Financial statements tell contractors, as well as sureties, bankers and other stakeholders, how well a construction company is doing. A contractor’s character, capacity and capital are determined by the numbers reported on the company’s financial statements. Commonly referred to as the “three Cs,” these indicators provide a foundation for sureties to form an opinion on a contractor’s past, current and future performance.

Sureties look at the three Cs to determine if the contractor has:

• working capital, or access to it, to finance a job and absorb losses (capital);
• experience, knowledge and equipment to perform the job (capacity); and
• a competent management team to fulfill obligations and contracts (character).

The four types of financial statements are the balance sheet, income statement, statement of retained earnings and cash flow statement. Notes and disclosures to the financial statements are required to comply with generally accepted accounting principles (GAAP). Schedules are also included to provide additional information and explain certain numbers. Financial statements audited by a CPA who specializes in construction accounting are sometimes required for bonding.

Balance Sheet

The balance sheet reports the assets, liabilities and owner's (stockholders') equity at a specific point in time, such as Dec. 31.

Assets are resources owned by a company that have future economic value that can be measured and monetized. Examples include cash, investments, accounts receivables, inventory, supplies, land, buildings, equipment and vehicles. Assets are bought or created to increase a company’s value or to improve operations. Assets are typically reported on the balance sheet at cost or lower.

Goodwill is an intangible asset since its value is perceived by the contractor The actual value of goodwill is based on what someone would pay for the company above its fair market value. For instance, if the value of a contractor’s ongoing business is worth $5 million and goodwill is $1 million, the total value of the business would be $6 million only if a potential buyer is willing to pay $6 million. Examples of goodwill include brand equity, loyal customer base, good customer and employee relations, and any patents or proprietary technology.

Liabilities are company obligations that are not paid for or completed. Liabilities are presented on the balance sheet in two categories:

• current liabilities, which are due within one year of the balance sheet date; and
• and long-term liabilities, which extend beyond the current year or current operating cycle.

Current liabilities include accounts payable, accrued liabilities, accrued wages, deferred revenue, income taxes payable, interest payable, payroll taxes payable, salaries payable, sales taxes payable, use taxes payable and warranty liability, as well as amounts owed to lenders and suppliers. Examples of long-term liabilities are long-term debt and company-issued bonds.

Equity (owner’s or stockholders’) is the difference between a company’s assets and liabilities. Equity is the book value of the company to its owners. It can consist of capital stock or members capital, retained earnings and treasury stock.

Sureties typically analyze a contractor’s mid-year and year-end balance sheet position to ensure that everything is going according to plan. Sureties want to see that the assets and liabilities are properly classified. They will also analyze contracts, job cost efficiencies and billings (overbillings and under-billings), as well as other indicators that jobs may not be well managed, adequately financed and being completed on or under budget. Items that sureties do not want to see on a balance sheet are cash overdrafts, loans to officers, loans to employees, certain current assets, increases in current liabilities and negative equity.

Income Statement

The income statement is a summary of the results of a company’s operations for a specific period time. It presents a picture of a company’s revenues, expenses, gains, losses, net income and earnings. The income statement is also referred to as the profit and loss statement (P&L), statement of income and the statement of operations. The key line items are that generally presented on the income statement are revenue, cost of sales, gross profit, operating and administrative expenses, income from continuing operations, income from discontinued operations and net income. Public companies must include earnings per share (EPS) on the income statement.

Sureties will compare a contractor’s year-over-year and period-over-period financial statements. They look for significant changes in reported revenue and expenses. Key Performance Indicator will also be analyzed to determine if a contractor’s performance is in alignment with past periods, benchmarks on similar companies and industry trends. Sureties want to see consistency in performance and that the contractor is operating as well as, or better than, other companies in the same market.

Statement of Retained Earnings

Retained earnings represent the amount of net income or profit left in the company after dividends are paid out to stockholders. The statement of retained earnings shows the changes in retained earnings from one point to another.

Retained earnings is reported as a separate component of the stockholders' equity section of the balance sheet. Negative retained earnings are reported on the balance sheet as a deficit or accumulated deficit instead of retained earnings.

Sureties look at the statement of retained earnings to determine if a contractor is over-extended. Although a contractor may have a positive amount of retained earnings, they may not have a large amount of cash if it was invested in buying property, materials and equipment, or used to reduce the corporation's liabilities.

Cash Flow Statement

The cash flow statement reports the sources and uses of cash and certain supplemental information for the period specified in the heading of the statement. The cash flow statement is also known as the statement of cash flows.

Cash flows into and out of a company from a contractor’s business activities, investment activities (sale of a property or payments, gross proceeds from selling certain assets or purchasing land, equipment, materials, etc.) and financing activities (borrowing money, paying off debt, issuing stock, purchasing stock or paying dividends and making distributions to owners).

Sureties analyze a contractor’s cash flow statement to see if they can pay bills in a timely fashion.

Notes to the Financial Statements and Schedules

The notes to the financial statements (footnote disclosures) provide information on a company's operations and financial position. The footnotes summarize significant accounting policies, business activities, the use of estimates, cash equivalents, method(s) of accounting used and other key pieces of data. Notes to the financial statements are required by the full disclosure principle and are important to communicate relevant facts and explain certain numbers.

Supplemental schedules give more detailed information. These include, but are not limited to the:

• schedule of contract revenue;
• schedule of general and administrative expenses;
• schedule of completed contracts; and
• schedule of Contracts in Progress.

Sureties will analyze each footnote and schedule to determine the concentration of risks, costs and estimated earnings on uncompleted contracts; if the contractor took out or used its line of credit, if there are long term notes payable, excessive overhead expenses; the collectability of accounts receivable, as well as any financial exposure due to retirement plan obligations, backlog, lease commitments, related party transactions, and commitments and contingencies. In addition, sureties want a breakdown of the cost of labor, materials and subcontractors per job; the number and size of jobs in progress, gross profit per job, and job fade. Sureties want to see that the contractor is making money and that the gross profit is enough to cover 12 months of overhead expenses.

KPI Standards

The 10% rule (10% working capital and 10% equity of total cost to complete work on hand) is a recognized standard used by sureties to determine if a contractor is bond-worthy. Other general guidelines are:

• working capital—10 to 15 % of annual revenue;
• backlog—equal to one year’s worth of revenue;
• debt-to-equity ratio—below a three to one ratio of total liabilities to equity;
• under-billings—under 25% of working capital; and
• profit fade—less than 10% of the original estimate.

Sureties do not like surprises and respect contractors that bring issues to their attention. Contractors should explain the situation, why it is a problem, and their proposed solution. Contractors should also prepare written plan outlining realistic, achievable and time-sensitive goals. Being proactive is essential to having a positive working relationship with sureties.