. They should be a source of pride that an independent organization is willing to stand behind the quality of your work and capability to perform as you are contracted to do.