Key Takeaways
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What is bonding capacity and how is it calculated
Bonding capacity is the maximum amount of surety credit that a surety company is willing to extend to a contractor at one time. Sureties will evaluate everything from your finances to your reputation, with a stronger emphasis placed on the strength of your balance sheet.
Sureties calculate bonding capacity by taking the lesser of 10-20 times working capital (current assets minus current liabilities), or 10-20 times total net worth. For example, if a contractor has $250,000 of working capital, and $750,000 of equity, a bonding capacity of $2.5 million would be the starting point.
In addition to this calculation, sureties will often discount certain items to arrive at “surety-calculated working capital”. Items sureties will discount include but are not limited to, receivables over 90 days outstanding, certain prepaid expenses, shareholder notes receivable, and 50% of reported inventory. This directly affects a contractor’s bonding capacity.
What sureties look for
Sureties want evidence that of financial discipline, operational experience, and resources required to complete bonded projects.
GAAP financial statements: Reliable and timely-filed financial statements help create a strong surety relationship. These statements should include a WIP schedule that reflects gross profit year-over-year.
Contractor reputation: Sureties will look at how long a contractor has been in business, past contracts and their outcomes, as well as the strength of management and the overall workforce. A contractor that has an impressive record of performing a similar type of work is attractive to sureties.
Financial Ratio – Favorable ratio ranges include:
Current Ratio (Current Assets divided by Current Liabilities): A current ratio of greater than 1.20 is preferred. This may need to be higher in certain situations.
Debt to Equity Ratio (Total Liabilities divided by Total Shareholders’ Equity): A debt to equity ratio less than 2.50 is preferred.
Red flags to the surety
Several concerning financial trends can indicate higher risk from the perspective of a surety:
Negative working capital: This is a large red flag to a surety because this indicates insolvency, as well as a contractor’s financial inability to carry a contract to completion
Gross margin declines: Declines in gross margin year over year indicates problems within the contractor’s operations.
Excessive under billings: Consistent under billings can be an indicator of inaccurate gross profit estimates, poor cash flow, and slow collections. When this exists, several questions may be raised regarding issues that need to be addressed by the contractor. This makes the contractor riskier in the eyes of the surety.
Bonding capacity maximization strategies
Due to the relationship of bonding capacity and working capital/net worth you may be able to improve your position through balance sheet management. Those strategies can include:
Receivables management: A/R that is older than 90 days may be discounted from working capital. Contractors should ensure they speed up collections to keep as much of their A/R under 90 days outstanding. Collecting $100,000 of A/R over 90 days outstanding can increase bonding capacity by approximately $1 million.
Inventory management: Sureties will generally discount 50% of inventory when calculating bonding capacity. It is important to manage inventory levels near the balance sheet date to maximize bonding capacity. Delaying purchasing $20,000 of inventory until after the balance sheet date, discounted working capital increases by $10,000 and in turn, increases bonding capacity by approximately $100,000.
Accelerate payment of short-term receivables from owners: Since sureties will discount owner receivables that are classified as current, collecting on those receivables is a strategy to increase bonding capacity. The collection of $250,000 in short-term owner receivables would increase bonding capacity by $2.5 million
Reduce distributions: When you are profitable, there may be added pressure to distribute earnings to the owners, which hurts contractors. The more profit that stays in the company, the higher your working capital is. A suggestion would be to evaluate the amount of distributions that are needed cover the owners’ tax obligations. If distributions are reduced by $30,000, bonding capacity would increase by $300,000.
Owner capital contributions: If all other strategies have been executed and there is still need for additional working capital, owner capital contributions are a great way to increase working capital and bonding capacity. Owner contributions totaling $100,000 will increase bonding capacity by $1 million.
Strengthen the financial foundation behind your bonding capacity
Bonding capacity depends heavily on the quality, accuracy and strength of a contractor’s financial information. Timely financial statements, reliable work-in-progress reporting and proactive balance sheet management can all influence how a surety evaluates the business.
UHY’s Construction Practice helps contractors manage the accounting, reporting and financial planning needs that support stronger surety relationships and greater visibility into bonding capacity. Connect with our construction practice to discuss how we can support your accounting needs and help position your business for future opportunities.
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