Prompt Payment: The Bonding Industry’s Biggest Secret
In 2018, the new Construction Lien Act in Ontario was introduced with the intent of modernizing the construction industry. Prompt Payment was included as part of this legislation and came into effect in Ontario in October of 2019. Prompt Payment, simply stated, requires prime contractors to be paid within 28 days of submitting an invoice and subtrades to be paid within 7 days of the prime contractor receiving payment. Provinces across Canada are now working on similar legislation with many having already passed their own versions of ‘new construction lien acts’ that will be coming into effect over the next couple of years and most include some form of Prompt Payment. The Federal government also passed the Federal Prompt Payment for Construction Work Act in June 2019 that has not yet taken effect. While we wait for the other provinces and federal government to catch up, Ontario is paving the way with these much-improved payment practices.
So how does Prompt Payment affect your bonding capacity?
Surety leveraging and capacity are often a hot topic of conversation between contractors, surety brokers and their sureties. As contractors grow, they will typically look for access to additional bonding capacity to ensure they can bid and secure profitable work to fuel their businesses. Sureties on the other hand are often balancing the requests for additional bonding capacity with the contractor’s financial position and adherence to certain financial ratios.
One of the most important ratios in determining a contractor’s ability to secure construction bonds is working capital. At its simplest, working capital for any contractor is calculated by subtracting current liabilities from current assets. Surety companies will take a contractor’s financial statements, review the current assets and current liabilities, make adjustments and determine their working capital figure. Things like overdue receivables, work in progress and delay claims may be excluded from the working capital thus reducing the contractor’s bonding capacity.
While working capital isn’t the only factor that determines bonding capacity, it is the ratio which is most commonly leveraged to achieve a contractor’s aggregate limit. The aggregate limit considers the cost to complete of all the contractors ongoing work and thus a higher limit will allow a contractor to execute more work concurrently. The sureties will leverage working capital a stated number of times to achieve the aggregate limit. Generally, there are some rules of thumb on how much leverage certain types of contractors receive.
Historic Common Working Capital Leveraging Ratios in Ontario by Class:
- General Contractors & Heavy Civil Contractors – 20 times working capital
- $1,000,000 in working capital translates to approximately $20M in bonding capacity
- Sub Trades – 10 times working capital
- $1,000,000 in working capital translates to approximately $10M in bonding capacity
Most sureties have been relying on these ratios for decades; however, these traditional leveraging ratios are out of date in Ontario and will soon be in the other provinces that have enacted or are planning to enact Prompt Payment Legislation as well. We first brought this to the attention of the industry during a surety round table at the OGCA Construction Symposium in Collingwood during the spring of 2019. This was not warmly received at the time by the underwriters in the room but now two years later it is clearly evident to see the positive impact that Prompt Payment has had on the turnover of receivables of contractors from all levels of the construction pyramid.
We have had multiple conversations with clients who have confirmed our view of this. Contractors in Ontario are no longer waiting 60-90 days (or more) to get paid. Funds are flowing at a much quicker rate resulting in less borrowings and higher net cash positions across the industry. At the end of the day cash is king and a balance sheet with working capital based mostly in cash should be looked at more favorably. In addition, the legislation likely improves the items sureties would take provisions for (overdue accounts receivable as an example). In essence, the Construction Lien Act is de-risking a contractor’s balance sheet by making the likelihood of strained cash flow due to aged AR or a project dispute, less common.
With the quality and turnover of working capital improving for many contractors, sureties are now beginning to understand the positive impact of Prompt Payment on our industry. As a result of the legislated payment terms and enhanced mechanisms for project dispute resolution (adjudication), sureties are finally starting to leverage their contractors more aggressively than they have in the past and we expect this pattern to continue and expand as these legislations are enacted across Canada.
This results in contractors having an increased ability to secure more performance bonds. With the right advisor in your corner these positive changes should directly result in an increase in bonding capacity for contractors.