Contractor Bonding Capacity
Surety Bonds: Backpedaling And How To Avoid It
Individual Sureties and corporate sureties commonly rely on a variety of elements when deciding if they will provide bid and performance bonds for contractors. Because Individual Sureties are required to fully back their bonds, their underwriting process may be the most thorough. When an individual surety issues a bid or performance bond on a federal or state project, all relevant underwriting factors are considered including the applicants financial condition.
In most bonding scenarios, the applicant for the bonds is the contractor, a Construction Company – typically a corporation or LLC. The focus of the financial evaluation and decision-making is an annual document: The company’s Fiscal Year-End Financial statement.
Why so much emphasis on this one document? The financial statement is considered a report card on the quality of company management. It shows a range of important indicators. To name a few:
- How strong a financial commitment the owners have made to the company
- The amount of revenues management has acquired in the previous operating cycle
- The extent to which Construction Contracts were realistically estimated and successfully managed
- The management and efficient use of overhead dollars
- Tax planning
- Adequacy of cash flow
- Liquidity
- Profitability
- Reliance on banks and other creditors to finance operations
- Collectability of receivables
The analysts favorite date is the Fiscal Year-End, which is “tax day.” For most companies that date is December 31st. On 12/31 revenues will be reported on the company tax return, and the annual tax bill will be calculated. This annual event is thought to be a convenient and appropriate time to make the financial evaluation that is part of a bonding relationship. Underwriters need to make these reviews periodically to monitor the company’s financial status. The annual financial statement on tax day is a natural for this purpose. A second reason to use this date is that the tax day numbers will be realistic and even conservatively presented – to minimize the tax exposure. This conservative approach is perfect for the bond underwriters who hope to make a realistic analysis of the applicant.
So where does the backpedaling come in? Company managers will rely on their Certified Public Accountant for financial advice, especially tax planning. Limiting taxes is a popular goal, but at what price? Lower taxes may be a result of lower pre-tax profits. Lower profits mean less financial growth, a net worth that may be inadequate to support future expansion and casts a shadow over the company’s future. Why should the owners continue a support a company that fails in its primary mission: Producing a profit for its stockholders/members? Obviously these issues are a great concern to a surety underwriter, who wants successful, well-managed companies in tip top condition for clients. If tax avoidance is aggressively pursued, it is not unlikely that bonding capacity will be compromised. The surety may limit their support or even terminate the relationship if financial performance is weak. Once the document is carved in stone, company management may have an entire year of backpedaling until the date when the next Fiscal Year-End Report can be produced in a more favorable form.
The problem is not uncommon, and the solution is simple if executed properly. Avoid the backpedaling by having a Draft Financial Statement initially produced by the CPA. The document will be marked “for discussion purposes” and that’s what should take place. A review and discussion with the underwriter will determine of any elements of the report are detrimental for bonding purposes. Plans for the coming year can be discussed and bonding capacity evaluated. If the financial statement does not support the desired capacity amount, now is the time to make adjustments – and avoid backpedaling all year.
With a bit of planning and open dialogue contractors can avoid the missteps that prevent companies from realizing their full potential.
About the Author
Steve Golia is Executive VP of The IBCS Group, Inc. The company issues Bid and Performance / Payment Bonds for construction projects. IBCS is the Authorized Risk / Claims Manager for the Scarborough Bond and Guarantee Program.
The experts at The IBCS Group are always available including nights and weekends – every day, because nobody provides better service. 856-673-4135.
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