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. These ratios provide insight into the company’s liquidity, profitability, and overall financial strength.
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:
- 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: It 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.