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?”
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.
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.
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.
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.