By the numbers – five key performance indicators that sureties watch
When surety underwriters review your financial statements, they are looking for evidence of sound financial condition. Every underwriter has its own standards and expectations, but here are five key performance indicators (‘kpi’s) many bonding companies look at closely:
1. Working capital: Sureties typically adjust the textbook definition of working capital – current assets minus current liabilities – to reflect certain real-world considerations. For example, they usually discount assets like related-party receivables and generally do not include inventory, prepaid expenses or other assets that cannot be readily converted to cash.
Maintaining working capital equal to about 10 percent to 15 percent of annual revenue is a good rule of thumb, but underwriters’ specific requirements can vary widely. A more useful metric for many sureties is to compare working capital to backlog. If backlog exceeds 12-15 times working capital, this could indicate possible cash flow problems ahead — especially if there is inadequate credit capacity to help cover shortfalls.
2. Backlog: In addition to watching for excessive backlog, bonding companies also worry if backlog falls too low. This could be a sign that your company is struggling to win work and might be unable to generate adequate cash flow to fund jobs already on the books.
One common guideline is to maintain backlog that is equal to about one year’s worth of revenue. However, every surety will have its own standard.
3. Debt-to-equity ratio: Most underwriters would prefer to see the ratio of total liabilities to equity kept below 3-to-1. But remember that bonding companies subtract certain assets out of the net equity position.
Recent changes in the lease accounting rules could also affect this ratio (turn to page 2 for more details on these rules). Discuss these changes with your surety and your CPA to determine how they might affect your bonding capacity.
4. Overbillings and underbillings: Overbillings on a job occur when billings outpace the costs and earnings computed under the percentage-of-completion method. This can be a sign that you are managing cash well and working on the owner’s capital instead of your own.
But excessive overbillings can also be a sign of ‘job borrow’ – using cash from one job to fund losses on another. Consistent overbillings can also cause underwriters to question the accuracy of your estimating procedures.
Meanwhile, underbillings – when billings are not keeping pace with the costs incurred – are often a warning sign that the job will be less profitable than projected. At the least, excessive underbillings can be interpreted as a sign of poor cash management.
Sureties naturally prefer to see overbillings exceed underbillings. If total underbillings start to approach 25 percent of working capital, expect your bonding company to ask for an explanation.
5. Profit fade: Many factors may cause the profit from a project to be less than anticipated — and all of them can shake a bonding agent’s confidence. Repeated instances of profit fade will almost certainly cause a surety to discount your bond-worthiness, especially if profit fade exceeds 10 percent of the original estimate.
These are only a few of the many kpis sureties may consider when evaluating your bonding capacity. To calculate these metrics, you must maintain detailed records of all transactions, along with extensive and up-to-date job records.
Courtesy: Bauerle and Company, P.C.