Inside the Mind of a Surety Company: Generals & Sub Trade Edition
There are currently over ten surety companies writing construction surety bonds in Canada. At heart, it is important to remember that surety companies are financial institutions. It is their job to measure and quantify the risk of a contractor’s business and to decide how much in construction bond support they will provide.
As we’ve mentioned in previous articles, the surety’s underwriting comes down to the three C’s of surety; Character, Capacity and Capital. It is important to note that Capital, Capacity and Character all factor into the terms and conditions a bond company presents to a contractor. This will include contractor’s expected performance bond cost, bond premium, the types of bonds available, the type and scope of construction projects they will support and any security requirements.
However, while all of the three C’s are important, Capital is always the most important consideration. Capital refers to the financial resources that businesses can use to fund their operations like cash, machinery, equipment and other assets. All of these are considered with each Performance bond request.
Sureties will always require a copy of your CPA prepared year-end financial statements and often quarterly or semi-annual internal statements as well. Upon receipt of the financials the surety companies will complete their financial analysis. This is essentially a review of the capital position of a company and there are some specific ratios that surety companies focus on.
The ratios they place importance on will often depend on the class of construction that the contractor is performing and the unique capital requirements of that business. Today we are going to focus on general contractors along with electrical and mechanical sub-contractors.
For these contractors, the surety is most focused on a ratio called Working Capital. Working capital is a contractor’s current assets minus its current liabilities and is a reflection of a contractor’s ability to cash flow its projects.
Currents assets are assets that can be converted into cash within a 12-month period (ie. cash, receivables, short term investments, inventory, etc.). Current Liabilities are debts payable within a 12-month period (ie. trade payables, taxes payables, current portion of loan payments, etc.).
A surety company will often adjust the assets and liabilities on your balance sheet based on their assessment of risk factors to those individual items. For example, if you have receivable that is more than 90 days past due the surety may not give you credit for that money until it is paid. This adjustment reduces working capital.
Working capital is important because it determines how much bond support (also called an Aggregate Limit) that a contractor can secure. The aggregate limit is defined as the costs remaining on a contractor’s total backlog (costs remaining on all jobs) including any outstanding bids. Outstanding bids are factored in as the surety must consider the working capital needs of these jobs if the contractor is successful in their bid.
In the case of a general contractor surety companies will leverage (multiply) their working capital by a certain factor to determine an aggregate limit. For strong and experienced general contractors, the aggregate number can be 20-25 times working capital or in some cases even greater.
Let’s take an example, a surety calculates a contractor’s working capital at $100,000 and will leverage this by a multiple of 20 times. This would result in an aggregate limit or total work program of $2,000,000. For a company with working capital of $500,000, the aggregate limit at 20 times would be $10,000,000.
General contractors are often provided with the most significant leverage. The primary reason is that they are at the top of the construction pyramid, closest to the money and rarely require large capital expenditures on equipment.
A sub-contractor such as mechanical and electrical contractors are a little different. These are primarily labor dominant businesses. Wages need to be paid weekly or every two weeks and suppliers often want quick payment. Mechanical and electrical contractors are also generally one level removed from the money (working under a general contractor).
As a result, surety companies typically provide less leverage to these trades when looking at working capital. This is typically in the 10-15 times range. Perhaps even slightly more for those considered to be best of class.
Using the same example above, if a mechanical contractor has $100,000 in working capital, they can expect an aggregate facility or total work program of $1,500,000. If an electrical contractor has $500,000 in working capital, they can expect an aggregate bonding program of up to $7,500,000.
Understanding working capital, how it is calculated and what leveraging a contractor can expect are critical to ensuring how much surety support your business can expect to receive. This understanding will help you to plan with your accountant how to grow your working capital as needed in support of the growth of your business. An experienced surety broker should also be able to provide some excellent guidance around this topic as well.