We often get questions about financial statements and why they are important to the bond underwriting process. Underwriters will generally ask for several key financial documents, including a balance sheet and an income statement. These financials help us determine the liquidity of a business and its ability to generate income.
A balance sheet indicates a company’s financial condition on a specific date. It’s a look at the company’s assets, liabilities and equity at that particular moment.
The income statement tells us how the company is doing over time, generally a one-year period with an end date of December 31. Sometimes called a profit and loss statement, the income statement shows income, expenses and net income (income minus expenses).
Both are essential underwriting tools. The balance sheet describes how liquid the company is. Liquidity is defined as how easily assets can be converted into cash. Assets like stocks and bonds are very liquid since they can be converted to cash easily. However, assets such as property, plant, and equipment are not as easily converted to cash. The income statement shows us how profitable the company is. Does it have a positive income after paying its expenses?
Let’s look at each of these financials a little more closely and consider what’s important to a surety company.
Balance sheet
More than anything else, a surety looks at the equity on the balance sheet. This is what the company is worth after all its obligations have been paid. If it’s not a positive number, we want to know why.
It’s also critical that a business have enough working capital to operate. Working capital is current assets minus current liabilities. It’s what you use to pay short-term expenses, purchase inventory, pay off short-term debt and pay for day-to-day operating expenses.
We like to see positive retained earnings on the balance sheet as well. Retained earnings are profits earned over time that are retained by the company and not paid to the shareholders. We get concerned when there aren’t any retained earnings.
There are a few things underwriters will take off the balance sheet. A big one is goodwill. Goodwill is an intangible asset whose value is highly subjective. It’s what the company believes their brand is worth. Since we can’t quantify this, we subtract it from the assets.
Income statement
On the income statement, we look to see if the principal is keeping expenses in line compared to their income. Are they making a profit? How do their profits compare to the last reporting period? We like to see gross profit go up over time.
We also look at net income. This is gross profit minus your operating expenses and overhead. That should be a positive number. If it costs a lot to make that income, we want to know why.
In summary, the balance sheet tells us if there is sufficient liquidity to meet the principal’s obligations. The income statement is used to examine performance and results and to identify any issues that may need to be corrected.
Ask yourself these five questions
If you can answer these five questions in the affirmative, your company is likely in good financial shape:
- Is there a healthy amount of working capital?
- Are sales continuing to increase?
- Are expenses in line?
- Is cash flow strong?
- Are there retained earnings and positive equity?
If you have questions about preparing financial statements, a good resource is your CPA, your surety agent or an Old Republic Surety representative.
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