WORKING CAPITAL & SURETY BONDS
Updated: Jun 8, 2021
CURRENT ASSETS - CURRENT LIABILITIES = WORKING CAPITAL
Working capital indicates a company’s ability to pay off its liabilities and is one of the main financial indicators sureties use to determine the amount of support that will be given from a single and aggregate standpoint. Having a clear understanding of working capital will benefit a contractor who is attempting to grow by enabling them to make better-informed decisions that will ultimately impact the bond line.
Keep in mind that when a surety is determining the amount of support to be given - experience, quality, assurance of financial statements, along with other factors, are also considered when establishing the single (single size project) and aggregate (total combined projects managed at one time) bond line.
Calculating a Contractor’s Working Capital:
Working capital is calculated by adding all current assets and subtracting all current liabilities.
Current assets include cash, contract receivables, and retentions, a portion of inventories, short-term investments, prepaid expenses, and underbillings.
Current liabilities include accounts payable, lines of credit, accrued short term liabilities, unearned revenues, and overbillings.
Example: A contractor with current assets of $20 million and current liabilities of $10 million will have a working capital of $10 million.
Working Capital is calculated differently between CPAs and Sureties.
A surety will typically discount or remove the following items from the working capital calculation: prepaid expenses (depending on the makeup), inventories if not turned over in a 12 month period, owner/officer receivables, notes or other related party receivables, contract receivables aged over 90 days unless evidence of expected payment can be verified, and investments discounted (depending on the volatility). Sureties will also add back cash surrender of life insurance to increase working capital. Working with us, as experienced surety agents, will help you understand how sureties calculate working capital as each surety reviews this information differently. We have the benefit of working with over 80 sureties and have a unique opportunity to find a surety that will best work with your organization.
Understanding the numbers further: Working capital also acts as an indicator of a contractor's ability to complete projects while remaining in a strong financial position. The amount of single and aggregate projects will be looked at differently depending on your trade, experience, and financial presentation. As you will come to understand bonding is very subjective and there is no one size fits all. This is simply a guide and not the line in the sand.
Typically for a Subcontractor: A strong subcontractor typically receives around 10 times (10%) multiple of working capital. To explain what a 10 times (10%) multiple is, using the same example as before, we would take the $10 million in working capital, multiply by ten and come up with a $100 million total in working capital. Theoretically, this subcontractor could comfortably perform $100 million in revenue with its $10 million in working capital. Keep in mind the surety will analyze the experience, as well as if the largest project to date completed by this subcontractor is $500,000, we will not be pursuing $100 million projects from the start line. The surety likes to see contractors take a levelheaded approach to growth!
Typically for a General Contractor: Analyzing the difference between a subcontractor and a general contractor comes down to the fact that GC’s normally do not have to pay their payables to a sub until the customer pays them, allowing them to have a lower demand of cash flow compared to a sub. Due to this, a general contractor can receive up to 15 (7%) or 20 (5%) multiple.
Steps a contractor can take and how they affect their working capital?
1. Fixed Asset purchase (equipment, machinery, vehicles) with cash vs financing: When considering a purchase of fixed assets, we ask that you always consult with us first so we can collectively determine the short and long-term effects the purchase will have on your working capital and overall support. When you spend cash on a fixed asset, you are reducing a current asset and creating a long term one. While creating a long-term asset has no effect on working capital, minimizing your cash position will reduce your working capital, dollar for dollar, and affect your overall support. Financing the purchase would create a long-term asset and long-term note liability, this would affect your working capital less since you are only reducing a portion of the cash.
2. Prepaying certain expenses at year end: At the end of the year, a contractor will most likely get an insurance bill for the subsequent year. Some companies will prepay the entire insurance bill for the full policy year. By doing this, the contractor technically creates a current asset (prepaid expense) and reduces another current asset (cash) and so the working capital remains unchanged. However, sureties may discount prepaid expenses or remove them altogether in the working capital calculation. In that case, prepaying expenses may hurt bonding capacity. This is also true with paying health insurance which is due prior to the month it relates to.
3. Sometimes investments (current assets) will be discounted: If the investment does not have the strength or is volatile in nature, the surety may not consider it a current asset in the working capital calculation. We always ask that these investments are mentioned beforehand to help determine the effects on your working capital.
Working capital is the key, as is the importance of working with a construction-oriented CPA. Working with a specialist will do more than just provide quality statements a surety can rely upon. A construction CPA will better understand tax implications and help develop long term strategies that can benefit the health of your company. As bond only specialist we only offer advice and try to minimize the potential impact certain actions will have on your overall surety relationship. At the end of the day, it is your business and we respect your decisions