Industry Insights

In today's highly competitive business environment, it is more important than ever for construction company owners and management to be aware of how the company’s financial and operational performance affects its bonding capacity. If bonding limits are reduced or eliminated, it will significantly affect the types of jobs a contractor can bid in the future. Therefore, it is critical for management to identify areas that could improve the company’s bonding capacity.

Bonding companies assess a number of business attributes—along with the contractor's financial stability—to determine bonding capacity. The bonding company will pay particular attention to management’s experience in the area of contracts, the company’s job completion history and its financial outlook, in addition to the integrity of company management.

The company should engage a highly qualified bonding agent to oversee and coordinate the bonding process. The agent will advise the company on what content to present to the surety to portray it in the best possible light.

Management also should know how its bonding capacity is determined. Familiarity with these matters may influence the company’s operational decisions. The surety’s analysts look at a combination of financial ratios and compare the company’s performance to industry standards. Ratios used by the analysts will include, but not be limited to, working capital, net equity and debt-to-equity ratio. Analysts also will look at certain balance sheet activity. Balance sheet items that affect their opinion on bonding capacity include, but are not limited to:

• Cash on hand
• Accounts receivable balances greater than 90 days
• Inventory classifications
• Underbillings on jobs in progress
• Significant overbillings on jobs in progress
• Gross profit on open and closed jobs
• Any outstanding contingencies, claims or litigation

There are several strategies management could consider over a period of time to improve their company’s bonding capacity, including:

• Investing additional cash in the company
• Improving collections on accounts receivable balances
• Selling or returning inventory not designated to a specific job
• Selling idle equipment to increase cash
• Purchasing equipment with long-term financing, so as not to deplete cash-on-hand balances
• Improving the debt-to-equity ratio at year-end

Here are some other quick tips:

• Accounts receivables greater than 60 days old will be scrutinized by the surety and may be highly discounted. It is a best practice to highlight and discuss aged receivables and provide an explanation along with a current status.
• Trending is a critical aspect for an underwriter’s evaluation. Items to be evaluated could include bank line of credit balance, gross profit, net income, profit fade per job and working capital.
• No matter what level of service is needed or desired, a work in process (WIP) schedule should always be included for any audited, reviewed, compilation or internal financial statements.

There are many factors to consider when a company applies for bonding. Virtually every company action and performance result has a related effect on bonding that should be considered. To avoid unexpected consequences related to a company’s bonding capacity, we recommend that management discuss significant planned transactions with their bonding agent prior to implementation. Such communication will be an important factor in the continued success of the company and other parties to the contract—the owner and surety.

If you have other questions on bonding issues or related topics, please contact your BKD advisor.