When contractors apply for Performance Bonds, the underwriting review always includes a financial analysis along with other elements.
Two key components of the financial analysis are Working Capital (WC) and Net Worth (NW). WC is a measure of short term financial strength. NW is the ultimate value of the company upon liquidation.
The inspiration for this article came from a new bond account we recently reviewed. The company is a trade contractor, the kind that normally performs their own work rather than subcontracting. This means their financial statements should show appropriate levels of labor, plant, and equipment.
In this case, the Profit and Loss Statement (P&L) showed sales in excess of $10 million, not a small company. The Balance Sheet showed an acceptable amount of WC, but NW was low – resulting in some weak ratios.
Another element caught our attention: On the Balance Sheet, the net value of the equipment asset was only $65,000! This made us wonder how a company could perform $10 million in sales with so little in physical resources.
There could be a couple of explanations:
- They could be subcontracting most of their work. This is unlikely, however, because they themselves are subcontractors. Typically there is not enough profit to share between two firms. A review of this company’s P&L statement did not indicate extensive subcontracting.
- They could be renting almost everything (instead of owning). This doesn’t sound like a practical approach with sales as high as $10 million, and the P&L did not show high rental expenses.
- The equipment could be substantially depreciated resulting in a low net value on the Balance Sheet. This did turn out to be the scenario in their case.
Let’s talk more about #3. But first off, what is depreciation?
IRS definition: http://www.irs.gov/Businesses/Small-Businesses-%26-Self-Employed/A-Brief-Overview-of-Depreciation
It says in part, “Depreciation is an income tax deduction that allows a taxpayer to recover the cost or other basis of certain property. It is an annual allowance for the wear and tear, deterioration, or obsolescence of the property.”
This means when a $100,000 backhoe is purchased, its value as an asset on the Balance Sheet goes down each year as the depreciation progresses. Bear in mind, this is an accounting entry. It is not an indication of the current market value of the asset.
Eventually, the asset is depreciated to zero. However, even if it is valueless on the Balance Sheet, it may still be out on a job site working and producing revenues. It may still have a market value. So therein lies the Gold.
Assets such as heavy equipment (referred to as “Iron”), may have value that is not reflected on the Balance Sheet. So the question is: How to recapture that value and help the bond worthiness of the account?
One way is with a professional appraisal. Even if the backhoe is depreciated to zero, if the current market value is $25,000, that represents NW that can be added to the financial ratios.
Imagine the effect for the company in question. Upon further review, we determined that the cost of their equipment was nearly $2 million. They had a lot of it and it was older so depreciation had reduced the net value on the Balance Sheet to $65,000. However the current market value was actually $500,000!
Q. Based on these facts, what value should the bond underwriters use for the equipment: $65,000, $2,000,000, $500,000 or some other amount?
A. If you’ve been following along, that’s where the appraised value comes in. You need an independent determination of current market value that recognizes the amount of cash these assets could bring. If well maintained, they have a value higher than that shown on the Balance Sheet. ($500,000)
How else can the value be determined? The client could provide a copy of their equipment floater as evidence of current value. You could also get an informal appraisal from their equipment dealer. Any of these options are better that living with the unrealistically low value shown on the Balance Sheet.
Going back to our example, if the backhoe’s market value is currently $25,000, give that info to the underwriter. The newly found net worth for all such assets can be added to the bonding analysis. You turned the Iron into Gold, a POT of Gold! It can totally transform the ratios and the client’s ability to qualify for the bonds they desire.
Consider this technique for companies with a sizable fleet of mature equipment, especially when their Net Worth is less than desired for bonding purposes. This analysis can also help strengthen the banking relationship.
FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
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