There is a little-known rule that prohibits writing about bonding without mentioning the three “Cs”: capital, capacity and character—but there is a fourth “C” that may be even more important when sureties review contractors’ financial statements. While the first three Cs let contractors know “what” they need to have, they do not explain “why” they need to have it. In order to understand the mysterious surety world, contractors need to know the fourth “C.”
The 1st “C”—Capital
Cash may be king, but capital is next in line to a king who is on his death bed. The contractor’s financials statements are the best source for surety analysis of capital.
The surety will look at many key performance indicators (KPIs) for insights: profitability, liquidity, backlog and job fade. It will take a long look at a contractor’s working capital for signs of financial strength and agility.
The surety will study the numbers from the financial statements and adjust them up or down for items such as aged receivables (over 90 days), inventory, related party loans, deposits and lines of credit available in order to arrive at “adjusted working capital,” which is used to calculate total bonding credit. Adjusted working capital indicates the ability of a contractor to make the next payroll and continue to keep the doors open. The surety will look to make sure that the contractor has ample resources and will take a thorough look at contract assets/contract liabilities under Topic 606 guidance.
Sureties hate underbillings/contract assets; in general, they are signs of poor or slow billing practices, work performed on unapproved change orders (that they may or may not be able to bill) or unrecognized contract fade.
Conversely, sureties love overbillings/contract liabilities. Seasoned sureties recognize that too much of a good thing can be dangerous. It may sound silly, but contractors need to be careful about getting too far ahead on billings. Contractors have to be disciplined with their money; if a contractor gets too far ahead, it may qualify as a “job borrow” position in which the estimated costs to complete exceed the remaining amount billable.
Sureties also look at the equity section of the balance sheet to make sure that the contractor has some skin in the game because contractors that take significant distributions or are heavily leveraged are riskier than those that keep the money in the company.
The 2nd “C”—Capacity
Capacity is viewed as the contractor’s equipment, resources and ability to do work. It may also refer to the typical-sized project the contractor has previously undertaken. If the contractor is looking to bond a $20 million contract and their largest contract completed to date is $2 million, the surety will be concerned that the contractor is getting in over its head.
Capacity can also be defined as the additional work a contractor takes on. If a contractor has $15 million of bonding credit and $14 million in current bonded contracts, acquiring another $3 million bond may prove difficult.
The 3rd “C”—Character
Character is often referred to by surety agents as the “Variable C” with the “variable” being the personal morality of the contractor. When the market is good, backlog is strong and surety agents are pushed for growth, the emphasis is on getting the bond written.
Character becomes the “character”-istic of a contractor. The owner and management team’s qualifications emerge as more significant factors to the surety. The surety wants to know that the contractor is well-managed, profitable and have measures in place to reduce risk. Only when the bonding market is tight does the surety look at moral strength and fiber.
Honorable Mention “C”—Communication
Sureties do not like surprises. They are happier when informed in advance of potential situations; they like routine and informative communication. Monthly financials including aged contracts receivable and an uncompleted/completed jobs schedule are preferred.
Contractors should err on the side of over-communicating. It may be safe to say that no information is too much information for a surety.
The 4th “C”—Completion
It is important to understand what the surety does and what true risks the surety takes. There may be examples of individual sureties being altruistic and helping start-up contractors get on their feet but, at the end of the day, the surety is a business. The surety profits by absorbing risk on behalf of another. The risk to a surety is not that a contractor goes out of business, doesn’t pay their bills, does poor work or has owners get into personally challenging situations. The true risk to a surety is that the contractor it bonds does not “complete” the work.
The first three “C’s” are only indicators that completion will happen. Sureties look for a history of successfully completed projects and for factors that indicate potential completion issues. During the last recession, contractors that completed their jobs, even though it may have crushed their balance sheets, received more bonding grace than those that had stronger financials but dumped jobs.
In many ways, the construction industry is driven by a contractor’s ability to bond. Knowing the “why” of what a surety wants provides insight into the workings of the surety industry. This knowledge will help the contractor position the business properly to meet the challenges it may face and better prepare it for success.
