In the third segment of Is your bond company slowing your growth? we are continuing to look at capacity, one of the three Cs of surety underwriting.
Capacity is essentially a contractor’s ability to take on and successfully manage their workload. Many expect this refers simply to the ability to successfully execute contracts in the field. While this is of course a key aspect for any contractor, from a bonding underwriting standpoint, a contractor’s ability to properly provide accurate and timely financial reporting as well as accurate job progress and costing reports is also an integral part of their capacity consideration.
A contractor that can provide good quality financials on a timely basis will help convey they are on top of their costs and monitoring their jobs closely. Surety company’s put a lot of emphasis on reporting and it gives them comfort that any potential issues on a job can be detected early and corrected before it becomes a real problem.
Quality and timely reporting
When we talk about quality financial reporting, we are referring to both the year-end financial statements prepared by your CPA as well as your internal, interim reports. The bond company will be looking for different things when determining if they are of good quality and ultimately reliable.
When it comes to year end statements, the standard for bonding is a CPA review engagement. A CPA review engagement is preferred over a notice to reader because of the level of scrutiny required by the CPA to verify that the numbers are accurate.
Compared to notice to reader statements, a CPA review engagement requires the accounting firm to perform various analytical procedures, as well as undertake discussions with the client to ensure the financial statements are accurate. Should the CPA have that level of comfort, a review engagement report can be issued.
By contrast, a CPA notice to reader provides no such assurances from the CPA that the statements are free from material misstatements. They are effectively taking the numbers provided by the contractor and putting them into a financial statement format. It is for this reason that a bond company will find it easier to rely on the accuracy of a review engagement and in turn feel more comfortable extending support for larger jobs and higher bonding limits. In fact, when contractors reach certain annual revenues, or are looking to get bonds for projects over $1 millon, a review engagement is often a firm requirement.
Internal financial reporting – quarterly or semi-annually
The focus on quality Internal reporting is a different issue in that the statements aren’t typically done by a CPA, rather it can be done internally using a software like Quickbooks or with the help of a bookkeeper.
It is very important that the internal statements make sense and all of the entries and adjustments are made so that there are no errors on the statements. For example, last year’s retained earnings plus net profits should equal this year’s retained earnings. If they don’t, the bond company will lose confidence in the other numbers and this can affect your ability to stretch to higher limits if need be. The internal financial statements should include a balance sheet, income statement, aged payables and receivables listings and a work in progress statement regardless of whether there are over/under billings. The more details that can be provided the more organized and fiscally responsible your company will appear only leading to underwriter confidence and ultimately higher bond limits.
Timely reporting is also imperative. It gives the impression you are up to date with your accounting and not only know the operational side of the business, but also the financial side. This is especially critical for smaller or growing contractors, as this is a common growing pain for these types of contractors and a reason for concern amongst surety bond underwriters. The theory goes that if you don’t know if you’re profitable, how can you expect a bond company to support your business? It’s simply not enough to tell an underwriter how great things are going, you have to show them.
Circling back to our example with XYZ Contracting and their need to increase their aggregate bonding limit to $12 million. XYZ Contracting provided their bond company with their Dec. 31, 2020 review engagement financial statements which showed $500,000 in working capital. As we are now more than six months past their year-end date, XYZ has recently provided their bond company with an internal balance sheet and income statement from their internal accountant as of June 30, 2020. The six months results are excellent with $300,000 in profits on $1.5 million in sales. These profits have increased XYZ’s working capital position from $500,000 to $800,000, which exceeds the bond company’s requirement of $600,000 in working capital for the increased aggregate bonding program.
However, the bond company does have some concerns about the high level of profitability relative to sales and is questioning whether XYZ is over stating its interim profitability. Could XYZ be over billed on some of its contracts? We will be discussing this and more in Part 4 of this series.
Jamie Collum is the vice-president of construction for FCA Insurance. He has delivered numerous seminars and presentations on construction bonding and general industry updates in Ontario to various construction associations over the years. Chris Dardarian is a surety bond broker at FCA Insurance. He has been in the industry for 15 years working as both a surety bond underwriter and a broker in Ontario and Quebec. He has helped numerous growing contractors access higher surety capacity to meet their goals.
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