Over the years, I’ve had a lot of education. From business school to consultants and licensing to continuing education, I’ve learned many things and heard lots of great ideas. Unfortunately, I’ve probably forgotten many of them, too.
Even so, there is one quote I never seem to forget. It didn’t come from business school or a high-priced consultant. It came from my “Intro to Psychology” professor, of all places. She said that we could sit wherever we want. She wouldn’t assign us seats because it didn’t matter. We would assign ourselves the seat we would be in for the rest of the semester.
For the rest of the semester, my classmates and I came in and sat in the same seats every day. In fact, I noticed this happened in every class I was in, no matter the environment. It continued even after I left college. At the office, people also sit in the same seats in conference rooms for meetings. They park in the same place every day, even though we don’t assign parking spots.
People are creatures of habit. This fact is important for contractors to understand—especially as to the effect it has on their surety bonding. In surety, this is called trend analysis, and it’s plays an important part in underwriting an account and making the decision to support them. And, as discussed, past performance is often indicative of what a person is going to do in the future.
Let’s look at some of the different areas surety bond underwriters monitor for their trend analyses.
Profit is necessary to make business work. Without profit, it will be difficult for a contractor to survive long term. It will also make it more difficult for a contractor to pay its bills and complete its work, which are the very guarantees provided by performance bonds and payment bonds. Underwriters will closely monitor the company’s profit trends—both as a whole and on a per job basis.
That’s one of the reasons that a contractor’s work-in-progress and completed contract schedules are so important. Do your projects hold their profitability from beginning to end? If not, an underwriter may lose confidence in your estimates, or it could be a sign of management issues or lack of controls.
In general, overhead is a sum of a contractor’s expenses that are not directly tied to a project. Bond underwriters monitor overhead trends extremely carefully. They usually increase over time, as salaries and expenses naturally increase with the cost of living. However, the more overhead a contractor has, the more difficult it will be to show a profit.
The contractor will either need to get more margin on its work or increase the amount of work it performs on an annual basis. Both are doable in a good economy. The problem is that construction is cyclical, and overhead is often difficult and slow to reduce. Therefore, bond underwriters do not like to see a continual trend of overhead expenses that are outpacing growth. A best practice is to keep overhead percentages in line with revenue.
3. Over- & Under-Billings
Underwriters also look at your over- and under-billings trends. For most companies, a trend of slight overbillings on a job is usually a good thing. On the other hand, if your trend is constant job borrow, your underwriter is going to worry where future cash is coming from. For under-billings, a trend of constant under-billings is usually the sign of bad billing practices.
On the other hand, if you usually don’t have a trend of under-billings and show a large amount, the bond company will be worried that you are hiding a loss, and you need to be able to explain the reasoning behind it. The more underwriters understand your trends, the more comfortable they will be.
What is your history with distributions? Do you take all the earnings out each year? Underwriters are wise to this pattern. Many accounts show a strong balance sheet midyear but distribute all the profits (or more) at year-end. This is a surefire way for bond companies to lose confidence in you. If you want to maximize your surety credit, you will need to show a trend of leaving money in the company and building up the balance sheet.
5. Working Capital
Part of leaving money in the company is building up your working capital. Working capital is the primary way that most bond companies measure liquidity. A major component of working capital is cash, which is why distributing all your cash is another trend that will decrease your bonding capacity.
Many contractors feel that they can easily pull cash from their bank lines when needed, so they don’t need to hold much cash. You read about demand clauses here and why that may be a problem. This trend may also restrict your bonding capabilities. A better trend would be to hold an appropriate amount of cash to fund your operations and meet your short-term obligations.
Bond underwriters carefully analyze trends in debt. Does a contractor use debt to fund short term cash-flow cycles, or are they relying on it to fund operations? Problems arise when underwriters see trends, such as unnecessary construction equipment purchases, reliance on bank lines of credit or other interest-bearing debt. That debt must be serviced in good time or bad. Not all debt trends show up as liabilities, though.
An even more troubling debt trend could be from the shareholder(s). This shows up typically as a “Note Receivable Shareholder.” It shows that the owner had to take money out of the construction company for another purpose. Surety bond underwriters will completely remove this amount from their analysis and contractor’s bond capacity will be decreased accordingly.
There are many areas of business that surety bond underwriters look at to analyze a contractor’s credit worthiness. In reality, they look at trends for all aspects of a contractor’s balance sheet, income statement, overhead and job schedules to try to predict their future results.
Contractors who need bonding would be wise to understand this and put the right trends in place if they want to grow and maximize their surety credit. Warren Buffet is quoted saying, “Chains of habit are too light to be felt until they are too hard to be broken.” Don’t wait until bad habits are too hard to break.