Member Columns

By: Jonathan Mangels, CPA, Partner-in-Charge of Construction Services with GREER & WALKER, LLP

IMPROVING BONDING CAPACITY THROUGH FINANCIAL MANAGEMENT 

With tighter budgets governing projects everywhere, owners want stronger protection against contractor default.  As a result, contractors these days are facing widespread bonding requirements on all types of projects.  Contractors that have a strong relationship with a surety that provides an adequate amount of bonding capacity have a competitive advantage. 

Some construction companies face the challenge of establishing a new surety line, while others seek to maintain or increase their limits. Regardless, every contractor should be aware of the primary financial indicators that interest surety companies.

Working capital and net worth

Sureties look at how assets are allocated. A contractor may show a strong bottom line, but if its capital consists almost entirely of equipment, can it really fund a job? If such a company’s cash and credit line were to dry up, it couldn’t simply sell equipment to pay wages and other job costs, because then it couldn’t do the job at all.

That’s why a surety company likes to see contractors with strong working capital (i.e. current assets minus current liabilities).  Working capital gauges a firm’s ability to finance its operations and indicates the level of liquidity creditors and surety companies can expect when underwriting the firm’s operations.  In assessing a contractor’s working capital, a surety will typically discount or not recognize receivables over 90 days past due, inventory, prepaid expenses, and loans to officers or stockholders.

Since most construction companies are booming these days, now is the time to build up a company’s net worth in the event of a bad year or a bad job.  Improved profitability on jobs increases a company’s net worth as long as overhead costs are controlled and stockholder distributions are kept to a reasonable amount.

Cash flow

Cash flow isn’t just money in the bank; it’s also borrowing ability, so a strong line of credit with a bank is a plus. But keep in mind that interest-bearing debt, which is a fixed cost which must be serviced even if the market slows, is an unfavorable liability in a surety’s eyes.

A surety may use the following formula to calculate free cash flow: net income plus depreciation, amortization and other non-cash items, less principal payments on debt. If this number is small and the balance sheet shows that the company is highly leveraged, the surety may reduce the bonding capacity of the contractor because of a concern about the entity’s ability to fund its debt service.

Work-in-process (WIP) calculations

Surety companies prefer to underwrite contractors who operate with steady work and accurate WIP estimates.  Without accurate estimates being reflected in the company’s WIP schedule, the contractor will experience repeated gain or fade on job profitability for financial statement purposes. These gains or fades will cause the surety to question the contractor’s estimating ability, which could have a negative impact on bonding capacity.  

Profit gains are less worrisome, and may merely indicate that a firm is conservative with its projections.  However, a construction company’s ability to accurately estimate work is critical, and steady WIP figures offer evidence of that strength. 

Overbillings and underbillings

The percentage-of-completion method for recognizing income is required for most construction companies. This calculation determines whether a contractor has overbilled or underbilled on a project in progress.

Overbilling has advantages when a job is going well. An overbilled contractor is either managing cash well (i.e. working on the owner’s capital instead of its own, saving money on interest) or building profit in the job that will show up as gain.  But when a contractor is struggling, overbilling can indicate “job borrow” (i.e. using cash from one job to fund losses on another), which will show up eventually, too.

An underbilling means that a contractor has not billed the owner or general contractor enough based on the percentage of completion as reflected by the actual costs to date compared to the total estimated costs for the job. This could be a result of the billing cut-off as outlined in the contract. It may also be an indicator that a job is less profitable than projected and that the gross profit could be overstated. Either way, underbillings can be a potential sign of poor cash management.

Whatever the cause, underbillings that reach 20% percent of working capital and/or 10% of equity raise a warning to sureties, and the construction company should always be prepared to explain what caused them.

Accounting for change orders and claims

A change order recorded by a contractor for $100,000 will increase revenues and profit.  However, if it was a verbal order issued in the field in the rush to complete the job, and then the owner says it was never approved, the contractor may never realize that revenue, resulting in profit fade on the job.  As a result, contractors should be wary of recording change orders that have not been properly approved.  In a perfect world, the contractor should not do any additional work until they have obtained the necessary approvals.

Claims are standard in construction and surety companies look at a company’s experience with them over time.  Never the less, a high number of claims going out or coming in may signal that a contractor has a history of problems with owners or suppliers.  Generally, contractors shouldn’t recognize revenue from their own claims against an owner until the claim is won. As for claims against the contractor, they represent liabilities that can reduce profit on the job.

Preparing a company for bonding success is complicated, like the construction industry itself, and it requires a strong team. Seek help from a bonding agent, a banker, a lawyer and an accountant who know the terrain, maintain close ties with the surety industry and know what the underwriters want.  Advisors like this will not only give you good advice, they’ll also build the surety’s confidence in dealing with your construction firm and smooth the way considerably.

By Jonathan Mangels, CPA, Partner-in-Charge of Construction Services with Greer & Walker, LLP, a member company of  ProfitCrew, an association of accountants and business advisors dedicated to helping contractors build profitable businesses. (704) 377.0239 or jmangels@gwllp.com or visit us on the Web at www.greerwalker.com