Obtaining contract surety bonds can be significantly impacted by debt. Learn how surety bond companies look at debt and how you can maximize your bond capacity.
Debt is an obligation owed to another party. From a financial standpoint, it is money due to another company or person. Debt is called “Liabilities” on a balance sheet. Debt is a significant underwriting factor for Contract Surety Bond companies.
It is important to understand the difference between short term debt and long term debt. Obligations that are due within a 12 month time period are referred to as short term debt or Current Liabilities.
Current Liabilities often include items such as Accounts Payables, Lines of Credit, and the Current Portion of Long Term Debt.
Obligations that are due in longer than 12 months are long term debt or Long Term Liabilities.
Long Term Liabilities often include amortized loans such as real estate, equipment, and vehicle loans.
Another important factor that contract bond underwriters look at is whether debts are interest Bearing.
Interest Bearing Debt is a liability that carries an interest payment. Debt such as bank debt is usually Interest bearing.
Interest Bearing Debt is of particular interest to surety bond companies. Interest payments create an additional cost for a company. That means the company needs additional profit to cover interest payments.
Interest Bearing Debt is also difficult to get rid of if the company gets into financial difficulties. Therefore, contract bond underwriters want to make sure that the company can handle the current interest payments and that the interest Bearing Debt to Equity is manageable.
Non Interest Bearing Debt or operating debt is a liability that typically does not carry interest payments. An example would be Account Payables.
Contract Bond underwriters like to make sure that non Interest Bearing Debt is in line with cash and receivables. For example, a company should have more cash plus account receivables than account Payables.
Working Capital is the primary factor that most contract surety bond companies use to determine a company’s bond capacity. Working Capital is a company’s current assets minus its current liabilities. This gives an indication of a company’s ability to meet its short term obligations.
Debt impacts Working Capital. Short term debt including the current portion of long term debt directly decreases a company’s working capital. Companies should be aware of this as they increase their borrowing. Bank line of Credit usage, equipment purchases and other borrowing reduces working capital, which in turn, reduces a company’s bond capacity.
Another important financial metric for contract surety bond underwriters is Equity or Net Worth. Equity is a company’s Total Assets minus its Total Liabilities.
As you can see by the equation above, additional debt or Liabilities decrease a company’s equity. This also has a negative effect on their surety bond capacity.
Contract Surety Bond companies are especially interested in a company’s Interest Bearing Debt to Equity. The lower the ratio, the better.
Company stockholders often loan money to the company. This is especially true in privately held businesses. These transactions show up on a company’s Balance Sheet as a liability called “Stockholder Note Payable.”
Different contract bond companies view this debt in different ways. Some companies view these transactions negatively. The thought process is that the shareholders should properly capitalize the company and that these monies should not be a loan.
Other contract bond companies have no issue with this debt. These bond companies treat it as any other loan that increases Liabilities and decreases equity.
One easy way to improve contract bond capacity if a company has stockholder Debt is to subordinate that debt to the surety bond company. This means the stockholder(s) with the loan(s) from the company agree not to pay back those loans without permission from the surety bond company.
This process is handled through the signing of a Subordination Agreement with the Surety Bond company. Once this is accomplished, most contract bond companies will remove that debt from their analysis and add it to Equity. This can significantly improve bond capacity for a company with Shareholder debt.
Every contract bond company looks at the personal debt of shareholders differently. Some care very little about the personal statements but most care a lot, especially for small and mid sized, private companies.
The reason bond underwriters scrutinize personal debts is because they want to know what a Shareholder is going to have to distribute from the company to cover their personal obligations.
A Shareholder with lots of personal debt has less flexibility and will put more pressure on company earnings. They will likely need to take distributions even if the company does not perform. For this reason, contract bond companies prefer Stockholders to have manageable personal debt or offsetting personal cash and liquid assets.
Most companies and shareholders have some debt. If a company needs contract bonds such as Performance Bonds, Payment Bonds, and Bid Bonds, the key is managing that debt to help you maximize your bond capacity.
Be careful before paying off long term debt. It sounds counter intuitive, but this is a mistake I see many companies make. They take cash which is a Current Asset and pay down a Long Term Liability.
This significantly decreases Working Capital and bond capacity. Many companies are surprised that paying down debt hurts them but this will. If a company really wants to take this strategy, they need to make sure they are with a surety bond company who values net worth over working capital.
Many companies like to use their bank lines of credit for operating needs. Unfortunately, that borrowing is considered a Current Liability and will directly decrease bond capacity.
If a company needs more contract bond capacity, they should go to their lender and discuss refinancing this debt into a term loan. By “terming” this debt out, a significant portion is then moved to a Long Term Liability. The result is a boost to working capital and therefore bond capacity.
Another method to boost contract bond capacity is to actually increase debt. A company would go to their lender and use their fixed assets to take out a term loan and inject the cash into the company.
This strategy works because it adds cash which is a current asset, but most of the debt is a long term liability. The result is a boost in working capital and contract bond capacity.
However, this strategy should always be discussed with your bond broker and surety bond company first. Not every surety bond company views this as a positive.
This is one of the easier and often unused methods for helping companies with Bonding in the short term. Contract Bond companies look at balance sheets which are a snapshot in time.
For companies with high debt ratios and heavy borrowings on their lines of credit, consider paying down the line at month’s end. Even if the company borrows the money back the next day on the 1st, the month end balance sheet will show less debt and better credit ratios.
Debt is a reality for many companies. It is a very important factor for all contract surety bond companies and managing it the right way can be key to getting bonds. Axcess Surety works with companies in all situations and can provide the best advice to maximize your bond capacity. Contact us anytime. You may also visit our Surety Bond FAQs page here.
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