Mitigating Risk & Uncertainty: Surety Prequalification for Contractors

Contractor performance has traditionally been measured by three factors: price, schedule, and quality.

By extension, there are natural risks associated with each of these factors, but mitigating these risks is a top concern of any active construction project. 

One method for risk mitigation has been to require bid, performance, and payment bonds as part of the tendering process. However, notwithstanding its powerful influence on the construction industry, the surety business has yet to adopt specific standards for measuring risk.1

Underwriters of bond policies each measure risk in slightly different ways, but each considers the character, capacity, and capital of the principal.2 Though sureties may consider these three Cs of credit through varied lenses, their perspectives in measuring the potential for contractor success can be helpful.  

Unfortunately, there is no perfect formula for assessing and mitigating contract-tendering risk (Exhibit 1). Ultimately, selecting a contractor as a building partner is anchored in the owner’s values, and the choice is often made based on qualitative responses provided in the contractor’s written responses to a formal request for qualifications and an interview.

This article delves into the nuances of contractor evaluation, covering key factors such as working capital turnover, current ratio, profitability ratios, efficiency metrics, and managerial strategies.

Instruments to Measure Capital

For sureties, measuring risk generally begins with the traditional evaluation of the financial statements and measuring the company’s capital concerns.

In surety underwriting, there tends to be a softening or hardening of the bonding market based on economic conditions, meaning that the standards are generally established by the underwriter. Based on good economic conditions, they may soften or expand those standards — essentially taking on more risk.

For the surety, the benefit of a soft market provides sufficient bonding revenue so that the risk of a single failure is spread over numerous projects and contractors. This may become significant for a developer, knowing that the surety may have relaxed their standards in these conditions. As such, the developer may prefer to raise standards for prequalifying a contractor. Whereas, during economic recession and recovery periods, the surety standards may become more stringent or harder to meet. In these conditions, a developer that requires performance and payment bonds might be able to soften their own standards, knowing that a bonded company has met a higher standard for the bond. This means that they may be able to take on more risk associated with the financial analysis in the case that the contractor’s character and capacity are held in high standard.

Yet, a study found that regardless of the qualitative, formative methods for evaluating the character and capacity concerns for contractor tendering, contractors must first meet a quantitative analysis of their capital.3 These minimum standards (as ambiguous as they may be) must be acceptable or the entire evaluation is terminated. That is not to say that the financial statement review ensures the contractor will qualify to be shortlisted or bonded; it simply means they have not been eliminated.

Therefore, the evaluation of capital should include metrics that consider the company’s liquidity and solvency, profitability, efficiency, and equity structure of the contractor. There are myriad financial ratios and key performance indicators (KPIs) used for measuring financial performance, and the most common are discussed in this article.

The effective use of financial ratios has been documented extensively in relevant research.4 Financial ratios are often benchmarked against industry averages to measure a company’s performance against their peers. The following is a discussion of those ratios, how they are used as a measure of performance, their strengths and weaknesses, and the current industry benchmarks.

Working Capital (A Liquidity Ratio)

Regardless of the market and economic conditions, the first step to credit evaluation always begins with measuring capital concerns. If these concerns or standards have not been met, then an evaluation of character and capacity is irrelevant. No amount of good character and increased capacity can or should outweigh the concerns for poor capital.5

Sureties begin with an evaluation of a company’s working capital relative to their revenue, which is calculated by subtracting the current liabilities from the current assets. The ratio of revenue divided by working capital is often referred to as working capital turnover or turns.

During economic growth periods, a minimum ratio of 5% is the standard, while 10% is the elevated standard during recession periods. This is an excellent example of the softening and hardening of underwriting standards.

As indicated in recent research, an emphasis is always placed on working capital management; companies that maintain a history of a high ratio have a clear advantage and increased bonding capacity.6

For any financial analysis, it is important to know the minimum standards and the industry mean. A company that does not meet all minimum standards would raise concerns for an external reviewer, while being below or above a national average can simply be the result of company strategy or priorities at the time.

When considering the working capital turnover ratio, the mean score for the construction industry has been near 18.8 in recent years, which is considerably higher than the minimum 5% or 10% standard.

For example, a contractor with a ratio of 10% or 12% for working capital turns is lower than the industry average. However, the company’s current strategy may be to carefully maintain higher levels of liquidity (cash, securities, receivables, etc.) and working diligently to lower debt. In this case, a lower ratio is actually an indication of higher liquidity.

On the other hand, a company with a very good year in terms of annual revenue, and that is taking on increased debt, will have a higher ratio. In this case, the higher ratio cannot be seen as entirely associated with managing increased revenues with the same levels of working capital. In fact, a higher ratio may be an indication of the company taking on debt at a faster rate than increasing revenue.

This limitation for using working capital turns as a performance metric is therefore volatile. It becomes imperative to evaluate numerous financial metrics and consider the aggregate findings rather than a single score based on a single indicator.

Current Ratio (A Liquidity Ratio)

The current ratio is one of the most common indicators of liquidity. If solvency is a measure of the company’s ability to meet their debt obligations, then the current ratio is the first ratio to consider when measuring solvency. The ratio is calculated by dividing the current assets by the current liabilities.

In CFMA’s 2023 Financial Benchmarker, the national average was close to 1.7 for the construction industry, which is higher than 20-year historical means at 1.42. However, since the 2008-09 recession, this ratio has steadily been increasing from 1.40 in 2009. The minimum standard for most sureties, bankers, and investors has commonly been set around 1.15-1.20, though these minimum standards are most likely being raised as the industry as a whole is improving their liquidity levels. The analysis of this ratio indicates behavior that has a positive skew and kurtosis (tails of distribution) (Exhibit 2).

With a mean score of 1.7, 96.9% of companies in CFMA’s 2023 Financial Benchmarker are behaving within one standard deviation of 5.14. This standard deviation (a measure of variance) is high because of the significant number of sampling of companies with high levels of liquidity. The skewness of the distribution to the left is an indication that few companies in the sample maintain a current ratio less than the minimum standard of 1.15 (15.5% of participants).

The higher standard is encouraged when considering a GC. For an owner-developer, a payment bond does help to protect against a GC defaulting on their payments to subcontractors. However, the execution of a payment bond is generally the last line of financial defense in such cases.

In contrast, a history of current ratio above a 1.2 is an indication that the contractor actively meets their current debt obligations while a ratio closer to 1.5 may rightly be interpreted to mean that the contractor values their relationships with the trade partners. For an owner-developer, that relationship is critical to meeting schedule and quality standards.

The concern for using the current ratio as a sole metric for liquidity is that the ratio considers all current assets, whereas the only true current asset that can be used to pay debts is the cash and securities account. Therefore, if a company maintains disproportionate levels of receivables (a current asset) without active collection practices, then it may artificially inflate the current ratio.

Two ways to quickly assess the true liquidity of a company are to:

  1. Drill down with additional ratios such as the quick ratio and the days in cash ratio
  2. Consider the average days in accounts receivables (A/R)

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