In our last post, we covered how cost is determined in performance bonds. The other question we are often asked is how to increase bond capacity, or bond credit. While there are several ways bonding credit is determined, the “10%” rule is recognized and used in the surety industry.
The 10% rule is in reference to having 10% working capital and 10% equity of your total costs to complete work on hand. To understand this, let’s start with defining each, then consider an example:
- Working Capital – Defined as total current assets minus current liabilities. In general, (Cash + receivables + under billings + half of inventory) minus (credit card/lines + payables + over-billings + taxes due)
- Equity – Total Assets minus liabilities.
- Costs to complete work on hand – The total costs to complete all bonded and unbounded jobs in progress. The costs are determined using a Work-in-Process report.
Example – Let’s assume a contractor’s assets equates to $100,000 cash, $500,000 accounts receivables and $100,000 of under-billings for a total of $700,000 of current assets. He also has a $50,000 line of credit due and $250,000 of accounts payable for a total of $300,000 of current liabilities. His working capital is $400,000. Let’s assume he also has $2,000,000 of costs to complete work on hand.
Using the 10% rule, this contractor would qualify for bond credit of $4,000,000. However, since sureties consider the costs to complete work on hand this contractor would have $2,000,000 of bonding credit available, since $2,000,000 of costs to complete work were already in use.
The Real World
There are many underwriting factors that go into establishing bonding credit far beyond the 10% rule. Some contractors get more credit, some get less. However, once a contractor has invested in a quality CPA statement and has an established bond line, it’s a good rule of thumb to use when trying to understand why an underwriter is increasing or decreasing bond limits.
If you keep the 10% rule in mind, it’s easy to see that leaving cash in the company builds your bonding capacity. Keep that in mind when deciding to take a shareholder distribution, or purchasing unnecessary equipment and vehicles. It all makes an impact on the 10% rule, and thus your bonding capacity.
Use a surety bond professional and get set up to maximize your performance and payment bond needs. Call us for a consultation at 877-654-2327 or learn more about getting performance bonds.