Viewpoints

Sureties Want To See Strong Financial Statements

Scott Cresswell

Originally Published In:
April 2008
Author: Scott Cresswell, CPA 

Here are some insights on the relationship between your company’s financial statements and obtaining bonds. 

Irrespective of how good or bad the construction market may be, you can be sure of one thing -- your surety will want to take a close look at your numbers before it will issue a bond. What it finds in your financial statements will influence whether you’ll get bonds and how competitively priced they will be.

Ideally, the facts presented in your financial statement will show that your company is in good financial health. There are four measures that are commonly used to assess the strength of the financial statements:  working capital, cash flow, capitalization and debt, and profitability.

Let's first take a look at working capital.

The amount of available working capital determines your company’s ability to finance current operations. Two key measures of the adequacy of working capital are the current ratio and the quick ratio (also known as the “acid test”). The current ratio is simply the amount of current assets divided by current liabilities. Ideally, your company should try to maintain a 1.5 to 1 or better ratio of current assets to current liabilities. The quick ratio is the amount of cash, cash equivalents, and receivables divided by current liabilities. This ratio predicts your company’s ability to pay its current obligations with cash. One way to increase working capital is to use long-term debt instead of cash or short-term financing for fixed asset purchases.

Secondly, let's look at the importance of cash flow with respect to getting paid in a reasonable amount of time.

Slow collections are a serious problem for many contractors. You should monitor the amount of your accounts receivable over 60 days and try to hold that figure to a minimum. You can calculate the average number of days accounts are outstanding by taking net accounts receivable, multiplying by 365, and dividing the result by annual revenue. You can improve the number by sending bills out for work and materials as you complete each stage of the project. Be sure each bill clearly explains what stage of the work was completed. Send reminders when the customer doesn’t pay you within an allotted time. That usually works, but if you still don’t receive payment, you may have to threaten to stop work on the project until you’re paid.

Next, let’s review relationship of capitalization and debt.

Too little capital and high levels of debt can make your balance sheet look extremely unattractive to a surety. One common way to measure a company’s level of capital is the debt to equity ratio. It is calculated by taking total liabilities divided by net worth. The higher the ratio, the greater the risk creditors face.  Sureties prefer to see a debt to equity ratio of 2:1.

You also have to watch underbillings. Significant underbillings could indicate that your company is facing some problems on one or more jobs. You should be prepared to explain why costs that have been incurred cannot be billed currently.

Lastly, profitability.

Low profit margins on too many jobs will limit your company’s future growth. You can measure profitability by using a return on assets ratio or a return on equity ratio. The first indicates your company’s profits generated from its assets and is calculated by taking net earnings and dividing that amount by average total assets. Well-run construction firms typically derive a 10% or higher return on assets. Return on equity measures the return on money invested by the owners. You can find this number by dividing net earnings by total net worth. It’s not unreasonable to expect to have a 15% or greater return on equity.

Analysis of your company’s financial statements can provide valuable information you can use to effectively manage the firm. By paying close attention to the balance sheet items that sureties focus on most, you can put your company in a better position to obtain the bonding it needs.

Disclaimer: The Bonadio Group provides the information in Viewpoints for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice, or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal, or other competent advisers. Before making any decision or taking any action, you should consult a professional adviser who has been provided with all pertinent facts relevant to your particular situation. Tax articles in Viewpoints are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided "as is," with no assurance or guarantee of completeness, accuracy, or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability, and fitness for a particular purpose.