Key Elements Bonding Companies Are Looking for in Your Construction Financial Statements
- Apr 28, 2023
Your construction financial statements contain valuable information that bonding companies use to determine your company's financial strength and ability to complete contracts. Here are a few areas in your financial statements that bonding companies pay special attention to when determining your firm's bonding capacity.
To determine your bonding capacity, bonding companies compare your current assets to your current liabilities, take the difference and typically bond you 10 to 20 times that amount, depending on your experience and the type of contract. Current assets include cash, accounts receivable, prepaid assets, inventory, loans receivable and underbillings. You generally won't receive the total value of current assets that bonding agents deem potentially not collectible, such as loans receivable from officers or stockholders, loans receivable from employees or inventory. Typically, current assets for bonding purposes are those that can be turned into cash within 12 months, and current liabilities are liabilities that need to be paid within 12 months. Remember that underbillings are current assets and overbillings are current liabilities.
Bonding companies and banks look at your net worth compared to your debt (any money you owe as a liability on your financial statement). When debt-to-equity ratios start getting above three dollars of debt per dollar of equity, the bonding company will begin having more questions and scrutiny.
Due to the new lease standard ASC 842, everyone should have discussions with their bonding companies when looking at their debt-to-equity ratios. Under ASC 842, contractors are required to record all operating leases longer than 12 months as assets and liabilities on their balance sheets. Before ASC 842, operating leases were only included in the footnotes. Now that operating leases are reported as a liability on your balance sheet, bonding companies should not be counting that against you because they never had in the past. For example, the lease on the building you operate in will now show as a liability, even if you’ve had that lease for years, potentially increasing your debt-to-equity ratio.
The bonding company will next look at your gross profit percentage to determine if you're maintaining a realistic profit percentage for your company. Bonding companies look at the consistency of your profitability and how you compare to your industry peers. If you consistently made 20% gross profit, did it drop to 15% or 13%? If there was a change, be prepared to discuss why these changes occurred with your bonding company. Remember that bonding companies and banks are alike: you can explain one year of losses, but seeing two years can create challenges for them.
The next item that bonding companies are looking at is cash flow. Has your debt increased during the year? Are your receivables getting older? You've heard the saying "cash is king," and it is: bonding companies need to see that you're adequately liquid in the company. Bonding companies also want to see you have a line of credit, even if you don't use it, to assure that if you run into a problem on a contract, you'll have somewhere to pull funds from to complete the contract.
Work in progress schedule
The next and probably most critical item for bonding companies is the work in progress ("WIP") schedule, which is the holy grail of a construction company's financial statement. Within the WIP schedule, bonding companies will pay especially close attention to your budget, underbillings, overbillings, claims and unapproved change orders.
We highly recommend that our clients revise their budgets on contracts monthly in case the cost to complete the contract changes. Most clients will stay close to their original projected profit even if their budget improves as the project progresses. But if their budget starts deteriorating, clients will adjust their budget downward since the bonding company monitors how these contracts perform. For example, suppose you tell the bonding company on your WIP schedule that you'll make 15% profit on a particular contract, and you only make 10%. If they see you consistently making over projections, the bonding company will lose confidence in your ability to bid properly or execute these contracts efficiently, limiting your firm's bonding capacity. Bonding companies don't want to see profit fade, so always aim to exceed your bonding company's expectations to be held in a more favorable light.
If you have significant underbillings on contracts, it's an indication that either your projected profits are too high and you won't realize them, or you've done a lot of work for unapproved change orders, making the job appear further along than it is. We typically see the former to be true, so if you have underbillings, it's essential to find out why.
Most contractors try to overbill contracts; however, the schedule of values built into the billing document is intended to minimize their ability to do this. If you have significant overbillings, you are able to work with cash from your customers that you haven’t earned yet, but you need to budget properly to avoid cash flow challenges in the future as the contract nears completion.
- Claims and unapproved change orders
When preparing financial statements, clients are allowed to accrue construction revenue up to the amount of the cost but show no profit on a construction claim or unapproved change orders if management believes they will ultimately recoup at least that cost. We've experienced clients recording construction revenue of up to 20-40% of the cost on unapproved change orders and claims (which requires extensive footnotes in the financial statements), but never the full amount. The contract price on the WIP schedule should only include approved change orders, not pending change orders. This area requires careful planning and having conversations with your accountant. Credibility is critical, and it can cause irreversible damage to your bonding relationship if you recognize revenue, and it doesn't materialize.
These are some of the main things bonding companies are looking for when reviewing the health of your business. By understanding each of these areas, you can get a good idea of what your bonding capacity will be, as well as your planning opportunities and any other issues you need to address before meeting with a bonding company.
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Donald N. Hoffman
Donald Hoffman is Partner-in-Charge of the firm's Maryland office. His expertise includes accounting, tax planning, business consulting, strategic planning, business succession, buy/sell agreements, and estate planning.
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