Sunday, October 26, 2008
Surety Bonds in a Tough Construction Market
By Daniel Huckabay, President – Commercial Surety Bond Agency
With the halt in residential construction many contractors are moving into, or expanding their presence in, public works. As a result, competition has increased, bid lists have gotten longer, gross profits are declining and it’s harder to get work at any price. For these reasons, the ability of a contractor to get surety bonds has become even more critical; the question is, “What can contractors do to maintain or even increase their bonding capacity in this tough construction market?”
Communicate
The first and most important thing contractors can do is keep in touch with their surety agent and bond company. Meet with them periodically to let them know what is going on in your company. Tell them about the things you’ve done to be proactive and deal with the slowdown. Inform them of any problem jobs, assure them of the ways you are keeping it under control, and above all, avoid surprises.
One way in which surety companies will try to stay in closer contact with their contractors is to require more frequent internal financial information. Contractors can expect to see some sureties request quarterly financial reports including a balance sheet, income statement, contracts in progress schedules, completed contract schedules and aging accounts receivable schedules. With this information, sureties will look for how gross profits are holding on contracts in progress, how completed jobs are finishing up, they will try to identify any jobs that are having problems and how the company is doing financially overall.
Sureties will also be looking be taking a hard look at old receivables, because there is generally a rise in slow payments during hard economic times due to disputes and / or owners and general contractors trying to manage cash flow. Sureties typically discount receivables over 90 days under the assumption there is a problem with collection. For this reason, it is important when contractors provide these schedules that they let their agent and bond company know those over 90 day receivables that have been collected since the report date, those where payment is expected in the next 30 days and those where there is a legitimate reason for delay (such as an inability to receive payment until material is on site, etc.).
Contractors can take advantage of the slower times by working to improve their internal accounting systems and ability to produce those reports mentioned above. This will benefit not only the company’s operations, but enhance the contractor’s ability to communicate with their surety. As a result, the surety will be more comfortable and in tune with the contractor’s operation increasing their likelihood to extend bond credit. Furthermore, they may even waive the need for a CPA six-month financial statement, which would be a cost savings.
Reduce Expenses
Almost all contractors are facing lower revenues and gross profits from prior years, and consequently, more and more contractors will have trouble generating enough gross profit to cover their fixed expenses – primarily overhead and equipment debt. For those contractors in this situation, sureties will want to know what overhead expenses have been cut, and there will also be a strong emphasis on reducing debt, particularly debt on idle equipment.
Typically surety companies look for a Debt to Equity Ratio of less than 3 to 1 (calculated by taking total liabilities and dividing it by net worth as analyzed by the surety) and an Interest Bearing Debt to Equity Ratio of less than 0.75 to 1 (calculated by taking the total bank debt or other interest bearing debt and dividing it by net worth as analyzed by the surety company).
The rental for equipment has become very competitive making it a good time to analyze whether it makes sense to sell encumbered idle equipment and rent instead, which will cut expenses and generally improve working capital and these debt ratios. Outline your plan to your surety for generating revenues, managing costs and producing a profit for the company.
Retain Capital
Last, but just as important as all of the above, there is no more important time to retain all the money you possibly can in the company. With thin profits or even losses, many companies will face a deterioration of their balance sheet. Since a contractor’s balance sheet is one of the main factors sureties use to grant credit, it can lead to a spiraling cycle: losses lead to lower working capital and net worth, which could lead to lower bonding capacity, which limits the contractors ability to bid work, which then affects their ability to earn the revenue necessary to be profitable. To combat any possible deterioration, contractors should defer nonessential fixed asset purchases and personal expenditures. Also, consider lowering officer salaries if possible and temporarily eliminating any distributions from the corporation to the owners.
If you do have a loss and erosion of your company balance sheet, the best way to convince the surety to maintain your bond program is to communicate the problem early, outline a plan to resolve it, and show a commitment to your business. Discuss with your agent and CPA the possibility of making a personal loan to the company and subordinating it to the surety. This can provide a temporary fix, because the surety will treat this subordinated shareholder loan as capital, but it can eventually be repaid without any potentially negative tax consequences as characterizing the contributed amounts as capital.
Conclusion
Whether it comes to trying to maintain or increase your bonding capacity during this down cycle, the key point in all of this is to communicate with your surety agent and bond company. Treat them like a partner in your business and use them as a resource. After all, their success depends on yours.
Daniel Huckabay is President of Commercial Surety Bond Agency, which has specialized in providing surety bonds to contractors since 1984.
Communicating with your Bond Company
As CPAs who work in the construction industry, we have developed many positions and strategies to help our contractors become best of class and manage successful businesses. No matter what industry you are in, communication will be a cornerstone in your success. Many of our contractors regularly use their surety line while others obtain a bond once in a while. Still other contractors working in the private sector are rarely, if ever, asked to provide a bond. My advice to contractors falling in any of these categories is all the same…be sure to regularly provide financial reports and communicate with your agent!
It seems obvious for contractors who regularly use their bond program to be in regular contact with their bond agent and providing financial information, however it isn’t always the case that they do so. If your company gets bonds less frequently or rarely to never, you probably aren’t too concerned about proactively keeping your agent in the loop. This is a mistake for many reasons. The contractor must continuously, in all aspects of business, strive to position their companies as best of class. This basically means doing things better than most, if not all, of their competitors. There are few areas easier to do this in than in keeping the lines of communication open with your bond company. If your company rarely or never is asked for a bond, it is still a good idea to develop a relationship with a quality bond agent to prepare for the moment when an opportunity arises. I have seen many times over the years where a contractor is awarded a job and needs a bond. The problem is the contractor doesn’t have a relationship in place and has to scramble to convince a bond agent (who then needs to find the right market and convince a bond company) that their company is worthy of a surety program. It is so easy, without any time pressures involved, to ask your CPA or other business advisor to connect you with a good bond agent. They will ask for basic corporate data and have a market on standby for when you land that great opportunity requiring a bond. Have the relationship in place before you have the need!
My recommendation is basically twofold in terms of a proactive communication plan with your bond company. The first is to provide, without being asked, quarterly financial statements and job schedules (which obviously reconcile) to your agent. It is always prudent to have your outside CPA review your internal financial reports before you send them on to the bond agent. I have seen cases where financial reports, with errors, were sent to the bond agent (and the bond company) and this is counterproductive as credibility (one of the 3 “Cs” in the surety world, character, capacity, credibility) is diminished. Providing accurate, timely financial information to your bond agent should be very easy as you are producing this type of information monthly (or at least you should be) in order to effectively manage your business. Since you are sending this package to your bond agent, you should also send this same package to your banker. There is a chance that the parties to whom you send this information may not spend a lot of time analyzing it but that is unimportant. The mere fact that you provide timely and accurate financial information speaks volumes about the type of organization you manage. The second part of my recommendation for your proactive communication plan is to call, at least once a year, an all hands meeting to communicate the state of your company’s financial and operational affairs to the surety underwriter and agent. You should also invite your CPA and perhaps your banker as well. Relationships drive business and there is no better way, especially in today’s world of email, phones, scanners, etc., than to do so in a face to face meeting. One way to do it is to schedule it at 11AM and have lunch brought into your office. If you don’t have a conference room suitable for this size of a gathering you might ask your CPA for use of his/her conference room resources.
The benefits of this communication strategy are numerous. First, no one likes surprises and this method of regular, proactive communication avoids surprises. Second, how many times have you bid on a job requiring a bond and then scrambled to provide financial information to your bond company? This method avoids that crisis and uncertainty as the bond company needs to get up to speed on your account. Also, I’ve heard people in the surety industry say “Oh, guess they need me now…now we’re important.” No one likes to feel like they are only a means to an end…it gets back to the relationship; the two-way mutual respect being shown by both parties.
Conclusion
Communication is a cornerstone for your business’s success. Communication is important inside your organization within your management team, office and field personnel. It is equally important with your outside business partners. As a business owner, you should regularly be reviewing various financial information including your financial statements. Other dashboard type reports should be monitored on a daily or weekly basis. These reports are also referred to as Key Performance Indicators. Providing quarterly financial statements and job schedules to your bond agent should be a very easy task as they are already being done monthly. The benefits are significant and there are no costs associated with doing so. Following this program will help place you in that “Best of Class” position with your bond agent and bond company.
Wednesday, October 1, 2008
Discovering Your Weaknesses Through Gap Analysis
Most owners of construction companies came up through the operations side. They were the ones in the field early in their careers, learning their trade from the ground up. Today, many contractors find themselves owning a business that has grown significantly from where it started. They generally aren’t experts in organization structure and therefore aren’t aware of the need to assess the organization they have in place to handle the current and future volume of the business. This is certainly not unique to business owners in the construction industry. Most business owners, no matter the industry, weren’t trained to run a business…any business. I would suggest that the core principles and skillsets involved in running a construction business are the same as those needed to run a manufacturing business, a professional services firm, a retail store, etc. Most of the skillsets involved in managing a business efficiently and effectively revolve around how one deals with the issue of people. One has to put the right team in place and then it’s important to keep the team together all working towards the same goals. It’s imperative to have the right people in our organization and have those people in the right places within the business. This article introduces you to a process which aids the business owner in identifying both the position slots needed, and gaps which may exist, on his or her team. The Gap Analysis is an effective way to accomplish that objective.
Keeping Up With Your Growing Business
We all tend to work within our comfort zones. If the construction business owner came up through the field operations, he or she will tend to run the business from that perspective. The office may be viewed as overhead and the number of people allocated towards office functions may not be appropriate. The accounting department may find itself short-staffed and the owner may find him or herself spending little on the accounting function. At the same time the owner is probably not getting adequate financial and management reporting resulting in poor and/or untimely decisions being made or not made costing the business far more than the savings in short spending on the accounting and reporting function.
The same scenario could be painted for the operations side of the house; not having enough people in a certain function or missing a function altogether. Most contractors started out doing a few million dollars in revenue (sometimes less) in their first few years and today finding themselves doing twenty, thirty, fifty or more million dollars annually in revenues. The organization structure for a five million dollar a year contractor is very different from that of a contractor doing fifty million dollars a year. Often times as a contractor moves through various revenue levels, he or she does not keep up with those revenue changes with the appropriate changes in the infrastructure of the business.
Over my career I’ve made an observation that many contractors can grow reasonably successfully up to approximately 40 or 50 million dollars in annual revenue without significant changes to their executive management infrastructure. That’s not to say that changes should not have been made during that growth period, I’m just noting that many of these businesses tend to perform at least at an average level. When the business grows past approximately 40 to 50 million or so in annual revenues few contractors can successfully navigate those volume levels without significant mistakes and financial pain with their incumbent management team. The reasons usually trace back to not having the appropriate personnel in place in key management positions to be able to deal with the issues which invariably arise in organizations of that size. There are significant “gaps” in management which, in best case scenarios, would have been filled as the contractor was approaching the fifty million dollar revenue levels to begin with. It is important to put the management team infrastructure in place before crises develop.
Many owners refuse to allow other top level management personnel do their jobs without some micromanagement or they don’t acquire top level management to help professionally run the business as many contractors are “overhead” averse. Those actions by an owner can ultimately cripple a business that otherwise has solid prospects as long as the right team was put in place each fulfilling the correct areas of responsibility. A Gap Analysis engagement can be a very useful tool for the business owner who lacks the time and/or perspective to be able to see and understand all aspects and requirements of the business at a high, professional and objective level.
Benefits of a Gap Analysis
Our firm has performed many Gap Analysis projects for contractors and they are always an interesting assignment because we are taking a holistic view of the contractor and his/her business. The business owner generally is not very sure of what his or her team is specifically doing on a daily basis, nor should s/he be. S/he should, however, have a good understanding of what those who directly report to him/her are doing, however this isn’t always the case. This knowledge of what team members are doing is generally the responsibility of a person’s direct supervisor. Throughout the organization supervisors are not precisely sure what their team members are doing and sometimes there are no supervisors for a team when there should be. The problems arise when the reality of the day to day world set in and people starting moving in different directions and assumptions are made about who is doing what. Often times no one is performing a critical function while other times the same functions are being performed unnecessarily by multiple people or in some cases the wrong people. Sometimes a task is being performed with little or no commensurate value and no one is questioning why they are doing the task relying on the knowledge that “this is what we’ve always done”. It is at these times where profitability is eroded and frustrations, mistakes and breakdowns in quality and service are maximized. The team is not pulling in the same direction or they are pulling but their hands may not be on the rope so to speak.
The Gap Analysis helps to identify gaps in areas of responsibility or overlaps within a company. The gaps are created over time through lack of attention to process evaluation and improvement or growth in the company’s business which gives rise to new needs which are never addressed. In order to perform a successful Gap Analysis it is important to first understand the business as it currently exists and operates and fully document the needs of the business. In doing so, one can create an organization chart outlining all the roles and responsibilities of all the positions that should exist within the organization. Once the organization chart and position descriptions are created, we can then evaluate the existing infrastructure, including current roles and responsibilities, and compare them to an ideal organization structure. At this point gaps and overlaps are identified and either re-assignment of responsibilities between existing team members can be suggested and/or the need for new positions are identified. Further, it is possible that the existing organization structure is so far divergent from what the current business needs call for that a complete overhaul is the most efficient solution assuring the needs of the business, its customers and team members are being met.
The Process
As mentioned above, it’s imperative to have a good general understanding of the business including its nature (what does it do and how?), scale, market(s) served and existing structure. One of the best ways to gain an understanding in these areas is to interview key employees. Once the interviews are done, a findings and observation memo is created and presented to the management team. The memo often gives management a different perspective of what is going on in their business versus what they think is going on. The interviews will yield both positive and negative results, each of which are equally important in the process. Many of the comments and feedback are based in tangible events and observations occurring in the business while other comments may be based more in perception and feelings. Both types of feedback are also equally important as the organization is built on both tangible (policies, procedures, methodologies, etc.) and intangible (primarily core values, mission, vision, corporate culture, etc.) fundamentals.
After input and discussion from the management team, with the Gap Analysis Project Manager serving as facilitator, a customized Gap Analysis questionnaire is developed. The Gap Analysis questionnaire is given to all key employees and addresses how each views his or her role. For each task listed, the employee notes whether s/he manages, performs, or assists in that task. Once the results in this area are analyzed, it becomes evident who is doing what and whether the right person is performing the function. Also this analysis will identify whether no one is performing a function or if certain functions are being performed but no longer need to be due to changes in the business and/or its processes.
A Responsibility Delegation Summary is also created in chart format. All of the company’s key operational tasks are outlined by responsibility codes for different departments and displays in chart form who should be delegating which duties, tasks and responsibilities to whom.
A Functional Organization Chart is developed which outlines the departments and the roles and functions of each department. Think of this chart as one level up from a traditional Organization Chart which outlines positions. This Functional Organization Chart shows a broader view of the overall company and serves as a good basis from which to create the more traditional Position Organization Chart.
When we build a Position Organization Chart for a construction company, we are sure to include the roles and responsibilities of each position right on the chart. We find titles are simply not enough to convey what that team member means within an organization. A CFO in one company will not operate in the same exact way as a CFO in another company. Many other variables are in play that affect roles and responsibilities and it is also best not to leave it up to subjective opinion as to what is expected from each position. Clearly defining the roles are the best way for the expectations we have for each team member to be met. Position Guides are also created for each role. We also provide a Position Guide Development Procedure to ensure consistency when they are developed in the future as the organization grows and its needs change. Each Position Guide is reviewed with each employee and s/he, as well as management, sign off on the document.
CONCLUSION
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