While the latter half of 2022 brought some relief from the worst impacts of the global pandemic, supply chain disruptions, labor challenges, and significant commodity price spikes, we are now challenged with a national economy that is dealing with the highest inflation in 40 years. This inflationary pressure and increasing labor costs have caused key central banks to take action to tame inflation, creating the swiftest rise in interest rates in decades, which opens up a real potential for a recession in 2023.
For our industry, the next logical question becomes, "What impacts will this have on the construction community, and specifically, how will sureties react when it comes to underwriting new (and even existing) clients?"
Surety Underwriting in a Recession
There is a consensus building within the surety community that we will face a rise in loss activity in the near to midterm. That said, there has yet to be any substantive withdrawal of capacity in the surety marketplace, which can largely be attributed to new capacity being offered by recent entrants in the market. However, many of the more tenured sureties have become more cautious and, in certain instances, have pulled back on capacity, with one or two of the major sureties currently not taking on any new subcontractors.
While new project opportunities continue to progress due to newly legislated spending programs, underwriters and executives are extremely focused on a number of macroeconomic issues, including rising interest rates, inflation, supply chain disruption, and the availability of labor. We can expect that these larger issues will boil down to an increased focus on fundamental underwriting and, in particular, a focus on work-in-progress (WIP).
So, what is a WIP schedule? The WIP is one of the MOST important reports produced by contractors and is relied on heavily by the surety and other readers of the financial statements. These schedules are accounted for under the percentage of completion, as required under Generally Accepted Accounting Principles. Best-in-class contractors' WIPs include the (a) contract price, total estimated cost, and gross profit, (b) inception-to-date for contract revenue, contract cost, and gross profit, (c) contract assets (underbillings) and contract liabilities (overbillings), and (d) year-to-date for contract revenue, contract cost, and gross profit.
WIPs are key to better understanding a contractor's financial position at any given time. Often, surety underwriters, owners, and suppliers who serve the construction industry find themselves relying too heavily on the balance sheet and income statements as a barometer for financial performance. However, these documents are static point-in-time reports and, in the case of surety due diligence, are typically reviewed months after the statement date.
Taken alone, sureties are forced to rely on dated financial information to make substantive support/capacity decisions, whereas a WIP schedule provides underwriters with project-specific data that they can track across accounting periods and even use to project cash flow and profitability. Additionally, while many construction executives do not operate day to day with the balance sheet and income statement in mind, per se, most—if not all—use the WIP schedule much more frequently to analyze movements on their project portfolio.
How do sureties analyze the WIP schedule? As mentioned earlier, the WIP accounts for all costs and billings on a project from start through completion. It will contain critical information for various stakeholders, including initial and current estimates of cost and profit, to see any changes (e.g., job gain/fade) to the profit estimate throughout the life of the project. From a surety perspective, margin fades represent a red flag that underwriters will want to understand, particularly if it's more than a one-off and the surety begins to see margin fades as a trend.
In addition to project margin trends, sureties may use the WIP to determine a contractor's backlog. This backlog figure (which is the difference between total estimated cost and cost-to-date) only tells part of the story. Most sureties will provide capacity based on, among other things, a ratio between analyzed working capital and backlog. As the elements of a WIP are constantly changing, sureties will want to understand their clients' project runoff for a given period. While this figure is generally based on billings for the period, it nonetheless provides additional insight into the amount of work that a contractor has put in place. These figures, paired with new project wins, will give the surety a more accurate estimate of backlog and allow them (in many cases) to provide additional capacity for their client.
WIPs and Underbilling/Overbilling
Another critical component of the WIP schedule that sureties monitor closely is overbillings and underbillings, which translate directly onto the balance sheet as contract liabilities and contract assets, respectively. Fluctuations in over- and underbillings will impact the balance sheet in meaningful ways. These impacts create changes to working capital, which, as stated earlier, is a key component of surety underwriting and managing available bonding capacity. So, what are the implications of over- and underbillings?
True overbillings are billings for work that have yet to be executed. This may come from setting up the project's schedule of values in a manner that allows the contractor to bill for items that are not yet complete or that the cost of those items has not yet been incurred (e.g., mobilization). Overbillings can also be achieved as a result of better production, which would be analyzed as unearned profit on the project. And, while overbillings are entered on the balance sheet as "contract liabilities" (and, therefore, have a deleterious effect on working capital), they are generally viewed positively by the surety underwriting community, as they provide a cash flow and ensure the owner is financing the work, rather than the contractor.
As we see in the sample below, Job 1 is underbilled by $5,000, while Job 2 is overbilled by $20,000. On the balance sheet, this will translate into a difference of $25,000 in working capital, which should be taken into account for firms that have certain bank covenants that may use leverage ratios; funded debt to earnings before interest, taxes, depreciation, and amortization (EBITDA); fixed charge coverage ratio; or other debt ratios as a compliance measure.
It is important to note that late-stage overbilling may also be a red flag for sureties that monitor "job borrow" or cash that is represented as overbilling for a project but is, instead, being used to fund a shortfall on another project (or commonly used to cover general and administrative costs). Surety underwriters will analyze cash balances and working capital to confirm this suspicion and will want to make sure there is sufficient cash to cover any additional costs associated with completing the project.
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On the other side of the ledger, underbillings are a current asset as they represent work that has been put in place but yet to be billed. While common and not necessarily problematic, excessive underbillings will cause a strain on a contractor's cash as they are, effectively, funding the work. Again, it is common for change orders to be executed before they are billed, and sureties understand that the merits of each situation are different. However, it is important to ensure that work performed under a change order CAN be billed, and sureties will seek to understand the contractor's process for executing change orders to ensure payment will come once billed.
While change orders (either approved or unapproved) are the main driver of a contractor's underbillings, other scenarios, such as decreased production levels, can also lead to underbilled positions, which can ultimately lead the contractor to write down the profit or cause a loss on that project. Early-stage jobs may also be underbilled due to mobilization and other start-up costs, while late-stage underbillings may show profit projections that are more optimistic than in reality.
As many in the surety community can attest, recessionary periods that impact the construction industry (e.g., the early 2000s and post-housing bubble in 2008) will separate those contractors that are on solid footing from those that are not. After analyzing how contractors fared during the last recession, the industry found one key takeaway: contractors who carried profitable work in their backlog leading up to the recession were able to execute on those projects rather than being forced to take work at—or below—cost (as many others did). Of course, much depends on how long any economic downturn may last, but a key factor to maintaining surety relationships and capacity through a difficult economic environment was that all of this information was available on those contractors' WIP schedules.
As we move through these uncertain economic times, maintaining frequent communication (with pointed discussion around the WIP) both internally and with your surety may very well be the difference between profitability and loss. For contractors, best practices should be identified and implemented throughout the organization to ensure proper internal communication and collaboration between the field and project accounting teams. Timely data sharing and review will make a difference for executive leadership (as well as sureties, agents, banks, and other vendors) to have the most useful dashboard of WIP data available to them. The adoption of new software tools can also assist in this data collection process.
As always—but particularly during an economic downturn—best-in-class contractors should surround themselves with construction-focused partners (surety, accounting, banking, legal, etc.) that have a broad view of the construction marketplace, together with all the necessary tools, resources, and relationships, to serve as true strategic advisers.
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