Secrets of Bonding #45: Backpedaling and How to Avoid It

Sureties commonly rely on a variety of elements when deciding if they will provide bid and performance bonds for contractors. All relevant underwriting factors are considered, including the applicant’s financial condition.

In most bonding scenarios, the applicant for the bonds is a construction company – typically a corporation or LLC. An important element of the financial evaluation is the company’s financial statement.

Why so much emphasis on this one document? The financial statement is considered a report card on the quality of management. It shows a range of important indicators. To name a few:

  1. How strong a financial commitment the owners made to the company (capitalization)
  2. The amount of revenues management has acquired in the previous operating cycle
  3. The extent to which construction contracts were realistically estimated and successfully managed
  4. Management of overhead expenses
  5. Tax planning
  6. Adequacy of cash flow
  7. Liquidity
  8. Profitability
  9. Reliance on banks and other creditors to finance operations
  10. Collectability of receivables

The analyst’s favorite financial statement date is the company’s fiscal year-end (FYE), which is “tax day.” We prefer this date for two reasons.

  • Underwriters need to make a periodic review to monitor the applicant’s financial status, so an annual review on the FYE is perfect.
  • The tax day numbers will be realistic and conservatively presented – to minimize the tax exposure. This conservative approach is ideal for the bond underwriters who hope to make a realistic analysis of the applicant.  For most companies tax day is December 31st.

So where does the backpedaling come in?

Company managers rely on their Certified Public Accountant for financial advice, especially tax planning. Limiting taxes is a popular goal, but at what price? Lower taxes may be the result of lower pre-tax profits. Lower profits mean less financial growth and possibly an inadequate net worth. (See Secret #3: Taxes) Why should stockholders continue to support a company that fails in its primary mission: Producing a profit?

Obviously these issues are a great concern to surety underwriters, who want successful, well-managed companies as clients. If tax avoidance is aggressively pursued, it is not unlikely that bonding capacity will be compromised. The surety may limit their support or even terminate the relationship if financial performance is weak.

Once the financial document is carved in stone, company management may face an entire year of backpedaling: “We showed poor results because…” until the next FYE report can show better numbers.

The problem is not uncommon, and the solution is simple if executed properly. Avoid backpedaling by having a draft financial statement initially produced by the CPA. The document will be marked “For Discussion Purposes” and discussion is exactly what’s needed. A review by the underwriter will determine if any elements of the report are detrimental for bonding purposes. Plans for the coming year can be discussed and bonding capacity evaluated.

If the financial statement does not support the desired amount of surety capacity, now is the time to make adjustments before the final version is produced. Backpedaling is avoided!

With some planning and open dialogue agents can help their contractors avoid the missteps that prevent companies from realizing their full bonding and financial potential.

Agents, for your clients with a 12/31 year-end, NOW is the time to act. Contractors, tell your accountant a draft FS will be needed for discussion with the bonding company.

FIA Surety is a NJ based bonding company (carrier) that has specialized in Site, Subdivision, Bid and Performance Bonds since 1979 – we’re good at it!  Call us with your next one.

Steve Golia, Marketing Mgr.: 856-304-7348

First Indemnity of America Ins. Co.

 

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