Year-End Balance Sheet Planning for Contractors

The famous actor and author Will Rogers once said, “You never have a second chance to make a good first impression.” You may ask what that has to do with your year-end financial statement? More than you might think.

Contractors who need surety bonds must provide their surety with a CPA prepared year-end financial statement. The year-end statement, while only a snapshot of a single day in time, may have a significant impact on the amount of bonding capacity provided to a contractor in the subsequent year. Although the year-end statement is not necessarily the first impression that a contractor gives the surety, it is a lasting one. Sureties place more weight on a contractor’s CPA prepared year-end financial statement than any other single item when determining the amount of surety credit they will extend to the contractor.

For the contractor whose financial strength is overwhelmingly strong in relation to their bond needs, the presentation of the year-end statement may be less important. But for most contractors, maximizing every dollar of bonding capacity is critical to the success of their company. It follows that a plan to arrive at year-end with the strongest, “surety friendly” balance sheet possible will help maximize a contractor’s bonding capacity in the succeeding year.

Surety underwriters know from experience that contractors rarely fail because they have run out of work. They usually fail because they run out of money. For that reason, underwriters place a high degree of importance on the working capital and liquidity in a contractor’s balance sheet. The more working capital and liquidity, the more bonding capacity the surety is likely to provide.

The term working capital, as used by the by the surety underwriter, is defined as Current Assets minus Current Liabilities after adjustments are applied to certain asset items. The more common adjustments to Current Assets are as follows:

Current Asset Item	Adjustment
Cash	No adjustment
Marketable Securities	-25%
Accounts Receivable	Over 90-day items are 100% excluded from working capital unless collectability is assured
Under Billings	100% excluded from working capital if from unapproved change orders or profit fade
Inventory	-50%
Prepaid Expenses	100% excluded from working capital
Shareholder Loans	100% excluded from working capital

Knowing how your surety underwriter analyzes your balance sheet is the first step in understanding how you can make decisions before year-end that will cast your balance sheet in the best light possible. It is important to note that a decision which is good for your surety capacity could have unintended consequences, such as costing you more in taxes. So, it is important to consult with your tax advisor as well before making year-end balance sheet decisions.

To illustrate the thought process, let’s assume you are a contractor who is looking to do some year-end balance sheet planning. Here are some possible decisions confronting you at year-end along with the corresponding effect on working capital:

Option	Effect on Working Capital
Put most of your cash into marketable securities to earn a better return on your liquid assets or keep your cash in a money market account	Every dollar moved from cash to marketable securities lose 25% of its value as working capital. Consider leaving cash in a money market fund.
Buy inventory in December or wait until January	Every dollar of inventory purchased loses 50% of its value as working capital. Consider waiting until January to purchase the inventory.
Prepay your annual insurance bill or have your agent put you on a monthly payment plan	Any expense that is prepaid is not available for use as working capital. Consider waiting until after year-end to pay the expense or spread the payments out over time.
Pay back that loan you took from the company prior to year-end or wait until you get your personal tax refund to pay it back	Amounts     borrowed    from    the     company    by shareholders or employees are deducted from working capital. Consider paying off shareholder loans prior to year-end.

These are just a few of the decisions that a contractor may need to consider as year-end approaches. There are other scenarios that a contractor may face when planning for the year-end, including whether to pay cash or finance equipment purchases, whether to pay down the balance on the bank line of credit, etc.

Here are a few tips to help increase working capital and make your balance sheet more “surety friendly.”

1. Consider paying late-year payables on the first day of the next year. This will result in an increased cash balance at year-end.
2. Decrease prepaid expenses, such as taxes, insurance, etc. by adjusting the coverage dates or payment dates to correspond with your year-end, or consider netting prepaids with related liabilities.
3. Reduce inventories by converting them to contract billings, or, if possible, classify them as unbilled receivables or under billings.
4. Collect officer or affiliate loans before year-end. If you have accrued a bonus to the same officers who owe money to the company, make sure that they are offset against the loans.
5. Aggressively collect accounts receivable (especially over 90 items) before year-end to increase cash position.
6. Minimize under billings by reasonably over billing contracts at year-end.
7. Defer stockholder withdrawals until after year-end.
8. Defer major equipment purchases until after year-end.
9. Convert short term debt to long term if possible. Avoid using your bank line to purchase equipment.
10. Notes payable to shareholders should be subordinated to the surety or converted to permanent capital.

Summary

The ability to secure and maintain adequate bonding capacity is important to the success of many construction companies. Financial decisions made just prior to year-end, or the absence of them, can significantly impact the bonding capacity available to the contractor in the succeeding year. Year-end balance sheet planning is a way to ensure that the contractor’s balance sheet is presented in the most favorable light possible.

The author is a Senior Vice President with The Fedeli Group, a leading Ohio construction insurance and surety agency. He is a former manager for several national surety companies. Kevin can be reached at (216) 643-6978 or at kkeller@thefedeligroup.com.