Performance Bond Underwriting Basics
What are underbillings and why do performance bond underwriters care about them? Let’s start with some basics. Once a contractor gets to a certain level of bond needs (say projects over a million dollars on a regular basis)the performance bond underwriters will increase the amount and quality of the underwriting information. One key requirement will be the financial reporting must be done on a percentage of completion basis. Percentage of completion means that a contractor will recognize the profits on a project based on the progress of the project. If a project is 50% complete and the profit on that project is expected to be $100k, the contractor will recognize $50k in profit in that reporting period. Underbillings are costs and estimated profits in excess of billings. For example, a contractor has:
- $1mm project with a 10% profit margin.
- That project is 50% complete at the time of the financial reporting.
- The total costs of that project at that time would be $450 k
- The recognized profit would be $50 k.
Suppose the billing to date on that project was $400k. That would mean the project was underbilled by $100k at that time (Cost of $450k + Profit of $50K). If the billing matched the progress of the project, billing to date would have been $500k.
Why underbilling could be a red flag to the underwriters
The obvious answer is the most telling here, why would a contractor not bill for all the work done to date? Most, (if not all) large projects allow for progress billing. If that is the case, it is in the contractor’s best interest to bill for the work performed, unless, the project is not going as well as planned. Sometimes underbillings are a sign that a project is not performing as well as anticipated. The billing is less than the costs and profit because owner and the contractor disagree about how far along the project is. Maybe there are un approved change orders that the contractor cannot bill for. In the surety’s experience, sometimes unapproved change orders never get approved and the project ends with a loss. While far from the majority of the time, sometimes underbillings are a sign that there is profit fade on that project (the anticipated profit on the project decreases through the life of the project).
Underbillings are considered a current asset on the contractors balance sheet. Working capital is one of the key financial metrics considered by the underwriters. Working capital is current assets less current liabilities. If it turns out, for any number of reasons that that underbilling cannot be billed, than the working capital was overstated and the underwriter made a credit decision on information that ended up not being accurate. Depending on the frequency and severity of the underbillings, the performance bond underwriters may discount the underbillings when making its surety credit decision.
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