Answers to 7 Financial Questions Contractors Ask About Bid and Performance Bonds
Being fully informed will help you feel confident throughout the bonding process, but there can be a lot to learn. We’ve compiled this list to help answer your questions surrounding financials in the bonding process. These are the seven financially-oriented questions we often get asked by contractors about bid and performance bonds.
1. What do bond companies require for financial reporting?
Bond companies (or surety companies) have several requirements for proper financial reporting.
- The statements must comply with Generally Accepted Accounting Principles (GAAP). GAAP outlines specific rules for treating revenues, expenses, assets, and liabilities.
- Year-end financials must be completed by a Chartered Professional Accountant (CPA) and must be done on a “review engagement basis”. For small jobs or small bond programs, a “Notice to Reader” may be accepted.
- Interim reporting is typically required either on a semi-annual or quarterly basis. This reporting can be done in-house without a CPA’s report, however it should still adhere with GAAP and contain at minimum a balance sheet, income statement and aged receivables and payables listing.
- A Work on Hand report should accompany all financial statements. This report outlines the contractors list of projects on hand detailing the contract value, amount billed to date, cost to complete and anticipated gross profit on each project. This report helps a bond company determine whether over and under billings are accurate.
2. What is the difference between a balance sheet and an income statement?
The balance sheet is a snapshot of your assets, liabilities, and shareholder’s equity as of a specific date. These dates normally coincide with a month end. For example, your company’s financial year end might be Dec 31st and you would have a balance sheet prepared at that date.
The balance sheet is used by bond companies to determine two very important ratios: (1) working capital, which equals your current assets less your current liabilities; and (2) tangible net worth, which is your total assets minus your total liabilities, adjusted for goodwill.
The income statement includes revenues and expenses over a period of time, such as the first quarter of your fiscal year. The greatest insights from the income statement are your gross margin and your net income. The gross margin shows how profitable each project has been, while the net income shows your corporations overall profitability after overhead items and taxes.
3. What are the main construction accounting methods and which method is required by the bond company?
There are two main methods of accounting for contractors: 1) the percentage of completion method; and 2) the completed contract method. It is important to note that bond companies would like your statements to be prepared on the percentage of completion method. Percentage of completion is done on an accrual basis and is a more precise and accurate measure of profitability on a day to day basis.
4. What determines my bonding capacity and how can I increase it?
Bonding capacity is based on numerous items, but the most important are the following:
- Working capital: This represents your ability to finance work and meet your obligations. It helps determine the aggregate limits your company commands. Depending on the type of contractor you are and your cash flow needs, a bond company will leverage working capital anywhere from 7 to 20 times working capital.
- Tangible Net Worth: This is the value of your company at any given point in time. It’s basically your assets less your liabilities adjusted for things like goodwill. The larger your tangible net worth, the more likely you can survive unpredictable events, or financial losses from bad jobs.
- Largest completed jobs: Bond companies will look at this to determine what your firm is capable of doing from an operational stand point. If your largest completed contract is $1,000,000, than bonded jobs in that range would make sense to a bond company.
- Management, organization, and experience: A well organized, experienced company will provide confidence to a bond company. It shows that you have been through different situations and succeeded and demonstrates that you have the capabilities to handle the complexities that the construction industry presents.
5. Why do I have to inject capital into my company, or post collateral in order to obtain bonds?
If your company isn’t capitalized enough to qualify for bonding but you have the ability to complete the work, there are still opportunities to get bonded. In these instances, a bond company might agree to provide bonding if a capital injection is made to your company.
This capital injection would improve the financial ratios the bond company is evaluating you on, making your bond request more likely to be approved. In more risky scenarios, a bond company may require collateral to secure the bond. These are used as temporary measures, however, as the goal is to improve these ratios through retained profits going forward.
6. Why do I need performance and labour and material bonds?
Performance and labour & materials bonds are requested by project owners to provide them with insurance against contract default and payments not going to the intended subcontractors. More specifically, the performance bond guarantees the performance of a contract according to its terms and conditions, and a labour & material bond guarantees that all subcontractors and suppliers with direct contracts to the prime contractor are paid.
In Ontario, as of July 1, 2018, performance and labour and material bonds are mandatory for all publicly funded projects in excess of $500,000. This new bond requirement is part of the new Bill 142.
7. Can I get a blanket bond to cover all my surety bond needs?
If only it was that easy! Each bond is issued for a specific purpose and provides unique protection to a project owner. Bid bonds, performance bonds, and labour & material bonds each guarantee a different obligation.
To help determine which bond you need, discuss further about financing for a bond, or answer any questions you might have, get in touch with us by email or phone today- we’re happy to help!