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Once found mainly in federal contracts, bonding requirements are becoming more widespread. Fortunately, surety companies have begun to rebound from several years of losses and have relaxed their criteria somewhat. But they will continue to require significant financial discipline.

Unlike a lender, which is concerned about a borrower's overall stability, a bonding company focuses closely on specific jobs. It wants assurance that a job is on course, both in time and gross margin. To a surety, a contractor's job schedule is often as important as its overall financial statement.

Regular job schedules normally include: original estimates; actual billings, costs and revenue recognized to date; percentage of completion; and costs and profits in excess of billings.

Whether you need to establish a bond for the first time, maintain an existing surety line or increase capacity, it’s important to understand which indicators surety underwriters monitor most closely.

1. Liquidity and working capital. A surety wants to know a contractor can finish a job, and the best candidates are those with solid, well-balanced assets. High net worth alone isn't enough. For example, a road builder can have plenty of equipment but be weak in working capital.

Working capital means current assets — cash, current receivables and some inventory, rather than property and equipment not easily liquidated — minus liabilities. Expect a surety to discount prepaid expenses, shareholder receivables and a third or more of inventory. The surety expects the best, but it plans for the worst — and it wants your assets ready if it must come after them.

2. Cash flow. Most contractor job defaults, and thus most surety losses, are the result of weak cash flow. To increase bonding capacity, maximize your cash on hand and establish a strong line of credit with a lender.

Sureties often calculate free cash flow as net income plus depreciation, amortization and other non-cash items, minus principal payments on debt. Too low a figure — especially if the contractor is carrying high debt — will reduce bonding capacity.

3. Work-in-process (WIP). A surety wants to see steady work, accurately tracked and estimated — not wide swings of gain or fade. Profit fade indicates the contractor overestimated WIP, recognized revenue too early and will face the shortfall sooner or later. Profit gain is not as troublesome, but still reflects badly on a contractor's ability to provide accurate estimates.

4. Overbillings and underbillings. Some overbilling is acceptable, but too much can mean a struggling contractor is borrowing from one job to fund another. A surety knows that deficit will show up eventually.

Underbillings can indicate poor management. A contractor that has not billed an owner for completed work may have overprojected gross profit. When underbillings reach 25 percent of working capital, be prepared to explain why.

5. Backlog expressed as a percentage of overhead indicates whether a contractor has enough other work on hand to pay its expenses.

6. Change orders and claims. After a big change order, it's tempting to recognize big revenue. But if the owner disputes the extent of the order or says he never approved it, profit fade may loom ahead. Too many claims can be a red flag, too. Is the contractor recognizing income prematurely from claims against the owner? Or is the contractor itself a frequent target of claims? Sureties don't want to bond companies with a history of problems.

Tips for Strengthening Bonding Capacity

• Break down large jobs. A surety that balks at a large contract may be more willing to write bonds for a series of smaller jobs. Contracts can often be broken down in this way without affecting a contractor's profits.
• A joint venture can help some contractors increase their own surety limits by leveraging the strength of another larger company.
• Find the right surety. Look for a surety whose clients include companies similar to your own, and understand which metrics and ratios it considers most important.
• Communicate. Set regular meetings and deliver a clear stream of reports. If trouble appears, speak up. The surety understands that problems occur in construction, but it wants the facts early, not as a last-minute surprise. And don't talk just with the local agent, but get to know the home office as well.

Strengthening a company's bonding capacity can be complicated. Contractors should assemble a strong team — a lender, a lawyer and an accountant who all understand the surety market and can provide the contractor with sound advice.

In meetings with a surety, an accountant can explain tax strategy and financial planning and give the surety greater confidence.