Bonding capacity can feel like the end-all, be-all for contractors. The amount of credit a surety company provides can greatly affect an organization’s success or failure in the industry, especially when markets are in flux and credit is difficult to secure. Fortunately, there are steps contractors can take to increase their bonding capacity. While these steps may not be quick, most of them are quite simple, and by making even just a few targeted changes, you are almost guaranteed to boost your bonding capacity.
What is Bonding Capacity, and Why is it Important?
Bonding capacity is the amount of bonds a surety company will underwrite for a particular contractor. There are two limits that underwriters will determine: how many bonds to issue for a single job, and how many bonds to issue in aggregate to any one company. When determining aggregate limits, surety companies will consider project backlogs as well as pending bids, so having sufficient capacity is essential.
Bonding capacity is also important to prospective clients. Before you bid on a project, the prospect will inquire about your bonding capacity to see if you can carry out the job. Having excess capacity can give you the flexibility you need to go after the jobs that really excite you and can make you marketable to the right people.
How is Bonding Capacity Determined?
Several factors play into bonding capacity, including the contractor’s prior performance, credit report, outstanding lines of credit, managerial experience, efficiency, access to labor, and available equipment. But financial history will almost always be the most important factor. A contractor with clean financials and a history of successful and profitable projects gives surety companies the peace of mind that their investment will pay off.
Tips for Boosting Your Bonding Capacity
The bonding capacity calculation is subjective, but you have more control over how underwriters view your business than you might think. Surety companies will look more favorably at your business if you can:
Improve Your Financial Ratios
If you have healthy financial reports and competitive financial ratios, surety companies will be willing to guarantee more credit.
Although debt is necessary in the construction industry, having too much debt can impair your ability to grow. Many in the industry shoot for a debt-to-equity ratio that is 2.0 or less. If your surety company thinks you’re too highly leveraged, you can reduce your ratio by either retaining more net income in the business or by making additional capital investments as owners.
Gross Profit as a Percent of Revenue
If you can prove that your business retains its contract revenue, you show that success from prior jobs can help support future jobs if the need arises. You can strengthen your gross profit percentage by learning from your mistakes and taking steps to improve profitability with each new project.
Your working capital helps the surety agent understand more about your short-term financial health. With a high net working capital, your company can better argue that a short-term financial setback won’t affect your performance. To improve working capital, you can expedite cash inflows by billing as soon as possible. If your debt-to-equity ratio can handle it, you may also consider replacing short-term debt with long-term debt.
Your backlog ratios should show your surety agent a few things. First, the number of months contracts remain in your backlog will show your surety agent how well you’re able to handle multiple jobs at a time. If these backlogs turn over quickly and at a predictable rate, they shouldn’t be concerning. Second, backlogs compared to revenues from backlogs shows not only how well you manage your work over time, but it shows that your working capital can accommodate the needs of your current and your backlog projects.
Improve Cash Flow
A healthy cash flow will put underwriters at ease because it promises you can support your overhead and make the cash purchases needed to complete the job. To improve your access to cash, you can do a few things.
- Make payments timely but stretch them out as far as possible.
- Stay on top of receivables and follow up on unpaid invoices regularly.
- Make sure cost estimates are accurate and refine them over time.
- Send invoices immediately.
- Accept electronic payments.
- Consider leasing or financing new assets.
- Avoid overstocking inventory.
- Align payments to subcontractors with your receipt of project billings.
Reduce Your Tax Liability
Taxes can make up a significant portion of cash needs for a construction business. Reducing or delaying tax payments can improve your position. You can do this by accelerating depreciation (remember, 100% depreciation is only available through 2022), looking into new credits (like the Research & Development Tax Credit or the Work Opportunity Tax Credit), or qualifying for new deductions (like the Domestic Production Activities Deduction). Your accounting method will also affect your tax position. Using the percentage-of-completion method will return different tax results than if you used the completed contract method. Changing your accounting method may not be possible, but it’s worth discussing with your CPA.
Establish Good Relationships
Your surety company will look at your business favorably if you have a team of supporters behind you.
- Establish a good relationship with your banker. Their support will come in handy if you need a line of credit increase or need short-term financing.
- Build a strong accounting department. Your team should understand your financial position, but they should also and be aware of the underwriter’s goals so they can portray you in the best light possible.
- Retaining good workers is difficult, but it’s a goal worth striving for. A reliable workforce can help you staff new jobs more quickly than a competitor and will ensure your existing jobs get completed on time and in a manner that pleases your clients.
Get to Know Your Surety Underwriter
You want a surety company that understands your business and your needs. Similarly, you want to understand what your surety underwriter is looking for. A good underwriter will want to see you succeed and will work with you to improve your bonding capacity. Take the time to find the right one. Determining bonding capacity is more of an art than it is a science; the actuaries at surety companies will use objective factors like financial reports and efficiency ratings, but non-financial factors can swing the pendulum in your favor. If you have questions or concerns about your construction business or about your bonding capacity in particular, we would love to talk to you. Contact Artola CPA, LLC today.