Once contractors need bonds above about $350,000, the qualification process is largely based on the financial strength and capability of the contractor. A surety looks at many key ratios and factors in order to develop a bond program. Just one of these is the “working capital” of the contractor. In this blog we’ll discuss what makes up working capital and how to calculate.
Definition: Working Capital = Current Assets minus Current Liabilities
While it’s easy for some contractors to understand, often times smaller or emerging contractors who are wearing many hats do not understand or see the importance in this ratio. While there are no absolutes, the surety market widely uses the “ten percent rule” to determine a contractor’s ability to finish work. This means that a contractor should have ten percent working capital of their total cost to complete their backlog. For example, if a contractor has $1 million worth of costs left of his entire backlog, he should have $100,000, or 10%, in working capital. First let’s break down each:
Cash, short term investments, accounts receivable, notes receivable, retention, inventory, and costs in excess of billings (under billings).
Credit cards, accounts payable, taxes payable, line of credit, short term portion of long term debt, and billings in excess of costs (over billings).
Taxes Payable $30,000
Credit Line $10,000
Under this example, working capital would be $200,000 minus $100,000 totaling $100,000. Using the “ten percent rule” this contractor is financially strong enough to complete $1,000,000 worth of backlog. If the contractor had no obligations, in theory he should qualify for $1 million in performance and payment bonds. Knowing this, it’s important to understand how to calculate backlog, which we will discuss in our next blog titled “Performance Bond Financial Analysis – WIP.”
WIP stands for Work-in-Progress and it’s a report contractors should utilize to accurately report revenue on a percentage of completion basis. It’s this report that ultimately calculates over and under billings, along with costs to complete work in progress; two key numbers that effect working capital and your bond line.