working capital

Secret #101: S-T-R-E-T-C-H  That Bonding Line

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Here is an easy and legitimate way to fit more projects into a bonding line.

Stretching-DollarVirtually all Surety Bonding programs include a “single job limit” meaning the maximum dollar value of one bonded contract, and an “aggregate amount” which is the maximum permitted exposure at any one time.

When a construction company gets close to their aggregate amount, it can hinder the ability to pursue additional projects and keep their pipeline full. Understanding how the aggregate is administered by surety underwriters can help get the most out of this critical element.

The Science

Current Data

The first thing to know is that current info is required.  If the underwriter has not been updated in more than 30 days, you can expect a request for an update.

Proper Format

This info may be conveyed as a dollar figure “We have $876,000 on hand to complete” or a detailed schedule may be required.  Such reports are called a Work On Hand (WOH) schedule or a schedule of Work In Process (WIP).  We call it the latter because computers hate to type “WOH.”

The WIP schedule can be a short form containing 5 or 6 columns of info on each incomplete contract, or they can be twice that involved. It is important to use the format the underwriter requires, and fill out the form completely.

The Art

So here are the interesting parts.

Contractors tend to think of their projects based on the status of the Billings.  Obviously, that’s how they make their money.  No billings, no cash flow, no company.

  1. How much do you have left on that job?
  2. (Contractor replies) We have $350,000 left to bill.

Surety underwriters and accountants view the projects based on Costs. This is because, even if the project is 100% billed, it is not complete until there are no more costs left to incur.

  1. How much do they have left on that job?
  2. (Bond underwriter replies) Their remaining costs are $290,000.

S-T-R-E-T-C-H  That Bonding Line

So the first point is to know that the surety is viewing the “Remaining Costs to Complete” when determining how much aggregate is in use / or available.  MORE costs incurred to date mean the job is closer to completion, and less aggregate is in use – and therefore available to support the next project. Contractors are cheating themselves if their cost data is not up to date, or they are failing to include materials delivered to the site, soft costs such as insurance, bonding, etc.

The second point is that most underwriters include ALL work in the calculation, but some only view the condition of the jobs they have bonded.

Be sure you know what is being requested.  It is incorrect to show tons of work if the underwriters only want details on the two jobs they bonded. If you’re not sure what’s needed, ask!

Understanding how aggregate capacity is calculated and providing the right info can dramatically increase the portion of a contractor’s line that remains available.

About us: FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secret #98: The Great Rate Race – Bonding

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Some years ago we met with a contractor and the conversation turned to Surety Bond Rates.  He had just become aware of different (lower) rates that were available from bonding companies.  He was clearly upset: “Do you know how many jobs I have lost over the years by a small margin?!”  Of course I didn’t…  The point was that he felt his bond rate caused him to lose opportunities.

GREAT RACE, JACK LEMMON PETER FALK 1965

Surely every expense and cost element is important when a contractor is pursuing “low bid” work.  The practice in the U.S. is for public bodies like federal, state and local municipalities to award work to the lowest responsible (meaning appropriately qualified) bidder.  Read this as “low dollar.”  It is a tough, competitive environment where margins are usually quite thin or zero!

The contractor’s ability to acquire new work is often linked directly to their control of all expenses, including the bond cost.  However the importance of the Rate Race may be overstated. 

Here are two important factors that are often overlooked:

  1. Assume the contractor is with Surety A, and Surety B has lower rates. There is no point in comparing the two if Surety B will not agree to bond this account.
  2. The contractor must remember, the extent of their discontent must be the difference between their current surety bond rate and another rate that is available to them. Example: Currently pays 2.5%, has an opportunity to pay 2%.  The discontent is over the rate difference: .5%, not 2.5%!

The first “Aha moment” is when the contractor realizes that every bidder is paying for a bond.  And the difference between the rates is usually quite small, not a significant factor in the outcome of the bid.

The second Aha comes from the realization that, when it comes to bonding companies, contractors may find CAPACITY is a much more important issue.

Contractors are restricted in the amount of work they can acquire.  The bonding company has a certain comfort level, and will withhold their support if the contractor acquires more projects than they feel is prudent.  The concern is that the contractor may become overextended and ultimately fail.  Think about this: Do the rates matter if the surety will not issue the bond?

Conclusion: We agree that bond rates, like all cost elements, must be monitored and controlled.  However, when selecting a surety and managing the relationship, the contractor may conclude that capacity is king and rate is secondary.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secret #86: Exoneration Nation – Why Get Off Performance Bonds?

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When it comes to performance bonds for contractors, the emphasis is always on getting them. They are normally required on public work. If you cannot bond the job, being a well-qualified low bidder is not enough. Once a contractor gets the performance bond, work commences and they may think they are done with the bonding company.  Actually, every bond has its own life cycle.  Issuance is the birth – but when and how does it end, and why should the contractor care? 

After a project is bonded, the surety may not require any further paperwork from the contractor. Sometimes the obligee wants the surety to provide a Consent to Final Payment or Consent to Release of Retainage. In such case the underwriter may ask for documentation regarding the health and status of the project. But absent that, the contractor may not think it is necessary to communicate with surety at the conclusion of the job. Why is doing so beneficial?

  1. Each bonded contract represents partial use of the contractors’ aggregate capacity. By officially closing out the project the surety capacity is restored. This is obviously important to enable the pursuit of new work.
  2. From the surety’s standpoint, any coverage for the warranty does not commence until the work is accepted and the performance bond is released. It is beneficial for both the contractor and the surety to start, and promptly conclude, the warranty obligation. While outstanding, the warranty is a risk for both.
  3. The third reason involves the payment bond. The recognition claims by suppliers of labor and material is affected by the last date of their supply or performance on the project. Officially closing the contract and performance bond creates one point of reference for evaluation of such claims.

Closing out the bond file is also important for the surety. It enables them to book any remaining unearned premium and concludes their liability. Both the contractor and surety are exonerated from the risk/obligation.

ex·on·er·ate   verb
past tense: exonerated; past participle: exonerated
– to relieve of a responsibility, obligation, or hardship
– to clear from accusation or blame

“The results of the DNA fingerprinting finally exonerated the man, but only after he had wasted 10 years of his life in prison.”

How to Close the Bond File

At the end of the project, whether requested by the surety or not, the contractor should obtain a letter from the obligee stating that the contract has been completed / accepted and the surety bond is released. The contractor retains a copy and sends this evidence to the bonding company. It’s just that simple.

Contractors should assume the responsibility for this action because not all sureties are diligent in requesting closure evidence for their files. It is true that in every case, it is beneficial for the contractor to submit this information to the bonding company.

Exoneration Nation: Be part of it!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

Secrets of Bonding #57: (4 of 4) Work In Process Schedules – Own Them!

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WIP Schedule, Effect on Balance Sheet Analysis

Now we pull it all together.

Here again is our sample contract.

Contract Price / Original % GP  /   Billed    /     Costs to Date  / Remaining Costs

$1,100,000     /        10%            /$550,000 /    $350,000      /  $700,000

What did we determine so far?

  1. We found that the job is 33% complete.
  2. The profit % has slipped from 10% to 4.5%
  3. The contract is Overbilled by $187,000

In addition to generating some discussion (What’s going on with this project?), these facts have an effect on the financial analysis and bond worthiness of the account. They could result in the bonding line being reduced and future bonds being declined.

How does this happen?

Remember the Overbillings are dollars the contractor has in hand, but at this stage of the project they are undeserved.  The dollars are comprised of costs and profits, and the profits are unearned at this point.

So where are these “undeserved funds” on the balance sheet?  There is no entry by that name on the Balance Sheet.  These dollars are sitting in the cash account, along with other cash owned by the company.  These dollars are not yet earned or deserved, yet they are sitting in the account looking normal.

The solution is to reconcile (recognize) the undeserved funds by creating a corresponding liability that offsets the Overbilling cash asset. This Current Liability will be called Billings in Excess of Costs and Estimated Earnings. In short, this is referred to as Overbillings.

In this case, there will be a $187,000 Overbilling Current Liability to offset the undeserved funds in the cash account (Current Asset).  This removes the extent to which the Overbillings inflated the Working Capital calculation (Current Assets minus Current Liabilities).

In an Underbilled situation, a Current Asset called “Costs and Estimated Earnings in Excess of Billings” would appear.  (Notice that it sounds like the opposite of the Overbilling title.) This adds to Working Capital by reflecting the earned funds that have not been collected because the billings are not current.

Here are some CPA comments regarding WIP schedules and their importance:

http://www.reacpa.com/the-contract-schedule

Conclusion: The analysis described in this series is critically important for contractors and their surety.  However, the analysis is impossible if the contractor does not keep valid records of the costs attributed to each individual project and then periodically re-estimate the Remaining Costs to Complete based on the actual realities experienced.

Watch for #58 – a Bonus Edition!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! 

Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

 

 

 

Secrets of Bonding #56: (3 of 4) Work In Process Schedules – Own Them!

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Profit Analysis

Every project starts with an estimate that attempts to predict the total Cost of labor and material needed to perform the work.  With this number and the contract price, we can find the Original Estimate of Gross Profit.  (Contract profits are always “gross” because overhead and other expenses have not yet been deducted.)

The same analysis can be performed during the life of the project to determine:

  1. if the contract is expected to produce a profit
  2. if the original project estimate was reasonably accurate in predicting the costs that are being incurred (and therefore the profit prediction is dependable)
  3. if field supervision and the labor force is as productive and efficient as expected
  4. if material costs are coming in as predicted

We use the original percentage of gross profit instead of the dollar amount so the contract performance can be compared over time, even if the contract dollar amount has changed by amendment.bookkeeper3

A short form WIP may not state the Current Estimate of Total Costs, or the Current Estimated Profit, but you can calculate them.

Formula to find Current Estimated Percentage of Profit:

On the WIP schedule, do you see, or can you calculate, the Current Estimate of Total Costs to Complete? (Discussed in “2 of 4”)

Find it by adding the Costs Incurred to Date to the Current Estimate of Remaining Costs to Complete.

To calculate the current estimated profit %, subtract the Current Estimated Total Costs from the Current Contract Amount (gives you the expected profit in dollars), then divide the profit dollars into the contract amount to find the profit %.  Try it on our sample contract.

Contract Price  /  Original % GP  /   Billed    /     Costs to Date  / Remaining Costs

$1,100,000      /     10%               / $550,000 /   $350,000     /  $700,000

Is the current estimated profit $50,000?    Yes, it is!

To find the % divide $50,000 into $1,100,000 which gives you .045 or 4.5%.

This means that now, after this project has commenced, a profit that was projected to be 10% of the original contract amount has now deteriorated to 4.5% of the current contract amount. This is vital info for the contractor to have during the project.  It shows a trend that must be controlled. Prompt action may prevent the project from producing a loss for the company or could even improve the final profit figure. The surety underwriter will monitor such projects, even if they are not bonded.

Critically Important: This analysis is impossible if the contractor fails to record the labor and material costs incurred specifically on each project. They must also make a CURRENT estimate of the remaining costs to complete. They cannot rely on the original estimate of costs and merely hope the profit will be there at the end.

Billings: Overbilled / Underbilled

Now let’s shift gears. The next point to determine is whether the project is billed ahead or behind the degree of completion.  For example, the contractor’s office may be slow in processing the invoices to the project owner, so they may not have collected funds that are rightfully earned (they are Underbilled).  Conversely, they may be billed beyond the degree of completion (they are Overbilled) and therefore have dollars in hand that are not yet earned. This is calculated in dollars by first comparing the % of completion to the % Billed to Date.  Try it on our example contract.

Here are the questions:

  1. What was the % of completion?
  2. What dollar amount is that percentage of the current/revised contract amount?  (This gives you the “correct” amount of billings at this stage in the project.)
  3. Are the actual Billings to Date more or less than this amount?  Are they Underbilled or Overbilled, and by how much?

OK, what did you get?

  1. The % of completion is 33.3%
  2. Therefore the “correct” billings are $363,000
  3. If the actual billings are $550,000, the company is $187,000 Overbilled on this project.

They have succeeded in billing the client beyond their current degree of completion. This may not be bad if the contractor knows they are overbilled.  Management should not be unpleasantly surprised when they are 100% billed but the work is still not complete (Yipes, no more money coming in! Who’s gonna pay for the labor and materials?)

Another issue: Overbillings can become a concern for the surety.  Overbillings (money) may be diverted by the contractor into another project.  In the event of contractor default and completion by the surety, this means there may be funds missing that rightfully belong in the project.  This could increase the surety’s net loss.

Underbillings may indicate an intentional, conservative billing practice on the part of the contractor – leave money in the project and take it out at the end when successful completion is assured.  If it is unintentional, they may be depriving themselves of earned profits that are currently needed.

Underbillings can also be an indication of poor management and / or administrative practices.

The point is that all these issues are important for the contractor and surety, and therefore, the agent.

Our last segment in this series will cover how all this affects the contractor’s financial statement.  Important!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it! 

Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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Secrets of Bonding #46: Turn IRON into GOLD

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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:

  1. 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.
  2. 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.
  3. 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
Office: 973-541-3417

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Secrets of Bonding #31: When Receivables are Not Receivable

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Surety bond underwriting involves many elements, and financial analysis is always one of them.  In this newsletter, let’s look at a single element, an important one, and how you can influence the effect it has on bonding decisions.

Accounts Receivable “A/R” are the funds owed by outside parties to the company for work it has performed.  This is a Current Asset and is part of Net Worth.   Active contractors always have such money due them.  The number can be significant for firms in a growth mode.  Problem: Sometimes bond underwriters discount, or disallow part of this figure, thus reducing the applicants recognized financial strength and bond worthiness.   Why does this happen and how can you influence the outcome?

One reason for such assets to be disallowed is the age of the individual receivable on the fiscal year-end (FYE) financial statement date.   In order to be conservative, A/Rs that are 90 days old or more “over 90” are assumed to be uncollectable, and therefore are disallowed.  (Key word: Assumed)

Same with receivables arising from change orders that are unapproved or in dispute.  Projects with performance problems may have all payments held up by the owner, and therefore related A/Rs may be disallowed.  In fact, receivables may be discounted if there is a dramatic increase over historic levels, even if there is no apparent reason to doubt the collectability of the funds.

When A/Rs are disallowed the Working Capital calculation suffers as well as the ratio analysis.

This can reduce or eliminate the contractors bonding line.

Here are some possible cures. 

Retainages – A/Rs over 90 days old may be acceptable if they are actually Retainage which is slightly different from a true “trade receivable.” Identify if any of the A/Rs are actually Retainages.  They should be separated from the A/R analysis and “allowed.”

Over 90s – Older A/Rs are allowable if they were subsequently collected (no matter how old they became.)  Ask the client or accountant for an update regarding the collection of year-end receivables.  All collected items are included in the financial strength analysis.  The underwriter should be updated if they are eventually collected at a future date.   The client will be penalized for a disallowed A/Rs for 12-15 months after the fiscal date.  Updating the file when funds come in could help achieve a bond approval any time during this period.

Change Orders – The same concept applies to COs no longer in dispute or project issues that are resolved.  All A/Rs that are ultimately collected are allowed, regardless of how late they occur.

Payment Bond – If our client is a subcontractor, there may be a Payment Bond “above them” available for claim.  An over 90 A/R might be allowed based on the existence of this safety net.

Caution: If an aged schedule of year-end A/Rs is produced at a subsequent date, items that were not over 90 at FYE (but remain open) may now may be old and therefore disallowed!  It works both ways.

Conclusion

The financial analysis associated with surety bond underwriting is primarily focused on the fiscal year-end financial condition of the company.  These numbers drive the bond line until the next FS is issued – normally about 15 months.

The receivable collection is an ongoing process that warrants interpretation and monitoring because of its changing nature.

Call us with you next Contract, Site or Subdivision Bond.

FIA Surety / First Indemnity of America Insurance Company
2740 Rt. 10 West, Suite 205
Morris Plains, NJ 07950
Office: 973-541-3417

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Secrets of Bonding #4: Working Capital

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The Magic Wand: WORKING CAPITAL.

Surety bond underwriters base their decisions on a wide range of factors including the contractor’s prior experience, quality of staff, credit history and financial condition.  Many of the factors are subjective but some are just cold hard facts. Working Capital (WC) is among the more straight forward elements, and is easily identified.  It’s worth knowing about because it is an unavoidable piece of the underwriting puzzle, and to many sureties it is one of the most important. If there is a magic wand you could wave over an account to get it accepted, this is it!

What is Working Capital and how do you find this element?

Working Capital is a prediction of the company’s future, near term, cash flow.  Based on one day in time, it predicts the amount of cash that will flow through the business to pay bills, finance new ventures and solve problems that arise.  These are all important factors for surety bond underwriters.

WC is located on the company’s most recent year-end financial statement (FS).  The most common date for this is 12/31 of the preceding calendar year. Turn to the Balance Sheet, then the Assets column, and then the subtotal called “Current Assets.”  Now find the corresponding figure in the Liabilities called “Current Liabilities.”  The difference between these numbers is called “Working Capital as Given” meaning it is taken right off the FS without analysis or adjustment. Underwriters will hope to find that the WC is about 20% of the single contract size the client wants to bond.

Example:

Current Assets: $600,000 – Current Liabilities: $400,000 = Working Capital of $200,000

$200,000 is 20% of $1,000,000 which could be the maximum single job size (assuming other factors are also in line.)

If the WC is too low, the account may be found financially deficient for the amount of capacity requested.

  • That’s the cut and dried part.  Now comes the art.  What can be done if the WC is insufficient? Some ideas:
  • First, it is important to review a draft of the year-end FS so an early version of the numbers can be evaluated. This is the time to make adjustments before the FS is carved in stone.
  • On the asset side, debt collection from stockholders / owners (money owed TO the company) directly helps WC.
  • Refinance fixed assets.
  • Unused equipment and other fixed assets such as real estate can be sold and the proceeds held as cash.
  • WC can be increased by shifting bank debt from current to long term.  Companies with all their debt as current should consider refinancing for a longer payback period.
  • Money can be loaned temporarily or permanently to the company by owners. If there is room to add bank debt, it could be beneficial if the payback is long term.
  • The draft FS is the key to this process.  Get the underwriter’s opinion regarding the capacity desired.  If the FS doesn’t support the figure, make adjustments now so that surety capacity will not be inadequate for the next 12 months.

Working Capital can be a magic wand if you know how to wield it!

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

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