Bonding capacity is one of the primary factors limiting your ability to grow and acquire larger projects. What does your surety want from you, and how can you make sure your bonding capacity is there when you need it?
Traditionally, bonding agents used the Three C’s—capacity, capital and character—to evaluate contractors’ bond worthiness. Capacity is a measure of assets available to do work, such as equipment, personnel, experience and technical knowledge.
Capital includes working capital (current assets minus current liabilities), the ability to raise additional funds as needed, sufficient equity or retained earnings to absorb occasional losses. Character, the least tangible of the three, reflects the willingness of the company to honor commitments and complete projects as well as paying bills on time.
During market upswings, the traditional criteria are often loosened, and during subsequent slowdowns, bonding companies tighten capacity, parallel to the practices of the banking industry. Although the C’s are still important, other parts of your business and management practices come under scrutiny when bonding capacity tightens.
For example, the types of projects you perform will be analyzed. Are you doing jobs similar to those you have successfully completed in the past or trying to break into new niches or wider geographical areas? Do you have the management expertise, project management and site leadership to perform additional work efficiently and profitably? Will you be able to understand regulatory environments in new locations? Can you adapt to new technologies and the demands of a new customer base?
The quality of your customers becomes increasingly important, along with the fairness of the contracts you are willing to sign. How are your customers (especially project owners) paying their bills? What is their reputation? Are you agreeing to onerous contract terms? If you are guaranteeing the efficiency of a system you install, instead of simply its completion, the surety will be more concerned with the contractual risks you have accepted. If you perform design-build work, have you insured for design errors and omissions?
There are several “early warning signals” used in the bonding industry, so be sure to avoid them if possible. In terms of how your company is run, you might want to take a new look at how efficiently you use your equipment and whether your balance sheet should be restructured.
Are you holding notes to stockholders? Consider converting them to common stock. If stockholders owe the company money, collect it. Don’t use short-term debt, such as your line of credit, to finance fixed assets, such as a new building.
Maximize liquidity, so that you have enough cash to pay your bills and take timely advantage of good purchasing deals. Most important, make sure that you are converting profits to cash flow.
If your last few years of profit (net income after tax, plus depreciation and any other noncash income statement items) is not equal to your cash flows during the same time period, you are not effectively converting your profits to cash flow. If you are growing the business, however, it is usually acceptable to violate this rule as your total receivables increase.
Factors that contribute to effective conversion of profit to cash flow include tighter collection of receivables and avoidance of underbillings. Sureties will discount uncollected receivables after 90 days and dismiss them completely after 120.
If the ratio of underbillings to stockholders’ equity is greater than 3-to-1, it sends up a red flag in the bonding industry, so keep your underbillings below 30 percent of your equity. Even overbillings are a concern, since they are liabilities until the work is performed; however, substantial increases in cash may offset the effect of overbillings on your balance sheet.
The accuracy of your field information and your ability to correctly forecast the cost of completion of ongoing work are important to your surety. You must consistently pursue approval and collection of change orders and claims. Close out your projects quickly, and avoid profit fade by keeping project managers in place until their jobs are completed.
The most important factor in preserving your bonding capacity is the quality of your relationship with your surety. Communicate openly and often, especially when there are problems, and you will preserve the trust essential to a good working relationship.
Also, provide notice of major financial transactions or changes in strategy. Regardless of the quality of your financial picture, trust is still the linchpin of your ability to bond your jobs. If your surety is a partner in your vision, and understands your business plan, you will weather bonding cycles with “surety.” EC
NORBERG-JOHNSON is a former subcontractor and past president of two national construction associations. She may be reached at firstname.lastname@example.org.