Financial Statements: What to Expect in the Underwriting Process

Financial Statement Blog imageDuring the underwriting process, a surety company may request financial statements from both new and established clients. Financial reports provide us with a snapshot of our client’s financial picture at a moment in time.

Financial statements can be prepared internally or by a CPA. An internal statement is generated from the company’s accounting software by a company employee.  This is considered the least reliable type of financial statement since it can vary greatly based on the type of accounting software being used, the accounting method, and the experience of the person entering the information.

A CPA-prepared statement is considered the most reliable, and it can be done at three different service levels.

  1. A compilation is the lowest level. No opinion or assurance is made by the CPA as to accuracy or completeness; this level takes the information from management and assembles it into the proper format without verification or testing.
  2. A review is the middle level. It can provide a limited assurance that no material modifications are needed to conform to the applicable reporting framework — but can’t give an opinion as to the fairness of the statement as a whole. A review is the most commonly utilized level.
  3. The audit is the top of the line level of preparation. It verifies the information with sources outside the organization and tests it for consistency. It also provides an opinion as to the statement being free from material misstatement and prepared in accordance with acceptable accounting standards.

We request the statements so that we can evaluate the ability of the business and its owner to complete the obligations covered by the bond, as well as to indemnify the surety in the event of a claim. Here is a brief overview of what we look at during the underwriting process:

Balance Sheet

The balance sheet is one of the main components of a financial statement. It indicates the financial position of a business. It provides us with a snapshot of the company’s assets, liabilities, and the owner’s equity at a given point in time (i.e., 12/31). It allows us to look at what a company owns, what it owes, and how much equity the owners have in the company.

Sureties rely on this information to analyze key ratios and factors, which include working capital and equity. Working capital is calculated by taking current assets minus current liabilities, while equity is calculated by taking all assets minus all liabilities. Sureties love to see the equity increase from year to year. Assets include cash on hand, outstanding money owed to the company, and property owned by the company. Liabilities are how much money a business owes and to whom.

During our analysis, we are going to manipulate some of these numbers. The amount of the receivables may be reduced based on our determination of how likely they are to be collected.  Inventory will be evaluated; we may reduce this number based on the probability of the items being used. Goodwill will usually be removed. The surety is determining how liquid the company is and the amount of equity the owners have in the company. This gives us an indication of how they have leveraged their money and how quickly they can raise cash.

Income Statement

The income statement shows how a company is managing its expenses in relation to its income. Also known as a profit and loss statement, the income statement provides the end user with an overview of the company’s results over a specific period of time.

The income statement is based on the following equation: Sales minus cost of sales equals gross profit; gross profit minus overhead (operating and administrative expenses) equals net income.

The surety is looking to see that the company made money and has kept expenses in line with income. We look to see what the expenses are, how stable they are from one year to the next, and whether costs increased or decreased proportionally to the increase or decrease in sales.

Cash Flow Statement

The cash flow statement shows where the business’s money came from and how it was spent. It is broken down into three categories:

  1. Operations.
  2. Investment activities. Proceeds from selling certain assets, purchase land, equipment purchases, etc.
  3. Financing activities. Paying off debt, borrowing money, distributions to owners, etc.

Similar to the income statement, a cash flow statement is reported over a specific time period. The statement measures cash collected versus cash paid, showing the resulting increase or decrease of cash from one year to the next.

Changes in Equity

Also known as a statement of retained earnings, this report details the changes in stock, net income, and cash dividends — and how they either increased or decreased equity position. This illustrates the changes in the owner’s equity position in the company, including the money they took out as distributions. While profitability is a key focus, the surety likes to see retention of funds amounting to an increase in equity.

Work in Progress (WIP)

The WIP report shows the jobs that the company already has in progress, their completion, and their billing status.

This report should include details such as:

  • Job name and number
  • Total contract value including change orders
  • Total estimated cost to complete, including change orders
  • Estimated gross profit
  • Percent complete
  • Actual cost to date
  • Recognized revenue
  • Gross profit
  • Total billed to date
  • Underbilled or overbilled amounts

The WIP report flows to the balance sheet showing under- or overbillings. Overbilling is shown as a liability on the balance sheet, consisting of the amount billed beyond the project cost and the gross profit earned.

Underbilling appears as an asset on the balance sheet; it is the revenue earned but not yet billed. The job schedule also flows into the profit and loss (income) statement, based on the “earned revenues” calculation (total cost to date divided by the total estimated cost equals the percent complete; the percent complete multiplied by the total contract price equals the revenue earned) from both WIP and closed job schedules. 

The WIP schedule provides an overview of how successful the projects are in relation to profit and what their billing practices are. A list of completed contracts including the final contract amount and the final profit for the projects that were completed during the accounting period should also be included.

Accounts Receivable (A/R) Aging

The A/R aging report shows the age of the company’s accounts receivables by line item. It also lists who owes the receivables, the amount, and what the A/R line item is for. This report allows us to determine the probability of the collection of each A/R item. We evaluate receivables to ensure there is enough money collected to finance the current work program.

Retainage is usually not paid until a project is complete; it can sit on the receivable list for a long time adding to the over-90-day total and sabotaging a contractor’s cash flow. Typically the surety decreases the accounts receivable amount by the total uncollected more than 90 days unless they are undisputed retainage amounts. Accounting for retainage separately can lessen the impact of this deduction. It decreases the asset total, making the assets-to-liability ratio less attractive and reducing the amount of working capital that is available.

Accounts Payable (A/P) Aging

This report shows us the age of the items to be paid by the company. Details should include how much money is owed and who it is owed to. This schedule provides us with an overview of the company’s payment practices.

Personal Financial Statements

The underwriting process may include evaluating the business owner’s personal financial statements. Therefore, we may request personal financial statements from each owner. The statement should include details of their assets and liabilities (for example, what they own; how much cash they have on hand; and what they owe). This information gives us an idea of their ability to pay debt.

If you have any questions about the underwriting process or anything regarding surety, contact an appointed agent, or reach out to an Old Republic Surety branch nearest you.

Tammy McBurney

Tammy McBurney is a Senior Surety Marketing Representative at our Desert States Old Republic Surety branch office. She's worked in the surety industry since 2010. Prior to joining Old Republic in October, 2017 Tammy worked as a Commercial Account Manager at an insurance agency. She has a Bachelor's degree in Business Management and received her AFSB certification. Tammy enjoys hiking.