How Surety Companies Really Analyze Your Construction Financials

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ℹ ABOUT THIS EPISODE

Ever wonder why your bonding agent scrutinizes your profitable financial statements like they're hiding serious flaws? In construction, your numbers tell completely different stories to banks versus bonding companies - and understanding this difference could make or break your business growth.

Wade and Stephen break down the critical distinctions between how banks and bonding companies analyze your financials. You'll discover why taking cash out of your company tanks bonding capacity, how working capital calculations differ dramatically between the two, and what profit fades really cost you in credibility.

This episode reveals practical strategies to strengthen your position with both lenders and bonding companies, plus the most common financial mistakes that destroy contractor relationships. Learn how to present your company's true financial strength instead of just looking good on paper.

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⌚️ In this episode:

• 00:42 Common Financial Mistakes Contractors Make
• 01:45 Differences Between Banks and Bonding Companies
• 04:57 The Importance of Working Capital
• 06:13 Paperwork and Financial Reports for Bonding
• 15:10 Loans to Shareholders and Subordination Agreements
• 19:26 Over and Under Billings: What You Need to Know
• 22:50 Backlog Gross Profit and Profit Fades

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

Transcript

Wade Carpenter: [00:00:00] Ever wonder why your bonding agent looks at your profitable financial statements like it's a house built on sand? In construction, your numbers tell one story to the bank and a completely different story to the bonding company. Kinda like how that perfect looking concrete pour can hide serious problems beneath the surface.

Today we're breaking down how bonding companies read between the lines of your financials, what they adjust that banks don't, and how to strengthen your position with both. You'll learn practical ways to present the company's true financial strength instead of just looking good on paper.

This is the Contractor Success Forum. I'm Wade Carpenter with Carpenter Company CPAs, alongside Stephen Brown with McDaniel Whitley Bonding and Insurance. Stephen, what's the most common financial mistake contractors making that tanks their bonding capacity, even when their banks look healthy?

Stephen Brown: Number one is taking cash out of the company. You need to know how much cash you need in the company to know what kind of bonding capacity. To take cash out [00:01:00] and then ask for bonding credit is always a struggle, but it happens all the time.

Wade Carpenter: Again, as I was telling you, this sort of was born out of a team meeting I had with my people this week. We were talking about contractor financial ratios and how I look at it and how you look at it. And then as we went into some things, a bank really looks at some of these things very differently.

And so that's where we're approaching this somewhat differently. I think it's a good exercise for our listeners to understand why we look at some things a certain way. It's really about the health of their company. And so my message is they should be knowing what these numbers look like.

It's sort of like your dashboard for knowing if you're healthy and growing and profitable. What are your thoughts?

Stephen Brown: Wade, that's a really good point. Perceptions are everything. You had mentioned to me earlier, that's so true that banks, when they're analyzing your financial information, they're looking backwards and bonding companies are looking forward.

What you meant by that, which is so true, is just how your financial information is [00:02:00] analyzed to get what you want from a bank or a bonding company. We've talked about this a lot of times in the past. Surety bonding for contractors, it's called surety. Like construction is the overall term for building things, surety is the overall term for everything that needs to be bonded by a surety company.

And the way a surety company analyzes your financial information is so different from a bank. You put your financial statement together that looks good for your surety and your banker and looks good for you and how you manage your company. Those three go together like that. Well, there's two. Okay. So anyway they go perfectly together.

Everyone says you've got taxes too. We got that issue to deal with. There's always the issue of how you balance what your financial statement says and still get everything you want. And there is a way to do it.

Wade Carpenter: Yeah. And part of my message was, banks are looking for collateral and, we could [00:03:00] talk about the components you were talking about that before we started this. What they're looking for is the ability to pay somebody back, or pay them back.

 They're basically looking in the past. And you have to look at the past, but also look into the future and say what's coming along and can you be able to bond this and complete the job, where you're basing that on what you think's gonna happen in the future. So you really do have to look at it a different way.

Stephen Brown: Absolutely. You would think that bankers would look at your backlog gross profit, and your estimated cost to complete the work that you've got on the books. But then again, they don't seem to do that like they did in the old days. There were construction oriented bankers that really looked at both sides when making the decision to lend you money.

But from a surety perspective, your backlog of work is the number one predictor of the future. It predicts, first of all, you can look at the past and say, do you generally have a lot of profit fades? And I'm jumping around, but all this is so important for a [00:04:00] bonding company. They're looking whether you maintain the profits you seem to make, maybe one, maybe two jobs losing money can be explained, but a lot of jobs means there's a serious problem that has to be dealt with. And we can talk about that some more.

But also looking at your backlog of work shows you what kind of profits you have coming up within the next, say, 12 months. A snapshot picture. It's called a Work in Progress report.

You look at that and you also analyze how much debt current liabilities are owed in those 12 months versus the income and the estimated expenses. And a bonding company can pretty much tell from that how you're gonna be able to finance your work. That's the thing that makes some contractors crazy.

Well, I do federal contracting. I don't finance anything. I do work for municipal governments. I don't finance anything. Have you ever heard him say that? And yet at the same time, you need cash.

Wade Carpenter: Absolutely. I think that's one of the things that we'll get into [00:05:00] is how do we look at working capital differently? But from an overall standpoint, and I'm not trying to knock bankers, but most people think, okay, the banker's gonna be the ones that really are digging into this stuff and they're really trained to do this well.

But actually the bond agents are, they basically take a harder look at some of these things, and a more sophisticated look. What I see banks out there doing is they will take a tax return, and it doesn't matter if it's on the cash basis, accrual basis, or really even percentage completion basis, they don't care.

They're looking so far in the rear view mirror and just basically what's your history?

There are a lot of things that they don't pick up on. I've had conversations with bankers all the time. It's like, okay, you're looking at a cash basis financial statement. These are cash basis tax return. And these contractors obviously never wanna pay tax. So they're running the profit down every single year.

If it's a cash basis, we may not have the receivables or the payables on there. And it may not be a true balance sheet. And when we get into the working [00:06:00] capital stuff, I think we'll talk about like some of the stuff that they would leave in there that obviously if you're trying to figure out if this is a healthy company doesn't make sense to me that you would do it, but bankers do it anyway.

Stephen Brown: That's so true. Another thing our listeners need to absolutely grasp a difference between bankers and bonding companies is the paperwork involved. What kind of financial reports are needed. And also if a bank lends you money, you walk in the door to any bank, you sit down with a loan officer.

They don't know you, and they're gonna ask for a million pieces of papers. They're gonna dot every I and cross every T before they give you a loan. And what you think will take place in an hour or two, takes a month or two to get worked out. With the bonding company, they might can move faster. It all depends on how fast you can communicate your information.

For example, there's credit scoring bonds that require little or nothing beside a good personal credit score for you and your spouse. If you have multiple [00:07:00] partners, they're gonna look at everybody's credit score, both partners and the spouses. It just depends on how much they own of the company. If your partners own 15% or less they won't scrutinize that. That's a credit scoring model.

But for looking at surety credit standard, they have to have balance sheet income statement, work in progress report showing jobs completed since the last time they saw your statement, and your work in progress.

In the old days, it was called a work on hand, but it's a WIP. Everybody knows it as a WIP. No bankers that I know of really understand the WIP and how to read it and what it means. And I apologize to you, bankers, if you're listening and you do regularly analyze backlog gross profit and lending. I want to meet you. Please reach out to us because we certainly need you in Atlanta and Memphis operating territory.

But nevertheless, surety bonding is about, as we mentioned, it was looking to the future. Okay. [00:08:00] Can you finish the job?

And here's a situation I may have mentioned to you. We have a young fellow in our office who was a construction only CPA, who is now a bonding agent. And he was reading the financials and he was crashing his head. He goes, how in the world are they given bond credit for numbers like this? And I said, first of all, you gotta take off your hat. You're no longer an accountant. That's not your job anymore. Your job is to get bonds approved that makes sense. You and I both know that this job's right up their alley. They do it all the time. They can do it in their sleep. They're gonna take a chance and say yes on this, because it's not just about collateral like a bank would require, but it's about your character.

So we mentioned the three important things for bonding: cash, character, and capacity to do the work. Character means you do what you say you're gonna do traditionally, that means a lot. Cash means you've got enough working capital to support your backlog.

[00:09:00] And the capacity means the job that you wanna bid is something that you're capable of doing. You have a track record of doing it, or you have a game plan for doing it that makes sense to a bonding company.

So it's all about communication and we talked about that. Banks have those three plus collateral and they're gonna weigh their loan more heavily on collateral than the other three. Where in bonding all three are pretty much equal. You would say the cash situation will rule more than the other three, but not in a good long term, serious standard surety bonding relationship.

Wade Carpenter: I think I want to get into some of the nuances of this, but just since you mentioned it, and the more I'm thinking about it, again, this is no disrespect to bankers, I gotta hand it to you is in the surety industry, you were talking about how fast you turn it around and sometimes you are having to make quick decisions and get stuff at the last minute.

This is sort of a personal thing. I'm actually buying a commercial building right now. And the bankers, okay, we'll rush it through and [00:10:00] get it done in eight weeks. Really? It's a little disappointing with that. But anyway, that's a different story. They are looking at sort of the same ratios maybe on the balance sheet, which, you know, one of the main ones I wanna talk about is like the working capital and the debt to equity and some of that stuff.

Can we start with the working capital? I wanted to throw out some of the things that I see that a banker might leave in, obviously you probably would throw out, or if they actually looked at it, they would probably not take as collateral as well.

Stephen Brown: Sure. For our listeners, let's define what working capital means. It's your current assets, which is anything that's considered liquid that can be converted into cash readily. It's cash. Cash accounts receivable, even cash value of a life insurance. Anything that's liquid. Stocks, investments, anything that's liquid is considered current assets.

Current liabilities that any debt you owe over the next 12 months. So the difference between the two is working capital. If that number's large, then you [00:11:00] can get more bank credit and you can also get more bonding capacity. Where banks will lend more on hard assets like equipment and office buildings, property, real estate, they will lend on that. It does take longer to get that loan in place, but it's a real good thing to put that in place to secure a line of credit.

That's the first and foremost thing you need as a contractor is a line of credit. It also helps you with your Surety Capacity. So those two go hand in hand. You remember that expression and this just shows how old I am, Wade. If you have to look in the yellow pages for an attorney, it's too late.

Nobody even knows what Yellow Pages are. If you have to hunt and search an attorney online locally that specializes in contractors, and you need one, it's too late. That relationship needs to be in place before you need one.

Wade Carpenter: Yep.

Stephen Brown: They're putting a new heating and air conditioning system in my house today. My negotiating power when it's a hundred degrees outside and everybody's [00:12:00] slammed is just gone down the tubes. It's the same with an attorney. You meet with an attorney, you hire them, you listen to their advice. You have them scrutinize your contracts and they know two things from you.

You're gonna pay your bills on time and you take their advice, okay? You're in. Banks, you have good paperwork. You dot the i's, cross the T's, pay your bills on time. They make money off of you. You're in. Surety bonding, you finish the jobs we bond. And you retain cash and working capital into your company to support those jobs. You're in. 

Wade Carpenter: Yeah, let's get into some of the nuances if we can. So like working capital, let's start with that. Some of the things that I see that a bank might leave in working capital and your current assets, things like prepaids. You had prepaid rent or prepaid taxes or something like that. The money is spent and the way I see it is the bonding company says, okay, the money's gone. You can't get that [00:13:00] money back. So it's not an asset.

Whereas, that's one of the nuances is like when you got a construction CPA and you're doing some planning at the end of the year, or if you're going to have prepaid taxes versus getting it refunded, even if you're going to turn around and pay it right back, a tax refund is probably something that bonding company would include. Things like inventory. What contractor has inventory. Banker might leave it in at best, I would say the rule of thumb is like 50%, but usually there's probably no credit for inventory.

Stephen Brown: Generally you're right. And our listeners would say that isn't fair. That isn't right. Man, you surety folks are a bunch of jerks. But here's the thing. A bonding agent, needs to explain how those things that have been taken off your working capital adjustment that you just mentioned are gonna apply toward a particular job that's coming up.

So you may have inventory that's discounted to 50% or less as cash, but if you have [00:14:00] inventory that's set aside specifically on a project you're getting ready to do that you're not gonna have to bill in inventory, you can get some more bond credit. It's gonna help move things over into the right end of the column.

There's some construction companies that are regularly gonna have receivables over 90 days. I'm thinking railroad contractors. There's just certain customers and vendors that are not going to pay as quickly, but they know that the receivables good. So you have to be able to pick out who the receivable is and make a pitch for that.

What if it's a municipality that owes you money? They'll give you credit for that if there's a reason for it. A lot of times your receivables will show up as overdue. We've talked about this so many times about over and under billing your jobs, and how that affects cash flow and your receivables.

Wade Carpenter: Like I said, the receivables, the retainage a lot of people that are doing this don't look at the retainage if it's [00:15:00] like you're gonna collect it over a year in the future. That's really supposed to be a long-term asset. And there's a lot of people out there that are doing financial statements that don't know that and never classify it properly.

But one of the things that also leads into the next topic I wanted to go into is loans to shareholders because it gets thrown out. I've seen bankers leave that in. And a lot of times that's where your shareholder has taken more money out than they take it in cash. And sometimes it's because of tax purposes, so that you're not paying tax on something you didn't deduct. Or getting double taxed on it.

These loans to shareholders, a lot of times that gets thrown out. Why? Because obviously, whether they're gonna get that money back or not, the bonding company's gotta be able to have that as some kind of asset they can, say, hang their hat on that but it also can affect your equity.

I had one contractor do it. He didn't understand he had a $700,000 loan to shareholder. Why are you throwing that out? What's your thought on that?

Stephen Brown: Think about it from the bonding company standpoint. [00:16:00] They are underwriting your business first, not you personally. You might say it's right here in my personal checking account. Really? Okay then, pay back the loan to the company. I don't want to, I like it sitting in my personal bank account.

If you want surety credit, pay it back. You can make a capital contribution loan to your company. You can subordinate that debt where you agree with the bonding company, I will not pay that off over 18 months, two years, three years. You have an agreement with the bonding company, that paid in capital will stay there and you get immediate working capital credit for it.

 But you keep playing games where you take all the money outta your company. Then you want bonding credit and you agree to whatever they say, and you put it back in. You do that back and forth so many times, you're gonna destroy your relationship.

You may get bonds approved every now and then. There's always a bunch of different folks you can call and say, so and so won't do my bond, I need it. Let's figure out a creative way. We'll get it done for you. [00:17:00] That works a couple of times. But it destroys your relationship in the long term.

Wade Carpenter: The two major things as a bonding company usually is working capital and then your debt to equity. So we were talking about the loans to shareholders and that's gonna probably be thrown outta your equity as well, especially if you got a large amount of it.

But you just also talked about subordinated debt, which also can be thrown out of some of the liability side, if you're doing that. I have seen that offset, you just have to have a subordination agreement.

Stephen Brown: Sure, the subordination agreement is something that you agree to the terms and conditions. You'll make a capital contribution to the company and you'll pay yourself X percent interest on that loan. The bonding company agrees that you're gonna pay interest on it as if it was a loan and an expense, but they're still gonna give you working capital credit for it under the conditions you agree not to take it out. And that's the big deal here. If you sign a subordination agreement. And you agree to keep the [00:18:00] money in there for 18 months, 24 months, three years, whatever you agree to with the bonding company, then you cannot take it out. You've agreed to the company in writing that it will stay in.

You say that's just a gentleman's agreement. No, it's a legal document. You are subordinating that debt, which means you are saying, I will not pay this debt back. Now, however, at any time your working capital gets above the point where that subordinated debt isn't needed anymore, they'll retract the agreement happily. They don't care. They just wanna make sure it's there. That's all.

Wade Carpenter: Yeah. The other option is like you've got a whole bunch of money loaned into the company versus you owe the company. And if you're loaning to the company, you could convert it to additional paid in capital or stock, depending on how you're set up, that's a more permanent thing. So a lot of times the owners don't wanna do that to eventually get their cash out. But that's just another thought about it. 

Stephen Brown: You may have enough profit coming in from your backlog of work that your working capital is no longer [00:19:00] a problem. And it's fixed itself and you can pay yourself back. But then the worst thing I see is someone will get a big hit on a job and they'll make a big profit and they just distribute it. They just take it all out. It's the first order of business. We're getting it out of the company.

And I beg you just talk to your bonding agent first. They're not gonna make you feel guilty or tell you what to do. They'll just tell you exactly how it'll affect your bond credit.

Wade Carpenter: Can we go back to the WIP schedule and what over and under billings do, and how a bank may just gloss over that number if it's on the balance sheet at all?

There is a point where there's too much of a good thing. From a cash flow standpoint, it's great to say, hey, we overbilled, a million dollars or whatever. Or if you're underbilled, there's pros and cons. You wanna talk through that and explain a little more what I'm talking about there?

Stephen Brown: Sure. Billing's in excess of cost is a current liability. Cost and excess of billings is a current asset, because you've incurred that cost but you haven't [00:20:00] billed for it yet. And in either situation, if those numbers are 20 or 30% more of your equity in your company then the bonding company's gonna make some adjustments for it. Those adjustments are in term of how much bond credit they extend to your overall backlog of work.

Wade Carpenter: Yeah. This personal situation that one of my contractors had, it was a school contractor that had a may year end it was sort of weird. But--

Stephen Brown: This wasn't Radcliffe, was it? I'm kidding. That's the hero of your book. I'm sorry.

Wade Carpenter: That was the company in the book. Yeah, they were a general contractor too. But this particular general contractor built schools. And obviously school building, You're doing your heaviest work when the kids are out of school, which is the summer months. Actually this particular county, all their administrative people took off in the summer too, or the school board people.

Stephen Brown: The summer is now just June and July.

Wade Carpenter: Yeah, the county would allow them to bill like three months ahead so that they could go ahead and get everything done. [00:21:00] So they were actually like, I don't know, at the time it was six, seven, $8 million overbilled on the statements. And obviously that was making the bonding company nervous.

But when we explain to them like, okay, they've given them the cash flow. And we're getting, I mean this is a strong company anyway, this is why. If you can explain why you're so overbuilt or why you're so underbilled, the under billing I think is also a problem. Like, are you having problems actually collecting? Is that a billing problem that's probably affecting your cash flow?

Stephen Brown: What about unapproved change orders? 

Wade Carpenter: Yeah.

Stephen Brown: Showing up as over and under bill. That's a really good point, Wade, because how it's interpreted by the bonding company, you're exactly right. It makes so much sense from a bond company, They're just looking at your financial statement to see what your report is over and under buildings, and then they reconcile the two and you say, wait a second, there's a reason for this because we didn't post this to this and we didn't post this to this and this wasn't building. Okay, that makes sense. So you talk about it.

Bond [00:22:00] underwriter, your bond agent, the contractor, bookkeeper, the accountant, you just talk about it, you work it through. The most important thing is to regularly go over your financial statements with the bonding company, not just at the last minute when you need a bond, and develop a true partnership.

That's where magic happens in the surety industry.

Wade Carpenter: Yeah, absolutely. And just, along those lines, unapproved to change orders. I've seen this more times than I can count and actually admit. But there are contractors out there that don't book their retainage. And I've seen reviewed and even one type case audited financial statements where the retainage was not on there. And so they were way underbilled. It looked like they were way under billed, but they weren't including their retainage.

Obviously finding these things out is, really, you know, like, are you really healthy? I think that's part of the exercise in talking about this. But I would like to maybe spend a little more time talking about backlog and backlog gross profit and how a bonding company, I mean, you've already said a banker would never look at it.

 [00:23:00] If you know you've got the next six months of overhead covered or something like that, and backlog gross profit, you wanna talk about that? 

Stephen Brown: Well, your backlog gross profit is only as good as how you've performed in the past. So a banker looks at the past. Bonding companies look at your backlog gross Profit on your traditional ability to produce X amount of work a month. And so it's important when you look at backlog that the surety company is looking at your working capitals to support that backlog.

It's a percent of your overall backlog that they wanna see in working capital. But that's constantly changing. So the more you communicate, the better chance you have of getting more work and a lower working capital ratio. Because you're showing this amount of money's coming in. And traditionally we are making that amount of money with no profit fades. Did I answer that question?

Wade Carpenter: Yeah, absolutely. And you actually led into the next topic I wanted to [00:24:00] go into was profit fades. That's one of the things that we put a work in progress schedule on the financial statements, it all looks rosy. And then the next statement the bonding company gets that job completely tanked, they were supposed to make 25% of 30% gross profit. They ended up losing money on that.

Stephen Brown: What if the project took place over multiple years or through your fiscal year end? And you took more Profit in one year and less in the second? That's something that has to be adjusted for by the bonding company as well.

Wade Carpenter: Absolutely. My point is if you do it like once or twice, it's one thing. Things are gonna happen in construction. But if you have a history of doing that, the bonding company's gonna think you can't bid your job properly or you're purposely pumping this up 

Stephen Brown: You've got people error or you've got system error.

Wade Carpenter: Yeah. That particular contractor that I was talking about, they had the opposite problem. They were actually trying to tamp down their jobs when they did the [00:25:00] financial statements because they didn't wanna pay taxes on the wrong percentage of completion. So they were actually having profit gains and the bonding company loved it.

But if IRS ever caught on to some of that, it's sort of like the problem that very few contractors have, but it's more, does the bonding company trust your bidding?

Stephen Brown: Absolutely. And does the bonding company trust your project managers? What project manager is managing what particular project? What's their track record? And again, it's just typical among males to not talk about personal problems and issues, but you'll see a loss on a job from one of your very best project managers that is going through a personal crisis. It affects everything. And you gotta make allowances for that and know ahead of time what's going on so you can support them, so that doesn't happen. And also have systems in place that support the whole process of the control that project manager has on the job.

A good project manager that [00:26:00] loves the type of project they're doing and has a track record or turning in those projects at the profit margin that's been estimated, under promising, over delivering. That's what you want to do. That's worth its weight in gold as well. So I mentioned the magic of surety bonding and all of this comes together to make good things happen.

Wade Carpenter: Yeah, I know we've hit a lot this time. We're getting a little long on this one. Hopefully if you're listening to this, you got some insights that you've never thought about before in your business. And the purpose of all this is looking at yourself and are you really healthy in your business, and are you building profit and wealth?

We appreciate you listening to us. We hope you learn something. If you got some insights, we'd appreciate it if you put it in the comments below or had questions about what we do, we'd love to hear it.

We do this every single week. If you would like, share, subscribe, do all that stuff, we appreciate it and we will see you on the next show.

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