Surety bonding for contractors involves a detailed analysis of their financial and operational health. Surety underwriters use several key ratios to evaluate a contractor’s ability to complete projects successfully and meet their financial obligations. Here are the most common ratios assessed:
1. Working Capital Ratio
- Formula: Current Assets – Current Liabilities
- Significance: Measures liquidity and the ability to cover short-term liabilities. Adequate working capital shows financial stability and resilience.
- Benchmark: Sureties often require working capital to be at least 5% to 10% of the current backlog (cost to complete all ongoing projects).
2. Current Ratio
- Formula: Current Assets / Current Liabilities
- Significance: Reflects the contractor’s short-term financial health. A higher ratio indicates a strong capacity to pay short-term obligations.
- Benchmark: A ratio of 1.5 or higher is generally preferred.
3. Debt-to-Equity Ratio
- Formula: Total Liabilities / Shareholders’ Equity
- Significance: Assesses the degree to which operations are financed by debt versus equity. Lower ratios indicate less financial risk.
- Benchmark: Sureties prefer a ratio below 3:1, but this can vary by industry and project size.
4. Profitability Ratios
- Types:
- Net Profit Margin: Net Income / Revenue
- Gross Profit Margin: Gross Profit / Revenue
- Significance: Demonstrates the contractor’s efficiency in generating profit. Consistent profitability signals operational efficiency and sustainability.
- Benchmark: Varies, but sureties value consistent or growing profitability.
5. Leverage Ratios
- Interest Coverage Ratio: Earnings Before Interest and Taxes (EBIT) / Interest Expense
- Significance: Shows the contractor’s ability to service debt. A higher ratio indicates stronger financial health.
- Benchmark: Should be well above 1.0.
6. Backlog-to-Net-Worth Ratio
- Formula: Total Backlog / Net Worth
- Significance: Measures how much work (in terms of cost) is being carried relative to the contractor’s financial capacity.
- Benchmark: Ideally below 10:1 to ensure the contractor isn’t overextended.
7. Quick Ratio (Acid-Test Ratio)
- Formula: (Current Assets – Inventory) / Current Liabilities
- Significance: A stricter measure of liquidity than the current ratio, excluding inventory.
- Benchmark: Ratios above 1.0 are generally acceptable.
8. Bonding Capacity
- Surety companies often consider:
- Single Job Limit: The largest bond they’ll issue for one project.
- Aggregate Limit: The total bond capacity across all projects.
- Ratios like Net Worth x Multiplier (e.g., 10x) or Working Capital x Multiplier (e.g., 5x) are used to set these limits.
9. Net Worth
- Formula: Total Assets – Total Liabilities
- Significance: Indicates overall financial stability. A stronger net worth reduces risk for the surety.
- Benchmark: Sureties expect the net worth to cover at least 10% to 20% of the total backlog.
Additional Factors Sureties Assess:
- Quality of Financial Statements: Audited statements are preferred.
- Management Experience: Track record of completing similar projects.
- Credit History: Demonstrates financial discipline.
- Contractor’s Backlog: Balance between capacity and workload.
- Subcontractor Management: Reliance on and oversight of subcontractors.
By maintaining healthy financial ratios and demonstrating strong operational capabilities, contractors can secure better terms for surety bonding.
Conclusion
These ratios help surety companies assess the financial health of a contractor and determine the level of risk involved in bonding a particular project. Contractors with strong liquidity, a healthy balance sheet, and a solid track record of profitability are more likely to qualify for higher bonding capacity, which is crucial for winning larger projects.