Authored by Brian Lydigsen, CLCS, NASBP | Vice President, Risk Advisory Solutions
A contractor's fiscal health, reputability, and reliability are more important than ever.
The U.S. economy, especially the construction industry, took a massive hit during the Great Recession. While the forecast looks favorable for the construction industry, landing construction projects for subcontractors remains as competitive as ever. Moreover, there is a growing risk at the helm: subcontractor default.
Subcontractor default is on the rise as markets rebound, due in large part to the cash requirements of a growing company. One of the primary methods general contractors use to evaluate potential partners is subcontractor prequalification.
What is prequalification?
It is the process of assessing any potential subcontractor's ability to borrow money and honor that debt. It is used to determine the estimated amount that a person or company can afford to borrow.
Sounds easy, right?
It's actually a bit more difficult than that because subcontractors navigating the prequalification landscape can easily get sidetracked. It is imperative to understand the basic principles of prequalification and the attributes of which companies who offer insurance or bonds focus on.
Key areas to consider when evaluating your prequalification process:
Safety Record – Does your contractor have a solid safety record?
Often contractors review “lagging indicators,” OSHA 300 logs, and Experience Modification Ratings (EMR) rather than focusing on the state of their current program to prequalify the subcontractor. An EMR above 1.0 could indicate trouble! It is crucial you take the Safety Record review a step further. The following are useful “leading indicators” to use in prequalifying subcontractors:
Insurance – Are you requesting the proper additional insured forms and waivers of subrogation?
Most companies do a thorough job of making sure the subcontractor has sufficient limits of coverage on the certificate. However, they struggle with the contractual risk transfer review. Work with your insurance agent to make sure you are requesting the proper additional insured forms and waivers of subrogation. Many agencies have access to software programs (i.e., CSR 247) that can help assist with the certificate management of your subcontractors.
Financial Ratios – Have you benchmarked your financial ratios against similarly sized companies?
When reviewing a subcontractor’s finances, it is essential to know what type of statements you are analyzing (audits, reviews, compilations or internals). If possible, you will want to benchmark these financial ratios against similarly sized companies in the same industry. Some key financial ratios to keep in mind are working capital, current ratio, debt to equity, days in accounts receivable and days in accounts payable.
Surety Bonding – Are you using surety bonding as another way to financially qualify a subcontractor?
Consider implementing a subcontractor bonding policy. The surety bonding process will identify financially qualified subcontractors with expertise in the work required. A useful tool for subcontractors is a "good" guy letter that will come from their surety or insurance agent. This provides assurance of the subcontractor's bonding program and the capacity levels at which the surety will support the firm.
Claims & Litigation - Are you prepared to defend against claims and litigation?
Ask specific questions about the subcontractor’s history and obtain an explanation. Request five years of claims history from the subcontractor. This information is easy to obtain as they are required to provide it for their insurance renewal every year. You can also utilize Dunn & Bradstreet reports and PAYDEX scores to get a better picture of the subcontractor’s payment history.
In Summary
With a better grasp of these critical areas, you are now in a better position when prequalifying subcontractors for your next project. Don't be a victim to the risks at the helm - protect yourself from subcontractor default. Contract one of our Construction experts for more information on any of these prequalification areas for your next big project.