There are three main factors that companies will be assessed for when applying for a surety bond: capacity, character, and capital.
There are bonds that will require other factors aside from those three. But the three C’s of surety bonds—as they are commonly referred to—is a standard in risk assessment.
Just like in checking the capacity and character of the Principal (company/surety bond applicant), an underwriter will spend a long time assessing documents that shows the Principal’s capital.
To give you an idea of what financial documents you need to prepare prior to application and how underwriters assess your capital, read on.
What are the financial documents that underwriters require when assessing a Principal’s capital?
Checking the Principal’s capital means taking an in-depth look at the Principal’s historical financial performance. By doing so, the underwriter will be able to assess if the Principal has the means to stay in business long enough to perform the bonded obligations.
To check the financial position of the Principal, underwriters will ask for the Principal’s
Fiscal Year-End (FYE) Financial Statements. The underwriter might ask for an FYE financial statement from the previous year or within the last five years.
These financial statements will reflect a twelve-month accounting period. When assessing these financial statements, the underwriter will usually focus on the company’s balance sheet, income statements, and statement of cash flows.
How is capital assessed?
An underwriter uses several methods when reviewing financial statements. This will depend on several factors such as the type of surety bond, the validity of the bond, and the risk level.
Below are the different types of capital assessment (Vertical and horizontal assessments):
- Vertical assessment - The account entries per FYE financial statement will be checked. This type of analysis is often used when extending limited surety credit over a short period of time.
- Horizontal assessment - The underwriter will compare the financial ratios to understand the Principal’s financial performance trend.
The underwriters will convert the numbers on the FYE financial statements to percentages. By doing so, the underwriter will be able to fully check the consistency of the numbers per year, commonality, and clarity per analysis.
Below are some of the numbers that will be converted to percentages:
- Accounts receivables
- Accounts payables
- Total debt
- Gross profit
- Operating income
- Cash flow from operations
Short-term liquidity ratio analysis
These are ratios that underwriters assess to measure the company’s ability to survive within a short timeframe. Some of these ratios are as follows:
- Working capital
- Current ratio
- Quick ratio
- Accounts receivable turnover ratio
- Inventory turnover ratio
- Accounts payable turnover ratio
Debt ratio analysis
The underwriter will check how the company generates cash from debt from different credit sources such as the following:
- Finance companies
- Corporate debentures
Current liabilities to inventory ratio analysis
This type of assessment is commonly used for manufacturing companies. The company’s ability to turn its inventory to meet obligations to creditors will be assessed.
Long-term solvency analysis
Surety bonds that have long exposure require this type of assessment. For this assessment, the underwriter is checking if the company has the ability to pay long-term debts.
Income statement ratio analysis
This is an assessment of the company’s ability to generate profits from the product or services it offers. The underwriter will check the following factors:
- Gross profits
- Operating profits
- Extraordinary Items and Non-recurring Items
Cash flow analysis
The company’s survival rate depends on its ability to generate enough cash. During this assessment, the underwriter will check where the cash comes from, where it’s allocated to, and how the company’s increasing its cash flow.
The three main areas that will be assessed are as follows:
- Cash flow from operations
- Cash flow from financing
- Cash flow from investing
Through an in-depth check, an expert underwriter will be able to predict if a company can fulfill its obligations or meet the outcomes of a default. It’s a tedious task, but a highly important one.
If you’re applying for a surety bond, make sure that all your documents—including your financial statements—are ready so that your bond can be processed within a day.