Surety Bond Default – Signs Which May Lead to Failure
During a recent Florida Surety Association meeting, Gary Dunbar, President of Great American’s surety division, gave a presentation on what leads to surety bond default. His presentation dealt mainly with the performance and payment bonds in the construction industry although some information may apply to commercial bonds. We’ll discuss a few of these signs and some others in the paragraphs below.
Sign #1 – Divorce
Didn’t see this one coming did you? Well neither did the husband and wife team who split the duties of their bonded construction company. At first, everything was perfect. One of spouses handled the inside accounting/office management while the other supervised work in the field. As the construction company grew, so then did the stress in their marriage. Eventually, the couple decides to get a divorce. We all know divorces can often be contentious but they also distract from a person’s daily routine. Job site supervision begins to decline as does management of the in-house duties like tracking job profitability and invoicing on time. Additionally, the lawyers are trying to find a way to split the marital assets in the meantime.
The real threat, however, lies after the divorce has been settled. The partner who supervised the field operations may now find themselves managing the office, taking care of payroll, and other accounting tasks. On top of that, they’re still responsible for supervising each project. Payroll may fall behind along with invoicing, timely financial reporting, and other tasks. You can see how quickly a contractor’s fortune can change when they’re overwhelmed which brings us to our next sign.
Sign #2 – Inexperience
In this example let’s say you’re a contractor who performs contracts in the $200,000-$300,000 range. Similar to the situation mentioned above, the in-house bookkeeper handles your accounting and you handle the job supervision. Your bonding agent uses a Fast Track application which allows you to get bonds without a lot of financial information. Now let’s say a large job comes up and you’re in need of a $1 million performance and payment bond. You call in a CPA to perform a financial statement review, get the job, and find a surety company willing to provide the bond. All is well right? Well, maybe…
You get request from your surety for an internal balance sheet and income statement along with a WIP schedule. Your in-house bookkeeper sends the financials and WIP to your agent who reviews them. What does your bonding agent see? Negative cash balances, receivables over 90 days, and a poorly put together WIP. While negative cash balances can be explained (to a point), these factors often indicate your bookkeeper does not have the experience to handle jobs of this size. Accounts receivable balances over 90 days are usually the result of improper invoicing or poor collection practices. The inability to track job progress and profitability can show that job cost allocation is poor or a lack of understanding. Either way, these are signs of inexperience and can often lead to contractor bond default.
Sign #3 – Working Capital, Cash Flow, and Debt
While this one is somewhat self-explanatory, let’s discuss it for the sake of the article. Surety companies review your ability to pay your bills with a very close eye. This involves examining your working capital (current assets less current liabilities), availability of your bank line of credit, and debt service. They like to see that your company is able to pay its bills due within 12 months (current liabilities) with the amount of cash currently in the bank and accounts receivable (current assets). They also like to see that you have a bank line of credit to handle any slow pays or up front job expenses. Lastly, they look at your existing debt maturity to determine your cash needs in the coming years. Does one of your loans have a balloon payment? If so, have you began the process of restructuring that note or do you have the ability to pay it off?
There are many warning signs of contractor default and those mentioned above are only a few examples. The point we’re trying to make is that many of these signs of default can be mitigated through proper preparation. A prenuptial (and postnuptial) agreement can detail what happens if a divorce occurs. Hiring qualified people and knowing your limitations can often prevent mishaps from occurring as a result of inexperience. Proper cash flow and debt management can prevent financial crises in the future. There isn’t a magic bullet that prevents surety bond default but it’s important to plan for the worst case scenario.