Surety Bond Working Capital Analysis
- Any business that needs to guarantee its future performance will probably need a surety bond at some point. A surety bond is a legal financial guarantee that a contract party -- a construction company, for example -- will complete its obligations under the terms of a contract. If the construction company does not live up to its responsibilities, the owner of the project can make a claim on the bond. At this point, the surety company can step in and try to assist the contractor. If attempts to correct the situation fail, the surety company must compensate the owner for any losses.
- The reason for analyzing a surety bond applicant's working capital is to determine how much bond capacity is appropriate. Working capital is the amount of current assets remaining on the balance sheet after subtracting current liabilities. The analyst should use the most recent year-end or interim statement. The statement must have been prepared by a certified public accountant. Surety companies usually make adjustments to the working capital figure to obtain an "as allowed" number. To reach that number, the analyst will normally deduct accounts receivable aged over 90 days. He will also deduct any "under billings," which are costs and profits that have not been billed, prepaid expenses and any accounts or notes receivable that cannot be justified. For typical construction contractors, surety companies will approve credit for surety bonds at a rate of 10 times the "as allowed" working capital figure.
- The evaluations surety companies carry out on bond applicants go beyond working capital analysis. The process is similar to the credit evaluation that a bank, finance company or supplier would conduct. The surety company analyzes the company's entire financial statement. Conservative surety companies will want to be satisfied that the applicant scores well on the traditional "Three Cs" of credit. These are: character -- that the company has a good reputation for ethical conduct with other industry participants, including owners, lenders, suppliers and sub-contractors; capacity -- whether the company has the right experience, equipment and people for getting work done correctly and on time; and capital -- as shown by financial statements that have been prepared by a certified public accountant in good standing.
- Smaller construction companies can enhance their chances for surety approval by taking certain measures. They can join with well-established firms in applying for bonds. They should hire a certified public accountant who is well-grounded in the industry. They should use an industry standard job cost computer program that will track the progress of jobs and provide accurate data for the financial statement.