How to Build a Balance Sheet Your Banker and Bonding Agent Will Love
Key Takeaways:
- Manage Working Capital: Strong liquidity and collectible current assets help contractors fund projects and support bonding capacity.
- Build and Retain Equity: Balancing owner distributions, debt, and retained earnings can help maintain the capital needed for growth.
- Monitor Backlog and WIP: Evaluate project margins, timing, cash needs, underbillings, and job fade – not just total backlog.
- Prioritize Financial Reporting: Accurate, timely financial statements and WIP schedules give bankers and sureties greater confidence in a contractor’s financial position.
For contractors, financial statements do more than report historical results. They can directly affect a company’s ability to obtain financing, increase bonding capacity, pursue larger projects, and support future growth.
Surety underwriters commonly evaluate a contractor based on the traditional “three Cs”: capital, capacity, and character. Financial statements play a significant role in evaluating capital and capacity, including the contractor’s working capital, net worth, leverage, work in progress, cash flow, and historical project performance.
Understanding what these financial statement users are looking for can help contractors proactively strengthen their financial position.
Working Capital: Can the Business Fund Its Work?
Working capital, generally calculated as current assets less current liabilities, is one of the most important financial metrics in construction. Sureties use working capital when evaluating a contractor’s ability to operate, start new projects, and qualify for additional bonding. Contractors often need to fund payroll, materials, subcontractors, equipment costs, and other project expenses before receiving payment from customers. As a result, liquidity matters.
The quality of current assets also matters. Cash and collectible receivables may receive different consideration than assets that cannot easily be converted to cash. Sureties may adjust reported working capital based on the liquidity and collectability of individual assets.
Equity: How Much Is Staying in the Business?
A contractor’s equity provides another indication of financial strength. Surety professionals consider net worth and equity when evaluating whether a company has sufficient capital to absorb losses and support its operations. They also consider leverage, including the relationship between debt and equity.
Consistent profitability can increase equity over time, but strong earnings do not necessarily translate into a stronger balance sheet if most profits are distributed to owners.
Before making significant distributions, contractors should consider their working capital requirements, cash reserves, debt obligations, upcoming projects, and anticipated bonding needs. Establishing financial targets can help balance owner distributions with the capital necessary to support the company’s growth.
Backlog: More Is Not Always Better
A strong backlog can provide visibility into future revenue, but the total dollar amount tells only part of the story. Sureties evaluate both past and future work when considering a contractor’s capacity. The Surety & Fidelity Association of America identifies work in progress, cash flow, past and future work, and historical project profitability among the factors considered during contractor prequalification.
A contractor should, therefore, understand not just the size of its backlog, but also expected margins, project timing, customer concentration, labor requirements, management capacity, and the cash required to execute that work. Rapid growth can create financial stress even when individual projects are profitable. Additional revenue may require additional working capital, personnel, equipment, financing, and infrastructure.
Underbillings: A Number Worth Monitoring
Underbillings generally represent costs and earned profit in excess of amounts billed. They can arise from normal billing timing, pending change orders, contract requirements, or other project-specific factors. However, significant or recurring underbillings deserve attention. National Association of Surety Bond Producers notes that underbillings can affect cash flow, working capital, and reported performance and, in certain circumstances, may be viewed skeptically by surety underwriters if collectability or project profitability is uncertain.
Management should consider whether billings are being submitted timely, whether change orders have been approved, whether costs are tracking to expectations, and whether estimates to complete remain accurate. This is why the work-in-progress, or WIP, schedule should be viewed as more than a year-end accounting exercise. The American Institute of CPAs (AICPA) notes that WIP schedules help contractors monitor project budgets, progress, revenue, and profitability throughout the life of a project.
Job Fade: Are Estimated Profits Holding Up?
Job fade occurs when the estimated gross profit on a project declines as the job progresses. For example, a project originally expected to generate a 15% margin may ultimately finish at 10%. One project experiencing fade may not indicate a larger problem, but consistent margin deterioration may point to issues with estimating, labor productivity, project management, change-order management, or job costing.
Historical performance matters because sureties evaluate completed projects and profitability as part of assessing a contractor’s ability to perform future work. Contractors should regularly compare original estimates, current estimates, and final results to identify patterns of job fade or gain.
Related-Party Balances and Debt
Related-party receivables, including amounts due from owners or affiliated companies, may warrant additional attention because a surety’s analysis may focus on the liquidity of the assets supporting working capital. Some surety analyses specifically adjust working capital for shareholder, officer, and related-party receivables.
Debt also factors into the overall financial picture. Sureties commonly review bank lines of credit, loan terms, repayment requirements, leverage, and the relationship between debt and equity. Contractors should monitor line-of-credit utilization, principal payments, loan covenants, interest expense, upcoming maturities, and overall leverage.
Financial Reporting Quality Matters
Strong financial results are more valuable when supported by accurate and timely reporting. Sureties commonly request contractor financial statements, aged receivable and payable schedules, WIP reports, bank information, and other financial information as part of the prequalification process.
WIP schedules that do not reconcile to the general ledger, unexplained changes in margins, old receivables, or significant year-end adjustments can make it more difficult for outside users to understand the company’s true financial position. Conversely, reliable and timely financial reporting demonstrates that management understands the business and has systems in place to monitor performance.
The Bottom Line
A company’s financial statements tell a story to their banker and bonding agent; that story is about more than whether the company made money. It is about whether the contractor has the liquidity, capital, operating capacity, and financial discipline necessary to successfully complete its existing work and take on additional projects.
Contractors that proactively manage working capital, retain appropriate equity, understand their backlog and WIP, control debt, and monitor job performance can put themselves in a stronger position when the next opportunity arises.
A CPA who understands the construction industry can help management monitor these metrics throughout the year and identify areas that may need attention before additional financing or bonding capacity is needed. For more information about McKonly & Asbury’s Architecture, Engineering, and Construction (AEC) experience, visit the AEC Industry Page and don’t hesitate to contact a member of the AEC team.
About the Author
Zach Starner, MBA is a manager on the Entrepreneurial Accounting Solutions team. He provides back-office accounting and outsourced financial services to a diverse client base, including large contractors, family-owned businesses,… Read more
