ANALYSIS OF FINANCIAL CAPABILITIES
FOR PREAWARD AND POSTAWARD REVIEWS
Table of Contents:
|SECTION I - Introduction|
|Role of the DCMA Analyst|
|Importance of the Assessment|
|Implications of Prediction|
|Changes to this Guide|
|SECTION II - PREAWARD SURVEY (PAS) PROCESS|
|A Team Effort - Production, Quality, and Finance|
|Purpose of the Financial Preaward Analyses|
|SECTION III - PERFORMING THE FINANCIAL PREAWARD ANALYSIS|
|Obtaining Financial Information|
|Beginning the Financial Preaward Survey|
|Preliminary Review of the Offerors Financial Data|
|Contact the Offerors Banker|
|In-depth Systematic Statement Analysis|
|Consolidated Financial Statements|
|SECTION IV - ANALYSIS|
|Analysis of Financial Trend|
|Interpretation of Analyses|
|SECTION V - CLASSIFICATION OF ACCOUNTS|
|SECTION VI - AREAS OF ANALYSIS|
|Working Capital Analysis|
|Bank Restrictions on Debts|
|Secured Loans and Their Terms|
|Payroll Tax Liability|
|Offeror in Bankruptcy|
|Cash Flow Projection|
|Possible Problem Areas|
|Recording of Financial Data|
|SECTION VII - WORKING CAPITAL|
|Reconciling Working Capital|
|How the Offeror Can Indirectly Improve Financial Condition|
|Obtaining Additional Fixed Assets|
|SECTION VIII - COMPLETING THE PREAWARD FINANCIAL SURVEY|
|Completing Section I of SF 1407|
|Supervisory Review of Preaward Surveys|
|Maintain the Financial File|
|SECTION IX - FINANCIAL PREAWARD ON A PRIOR OFFEROR|
|Updating Financial Data|
|Depth of Analysis|
|SECTION X - POSTAWARD FINANCIAL SURVEILLANCE|
|Extent of Coverage of the Postaward and Frequency of Performance|
|Arranging for Submission of Financial Data|
|Reviewing the Data and Reporting the Results|
|APPENDIX A - SOME SOURCES OF FINANCIAL DATA|
|APPENDIX B - FURTHER READINGS|
|APPENDIX C - FINANCIAL RATIOS|
|Working Capital Ratios|
|APPENDIX D - BANKRUPTCY PREDICTION|
|APPENDIX E - FORMS|
SECTION III -
PERFORMING THE FINANCIAL PREAWARD ANALYSIS
A. Obtaining Financial Information:
1. Normally, financial information concerning a specific contractor is obtained directly from that contractor. It is usually more current than information from secondary sources, such as those listed in Appendix A, "Some Sources of Financial Data." However, these sources recommended in appendix for industry and economic information can be very useful for comparison and forecasting.
2. Site visits are the preferred approach for clarifying information with the contractor/supplier. Site visits are most useful after an analyst has studied the available information concerning the contractor's products, markets, financial history, competitive position, and goals. Analysis of such information will likely result in a number of questions that should be arranged in some logical sequence as preparation for the site visit.
B. Beginning the Financial Preaward Survey:
Key areas for determining financial strength are the company's profit record, net worth, sales, cash flow and projections. Financial analysis of major subcontractors should be considered. Always discuss this area with the PAS Monitor before proceeding.
1. Receiving and Processing the Request to Perform a Financial Analysis
a. A request is received from the PAS monitor to perform a financial capability analysis during the pre-award stage. A request is normally received from a Contracting Officer to perform Post-award reviews. It can be from an Administrative Contracting Officer (ACO) or Procuring Contracting Officer ( PCO).
b. The request is usually made via a SF Form 1403, "Preaward Survey of Prospective Contractor - (General) for Pre-award financial reviews." https://home.dcma.mil/onebook/1.0/1.2/Preaward.htm#3.6. Risk Documentation
c. The DCMA Analyst should assure that the following data are included in the survey request: (i) dollar amount of proposed contract, (ii) type of contract, (iii) item description, (iv) delivery schedule, (v) Government financing required, and (vi) identification of requesting element and phone number.
d. Additionally, the analyst should assure that the request shows the name, title, and phone number of the firm's representative who will respond to financial inquiries.
e. Ask the PAS monitor if the requestor of the PAS has indicated that the proposed contract price appears too low. This could indicate financial problems.
f. Any needed information not supplied with the SF 1403 should be requested from the PAS monitor.
2. Firms with Potential Financial Weaknesses. Understand the firm, the type of legal entity you are reviewing. Firms that require special attention because of their potential financial weaknesses are:
a. New suppliers or newly organized companies.
b. Contractors with a past history of defaults or delinquencies.
c. Companies with rapidly expanding business volume. There is a risk of overextending financial resources (working capital and facilities expansion).
d. Companies that are within a multi-structured corporation, under a parent or holding company and they don’t have control over their working capital or cash flow.
e. Small companies. They frequently have limited capital and often are poorer risks than large companies, since they are less able to absorb financial losses.
f. Companies refusing to disclose information about their financial condition: Such a refusal may merely reflect the firm's normal policy, but it may also be an attempt to hide financial weaknesses. In any event, such firms should be assured that financial data submitted will be used solely for determining financial adequacy and will not be otherwise disclosed. A firm that refuses to submit data should be informed that a refusal may have a potential adverse effect on the DCMA Analyst's recommendation and a possible loss of the proposed contract.
f. Firms where other known conditions raise reasonable doubts as to financial strength.
3. Check the CMO Financial Files. Prior to contacting the offeror, the DCMA Analyst should check the financial files to determine if the offeror is a new bidder at this DCMA office. If the prospective contractor is a current contractor, or a frequent bidder, the DCMA office may have adequate financial information to evaluate the firm's financial capability to perform.
4. Contact the Offeror. If current financial data are not available, the DCMA Analyst should immediately contact the prospective contractor and request relevant financial information for evaluation:
a. Copy of the firm's interim financial statements and the previous two completed years annual reports or financial statements.
b. Cash flow statements and/or forecasted cash flow projections, if applicable. Smaller companies normally won't have these. The statement of cash flow will be available with the annual financial statements for any company required to file with the Securities and Exchange Commission (SEC). See further information on the review of cash flow statements below under "Analysis" at F, the contracting officer should/may request one.. Where there are no cash flow statements or cash flow forecast, ensure you get as much information as possible to ascertain whether the company has sufficient working capital:.
b. Aged accounts payables and aged accounts receivables.
d. Statement of current dollar amount of the company's backlog of orders, broken out by Government and Commercial, and the proposed monthly delivery schedules. Obtain the approximate date of completion of the contract with the longest remaining period of performance.
e. Approximate date of completion of the contract with the longest remaining period of performance.
e. If a service contractor, the monthly billing for both government and Commercial.
g. In addition, the DCMA Analyst should determine:
(i) The type organization, such as proprietorship, partnership, or corporation. The top level parent if the company being reviewed is a subsidiary or business unit.
(ii) The date the firm's fiscal year ends.
(iii) Name and address of its bank, the bank's telephone number, and the name of the bank official most familiar with the contractor.
(iv) Will this be a loss contract?
(v) Will additional capital equipment be required?
(vi) Type of financial resources the offeror believes will be required to perform the contract.
(vii) Any liens or judgments outstanding.
(viii) Does the contractor/ potential contractor (bidder) control his own bank accounts or does a parent organization control the accounts? If the contractor operating unit that is to perform the work does not control the accounts, have cash management, then steps should be taken to ensure the availability of adequate capital to perform the contract. The surest means would be to obtain a parent guaranty agreement. A guaranty will make the parent or holding company financially responsible where the performing unit does not control its cash. ( link Guaranty form)
5. Certification of Financial Statements. The DCMA Analyst should advise the firm's representative that if the financial statements are not certified by an independent Certified Public Accountant (CPA), they should be signed by an officer of the company. In case of a qualified certification by an independent CPA firm, any exception(s) should be thoroughly reviewed and made a part of the analyst's final recommendations, as appropriate. Always read footnotes, comments made explaining certain accounting procedures and classifications used, and background information deemed necessary to evaluate the statements. Inquire, ask questions of the contractor as necessary . The following should be noted:
a. Information concerning profits.
b. Non-recurring gains; such as the sale of a subsidiary.
c. Change(s) in accounting practice(s).
d. Potential lawsuit(s)/liabilities.
e. Recorded Liens and/or Court Judgments. Prior subordination agreements in place.
Where the certifications are not made by an independent CPA firm, request the offeror to use the following certification:
"This is to certify that to the best of my knowledge and belief the financial data and the accompanying notes to the financial statements are accurate and complete and prepared in accordance with Generally Accepted Accounting Procedures from the company's general accounting records. The descriptions and amounts are based upon the _____________________ method of accounting and reflect the company’s financial status as of
Date __________________ Signed_________________________
If an offeror is unable, or unwilling to comply with requests for necessary financial information, the DCMA Analyst will find the offeror unsatisfactory and recommend no award. The burden for demonstrating financial responsibility rests with the offeror.C. Preliminary Review of the Offeror's Financial Data:
(c) If a business has borrowed from a bank without collateral, the bank
loan would be considered unsecured (no collateral pledged). It shows the
business has an alternative credit source available other than suppliers, and
the business meets the strict requirements of a bank. On the other hand,
if collateral has been pledged, then the loan would be listed as secured.
It is noted that loans might be secured by pledging the owner’s personal
property, or real estate, as
(d) Notes payable to banks should always show bank loans as a liability, and never as an offset against an asset. When bank loans are offset against an asset it gives a distorted balance sheet presentation.
(ii) Notes payable to officers or stockholders of affiliated companies. Notes payable to officers or stockholders of affiliated companies are considered loans from friendly sources.
(iii) Notes payable to the trade. A company may have a credit agreement with suppliers for merchandise or materials.
(iv) Notes payable to others.
(a) If the notes payable to a friendly concern or principal are sizable and have a pronounced affect on the company's overall financial condition, consideration should be given to obtaining a subordination of the loan.
(b) If a company shows outstanding notes and it is not in an industry that traditionally deals in then, this may indicate a weak credit standing.
b. Accounts Payable. Accounts payable represent merchandise or material requirements purchased on credit terms and not paid. Companies able to obtain bank loans frequently show small accounts payable relative to all of their current liabilities. The loans are often used to cover material and merchandise obligations. Sizable payables shown, when there are loans outstanding, may indicate special credit terms being extended by suppliers or poor timing of purchases. Accounts payable should include only those accounts arising out of merchandise transactions on open account terms.
c. Accrued Liabilities. Accrued expenses at the close of the fiscal or calendar year, as well as for any other interim period, are current liabilities. Such accounts as wages, salaries, taxes, and interest accrued are often omitted from balance sheets, either through oversight or intentionally. Failure to include these results in understatement of liabilities and overstatement of both working capital and net worth.
(i) Reserve for Taxes. Where the information is available, tax reserves (accruals) should be segregated as a separate account. Federal income taxes should always be listed as a current liability. In addition, a breakdown should be made available as to what part of the reserve for taxes applies to the income taxes accrued on the earnings for the year just completed, and what part of the reserve represents assessments or reserves for prior years' taxes. If a balance sheet does not show a liability for taxes and a profit is claimed, the company may be understating its current debt.
(ii) Due Officers, Stock holders1 etc. These accounts should be shown separately. The Price/Cost Analyst must keep in mind that if anything happens, the officers and stockholders of the business usually are in a position to get their money first.
(iii) Due Affiliated Companies. These accounts should be shown separately. If there is only one affiliated company, the name of the company should be shown as due "name of the company."
(iv) Dividends Unpaid. This account is also an accrued liability and should be shown separately if possible. Dividends declared and payable on a given date are a liability of the corporation and should be shown as a current liability.
(v) Funded Debt (Current). Serial bonds, notes on mortgage installments, mortgages, and other funded debts due and payable within one year are current liabilities. The amount which is current should be separated and included in current liabilities.
2. Long Term Liabilities. Long term liabilities are items that mature in excess of one year from the balance sheet date. Normally, items in this area are retired in annual installments. The items most often appearing in this category are mortgage loans, usually secured by the real estate itself, bonds, or other long term notes payable.
a. Funded Debt. Serial bonds, notes on mortgage installments, mortgages, and other funded debts due after one year are included in long term liabilities. These debts should describe as definitely as possible the kind of bond or mortgage involved, the interest rates, the schedule of requirement payments and in the case of bonds, a notation of facts about any default in principal, interest, sinking fund or redemption provisions with respect to any issue of securities. Bonds are a means of borrowing long term funds for large and well established companies. When a company is big enough and financially sound, it will sometimes be able to borrow money on a long term unsecured basis. When this occurs, the unsecured deferred notes are called debentures.
b. Miscellaneous Deferred Liabilities. Reserves which offset assets, as reserves for depreciation and bad debts, should be deducted from the assets leaving the net asset value for comparison figures. These reserves should never be shown as deferred liabilities. However, if there is a Reserve for Contingencies, this account should be classified as a deferred liability on the assumption that the reserve is set up with no particular asset in mind. Although the reserve might appear to be a part of net worth, the fact that the reserve has been classified as such, rather than a surplus, indicates that management may have some possible loss in mind when segregating it. If there should be such reserves as Reserve for Insurances, this account should be classified as a deferred liability.
c. A deferred credit may indicate that a business has received unearned revenue from customers on work yet to be completed. Since the completed work is still owed to the customer, the unearned revenue continues to be carried as a liability until the product is completed and delivered, or the unearned revenue is returned to the customer.
C. Capital Accounts:
1. Definitions. On corporate balance sheets, net worth may be broken down into the following categories:
a. Capital stock represents all issued or unissued shares of common or preferred stock. Usually preferred shareholders are entitled to priority over common stockholders if a company liquidates.
b. Paid in or capital surplus represents money or other assets contributed to the business, but for which no stock or owners' rights have been issued. This usually occurs from stockholders paying more than par value for the stock.
c. Earned surplus is the amount of earnings retained in the corporation and not disbursed as dividends. When a corporation shows a net worth that has as its components capital stock and retained earnings, capital stock represents shares of equity issued to owners. Retained earnings are the amount of corporate profits permitted to remain in the business by design of the officers. Analysts view a sizable amount of retained earnings as significant. It shows a business is profitable and successful if it recognizes the need for net worth growth as the company progresses.
d. Net worth represents the owners' share of the assets of the business. It is the difference between total assets and total liabilities. Total assets minus Total liabilities equals net worth or owner's equity. If liquidation occurs, assets are sold off to pay creditors and the owners receive whatever remains. This is why equity sometimes is referred to as "risk capital."
2. Net Worth.
a. Capital. If the statement is that of a partnership, the investment of the partners should be shown separately, as “Investment - John Doe”, “Investment - William Smith”, etc. If the statement is that of a proprietorship, the investment of the owner should be shown as “Capital - Name of the owner”. If the statement is that of a corporation, preferred stock, common stock, and surplus should be shown separately. When payments are received on preferred stock subscriptions or common stock subscriptions, the amounts received for full shares to be issued subsequently should be included with the preferred or common stock. Where a corporation has issued more than one class of either preferred or common stock, each class issued should be shown separately. In addition, where the capital stock of a corporation includes preferred stock, the latter's characteristics will largely affect both its position and that of the common. In listing preferred stock on the balance sheet, the notes to the financial statement should disclose information regarding any preference rights as required in all financial statements filed with the Securities Exchange Commission.
(i) If callable, the date or dates and the amount per share and in total which shares are callable shall be stated.
(ii) Arrears in cumulative dividends per share and in total for each class of shares shall be stated.
(iii) Preference of involuntary liquidation, if other than the par or stated value, shall be shown. When the excess involved is significant there shall be shown (1) the difference between the aggregated par or stated value; (2) a statement that this difference, plus any arrears in dividends, exceeds the sum of the par or stated value of the junior capital share and the surplus, if such is the case, and (3) a statement as to the existence, or absence, or any restrictions upon surplus growing out of the fact that upon involuntary liquidation the preference of the preferred shares exceeds its par or stated value.
b. Surplus. Generally speaking, surplus is of two major kinds, earned and capital. Earned surplus arises out of undistributed earnings and is the balance of net profits, income and gains of a corporation from the date of incorporation (or from the date when a deficit was absorbed by a charge against the capital surplus created by a reduction of the par or stated value of the capital stock or otherwise), after deducting losses and distributions to stockholders and transfers to capital stock accounts, when made out of such surplus. Capital surplus arises from all other sources, such as (i) accounts paid in by stockholders in excess of par or stated value of capital stock; (ii) donations of capital stock; (iii) write-up of assets; (iv) reorganization of recapitalization; (v) profit on sale of the company's own stock, etc. It is ordinarily assumed that the total amount of earned surplus is freely available for dividends. Where surplus is restricted for a specific purpose such as plant expansion, contingencies, redemption of funded debt, or additions to working capital, the amounts so designated should be listed separately as surplus reserves. The factors which account for the change in the amount of surplus usually are the things which show what the business is doing, whether or not it is making progress. If the profits, dividends, etc., are known, a reconcilement should be made of the change in the surplus accounts, as compared with the figures of the previous year. This is important, as appreciation of the assets or large dividends paid during the year may be detected; this otherwise might escape notice.
3. Reconciling the Net Worth.
a. The net worth of a company represents the margin of safety or protection to a company's creditors; therefore, the DCMA Analyst, on recommending financial capability is always concerned about the changes that take place in net worth from year to year.
b. It must be remembered that the balance sheet portion of a financial statement is only the cut-off point in the operations of business and is only indicative of the company’s position as of that date. Between the dates of two balance sheets, many changes can take place in the figures, and it is only by means of the profit and loss statement and the net worth reconcilement that these changes can adequately be explained. If a company wished to window-dress its balance sheet to cover up a loss, it could arbitrarily write up its assets in excess of the loss to increase net worth. However, in comparing the balance sheet with a previous balance sheet, without the operating statement and reconcilement of the net worth to explain the changes, it would be a normal assumption to believe that the increase in net worth was due to profits earned and retained for the period ended. The point to remember is that financial statements accepted at face value could be misleading and may not necessarily show the true financial position of the company. Therefore, the analyst must determine whether the information furnished is sufficiently complete and adequate for analysis before attempting to make an analysis, inasmuch as the results of such analysis could be misleading and inadequate to serve as the basis for a recommendation.
4. Recognizing Undercapitalization.
It is also important in financial capability analysis to be able to recognize when a concern is undercapitalized, a condition best reflected by a firm's inability to meet its debt at maturity. When this condition exists the financial statements usually show (a) Short Working Capital, (b) Heavy Debt in Relation to Working Capital1 and (c) Rapid Capital Turnover.
SECTION VI - AREAS OF ANALYSIS
A. Working Capital Analysis: The offeror may have adequate financial strength, but sometimes this is not the case. If not, the Price/Cost Analyst must determine the amount of working capital required for the prospective contractor to finance current production backlog and the potential contract.
1. Working capital represents the funds available to finance current business operations. This figure is important, as it is used to determine how much excess cash a business has to fund current expenses. Working capital is the difference between current assets and current liabilities. Since a company's resources to pay its current debt come partly from current assets, a business with a comfortable margin should be able to pay its bills and operate successfully. How much working capital is enough depends on the proportion of current assets to current liabilities rather than on the dollar amount of working capital.
2. Determine Working Capital Required. Additional financing may be needed to expand working capital or facilities. Some of the factors which determine the amount of working capital required are:
a. Size and type of Contract. The size of the proposed contract may require expanded working capital, if it is significantly larger than the offeror's general production backlog. The type of contract may or may not have interim financing and the contractor will need enough resources to operate and perform the contract.
b. Length of Production Period before Shipment. This is a key factor that determines the amount to be tied up in inventory and work-in-process at one time. An item which can be assembled simply, or can be produced quickly, will result in investment being minimal. Therefore, only a small amount of funds will be tied up in work-in-process or finished inventory. If the production period is long, funds will be tied up for a long period of time. (The above statements are made without giving consideration to progress payments or other means of financing inventories.)
c. Schedule of Deliveries. A contract calling for delivery over a short period will cause inventory and receivables to build up rapidly. This would mean a larger investment than for a contract which permits a slower delivery rate. Allowing shipment in small lots keeps down the investment in finished goods waiting to be shipped.
d. Raw Material Stocks. If the raw materials and components used are plentiful and easy to obtain, a relatively small in vestment is needed. However, if the stock must be bought in large quantities, working capital needs are increased.
B. Bank Restrictions on Debts: It is important that the DCMA Analyst determine the terms and conditions of the bank loans. A long term debt may become a demand note according to the terms of the bank loan. If the contractor is required to maintain a prescribed ratio of net worth to liabilities and the ratio falls below that prescribed in the loan terms, then the bank has the right to convert this long term debt into a demand note. The bank could also have a requirement that the contractor maintain a minimum working capital. If the working capital falls below the prescribed minimum the bank could convert the long term note into a demand note. Sometimes contractors may be forced into a Chapter XI situation (arrangement or reorganization with either the debtor or a referee in possession) because the bank freezes the company’s cash when it goes below the minimum working capital requirements.
C. Secured Loans and Their Terms: A typical secured loan issued by a bank reads as follows: In accordance with the "Uniform Commercial Code,"
1. All accounts receivable existing as of this date, together with any and all such accounts receivables hereinafter acquired and all proceeds thereof.
2. Any and all items of inventory now existing or hereafter acquired.
3. All machinery and equipment as delineated on the schedule attached hereto, together with all and similar machinery and equipment hereinafter acquired or replacements thereof and all accessories now or hereafter affixed or to be used by debtor.
4. All furniture and fixtures as delineated on the attached schedule together with all and similar collateral hereafter acquired or replacements thereof and all accessories, party and similar items now or hereafter affixed hereto.
When this clause is in effect and the contractor has progress payments, problems can occur since, in accordance with the progress payment clause, the Government has title to inventory. If a contractor has such a secured loan, then the Government and the bank both have title to the same inventory.
Thus, when a secured loan is found, the DCMA Analyst should assure that before the Government makes progress payment to a secured contractor where the bank has inventory as part of the security, the bank sign a release (Uniform Commercial Code Form UCC-3) for the progress payment inventory and/or a Subordination Agreement which will subordinate the bank's right to inventory on which the Government has made progress payments. This type of information and appropriate recommended procedures should be entered in Section VI of the SF 1407.
D. Payroll Tax Liability: A company is required to periodically deposit employees withholding and social security taxes with a bank. A review of the balance sheet may disclose a disproportionately large liability for payroll taxes. This is a red flag for the Price/Cost Analyst. It generally indicates that the contractor is delinquent in paying withholding taxes and therefore is probably running short of funds.
E. Offeror in Bankruptcy: When it appears that the potential contractor is almost, or is, in some stage of bankruptcy, you should contact the Bankruptcy Court to determine if bankruptcy has been filed. The offeror or creditors may be filing for a Chapter VII straight bankruptcy, a Chapter XI plan for credit arrangements, or a reorganization with either the debtor or a referee in possession. If Chapter XI bankruptcy is in process, the Analyst will have to be particularly astute in analyzing the potential contractor's ability to financially perform the proposed contract. Bankruptcy under Chapter VII and Chapter XI should be noted in Section VI of the SF 14O7 and fully explained.
F. Cash Flow Projection:
If your analysis shows only minimum working capital is available, the offeror should be contacted and advised of the situation. Ask the offeror whether or not additional financing has been arranged for, can be obtained. If the additional funds can be acquired, ask the offeror to promptly forward appropriate evidence regarding the additional financial resources available for financing the proposed contract. Request a cash flow projection be furnished for review and evaluation.
The potential contractor, if a small business, may not know how to develop a cash flow projection. Therefore, the following guidance should be given to the offeror to assist in the development of the cash flow projections. The cash flow projection, or cash budget, shows the effect production and sales plans have on the cash position of the company and is generally developed by monthly periods.
The cash budget is not tied to expected profit or loss; it merely forecasts the fluctuations in the company's bank account. Following are several key steps in its preparation:
1. A schedule of production and shipments should be prepared and broken down by months. This schedule is the heart of the company's planning. All of the company's production, commercial and Government, should be included.
2. The schedule of shipments is translated into a schedule of cash receipts. The time lag between invoicing and receipt should be taken into account. In many cases where cash flow forecasting is needed, Government contract terms provide for progress payments. Receipt of progress payments should be provided for in the cash flow statement.
3. Receipts from other sources, such as sale of property, stock, or bonds are added to the receipts from collections of accounts receivable. The result is the total cash receipts expected during the period involved.
4. A schedule of planned purchases of raw material, sub-assemblies, components, equipment, and facilities is made. This is then translated into a schedule of cash on delivery and accounts payable to suppliers.
5. Using the production schedule as a basis, cash outlay is figured for the main production expenses, including wages, factory overhead, and selling and administrative expenses. This does not include the noncash expense of depreciation or amortization.
6. Income tax payments (including withholding) should be scheduled at the time they accrue for payment.
7. Any other expected payments, such as dividends or loan repayments, are entered next. When withdrawals or dividends exceed profits, they diminish net worth.
8. For each period the total of all estimated payments is subtracted from the total of all estimated receipts. This is done for each selected interval. The result is the net increase or decrease in funds for the period. Adjustments are made for cash on hand at the beginning of the period and for the minimum working balance of funds needed for the period. The cash available or needed by the end of the month is the offeror's cash position at the end of the month.
G. Possible Problem Areas:
1. Accounts are not classified according to generally accepted accounting principles.
2. Financial statements are on a hybrid cash and accrual basis. They may show accounts receivable but not accounts payable. The offeror has not accrued the liabilities.
3. Errors may also be found where the offeror erroneously adds ending inventory to cost of goods manufactured in the operating statement, instead of subtracting it.
4. Progress payments are sometimes booked as a sale instead of treated as reduction of inventory or as a liability.
5. Error of omission occurs when liability for income taxes are omitted.
6. Unrealistic values assigned to fixed assets upon commencing business. This results in overstated net worth.
7. Recording accounts or notes receivable from officers of the company when the officers do not intend to repay the advances or loans.
8. Restricted cash (escrow account) included with cash as one figure on the balance sheet.
9. Footnotes are missing for the financial statement. The footnotes may be withheld because they contain adverse information pertaining to debts, contingent liabilities1 etc.
10. Investment in discontinued operations may not be written off.
11. Ratio of gross profit to sales appears unusual when it is compared to previous years. This could be because of inflated inventory.
H. Recording of Financial Data: The results of the analysis made of the company's balance sheet reflecting the financial position and profit and loss statement for the period, showing net sales and net profit, should be recorded to enable comparisons to be made with previous periods. Such recordings are important to the Analyst in determining trends. If a substantial downward trend is indicated, appropriate action must be taken to determine the cause, the prospects of recovery, and the effect on contract performance.
SECTION VII - WORKING CAPITAL
A. Reconciling Working Capital:
1. When a DCMA Analyst is determining financial capability, interest should center on the current assets and current liabilities of the company. The increases or decreases in "working capital or net current assets" do not necessarily follow the trend of profits or losses. It is not unusual for a company to experience a period of profitable operations and at the same time show no improvement in its working capital position. On the other hand, the company could show losses from operations without affecting its working capital.
2. In reconciling changes in working capital, there are two points of primary interest. They are the cause and effect. The effect is determined by comparison of the current working capital, with that of a previous date. The increase or decrease is the effect of a change. Since the effect is found in the working capital items themselves, it is necessary to look to the other elements of the financial statement for the cause. The factors which cause changes in working capital are:
Changes Which Cause Increases:
Increases in Long Term Liabilities
Increases in Capital
Changes Which Cause Decreases:
Dividends or Drawings
Increases in Fixed and Other Assets
Decreases in Long Term Liabilities
* Depreciation is an operating charge against the profits. However, the fact that the charge offsets other assets and does not affect the current assets necessitates its being added back to profits in reconciling working capital.
B. How the Offeror Can Indirectly Improve Financial Condition: The offeror may want to use subordination agreements, guarantee agreements, financial position, deferred payments, advance payments, etc., to improve the firm's financial position to satisfy the Government’s concerns. When this occurs, inform the customer and/or ACO.
1. Use of Subordination Agreement. The use of Subordination Agreements is appropriate to protect the Government’s interest when working capital has been provided by way of loans during contract performance. Specifically, the use of Subordination Agreements support the rights of the Government by certain clauses that may be in the contract that give title. There is a basic form for accomplishing this; it is DCMA Form 1619. Modifications to the form must be coordinated with legal counsel since this is a legal document.
When the offeror's latest current interim balance sheet shows current
monthly payments are being made on long-term loans, and even short-term loans in
some cases. Subordination agreements are to be put into place as soon as
possible on new awards, the need for these should be brought out in the
pre-award phase and drafted accordingly. Work with the contractor to ensure the
holders of the loans (creditors) are willing to execute a
formal Subordination Agreement to the rights of the Government. If
the creditors are willing to enter into a Subordination Agreement, the offeror
will request each creditor to execute the Subordination Agreement in 4 copies
and promptly return all copies to the DCMA Analyst in order to meet the time
allowed for performing the PAS.
Basically, Subordination Agreements should be obtained when funds are obtained and put into the business under a loan agreement, whether pre or post award. It is very important to make the Government’s rights known and protected as soon as possible. If the offeror finds sources ( lenders, or additional lenders) willing to loan additional funds after contract award, the procedures to be followed for requesting, executing, and returning Subordination Agreement forms to the DCMA Analyst, through the Administrative Contracting Officer (ACO). It is still important and not too late to do this during post-award, should loans and creditor/lenders be identified subsequently after award that are not already covered by a Subordination Agreement. This could occur in cases where new lenders loan to the contractor right after award and were not previously identified to the Government, or, later during contract performance the contractor obtains loans/new creditors to continue work. Once a new lender/credit source has been identified that is not covered, has no subordination agreement in place, work with the ACO to obtain one. DCMA, whether it is the analyst or the ACO will have to determine if the credit source has authority to enter into such agreement ; that the agreement will actually cover the contracting unit which is liable to perform/complete the work. Seek legal advice when not certain as to the business structure and relationship of the business unit actually performing the contract work.
2. Use of Guaranty
Agreement. The DCMA Analyst may suggest to the offeror (and advise the
customer) the use of a Guaranty Agreement as a satisfactory way for assuring
financial capability to perform the proposed contract (preaward) or the existing
contract (for contract completions in postaward). Coordinate this effort with
the Administrative Contracting Officer (ACO) or Corporate ACO (CACO) cognizant
over the Contractor when putting a Guaranty into place. Particular caution
is encouraged with Guaranty Agreements: First of all, understand the
Guarantor's relationship to the contractor or contracting entity, be sure the
legal structure and relationship is understood . Then, the analyst should
determine that the Guarantor is financially capable of supporting the
commitments made in the agreement. In short, in many cases, a
financial check must be made of the Guarantor. In addition, guaranty
agreements done by a Guarantor using their forms and language instead of
1620 must be reviewed by DCMA Legal Counsel prior to execution.
There will be times the contractor will want to use their own Guaranty
Agreement form or language and it may be acceptable but must be determined by
DCMA Legal Counsel before accepting/ executing. Also, the form can be modified
with legal guidance to make it work for an individual
3. Offeror Obtains Deferred Payment Arrangements for Material, etc. The offeror may get financial relief by requesting a supplier to defer payments until after the contract is completed. This should be part of the offeror's financial plan for demonstrating financial capability to perform. If the future supplier is willing to defer payments until after contract completion, the offeror should arrange with the supplier to promptly furnish the analyst an appropriate letter deferring payments. The letter should be specific regarding the amount and the duration of such deferred payments. The letter should be signed by an authorized representative of the supplier. The DCMA Analyst should also determine that deferred payment does not adversely effect the financial viability of the supplier.
C. Obtaining Additional Fixed Assets: If the potential contract will require the offeror to acquire additional fixed assets, increased working capital will be required for the down payment and monthly or quarterly payments. When the equipment is to be obtained by lease, working capital also will be needed. In this area, coordinate the need for the production equipment with the preaward monitor to assure the proposed equipment purchase or lease is required to perform the contract.
D. Progress Payments: There have been
indications that some contractors are improperly accounting for progress
payments as sales, instead of treating them as liabilities. This
has the effect of inflating working capital, unless a contra-asset account is
offset against work-in-progress. The preferred accounting treatment is to
debit a current asset account (e.g., Progress Payments Receivable) and credit a
current liability account (e.g., Unliquidated Progress
1. While the exact point at which a sale occurs might involve complicated legal question most accountants treat the point of sale as the point at which delivery takes place. Payments received in advance from customers give rise to a liability for the delivery of goods or services. The advance payments are originally recorded as liabilities and are then transferred from the liability account to the revenue account when delivered. Accounting Research Bulletin No. 43 specifically includes among current liabilities, advance payments for the delivery of goods or the performance of services in the normal course of operations. This treatment is correct for two reasons: (i) the advance is a current financing transaction rather than revenue producing, and (ii) the obligation to provide goods and services is generally a part of current operations.
2. An acceptable (although not preferable) alternative method of accounting for progress payments involves the use of a contra-asset account. This account is set up to record a subtraction from a related asset account which is reporting a positive balance. For example, a contractor who debits Progress Payments Receivable and credits Sales at the time of a progress payment would then be required to debit Cost of Sales and credit a contra-asset account (e.g., Progress Payments - US Government). The latter should be shown on the balance sheet as a deduction from the current asset account, Work-In-Progress.
3. Under either the preferable or alternative treatment, the computation of working capital would yield identical results. There are situations where revenue may be recognized at the time of production. However, this is more applicable to long-term construction contracts where failure to accrue revenue during the life of the contract would lead to considerable erratic fluctuations in reported revenues from one year to the next. For example, the "percentage of completion" method might be appropriate when an aircraft carrier is under construction.
4. FAR 32.0, "Contract Financing," and DCAAM 7640.1, "DCAA Contract Audit Manual" stress that contractors' accounting systems and controls must be adequate for the proper administration of progress payments. In order to comply with the above procedures and regulations, DCAA is often requested to review contractors' accounting systems to ensure that they are adequate for the proper administration of progress payments. It is DCMA's understanding, however, that auditors concentrate more on contractors' systems for cost accumulation rather than on how progress payments are treated on the balance sheet.
5. The DCMA Analyst should thoroughly review the financial statements of contractors who are receiving progress payments and who possess marginal financial capabilities. By identifying what accounts are charged at the time of progress payments, the analyst will be able to perform a more accurate evaluation of the contractor's working capital and determine if it is adequate to finance the current production backlog as well as the potential contract. If problems appear to exist, then DCAA may be requested to provide additional input relative to the contractor's specific treatment of progress payments.
6. The DCMA Analyst may also be able to uncover potential problems by comparing the unliquidated progress payment amount on a contractor's balance sheet to the contractor's total unliquidated progress payment amount indicated in the MOCAS reports. A significant difference could indicate that progress payments are not being properly accounted for. If a contractor's sales volume is known to be small, financial statements reporting significant sales and work-in-progress figures could be another indication of improper accounting treatment of progress payments.
SECTION VIII - COMPLETING THE PREAWARD FINANCIAL SURVEY
When financial information, including cash flow projection data (when applicable), has been reviewed, analyzed, and evaluated, the DCMA Analyst should prepare a report with rationale to support the conclusion for an affirmative or negative financial recommendation.
A. Support Your Recommendation: The report format and rationale to support your conclusions and recommendation should be prepared in accordance with SF 1407. It may be necessary for the DCMA Analyst to adjust the offeror's balance sheet data. Place an asterisk by the total as indicated below and explain your adjustments.
Current Assets $ ___________________*
Current Liabilities $ ___________________*
Working Capital $ ___________________*
Net Worth $ ___________________**
* Changes affecting working capital (list of accounts and their amounts)
** Changes affecting net worth (list of account and their amounts)
B. Completing Section I of SF 1407: Completion of Section I of SF 1407 is your most important contribution to the PAS. Your narrative should be concise, but thorough. Check with PAS monitor for current forms.
In response to Solicitation No. ________________________,
(Contractor]_________________ has submitted a bid of $ __________
to provide _____________________
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APPENDIX B - FURTHER
An academic library serving a business school would have a good selection of financial evaluation/analysis textbooks and materials. Check your local libraries, which should have some of these types of books. Here are some that have been used for reference in the past. For most recent publications and reference material, check the Web, use Google or Yahoo search engine for books on Interpreting Financial Statements, Reading, Understanding Financial Statements, Financial Liquidity Ratios, Cash Flow Analysis, etc.
Ameliss, Albert P. & Kargas, Nicholas A. Accountant's Desk Handbook. 3rd ed. 720 p. 05/1988. Hardcover text edition . (ISBN 0-13-001877-5, ). Prentice Hall. Try a web search on this and you will find an updated version 1989 , very limited availability.
Bernstein, Leopold A. Financial Statement Analysis Theory, Application & Interpretation. 5th ed. 05/1998. Irwin/McGraw Hill.
Droms, William G. Finance and Accounting for Non-Financial Managers: All the Basics You Need to Know 5th ed. ISBN 0738208183
Kimmel, Paul D; Weygandt, Jerry J; Kieso, Donald E. Financial Accounting 2nd ed. May 1997. Wiley, John & Sons, Inc. 4th package edition, Sept 2002. (Kimmel, Paul D has authored many other related text/reference books which a web search will reveal.)
Moody's Risk Management Course handbook, Principles of Credit Analysis 1999 ed.
Simini, Joseph P. Balance Sheet Basics for Nonfinancial Mangers, 02/1990, Hardcover text edition. $24.95. (ISBN 0-471-61418-1). Paperback text edition,. (ISBN 0-471-61833-0). Wiley, John, & Sons, Incorporated.
Tracy, John A. How to Read a Financial Report- for Managers, Entrepreneurs, Lenders, Lawyers, and Investors 4th ed. Wiley, John & Sons, Inc.
Tracy, John A. How to Read A Financial Report: Wringing Vital Signs Out of the Numbers, avail in 5th ed. Paperback