Improving your Bonding Capacity

Real estate and construction companies have been facing a tight surety market that is narrowly defining acceptable risk. The insurance industries endured unprecedented challenges in the opening years of this decade, resulting in a new strictness in the way surety providers look at construction companies and classify bond requests.

If construction companies can stabilize their businesses through better practices, smarter allocation of resources and more accurate measurements, they should be able to obtain higher bonding limits and compete for more bonded work.

Keep the following points in mind when reviewing contracts.

Key Indicators Sureties Watch

Whether your construction company is establishing a surety line from scratch or seeking to maintain or increase bonding limits, be aware of the main indicators that interest surety companies.

• Stabilize Net Worth and Improve Working Capital

  Surety companies take a hard look at a bond applicant's net worth because it tells them how much loss a contractor can absorb. They generally discount assets that include risk, such as aged receivables and inventory. Sureties also look at how assets are allocated. You may show a strong bottom line, but if your capital consists almost entirely of equipment and fixed assets, can you really fund a job? If cash and credit were to dry up, you couldn't simply sell equipment to pay wages and other job costs, because then you couldn't do the job at all.

  That's why a surety company likes to see contractors with strong working capital (defined as current assets minus current liabilities). Working capital gauges a firm's ability to finance its operations and indicates the level of protection creditors and surety companies can expect when they underwrite the firm's operations. In assessing a contractor's working capital, a surety will discount 30 percent to 50 percent of inventory. It won't recognize prepaid expenses or officer/shareholder receivables.

  Strong net worth combined with weak working capital is common, particularly for contractors like road builders with heavy investment in equipment. Sureties were once more flexible in bonding such firms, but most now insist on an adequate level of working capital.

  Takeaway: If the bond is called, the surety intends to recover its losses with claims against the contractor's assets, and it makes sure beforehand that there are assets at the ready.

  
  
• Conserve Cash Flow

  Most surety losses are the result of a contractor's cash-flow failure. Given cash or lending resources, most contractors can finish most jobs, even though they may take a loss. What stops them is a shortfall of cash and credit - in which case the surety must step in and finish the contractor's work, pay the contractor's subs and suppliers, or both.

  One step you can take to conserve cash flow is to decrease bonuses. Conserving your cash on hand is key to increasing your bonding capacity. Keep in mind that interest-bearing debt - a fixed cost that must be serviced even if the market slows - is an unfavorable liability in a surety's eyes. Evaluate the use of equipment to determine if some of it should be sold to pay down outstanding debt. Consider whether it is more advantageous to lease equipment rather than purchase new equipment.

  Construction companies with tax losses for 2007 and 2008 should carry those business losses back 2 years (and most likely 4 years depending on recently proposed 2008 legislation) to offset the profitable 2005 and 2006 tax years and generate tax refunds. Carrying back these business losses is a fast way to generate federal and state tax refunds. Instruct your CPA to electronically file the IRS carryback application forms without further delay. You may also have large overpayments on your 2006 federal and state tax returns that were credited to 2007 estimated taxes. Don't wait until September or October to file your returns. Electronically file the 2007 tax returns NOW and get your refunds immediately with direct deposit account numbers and routing numbers indicated on the tax returns.

  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. Evidence of a bank line of credit to augment working capital and to handle any temporary cash flow deficits is crucial. A surety will generally look for unsecured lines of credit or lines of credit backed by long-term financing of equipment or real estate.

  Takeaway: If cash flow is weak and the company is highly leveraged, the surety may reduce the bonding capacity of the contractor due to concern about the entity's ability to fund its debt service.

• Maintain Accurate Work-in-process (WIP) calculations

  Surety companies want to underwrite contractors who operate with accurate WIP estimates. Without accurate estimates in the company's WIP schedule, the contractor will experience repeated gain or fade on job profitability for financial statement purposes. A profit fade means the contractor recognized profit too early and must pay for it later. Profit gains are less worrisome, and may merely register a firm's conservative projections. But a construction company's ability to accurately estimate work is critical, and steady WIP figures offer evidence of that strength.

  Takeaway: Profit gains or fades will cause the surety to question the contractor's estimating ability, which could have a negative impact on bonding capacity.

• Closely Watch Your 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 a project. An overbilled contractor is either managing cash well — working on the owner’s capital instead of its own — or building profit in the job that will show up as gain. But when a contractor is struggling, overbilling can indicate “job borrow” — 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 be an indicator that a job is less profitable than projected and that the gross profit could be overstated. Either way, underbillings can potentially be a sign of poor cash management.

  The percentage of completion method best represents a contractor’s financial condition, most accurately measures results of work performed during the year, and is normally the preferred accounting method of sureties.

  Takeaway: Whatever the cause, underbillings that reach 25 percent of working capital 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 that adds $100,000 to a job can cause a contractor to recognize substantially more revenue. If the order was verbal, issued in the field in the rush to complete a job, and later the owner says it was never approved, the contractor may have recognized too much revenue, resulting in a profit fade.

  Claims can raise concerns, too, particularly when a contractor approaches a new bonding agent. While claims are standard in construction, a high number of claims going out or coming in may signal that a contractor has a history of problems with owners or suppliers.

  Takeaway: Always get change orders in writing. As for claims against the contractor, they represent liabilities that can reduce profit on the job. Generally, contractors should not recognize revenue from their own claims against an owner until the claim is won.

Improving The Surety Relationship

• Get to know the surety company and view him as a strategic business partner. Find out what ratios and figures it considers most important. What kinds of companies does it underwrite? You will establish a stronger relationship with a bonding company that tends to serve your type of company.
• Schedule regular meetings. Surety companies know that problems arise in construction projects; what they want is accurate and detailed information. Don’t surprise a surety with bad news late in the game; bring your surety into the loop immediately. Early involvement with your surety also allows for more creative options to mitigate potential losses.
• Notify your bonding company of changes in your company, such as shifts in ownership or top management, as well as forays into new markets or specialties.
• Ensure utmost integrity and strong character. Unjustified bonuses, questionable loans, powerboats on company accounts and well-paid relatives with vague responsibilities are all danger signs to a surety company. Maintain solid internal controls.
• Financial interactions with the company are particularly important to detail; Clearly delineate all related party transactions.
• Provide professional references, resumes of key management personnel, and continuity plans discussing how the business will continue in the event of the owner’s death.
• Provide a description of the firm’s cost accounting system, showing its integration into general ledger and how the job costing procedures operate. Provide summaries of significant accounting policies such as capitalization, taxation, and revenue recognition policies.
• Evidence of a bank line of credit. For a surety, this is the best demonstration of a strong banking relationship with good borrowing ability, especially if it’s unsecured or secured only against long-term assets.

To discuss strategies on how to maximize your bonding capacity and to improve your surety relationship, contact the author of this article, Adam Polakov, CPA and Practice Leader with Porter Keadle Moore, LLP, or PKM Partner, Arvil Stanford to discuss audit and accounting matters, strategic planning and general business issues.

Porter Keadle Moore, LLP is a founding member of ProfitCrew, an association of accountants and business advisors dedicated to helping homebuilders and real estate developers build profitable businesses. For information, contact Adam Polakov at apolakov@pkm.com or Arvil Stanford at astanford@pkm.com or visit www.pkm.com.