Secrets of Bonding: #163: Financial Statement Fraud!

You know the old adage, “Financial statements don’t kill people, people kill people.”

While it’s true there can be misrepresentation and deception in a financial statement (FS), the document is not inherently bad, it is the poor intentions of the preparer or company that is to blame.

As credit analysts, we always review and rely on FSs when underwriting surety bonds. We know there may be attempts to mislead our judgement or even downright deception. But the need to evaluate the financial report is unavoidable. It is considered a valuable “report card on the quality of management.”

There are three levels of financial presentation by Certified Public Accounts (CPAs):

Compilation – a properly organized report where the numbers have not been verified or evaluated by the CPA

Review – includes some checking “Review” of key elements

Audit – is the highest level and includes the CPA’s statement that they have checked and believe the numbers are correct

The reader of the FS is entitled to certain expectations: A candid and complete presentation that informs the reader. Are they entitled to more than that? Does the reader sometimes expect too much?

Let’s consider what the FS actually says, and what it doesn’t… 

The Balance Sheet

This shows assets and liabilities. It describes the dollars in the company (assets) and who owns them (liabilities and stockholder’s equity). You know many of the normal entries: Cash, accounts receivable, accounts payable, inventory, bank debt, the net worth / stockholder’s equity section, etc.

The balance sheet always has a date, such as 12/31/2017. It shows the status of these accounts on the one day. Credit analysts calculate the Working Capital aka Net Quick (NQ) which is considered a measure of short term financial strength. You find the NQ by subtracting current liabilities from current assets. When the bond underwriter has the NQ number, it can then be incorporated in the decision making.

“What size bonds will be approved for this applicant?”  “How much total capacity can they be allocated?” The NQ figure becomes a benchmark that is used for the remainder of the year.

For many analysts, this one number carries a huge importance for the following 12-15 months.

Let’s move forward one day in time, to 1/1/2018. “Happy New Year!” and let’s check the bank account. Some money has come in! The accounts receivable and cash have changed. Other elements are also different and so, if we calculate the NQ based on the 1/1 balance sheet, the NQ will probably be different from 12/31. Again, that’s because the balance sheet shows the state of these accounts on ONE DAY. It is always changing!

The reality is that the working capital number is only correct for one day, then it is subject to revision. This is not to say the number is not important or relevant. And certainly decision-makers must have annual benchmarks and a method for their determinations. It is very important, but so are other elements.

Financial Statement Fraud

The most common FS fraud is not committed against us by others. It is the self-deception we commit by over relying on these “one-day numbers.” To do so is to miss the big picture!

Underwriters love to see a big cash account sitting on that top line (of the balance sheet). But that’s a one-day number. Isn’t it even more important to determine the average funds on deposit for the prior six months or year? Many analysts fail to ask for this.

Accounts Receivable and Payable – here is another key area where the “one-day number” can easily be given a historical perspective. Aged schedules of A/R and A/P are easy to obtain and they give a view over more than one day. These documents are not automatically included in FSs, and underwriters may fail to ask for them.

Another example: A broader understanding of the banking relationship is accomplished by looking beyond the balance sheet bank debt.  A reference letter can reveal if the client has bounced checks, broken loan covenants or defaulted.

Conclusion

As readers of these documents and analysts, let’s not cheat ourselves by over relying on the balance sheet or thinking it is more than a one-day snapshot. It should be scrutinized and viewed in harmony with other key underwriting factors such as mid-year financial reports and supporting documents.

In this manner underwriters can make realistic, well-informed decisions.

Steve Golia is the National Surety Director for KIS Surety Bonds LLC, MGU for Great Midwest Insurance Company, an A-8 carrier specializing in contract surety.

The company provides Performance and Payment Bonds with speed and creativity, up to $10 million per bond.

Contact us today and let’s discuss how we can help – even if others have failed. Call 856-304-7348.

Visit us Click!

Secrets of Bonding #162: Burn Baby, Burn!

In the surety underwriting business, we are forward looking.  Bond decisions are based on a variety of factors including “The Four C’s of Bonding” (read our article #5).  Underwriters make a detailed analysis, then set surety capacity levels to administer the account. That all makes sense.

However, the forward looking analysis makes assumptions – that may or may not be correct.  If incorrect, the outcome could be devastating for the contractor and surety.

In this article we will delve into an aspect of evaluation used extensively by investors, but not so much by bond underwriters.  It is called the Burn Rate.  Mood Music: Click!

 

Here is the internet definition:  

Burn Rate is the rate at which a company is losing money.  It is typically expressed in monthly terms; “the company’s burn rate is currently $65,000 per month.” In this sense, the word “burn” is a synonymous term for negative cash flow.

It is also a measure for how fast a company will use up its shareholder capital.  If the shareholder capital is exhausted, the company will either have to start making a profit, find additional funding, or close down.

Very interesting. The reason our underwriters use the Burn Rate is because of the assumption it does not make…

Think of the typical decision-making process.  Working Capital (WC) and Net Worth are calculated then compared to the requested bonding limits. The underwriter wants to predict if the company’s financial strength is sufficient to support the amount of surety capacity.  (A 10% case?) This evaluation is important, but it assumes the client will have enough future work to fill the bonding capacity limits. But what if they don’t? Can we predict the company’s ability to survive with inadequate revenues and in the absence of profits?  Would this not be an important measure of financial strength and staying power?

The Burn Rate enables us to determine:

Runway

 A company’s “Runway” is the time it can survive on existing capital without new funds coming in.

Here’s how to calculate a company’s financial Runway. This is a hard core analysis that eliminates all expectation of new revenues. The formula requires two elements:

  1. Working Capital “As Allowed” by the underwriter’s analysis
  2. Average monthly fixed expenses

Working Capital (WC), as you may recall in Secret #4, is a measure of the company’s short term financial strength.  It calculates the assets readily convertible to cash in the next fiscal period.  Every underwriter identifies this number during their financial statement review.

If future revenues are inadequate, what is the company’s survivability?  The Fixed Expenses help us determine this fact.  These are the expenses that don’t go away, even if there are no new revenues.  Every month, you pay the rent, utilities, administrative staff, telephone, maintenance, insurance, etc.  These expenses are coming regardless of how much or how little sales are achieved.  In the absence of future revenues, it is Working Capital that must pay these monthly bills.  The Runway is how long the company can operate in this mode.  The Burn Rate reveals this survivability.

An actual client:

12/31 Working Capital As Allowed from the Balance Sheet = $1,099,000

1/31-12/31 Total Expenses from the Profit and Loss Statement (not including Cost of Goods Sold, aka Direct Expenses) = $1,243,000

Burn Rate: Average Monthly Expenses = $1,243,000 / 12 = $104,000 per month

Runway: WC Divided by Average Monthly Fixed Expenses

$1,099,000 / $104,000 = 10.6 months

Based on current expected cash flow, the company can cover it’s fixed (unavoidable) operating expenses for 10.6 months even if it has no income/ profits from new revenues.  The Runway is 10.6 months. This measure of survivability can be compared from period to period, by year, or from one company to another.

Don’t forget, when the mood music stops, the party is not over.  Our national underwriting department brings this high level of expertise and willingness to all your bid and performance bonds. 

Call us when you need a corporate surety with excellent credentials and capacity on surety bonds up to $10,000,000.  Excellence in underwriting, aggressive, creative, fast. Underwriting the way you wished it would be.

KIS Surety, exclusive national underwriters for Great Midwest Insurance Company.

 We’re available now: 856-304-7348

Secrets of Bonding #161: No More Performance Bonds!

This is the Bonding Company’s worst nightmare…

In this article we will cover the situations in which no Performance or Payment Bond is needed!  Some of the projects are big and federal, some are private, ALL are unbonded.  Here we go!

As a point of reference, you may expect that federal, state and municipal contracts demand a Performance and Payment (P&P) Bond equal to the contract amount.  Normally they do.  General Contractors working for a private owner, such as the construction of an office building or apartment project, may face the same requirement.  This can apply to subcontractors, too.

Federal Projects

This area includes all branches of the federal government. Examples: Army Corps of Engineers, General Services Administration, Dept. of Energy, etc. Their contracts are administered following the rules of the Federal Acquisition Regulations (FAR).

Suprisingly, the FAR says that no P&P bond is required on contracts under $150,000.

For contracts $150,000 and higher that require security, there are times when the bond requirement may be reduced below 100% or waived entirely.  These include:

  • Overseas Contracts
  • Emergency Acquisitions
  • Sole-Source Projects

If 100% security is mandatory, the FAR lists acceptable alternatives to a P&P bond:

  • US Government (investment) Bonds
  • Certified Check
  • Bank Draft
  • Money Order
  • Currency
  • Irrevocable Letter of Credit

Here’s another option: For contracts performed in a foreign country, the government can accept a bond from a non-T-Listed surety. (Circular 570) Crazy!

State and Municipal Contracts

The bonding requirements may vary by state, but generally their flavor is similar to federal.  They, too, may accept alternative forms of secutity such as an ILOC.

Private Contracts

Anything goes.  On private contracts, the owner has complete discretion to set the bonding requirements – including no bond needed.  Keep in mind, the cost of the bond is added to the contract, so the owner can save some money by not requiring a bond.  They may take other precautions to protect themselves.  Some examples:

  • Require a retainage. These are funds that are held back from the contractor and only released when the project is fully accepted (reduces the risk of Performance failure)
  • Lien releases may be required each month to prove suppliers and subcontractors are being paid appropriately (reduces the risk of Payment failure)
  • Funds Control / Tripartite Agreement – a paymaster is employed to handle the contract funds (Payment risk)
  • Joint checks are issued to the contractor and payees below them – to assure the funds reach the intended parties (Payment risk)
  • Physical site inspections to verify progress (Performance risk)

The Nightmare

In these articles we talk a lot about how contractors can obtain surety bonds and manage them.  But it is interesting to note: A construction company could go forever, performing state and federal projects – and NEVER get a bond.  It’s true!

If everyone did this, it would be the surety’s worst nightmare.  But in reality, there are financial advantages to using P&P bonds, so bonding usually is the first choice. 

Your first choice should be KIS Surety when fast, creative underwriting is needed on bonds up to $10,000,000.  We are the national contract bond underwriting department for Great Midwest Insurance Company, a corporate surety with an A-8 rating.  

We can help you solve your next contract surety need.  Call us now: 856-304-7348

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)

Secrets of Bonding #160: Deep in the Weeds with Set Aside Letters

In this article we will peel back the onion on Set Aside Letters (SAL) issued by banks in connection with construction loans.  What are they, when they are useful for bonding companies and when are they not?

Here is the essence of such documents:

“The agreement covering the project will provide that the funds in said impound account are … to be disbursed for payment of the (Name of Project) mentioned above and only after (Bank) has satisfied itself that the work paid for has actually been performed… In the event (Borrower) fails to complete the project described herein… all funds remaining in said impound account shall be immediately available to Surety to complete and pay the costs of said project, and in such event, (Borrower) waives any claim or interest in the remaining funds. Surety shall not in any way be obligated to repay said funds so used to (Bank).

This is an irrevocable commitment of funds which is not subject to recall or offset by (Bank).”

Pretty interesting!  This letter / agreement keeps the loan in play to fund the completion of the project  – even if the borrower (bank customer) fails / defaults.

When Are Set Aside Letters Used?

These documents are a common underwriting tool when a Site or Subdivision Bond is issued by a surety. If the bond applicant (who is also the developer and borrower) is relying on a construction loan to fund the bonded work, the SAL protects the surety by providing funds for the completion of the work in the event of a default.

What a great idea.  So why don’t we use these on everything?  Let’s look at another example.

Commercial Projects

The project owner hires a bonded contractor and a bank loan will fund the project.  The bank needs a guarantee that the asset / project (which backs the loan) will be built as intended.  A Performance and Payment Bond accomplishes this and assures there will be no Mechanics Liens against the property for unpaid bills.  These two aspects benefit the project owner and the lender.  Keep in mind, in a borrower default situation, the bank becomes the new owner of the property.

It is common for the bank to stipulate that a bonded contractor be used, and they may want to be a named beneficiary on the P&P bond – accomplished by issuing a Dual Obligee Rider.  In turn, should the underwriter require a SAL from the lender?

On Commercial projects, the normal practice is to NOT obtain a SAL from the lender.  Why not?  Why is this different?

Choose one:

a. The bank is a secured lender

b. The bank can subrogate against the borrower’s assets

c. The Dual Obligee Rider serves a purpose similar to the SAL

a. and b. are true, but the answer is c.

Welcome to the Weeds

We’re going in now. The Dual Obligee Rider adds the lender as a beneficiary with all the rights and obligations of the obligee named on the bond (the project owner).  And what are they?  Obviously they are entitled to make a performance claim and have the project delivered as indicated in the contract.

The named obligee also has obligations, one of the most primary is to PAY the builder. Important: The obligee is prohibited from making a performance claim if they have failed to pay the contractor.

Therefore, when the bank is included under a Dual Obligee Rider, they accept the benefits and obligations.  If the borrower defaults, the lender cannot make a bond claim unless they continue to pay the construction loan to the surety.  (Now the bank owns the project and the surety has become the contractor.)

Summary

Is this starting to make sense?  When a borrower defaults on a commercial project, a lender included by Dual Obligee Rider cannot make a claim unless they continue to pay the project funds to the surety.

Deeper Weeds

On Site and Subdivision there is a unique risk – the lender can take a free ride on the surety by having the bonding company pay out of pocket to complete the project.

Site and Sub-D bonds have the local municipality as obligee, not the bank.  The bank doesn’t want a Dual Obligee Rider because they automatically receive a financial benefit if the municipality makes a bond claim to demand completion of the project.  If the borrower has defaulted, the bank has the opportunity to withhold the balance of the loan (the borrower is gone), and watch the surety pay to complete a project they now own.  And they were not even the bond claimant…

This is the risk sureties avoid on Site and Subdivision Bonds by requiring the SAL that keeps the loan in play, even if the bond applicant / borrower has failed.

Admittedly, this is a pretty obscure subject, but also interesting to us “bond nerds.”  It never hurts to understand how things fit together.  These skills help us solve your complicated bond opportunities.  Take advantage of our expertise when the next one pops up.

KIS Surety is the national contract bond underwriting department for Great Midwest Insurance Company, a national, corporate surety with an A-8 rating.  We throw all this underwriting talent at your bond opportunities and support contracts up to $10,000,000.

If you have a contract surety case that needs a fast, creative response, call us: 856-304-7348

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)

 

Secrets of Bonding #159: Beware the False Asker

Surety Bond Producers have one main goal: produce the business and move on.

You know there is a process when submitting a surety bond for approval but hate that sick feeling when the underwriter comes back with a ton of questions.  Let’s face it, customers just want to complete the transaction and get on with their lives.  They have more important things to do than fill out forms, scan documents and complete applications.  You know you’ll get push back if you bug them.  

What’s more, the questions may result in a dead end, a declination!  Did the underwriter already form an opinion?  Did they already decide the account is not for them, but just want to complete the file… to have a complete file?

We will call such a person the “False Asker” – an underwriter who puts you through the paces, just to say no at the end.  They never really wanted to write the bond and are developing the file under false pretenses.  They send you on a fools mission.  It is 100% a waste of your time!

Or just maybe, questions are the opposite…  The bond underwriter thinks the account may be a fit, but just needs to check a few more points.  This could be the first step on a successful journey. Here’s more: There may be something wonderful about the questions good underwriters ask.  Let’s explore.

When reviewing the file, the analyst marks off elements of strength and weakness.  For example, the company is 10 years old, but current management has only been in place for a year (a plus and a minus).  Or maybe the net worth is strong, but debt is high resulting in too much leverage.  If there is more good than bad, an approval may be in order – after additional development. 

Now comes the gift: The key points, the underwriting questions, are an insight to the decision making process.  They are keys to the underwriter’s mind.  With favorable answers, authorization may ensue. The questions chart a course that the producer could imagine but not confirm.  In this manner, the underwriting questions are priceless, the keys to success.

Remember, there is room for frustration on the underwriter’s side, too.

Q. Which of the underwriting questions are optional? You know, the unimportant ones?

A. They are all important.

Sometimes we ask 5 Q’s and get back 3 A’s.  Then re-ask the 3 and get back only 2.  It’s like beating your head against the wall…

It all comes down to this:  Beware the False Asker.  You must avoid that person who churns the file and wastes your time.  Every producer has been through it.  You answer questions for two weeks and get a declination they could have figured on day one – and not wasted your time.

A good underwriter only develops an account they intend to support.  They like it and want to proceed, but must tidy up the file. Their Qs are a gift, the path forward, the key to your success if you follow through willingly and diligently.

Judge all of us by our performance:

  • Good underwriters are prompt. For example, our office provides a same day response on all submissions.
  • Are our responses concise and easy to understand?
  • Do we offer a prompt declination or clear path forward, defined by the underwriting questions that will get the deal done?

A good surety underwriter can be your important ally and business partner.  Choose us carefully based on performance, and always Beware the False Asker!

KIS Surety is the national contract bond underwriting department for Great Midwest Insurance Company, a national, corporate surety with an A-8 rating.  We throw all this underwriting talent at your bond opportunities and support contracts up to $10,000,000. 

If you have a contract surety case that needs a fast, creative response, call us: 856-304-7348

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)

Secrets of Bonding #158: Booby Trap Bond

Booby Trap Performance Bond

“The Surety, for value received, hereby stipulates and agrees that if the Contractor has been declared in default by the Obligee, and there has been no uncontested failure, which has not been remedied or waived, of the Obligee to pay the Contractor as required under the Construction Contract: (i) The Surety shall promptly remedy the default…”

Waaaa?!  We read this over and over to understand the implications. Is this just another boring bond form, or is there a Booby Trap, an elaborate effort to gain an advantage over the surety?

Every bonding company has their own standard Performance and Payment Bond forms. We prefer to use the AIA A-312 unmodified P&P bond. It is a well balanced, widely accepted form. Whenever we receive a special bond form, we must review it carefully. Why did the obligee spend the time and money to devise it? There must be some advantage – for them.

Last week we received an obligee’s mandatory bond form on a private contract and a key phrase is stated above. Our client is the GC / prime contractor. Sometimes the unique bond forms are not too bad. Let’s pick this one apart. Maybe you’ll run into it some time.

This language is very important because it concerns the Obligee’s responsibility under the contract. In order for them to be entitled to make a performance bond claim, they must fulfill their end of the bargain, which is to PAY for the work. Is a bond claim for lack of performance reasonable if the Obligee has failed to pay the contractor? Of course not! The contractor can’t work for free. 

What are the implications of the wording in that special bond form? Let’s use the A-312 as a benchmark. (Owner means Obligee) It says:

“If there is no Owner Default under the Construction Contract, the Surety’s obligation under this bond shall arise after…” And in the definitions it goes on to say:

“Owner Default. Failure of the Owner, which has not been remedied or waived, to pay the Contractor as required under the Construction Contract or to perform and complete or comply with other material terms of the Construction Contract.”

Pretty simple. If the owner fails to pay for the work, and then makes a bond claim, the surety has an appropriate reason to deny the claim. So how does it work in the Booby Trap Bond? Instead of the convoluted lawyer talk, let’s turn it into plain English. It says…

The Obligee is not guilty of failing to pay unless:

  1. They neglect to declare the Contractor in default and,
  2. There is an unremedied or unwaived failure to pay the Contractor that the Obligee has not contested

Ugh… that last part! Assume that in every case, the Obligee will contest an allegation that they have failed. When they do, the surety has no claim defense even if the contractor has not been paid.

What a trap for the unwary bond underwriter! It would have been more fair if the bond just said “Obligee is entitled to make a bond claim even if they don’t pay for the work!” But then people would understand…

Special bond forms can be benign or Booby Trapped and our underwriters review every one.  Good underwriting protects the bonding company and the Contractor from such excessive risks!

Summary: We have a lot of underwriting talent over here. But what good is it if we don’t produce any bonds?  Well, we do!

KIS Surety is the national contract bond underwriting department for Great Midwest Insurance Company, a national, corporate surety with an A-8 rating.  We throw all this underwriting talent at your bond opportunities and support contracts up to $10,000,000.  We are entertaining new agency appointments at this time!

If you have a contract surety case that needs talented underwriters, now you know where to find us 24 x 365!  Call: 856-304-7348

(Don’t miss our next exciting article.  Click the “Follow” button at the top right.)

Bonding Companies Are ALL The Same.

OK, you know that’s not true.  In fact, your success may depend on knowing the differences between sureties.  Each one has a certain appetite, a niche.  We are all the same, and yet we are all different.

So here is a little bit about us.

What We Do

  • OUR GOAL is to be your high capacity market that provides fast, reasonable, (maybe even wonderful) underwriting responses!
  • Exclusively contract surety.  That means bid, performance and payment, and maintenance bonds.
  • We bond construction, including subcontracts, plus service and supply contracts.
  • Sovereign nation contracts are supported
  • Also demolition, abatement and remediation
  • We will consider young companies
  • Production Underwriters: We can support companies with less than perfect credit – even with liens and bankruptcies. We’re not shackled by “bonding company bureaucracy.”
  • We are flexible regarding financial statement presentation on bonds up to $10 million each.
  • We have our own contractors questionnaire, bond request form and WIP schedule because after doing this for forty-five years, we know what info helps get your deal done.
  • Our standard bond forms are unmodified AIA forms, readily accepted throughout the construction industry.
  • Our rates are flexible / competitive.
  • We are licensed to write in every state, including D.C., and can also consider overseas projects.
  • We respond to all new business submissions on the day received.
  • We are offering new agency appointments.  No volume commitment is required.
  • Our underwriting staff is available every day of the week, including evenings, 365. (You can call us right now! 856-304-7348)

What We Don’t Do

  • Fidelity bonds or surety other than contract.  For example, we do not support license & permit, court & probate, or site & subdivision.
  • Waste your time.  We only develop files we expect to write.

We not bragging.  We just wanted you to know.

Our strong financial position (Best rating: A-8) makes us a perfect fit on a wide range of opportunities.  Aggregate programs to $15 million and fast service.  How can we help you succeed today?

 

KIS Surety Bonds, LLC is the exclusive surety underwriting department for Great Midwest Insurance Company an “A – 8” carrier licensed in all states plus D.C.  “steve@kisbonds.com” or call 856-304-7348.