Examine your working capital to maintain stability and obtain a strong bonding program.
A strong working capital gives a construction business security, flexibility and the capacity to outlast a recession. It also serves as the foundation for a contractor’s bonding program.
A Surety’s Perspective
When a surety company examines a contractor’s financial position at year-end, they will review their working capital (the contractor’s current assets and liabilities). When determining working capital, sureties typically exclude the following: any accounts receivable over 90 days and prepaid expenses; anything due from shareholders or affiliates (unless the balance is paid before year-end and prior to the opinion date on the contractor’s financial statements); and any costs or estimated earnings that exceed related billings due to a loss contract or if the contractor does not have a valid reason for being under-billed.
The surety may also discount inventory by 10 to 50 percent, and while rare, they may also discount marketable securities up to 50 percent.
A contractor’s current assets typically include cash, accounts receivable (including retainage), costs and estimated earnings in excess of billings, inventory and prepaid expenses. Marketable securities may also be counted as a current asset.
Current liabilities include the amount due on the line of credit, long-term debt, billings in excess of costs and estimated earnings and accrued expenses including payroll and related payroll taxes, insurance, income taxes and year-end bonuses.
The surety will review the current liabilities to ensure that all deferred income taxes and accrued expenses (including workers’ compensation and general liability insurance) have been correctly stated at year-end. Amounts included in both current assets and liabilities are expected to turn over in the company’s normal operating cycle the next year.
Maximize your company’s financial position since the balance sheet at year-end will be used to determine your bonding and banking programs for the upcoming year.
By year-end, a contractor should have a minimum of 10 to 20 days of cash available. This can be achieved by following up on cash collections and managing the accounts payable and line of credit balances. Monthly requisitions should always be sent out as timely and accurately as possible, and they need special attention during the last four months of the year to avoid payment delays.
Retainage, pending change orders and costs incurred should also be monitored for final billing and collection. Any pending change orders approved after year-end should be documented and placed on a list of unbilled accounts receivable.
Balances in costs and estimated earnings that exceed billings should be kept to a minimum—sureties typically view a balance in this account as a danger sign of potential loss contracts. The only exception is if the contract language causes the under-billing. Otherwise, the contractor should show that any under-billings were billed after year-end.
Outstanding balances from shareholders and affiliates should also be cleared up or kept to a minimum by year-end. If these balances cannot be paid before year-end, the contractor should disclose when the amount(s) are paid after year-end to avoid the surety excluding this from the working capital amount.
To reduce the inventory balance, a contractor should use available material on ongoing jobs. Balances for prepaid expenses should also be kept as low as possible. However, prepaid expenses often include items that cannot be avoided, such as deposits made prior to year-end on insurance policies that take effect the following year.
Sureties encourage contractors to keep any money as cash and avoid investing in marketable securities. The exception would be a well-capitalized contractor who has a mature balance sheet and excess working capital. Even then, any investments should be conservative.
Your current liabilities also need to be well positioned at year-end. Although a line of credit balance does not affect a contractor’s working capital, reducing the line of credit balance to zero or as low as possible (by applying any excess cash to the balance) does help improve the company’s debt-to-equity ratio.
Using excess cash to pay down the accounts payable balance has the same effect, but contractors should only apply cash receipts on current contract receivables against the accounts payable due on those contracts. Contractors need to be sure the outstanding accounts payable days meet industry standards and vendor expectations.
The long-term debt balance represents the total debt payments currently due on long-term assets financed through term notes with financial institutions. Typically, financing long-term assets is preferable to paying cash. The loan terms should match the asset’s estimated useful life.