When it comes to bonding capacity, the strength of a contractor’s financial statement plays a big role. While there are certainly other factors considered like the quality of management and operational capabilities, financial wherewithal is like the oil that lubricates the powerful engine. Without it, things can come to a screeching halt.
One of the easiest ways contractors can strengthen their financial profile from surety’s perspective is to understand the deductions sureties make to contractor’s financials, because many of these exclusions are at least partially in the contractor’s control. Let’s take a look.
Loans to Shareholders or Employees
In closely held businesses it is common for owners to loan themselves or their employees money. This removes capital from the company, and from a surety’s perspective it creates uncertainty of when and if these loans will be repaid.
- What you should do
It is generally best to avoid making these loans when possible, or at the very least, talk with your surety agent first to understand the possible impact to your bond program.
If you do not have any intention to pay a shareholder loan back, it can be better to simply reflect it as a distribution. However, this should still be discussed with your agent ahead of time if it is large, because distributions can negatively impact the financials in the same way.
Over 90 Day Accounts Receivable
Old receivables raise the question of whether there is a dispute and they are truly collectible, and as a result, sureties deduct them from a contractor’s financial statement. These can have a big impact on the way the surety views the contractor’s net worth. For example, imagine your equity in the business is $1 million and you have a receivable for $100,000 that is over 90 days. If the surety deducts that amount, your net worth from their perspective just went down by 10%.
- Practical Steps You Can Take
It takes most contractors 60 to 90 days after the close of a particular month to provide their financial statements to their surety. This gives you a lot of extra time to potentially collect those over 90-day receivables. When submitting your financials to your surety agent, note which over 90-day receivables have been collected. Also note any that are retention, because sureties don’t deduct those the same way they do regular receivables. It’s understood that retentions can take longer to collect.
If you do have a receivable that is in dispute and may not be collected, consult with your surety agent and CPA to determine whether it makes sense to write it off. If your surety isn’t going to count it as an asset anyway, it might be better to reduce your tax liability. That will help your cash flow and paying less taxes actually improves your working capital and net worth.
Disputed Change Orders
Change orders are a natural part of construction projects, but when they are disputed (either by the owner, general contractor or even subcontractors), their value and collectability is uncertain. Disputed change orders typically show up in a contractor’s financial statements as underbillings, because they can’t be billed for since they are not approved yet. A surety will sometimes discount or exclude revenues or receivables tied to disputed change orders until the dispute is resolved.
- Best Practices for Dealing with Change Orders
It’s generally best not to recognize revenue from change orders until they are approved. However, because the amounts can be so large, that can sometimes be impractical. What some contractors do is recognize a portion anywhere from 50% to 80% to account for the possibility they won’t be able to collect them all.
Be sure to communicate to your surety if you have larger disputed change orders or claims on projects. By helping them understand the nature of the disagreement, timing for resolution, and likelihood it will be resolved in your favor, there is a chance they may keep all or a portion of the disputed amount in your financials rather than just defaulting to excluding the entire amount. This is where your surety agent can really help in understanding the circumstances and communicating it clearly to the surety.
Why It Matters
Sureties have certain ratios that they use to calculate bonding capacity based on a contractor’s working capital and net worth. The deductions described above directly impact those calculations. To use a simple example, if a surety deducts $300,000 from your financial statements, that can reduce your bonding capacity somewhere between $3 to $6 million. If you make 5% net on your revenue, this could cost you $150,000 to $300,000 in lost profit!
Having a surety agent work through all of this with you before submitting your financial statements to the surety is key, because it will minimize the amount of deductions your surety company makes and thereby keep your financial statements as strong as possible to maximize your bonding capacity.
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