It is very important for construction companies to have bonding capacity during this ongoing period of economic recovery. Bonding capacity gives a project owner faith in a contractor’s ability to fulfill the terms of the contract, and it also gives contractors with higher bonding capacity greater opportunities to win work.
Bonding companies are careful about the contractors for which they stand as sureties and the amount of bonding capacity they are willing to provide. Since the early 2000s, sureties have been stringent when evaluating contractors they are underwriting. The main factors they consider are referred to as the three Cs: capital, capacity, and character. How contractors manage these three areas significantly impacts the amount of bonding capacity sureties are willing to provide.
Capital
Sureties look at capital to get a sense of the contractor’s financial ability to complete projects. They focus on working capital (current assets minus current liabilities), which gives them a sense of the contractor’s ability to meet their current obligations. If you have significant capital that is locked up in long-term assets that are not easily converted to cash, your bonding capacity will be limited.
Profitability is also important. If profitability has significantly declined or is negative and it lasts for more than one year, sureties get nervous.
There are many things contractors can do to improve bonding capacity related to the capital component:
- Collect accounts receivable in a timely manner. Understand your customer’s payment policies and manage the process so that cash is collected within 90 days.
- Invoice jobs in a timely manner and be ready to explain underbillings and unusual overbillings.
- Reduce bonuses and overhead when profits are declining.
- Review financing agreements and consider refinancing short term-debt for long-term debt.
- Limit riskier assets such as related party receivables, inventory, or other assets not easily convertible to cash.
- Provide accurate and informative reporting, and avoid large profit fade or gain.
- Pursue capital infusions, if necessary.
Capacity
When looking at capacity, sureties consider the contractor’s experience and skill, equipment resources, personnel resources, and availability under line of credit. They do not want to see a contractor working on projects with which they do not have prior experience. They also do not want to see the contractor overextending themselves by taking on more projects than they can handle. If contractors show they have a good business plan, understand how to manage their resources, and don’t over extend themselves, it gives sureties comfort and they are more willing to bond projects.
Character
Sureties are not willing to provide bonding capacity to those they cannot trust. Therefore, the contractor’s character is a very important consideration when evaluating bonding capacity. Character is something that is earned over time, and it is based on integrity and reputation.
Sureties make a determination of character by the quality of the work, relationships with suppliers and subcontractors, relationships with the bank and other service providers, and the ability and willingness to communicate problems quickly. Sureties do not like surprises and they want to be informed promptly when problems arise.
They also do not want to see contractor assets being mismanaged on non-business related activities. Contractors with bonuses that appear excessive related party loans that are not in the ordinary course of business, or family members’ earnings that do not appear to be in-line with their job responsibilities can all be cause for concern.
Increasing bonding capacity is not easy and it requires a dedicated effort throughout your organization. Using outside service providers such as bankers, accountants, or bonding agents can be beneficial, as they understand what underwriters look for in contractors. They can also give the surety an extra level of confidence in your company in situations where your service provider is someone they already know and trust.
For more information, contact Mark A. Guillaume, Director, Audit & Accounting and member of Kreischer Miller's Construction industry group at Email or 215.441.4600.
Information contained in this alert should not be construed as the rendering of specific accounting, tax, or other advice. Material may become outdated and anyone using this should research and update to ensure accuracy. In no event will the publisher be liable for any damages, direct, indirect or consequential, claimed to result from use of the material contained in this alert. Readers are encouraged to consult with their advisors before making any decisions.