The following article by Matt Burchett was originally published in the February 1st newsletter to clients of Calvetti Ferguson. Reprinted with permission.
Sureties and banks, as well as rating agencies and governmental customers, analyze a contractor’s financial strength using different metrics and methods. Liquidity (the ability to meet obligations as they arise) is generally prized as the greatest strength, with leverage and profitability close behind. For bonding purposes, the contractor must understand the surety’s unique approach to liquidity analysis, with the goal being to steer the bonding company – rather than being steered by it.
Working capital (current assets less current liabilities) is a liquidity dollar figure as opposed to a ratio. Bigger is usually better, but quality counts too. Banks often accept the number straight from the contractor’s balance sheet with little modification other than aged receivables, whereas bonding companies routinely “tweak” the number downward to arrive at surety working capital (SWC).
Two of these tweaks merit special attention. The surety will exclude prepaid assets and discount any inventory balance by as much as 50 percent (but perhaps as little as 20 percent for fast-turning materials such as asphalt). Following are several suggestions.
- Since estimated income tax payments will likely be excluded from SWC as a prepaid item, it’s critical to achieve the proper balance between minimizing penalty/interest later and maximizing SWC now. A compromise will usually be best.
- When renewing a general liability insurance policy, estimates of future labor dollars should err on the low side. Common practice is to highball these estimates to avoid a big settle-up payment later, but the resulting prepaid insurance will be excluded from SWC.
- Assets that are actually refundable should be captioned as such. The surety is much more likely to include a refundable item in SWC than one captioned as prepaid.
- If inventory is a major asset, it should be monitored continually for shrinkage. Associated writedowns will affect profit and loss unfavorably, but may be more than offset by reducing the SWC tweaks.
- Avoid beefing up inventory levels immediately prior to any financial measurement reporting date.
- Cash surrender value on life insurance policies is often overlooked as a source of working capital. This long-term asset can usually be tapped for cash at a low-interest rate with coverage left intact (and repaid afterward with no penalty).
- Excess cash held by owners can be loaned to the company on a long-term basis and subordinated to the surety, which will typically treat such loans as equity. The owners also benefit by earning interest income at rates higher than CDs or money market accounts.
Current ratio (current assets divided by current liabilities) is among the most common liquidity metrics. It’s too often treated as an afterthought but happens to be a ratio over which management can exert much control simply through wise use of cash.
For example, a contractor’s bonding agent has set a working capital target of $100,000. The company’s CFO runs a preliminary report and notes that the balance sheet will consist of $500,000 cash, $100,000 receivables, $500,000 payables and $100,000 equity. Target met, in other words. Left as is, the surety will calculate the following liquidity and leverage metrics, with real-world quality assessments in quotes:
- Current ratio = 1.2 “Acceptable ratio, a bit toward the low side”
- Debt-to-equity ratio = 5:1 “Much higher leverage risk than anticipated”
Without diluting working capital, both ratios can be greatly improved simply by using $450,000 of available cash to pay vendors before closing. It may seem counterintuitive, but that action alone results in the following favorable changes:
- Current ratio = 3.0 “Unusually strong, improved 150 percent over expectations”
- Debt-to-equity = 0.5:1 “Extremely low leverage risk”
In all the foregoing, the wise use of cash drives the balance sheet so as to receive the greatest favor in the eyes of the surety. Art and science are both involved, but what’s most important is a thorough understanding of what the surety does behind the curtain with a contractor’s published numbers. Holding onto cash as long as possible is usually best when a construction company acquires inventory and long-term property, pays insurance and income tax estimates, or retires long-term debt. However, letting cash go quickly is usually best when retiring short-term debt and paying off vendors, payroll taxes, withholdings and other current obligations.
There are no right answers for every construction contractor, and the optimum balance between the surety’s liquidity requirements and all the competing factors will change just as circumstances change. To find that unique optimum balance, it’s vital that construction executives seek advisors with proven expertise in construction accounting, reporting and taxation.
Matt Burchett is a partner in the Charleston, W.Va., office of Brown Edwards & Company, LLP, a Top 100 CPA firm in the United States. In addition to being a CPA/MBA/CVA, the author is registered with the CFMA as a Certified Construction Industry Financial Professional.