Financial Statements – an Integral Player in Surety CreditJanuary 12, 2011
By Virendra N. Shah, CPA
As a contractor, you are aware of the importance of obtaining, maintaining or increasing your surety credit. However, the underwriting of a surety bond can be subjective and is not actuarially driven. The most common factors that are considered during the underwriting process include capacity, character and capital.
Capacity is easily quantifiable and refers to the availability of skilled workforce and equipment to complete the specified project. The character is determined using a myriad of non-financial information including the company's business plans, past history of successful projects, expertise of the management and reputation of the firm and or principal.
Capital is the great unknown. Sureties depend on timely and accurate financial statements prepared by CPAs familiar with the construction industry to determine the amount of surety credit that can be extended to the company. Certain analytical procedures, ratios and percentages are also applied to the financial statements to perform an overall evaluation of a contractor's level of bonding capacity.
Sureties use working capital as a primary benchmark of liquidity in determining the contractor's bonding limit. Working capital is often calculated by taking the difference between current assets and current liabilities. However, when a surety calculates the working capital, they make certain adjustments to exclude items that are classified as current but cannot be converted to cash during the operating cycle of the business. Some typical surety adjustments include:
- Restricted cash and marketable securities: Adjustments will be made to exclude restricted cash and portions of marketable securities if it includes items with significant market volatility.
- Contracts receivables: Adjustments will be made to exclude receivables that are greater than 90 days as well as any other receivables that are in dispute.
- Receivables from owner/related entities: Repayment schedule and available assets of the owner/related entities will be reviewed to determine the amount of potential adjustment.
- Prepaid expenses and deposits: A surety often contends that items such as prepaid insurance, if refunded, would be refunded at a substantial discount.
- Underbillings: If there are significant underbillings, the surety may discount them if adequate support or explanation from the management is lacking.
- Inventories of parts and supplies: Sureties often discount inventories when their value upon liquidation is not readily available.
- Deferred tax assets: This is excluded, since it is considered a non-cash item.
- Short-term debt classified as long-term debt: Lines of credit that have terms due in periods greater than one year, but are not amortizable under typical term loan provisions, may be reclassified as reductions to working capital by the surety.
- Deferred tax liability: Sureties are not consistent regarding their treatment of deferred taxes. The key is to provide adequate information about deferred taxes in the notes to financial statements so that the surety can determine the underlying temporary differences that resulted in the deferred tax liability.
Another key indicator used by sureties is tangible equity/net worth computations. This is computed by taking the difference between assets and liabilities after certain adjustments, like investments in real estate (if it is in the development stage), investment in recreational assets and intangible assets (e.g. goodwill), preferred stock and dividends payable to shareholders.
Sureties also use the work in progress and completed contract schedules that are accompanied with the financial statements to review the under/over billings and fades on the bonded jobs. This information is also used in the determination of working capital and the contractor's surety capacity.
In order to keep the surety adjustments to a minimum and maximize bonding lines, you can take several steps when planning interim or year-end financial presentations:
- Release any restricted cash and minimize any non-marketable investments.
- Bill all contracts currently, thereby decreasing net underbillings and increasing receivables. Support all significant under- or overbillings.
- Provide support that would resolve any issues related to unapproved change orders or claims for their inclusion as receivables.
- Monitor the accounts receivable aging and promptly collect old receivables over 90 days.
- Consider repaying officer or affiliate loans receivable before the end of the year.
- Reduce inventories on hand.
- Decrease prepaid expenses, such as taxes, insurance, etc., by adjusting the coverage dates and payment dates.
- Consider refinancing short-term debt obligations with long-term installment notes.
- Pay off any notes payable to shareholders, subordinate them to the bonding company or contribute them to capital.
- Consider leasing equipment in lieu of purchasing.
- Provide adequate information in the notes to financial statements for certain items like deferred taxes, loans to owners/affiliates, joint ventures, etc.
These are just some of the steps to take to help your company maximize bonding lines; however, each company is unique. If you have surety questions specific to your company, please contact a member of our construction services group at email@example.com