Construction companies are required to obtain surety bonds on many types of projects — particularly those that are publicly funded. The bonds essentially guarantee that the work will be completed one way or another. Contractors are urged to manage their operations and financials carefully to preserve or, better yet, increase bonding capacity. But what is bonding capacity in construction, really?
The three Cs
Simply defined, bonding capacity is the maximum amount of credit a surety will extend to a contractor. It’s often expressed as the largest single project for which the surety would issue the subject company a bond. Capacity is, in fact, one of the “three Cs” of bonding:
- Character. This refers to whether a construction company can be trusted to honor its contract obligations. A surety will look at your business’s reputation, including its track record of successfully completing projects and consistency paying suppliers. Transparency about financial information and complete answers on the bonding application are also good indicators of character. So are the quality and timeliness of your communication with the surety.
- Capital. This indicates financial strength. Many sureties look at adjusted working capital — the difference between current assets (such as cash and accounts receivable) and current liabilities (such as accounts payable and short-term debt). A surety will scrutinize your financial statements to set your bonding limit, which generally ranges from 10 to 20 times your adjusted working capital.
- Capacity. As mentioned, this is the maximum amount of bonding you can qualify for, based on your total ability to fulfill the contract in question. Sureties look at your equipment, labor and other resources, as well as the type and size of contracts recently completed.
For example, if you want to secure a $10 million contract, but the largest contract you’ve completed to date is $5 million, the surety will likely question your capacity to deliver a project of that size. With the cost of materials rising, an increasingly common problem for many contractors is getting bonded for projects of the same scope that now cost more to complete.
Ideas for boosting capacity
Here are a few ways you might be able to boost your bonding capacity:
Take out a shareholder loan. Also called a capital injection, these loans are among the quickest, easiest ways to “inject” cash into the business and increase working capital. A shareholder loan is typically subordinated to the surety to be treated as equity and working capital. Thus, you’ll need permission from the surety to repay it.
Step up collections. Sureties usually remove receivables that are more than 90 days old from working capital unless you can show they’ve been collected or will be soon. Focus on collecting receivables in or near this 90-days-old bracket.
Sureties also tend to remove from working capital amounts a construction business has loaned to related parties, such as an affiliated company or subsidiary. Ensure these amounts are paid back or reduced before year end.
Defer insurance renewals. Work with your insurance rep to push back any renewal payment dates that fall before year end. Doing so will reduce prepaid expenses for the year, which will increase working capital.
Strengthen your position
Now’s a good time to build up your bonding capacity as public infrastructure jobs continue to come online. Mashburn CPA would be happy to help you better understand and strengthen your construction company’s working capital position.
