How Sureties Read Your Financials
Here is the thing nobody tells contractors, and it explains almost every confusing conversation you will ever have with an underwriter:
The surety does not use the balance sheet your CPA gave you.
They take it apart and rebuild it. Assets they cannot rely on get reduced or removed entirely. Debt that has been formally subordinated gets moved into equity. Underbillings get haircut. What comes out the other end is a different, smaller set of numbers — and those are the numbers your bonding capacity is calculated from.
The industry terms are as given (what your statements say) and as allowed (what the surety will credit). A contractor showing $800,000 of working capital on paper can easily have $350,000 of analyzed working capital. That is the difference between a $8M bond line and a $3.5M bond line, and nobody sends you a memo explaining it.
This guide is that memo.
Every surety has its own credit manual. The adjustment categories below are standard across the industry. The specific haircut percentages are typical ranges, not universal rules. Ask your producer for your surety's actual treatment of the items that matter to you — they know, and they will usually tell you.
Part 1 — The adjustments
Assets that get reduced or removed
| Item | Typical treatment | Why |
|---|---|---|
| Receivables from officers, owners or affiliates | Disallowed, usually 100% | The surety cannot make you collect from yourself. This is the most common single adjustment and often the largest. |
| Receivables over 90 days | Haircut heavily or disallowed | If it has not been collected in 90 days, it is disputed, the customer is struggling, or your billing is wrong. |
| Inventory | Haircut 50–100% | Contractors are not distributors. Materials on the shelf are worth much less in a liquidation than on the books. |
| Prepaid expenses | Disallowed | Cannot be converted to cash to pay a creditor. |
| Goodwill and intangibles | Disallowed, 100% | Worth nothing in a wind-down. |
| Deferred tax assets | Disallowed | Only worth something if there is future taxable income, which is exactly what is in doubt. |
| Cash surrender value of life insurance | Case by case | Sometimes allowed if pledged to the surety, often disallowed if it is collateral for something else. |
| Real estate held for investment | Reclassed out of current assets | It is not liquid and it is not the business. |
| Retainage receivable due beyond 12 months | Reclassed to non-current | It is real, but it is not current, and working capital is a current-only calculation. |
| Underbillings (costs and estimated earnings in excess of billings) | Haircut 0–100% depending on quality | This one gets its own section below. |
| Notes receivable | Case by case | Depends entirely on who owes and whether they pay. |
| Equipment and fixed assets | Not in working capital at all | They count toward net worth, not working capital. A yard full of iron does not help your working capital ratio. |
Liabilities and equity that get adjusted
| Item | Typical treatment | Why |
|---|---|---|
| Formally subordinated officer debt | Added back to net worth | If it is subordinated in writing on the surety's form, it behaves like equity. Verbal understandings do not count. |
| Line of credit balance | Stays a current liability | And the available portion is generally not credited as an asset. |
| Current portion of long-term debt | Stays current | Correctly classified, this hurts working capital. Incorrectly classified as long-term, it is a red flag. |
| Overbillings (billings in excess of costs and estimated earnings) | Stays a current liability, in full | You have been paid for work you have not done. That is a real obligation. |
| Accrued but unfunded distributions or bonuses | Treated as a liability | Even if you intend to waive them. |
Two adjustments that go your way
Most contractors focus on what gets taken away and miss the two levers that add:
-
Subordinate your officer loans. If the company owes the owner $400,000 and that debt is formally subordinated to the surety on their form, it moves from liabilities into analyzed net worth. That is an $800,000 swing in the debt-to-equity ratio and it costs you nothing but a signature and a phone call to your producer.
-
Reclassify short-term debt. Debt maturing inside 12 months is a current liability and reduces working capital dollar for dollar. Refinancing a $300,000 balance from a revolving line into a 5-year term note adds roughly $240,000 to working capital immediately (everything except the current-year principal), which at a 10× multiplier is about $2.4M of single-job capacity. Same debt. Same company. Different bucket.
Worked example: as given vs as allowed
A $12M-revenue subcontractor's year-end balance sheet:
| Current assets | As given | Adjustment | As allowed |
|---|---|---|---|
| Cash | $420,000 | — | $420,000 |
| Accounts receivable, current | $1,850,000 | — | $1,850,000 |
| Accounts receivable, 90+ days | $310,000 | (100%) | $0 |
| Retainage receivable (due under 12 mo) | $640,000 | — | $640,000 |
| Underbillings | $380,000 | (50%) | $190,000 |
| Due from affiliate | $275,000 | (100%) | $0 |
| Inventory | $95,000 | (100%) | $0 |
| Prepaid expenses | $60,000 | (100%) | $0 |
| Total current assets | $4,030,000 | $3,100,000 |
| Current liabilities | As given | Adjustment | As allowed |
|---|---|---|---|
| Accounts payable | $1,640,000 | — | $1,640,000 |
| Accrued liabilities | $210,000 | — | $210,000 |
| Overbillings | $520,000 | — | $520,000 |
| Line of credit | $400,000 | — | $400,000 |
| Current portion of LTD | $180,000 | — | $180,000 |
| Total current liabilities | $2,950,000 | $2,950,000 |
| As given | As allowed | |
|---|---|---|
| Working capital | $1,080,000 | $150,000 |
$1.08M of working capital became $150,000.
At a 10× single-job multiplier, this contractor thinks they can carry a $10M job. Their surety thinks $1.5M. Neither party is lying. They are using different numbers, and only one of them knows it.
The good news is that this is fixable and most of it is fixable fast:
| Fix | Effect on analyzed working capital |
|---|---|
| Collect or write off the 90+ receivables | up to +$310,000 |
| Have the affiliate repay the $275,000 | +$275,000 |
| Improve billing so underbillings drop | +$190,000 at current haircut |
| Refinance the LOC into a term note | +$400,000 less current-year principal |
None of that requires earning another dollar of profit.
Part 2 — Underbillings, and why they matter so much
Underbillings — properly, "costs and estimated earnings in excess of billings" — mean you have performed work you have not yet billed for. Overbillings are the reverse: you have billed for work you have not yet performed.
Every contractor has both across a portfolio. What matters is the pattern.
Why underbillings get haircut
An underbilling is an asset created by an estimate. It exists because you told your accountant a job is 62% complete, and 62% of the contract value is more than you have invoiced. If that 62% is optimistic — if the cost-to-complete estimate is low — the underbilling is partly fictional, and it is inflating both your assets and your reported profit at the same time.
Sureties know this. So underbillings get scrutinized harder than any other current asset, and the haircut depends on why they exist:
| Cause of underbilling | Typical treatment |
|---|---|
| Timing — work performed after the billing cutoff | Usually allowed in full |
| Unapproved change orders | Heavily haircut or disallowed. You are counting revenue on work nobody has agreed to pay for. |
| Billing process is slow or sloppy | Haircut, and it raises a competence question |
| Cost-to-complete estimates are optimistic | Haircut, and it calls the whole WIP into question |
Watch underbillings as a percentage of working capital. If underbillings exceed roughly 25–30% of your working capital, your working capital is mostly an accounting estimate rather than a liquid resource, and the surety will treat it that way.
The overbilling trap
Overbillings look great — you are being paid ahead of cost, which is free financing. But overbillings are a current liability, and more importantly they are borrowed from the future. A job that is heavily overbilled has already collected the cash it is going to collect. The costs still to come have to be paid out of somewhere else.
A contractor whose cash position is strong purely because of overbillings on a few big jobs is in a more fragile position than the cash balance suggests. When those jobs finish, the cash goes with them. Underwriters look at cash net of overbillings for exactly this reason.
Part 3 — Gross profit fade
Fade is the difference between the gross margin a job was expected to produce and the margin it actually produced.
It is the single most important trend in contractor financial analysis, and it does not appear anywhere on the balance sheet or the income statement. It only shows up if you compare your WIP schedules over time.
How to measure it
For every completed job, record three numbers:
- Bid gross profit % — what you thought when you priced it
- Gross profit % at 50% complete — what your WIP said at the halfway mark
- Final gross profit % — what it actually produced
Then compute the fade at the portfolio level.
| Fade | Reading |
|---|---|
| Within ±1% | Excellent. Your estimating and your job cost reporting are both trustworthy. |
| 1–2% fade | Normal. Every contractor has some. |
| 2–5% fade | A question. Expect the underwriter to ask about it specifically. |
| More than 5% fade | A problem. It means reported profit systematically overstates real profit. |
| Consistent gain | Also a question — it usually means you are sandbagging cost-to-complete, which makes your WIP unreliable in the other direction. |
Why underwriters care more about fade than about margin
Because fade tells them whether they can trust everything else.
Your net worth comes from retained earnings. Retained earnings come from reported profit. Reported profit on in-progress jobs comes from percentage-of-completion estimates. If those estimates fade by 4% every year, then your net worth is overstated, your working capital is overstated, and every ratio built on them is overstated.
A contractor with a 6% net margin and zero fade is a better credit than a contractor with a 9% reported margin and 4% fade. The first one's numbers mean something.
See advanced WIP analysis for how to build the fade report.
Part 4 — The ratios, and what they need to be
These are the screens. Every one of them varies by surety, by trade, and by size — but the targets below are representative of what a surety wants to see from a contractor seeking a meaningful bond line.
Throughout, backlog means cost to complete — the remaining costs on signed contracts, not the remaining contract value and not the total contract value. Using the wrong definition will make your ratios look far better than they are.
The capacity ratios
| Ratio | Formula | Target |
|---|---|---|
| Working capital to backlog | Analyzed working capital ÷ cost to complete backlog | over 5% for a general contractor; over 10% for a subcontractor |
| Net worth to backlog | Analyzed net worth ÷ cost to complete backlog | over 7% |
These two are the ones that actually set your capacity, and they are worth restating the other way round, because it makes the arithmetic obvious:
- Working capital to backlog over 10% is the same statement as backlog under 10 × working capital
- Working capital to backlog over 5% is the same as backlog under 20 × working capital
Which is exactly where the familiar "single job = 10× working capital, aggregate = 20×" rules of thumb come from. They are the same rule, expressed as a ratio instead of a multiple.
The GC-versus-sub difference matters: a subcontractor is expected to carry more working capital per dollar of backlog, because subs sit lower in the payment chain, wait longer to get paid, and have less control over the schedule.
The profitability ratios
| Ratio | Formula | Target |
|---|---|---|
| Operating income to revenue | Operating income ÷ revenue | over 3% |
| Return on equity | Net income before tax ÷ analyzed net worth | over 15% |
| G&A to revenue | G&A expense ÷ revenue | under 10% |
Operating income above 3% sounds low if you are used to thinking in gross margin — it is after overhead, and construction is a high-revenue, thin-margin business. A contractor running below 3% is not generating enough to build working capital, which means capacity cannot grow.
G&A above 10% of revenue usually means one of two things: you are carrying overhead built for a larger company than you currently are, or personal expenses are running through the business. Underwriters read the second possibility into the first.
The solvency ratios
| Ratio | Formula | Target |
|---|---|---|
| Current ratio | Current assets ÷ current liabilities | over 1.2; many sureties prefer over 1.3 |
| Debt to equity | Total liabilities ÷ analyzed net worth | under 3×; many sureties prefer under 2.5× |
| Quick ratio | (Cash + receivables) ÷ current liabilities | over 1.0 |
The ones your producer may not mention, and should
| Ratio | Formula | Target | Why |
|---|---|---|---|
| Revenue to working capital | Revenue ÷ analyzed working capital | under 15–20× | The overtrading test. This is how growing contractors fail — revenue outruns the balance sheet that has to finance it. |
| Days sales outstanding | 360 × AR ÷ revenue | under 60 days | Collection discipline. Rising DSO precedes cash trouble by about two quarters. |
| Underbillings to working capital | Underbillings ÷ analyzed working capital | under 25% | How much of your working capital is an estimate rather than a resource. |
| Cash to working capital | Cash ÷ analyzed working capital | over 20% | Whether your working capital is actually liquid. |
| Largest job to backlog | Largest contract ÷ total backlog | under 30% | Concentration. One bad job should not be able to take the company down. |
| Gross profit fade | Bid GP% − final GP% | under 2% | Whether any of the above numbers can be trusted. |
Run all of these at once with the surety readiness scorecard.
Part 5 — Trend beats average
A common mistake — including in some analysis templates brokers circulate — is to average five years of a ratio and look at the average.
Do not do this. Averaging is exactly the wrong operation, because it hides the pattern that matters most.
Consider two contractors, both with a 5-year average current ratio of 1.40:
| Year | Contractor A | Contractor B |
|---|---|---|
| Year 1 | 1.10 | 1.75 |
| Year 2 | 1.20 | 1.60 |
| Year 3 | 1.40 | 1.40 |
| Year 4 | 1.55 | 1.25 |
| Year 5 | 1.75 | 1.00 |
| Average | 1.40 | 1.40 |
Contractor A is a company an underwriter wants. Contractor B is a company in the middle of failing. The average is identical.
Look at the most recent year, the direction, and the rate of change. If you keep a five-year sheet, keep it as a trend line, not as an average.
The specific trend that kills contractors
Revenue growing faster than working capital. This is overtrading, and it is the most common cause of failure among profitable, growing contractors — which is what makes it so dangerous. Everything looks like success right up until the day payroll cannot be met.
| Year | Revenue | Analyzed working capital | Revenue ÷ WC |
|---|---|---|---|
| Year 1 | $8,000,000 | $900,000 | 8.9× |
| Year 2 | $12,000,000 | $1,050,000 | 11.4× |
| Year 3 | $19,000,000 | $1,100,000 | 17.3× |
| Year 4 | $27,000,000 | $1,150,000 | 23.5× |
Revenue tripled. Working capital grew 28%. By year 4 this contractor is financing $27M of production on $1.15M of liquid resources, and their surety has almost certainly already stopped increasing their line — which the contractor is experiencing as their surety being unreasonable rather than as the warning it is.
Part 6 — Statement quality
Two identical sets of numbers are not worth the same to a surety. How the statements were prepared matters enormously.
Level of assurance
| Level | What the CPA did | Surety's view |
|---|---|---|
| Audit | Tested the numbers, confirmed balances, examined evidence, issued an opinion | The gold standard. Required for larger lines. |
| Review | Analytical procedures and inquiry, limited assurance | The practical minimum for a real bond line. |
| Compilation | Put your numbers into statement format. No assurance at all. | Weak. Caps your line severely. |
| Internally prepared | You did it | Fine for interims. Not for year end. |
| Tax return | Prepared to minimize tax, not to present financial position | Nearly useless — tax accounting deliberately understates profit and equity. |
Basis of accounting
| Basis | Surety's view |
|---|---|
| Percentage of completion, accrual | What they need. Everything above assumes this. |
| Completed contract | Poor. Says nothing about jobs in progress, which is where the risk is. |
| Cash basis | Effectively unusable for surety analysis. |
Moving from a compilation to a review is usually the highest-return few thousand dollars a growing contractor can spend. It typically takes two to three consecutive years on the new basis before a surety fully credits it, so start early.
Timing
Get year-end statements to your surety within 90 to 120 days of year end. Late statements are read as a signal — either the numbers are bad and you are delaying, or the back office cannot execute. Neither reading helps you.
Part 7 — What underwriters flag
The list of things that cause an underwriter to slow down and start asking questions:
On the balance sheet
- Working capital flat or falling while revenue grows
- Growing underbillings, especially from unapproved change orders
- Officer or affiliate receivables appearing, growing, or reappearing every year end
- Large equipment purchases right at year end
- A fully drawn line of credit
- Receivable concentration — one customer over 25% of AR
- Cash that is low relative to working capital
On the income statement
- Gross margin declining year over year
- G&A rising faster than revenue
- Owner compensation moving sharply in either direction
- A loss year, obviously — but also a suspiciously smooth series of small profits
On the WIP
- Gross profit fade
- Any job in a loss position (a loss must be recognized in full as soon as it is foreseeable)
- One job that is more than 30% of backlog
- Jobs with no cost activity for months but still shown as open
- Estimated cost to complete that does not move from period to period
Everything else
- Changing CPAs, especially in a year with weak results
- Statements delivered late
- A change in the level of assurance, downward
- Distributions exceeding net income
- Litigation, liens, or tax issues discovered rather than disclosed
- Key personnel departures
None of these is automatically fatal. All of them are much better disclosed with an explanation than discovered.
Part 8 — The twelve-month plan
If you want a bigger line next year, in rough order of return:
- Stop distributing. Every retained dollar is roughly ten dollars of single-job capacity.
- Subordinate officer debt formally, on the surety's form.
- Clear related-party receivables before year end.
- Refinance current debt to long term.
- Collect the 90+ receivables or write them off. They are not helping you either way.
- Fix the billing cycle to reduce underbillings.
- Upgrade the CPA engagement level.
- Build the fade report and act on what it shows.
- Deliver statements within 90 days of year end.
- Hold the annual meeting and walk the underwriter through all of the above, in person. See the annual surety review.
The last one matters more than it sounds. An underwriter who has heard your plan and then watches you execute it will extend capacity ahead of the numbers. An underwriter who only sees the statements will always be a year behind.
Not financial advice. Every surety maintains its own credit manual, and treatment of specific balance sheet items varies. Work the specifics with your CPA and your surety bond producer.
When you are reviewing a subcontractor's statements instead of your own, the same adjustments apply with less depth. See Reading a Subcontractor's Financials and the Subcontractor Risk Scorecard.
Try it: Surety Readiness Scorecard — enter your balance sheet, income statement and backlog, and see your analyzed working capital, analyzed net worth, all twelve ratios against target, and an estimated capacity.