Monday, December 15, 2014

Secrets of Bonding 46: Turn Iron Into Gold

When contractors apply for Performance Bonds, the underwriting review always includes a financial analysis along with other elements.
Two key components of the financial analysis are Working Capital (WC) and Net Worth (NW). WC is a measure of short term financial strength. NW is the ultimate value of the company upon liquidation.
The inspiration for this article came from a new bond account recently submitted by one of our agents. The company is a trade contractor, the kind that normally performs their own work rather than subcontracting. This means their financial statements should show appropriate levels of labor, plant, and equipment.
In this case, the Profit and Loss Statement (P&L) showed sales in excess of $10 million, not a small company. The Balance Sheet showed an acceptable amount of WC, but NW was low - resulting in some weak ratios.
Another element caught our attention: On the Balance Sheet, the net value of the equipment asset was only $65,000! This made us wonder how a company could perform $10 million in sales with so little in physical resources.
There could be a couple of explanations:
  1. They could be subcontracting most of their work. This is unlikely, however, because they themselves are subcontractors. Typically there is not enough profit to share between two firms. A review of this company's P&L statement did not indicate extensive subcontracting.
  2. They could be renting almost everything (instead of owning). This doesn't sound like a practical approach with sales as high as $10 million, and the P&L did not show high rental expenses.
  3. The equipment could be substantially depreciated resulting in a low net value on the Balance Sheet. This did turn out to be the scenario in their case.