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By Erica Konieczny
March 28, 2016
With the recent signing of the National Defense Authorization Act of Fiscal Year 2016, small construction companies should find it easier to get surety bonds.
Included in the Act was a provision for the maximum guaranty percentage of bonds issued under the Small Business Administration Preferred Surety Bond Program to increase from 70% to 90%. That means many of the nation’s more than half a million construction contractors classified as small businesses will have more opportunities with both public and private projects that require surety bonds.
However, when qualifying for surety bonds one big challenge for small construction businesses is not having well-documented financials. A key requirement when applying for a surety bond is having the right amount of working capital. Without adequate records, it becomes impossible to fulfill that requirement, even if the business is flush with cash.
Bonding companies like the ones that underwrite surety bonds for construction contractors under the SBA Preferred Surety Bond Program carefully study a contractor’s working capital when deciding to bond or not. When documentation is sparse or nonexistent, the bonding company must guess, or simply discount assets that could apply to your working capital.
Bonding companies determine your working capital by adding up your cash, accounts receivables, and half of your inventory. Then, they deduct your current liabilities from that number to get your “available working capital.” Next, they multiply your available working capital by 10 to come up with your Total Bonding Capacity.
Here’s the breakdown:
CASH + AR + (½ Inventory) = Working Capital (WC)
WC - Current Liabilities = Available Working Capital (AWC)
AWC x 10 = Total Bonding Capacity
Well, not exactly. And there are pitfalls throughout those calculations because it’s not just the numbers that get scrutinized, but also the “quality” of the numbers.
The surety bond underwriter usually discounts any accounts receivables that are over 90 days old. They will also deduct any problem under-billings, which could even derail a surety application. If you aren’t familiar with under-billings or over-billings, here are the basics.
Since construction contracts happen over a period of time, invoicing and costs follow suit. It’s not like a factory that produces a product and sells it the same day. Instead, you complete the foundation one day, but don’t not complete the roof for another 30 days, and the entire project for another six months. During the life of the project, you often have completed work that clients haven’t paid you for (under-billed), or have received payment from clients before you’ve completed the work (over-billed). Therefore, when the surety company looks at your under-billings, and over-billings, they’re concerned about just how accurate your accounting is on your profit and loss statement.
This issue can extend into other aspects of your accounting. For example, if your under and over-billings raise eyebrows, then it’s likely your costs may need a closer look because they are all part of the same calculation. Under-billings problems arise when you have too much un-recouped costs, which not only put a drag on your cash flow, but also suggest potential problems collecting what’s owed to you. The bonding company is also likely to deduct any prepaid expenses, and any unsubstantiated receivables from other parties. All the deductions are simply placed into your long-term assets column and don’t count toward your working capital.
Other important bonding aspects that surety issuers consider are:
How you allocate assets to determine if you can effectively fund a project
Financial statements including balance sheet, income/cash flows, equity reconciliation, payables/receivables, and overhead costs
Personal financial statements of owners, including their financial transactions related to the company
What’s true today, might not be true tomorrow.
It takes the whole company to stay successful in contracting, so bonding companies look beyond the items directly related to finances and look at ones that relate indirectly. They look over your organizational chart that shows your employees and their positions. Resumes of owners and employees are also important from the perspective of assessing company abilities. And, the company’s policies and documented procedures show how much importance is attached to items like continuity and project performance.
Keep in mind that the bonding process is always evolving based on economic, regulatory, and political factors. This means that what’s true today, might not be true tomorrow.
Consider the issue of labor. The industry is facing serious worker shortages, and there are ample news stories about projects slowing down, and even coming to a standstill due to a lack of labor. For example, the MoPac highway project in Austin had 350 to 400 workers on site originally, but months later was down to 200. The very first reason cited for construction delays by the contractor was “lack of labor,” according to this report.
It’s not improbable that surety companies will start looking more deeply at the makeup of contractor workforces, and those of its subcontractors when deciding to issue bonds. In that case, documenting the ways you plan to mitigate labor shortages, or avoid them altogether, shows you recognize and plan for new challenges as they arise.
Getting a surety bond in many ways requires you to make sure you are attending to the behind-the-scenes aspects of your business that are critical for continuing success. At the heart of the process is making sure your financial records are complete, accurate, and easy to understand.
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