Contractor's Financial Capability
Contents |
14-300 Section 3 – Assessing a Contractor’s Financial Capability
14-301 Introduction **
a. Financial capability audits are performed to determine if a contractor is financially capable of performing on Government contracts as required by FAR 9.104-1(a) and DFARS 232.072. Contractor financial difficulties may disrupt production schedules, cause inefficient use of resources, and result in contract nonperformance. These conditions may also result in monetary loss to the Government on guaranteed loans and progress payments.
b. Financial capability audits are performed by DCAA when requested by the contracting officer due to unique circumstances requiring DCAA audit assistance (see 14-302). Occasionally, DFAS will request financial capability audits on contractors requesting installment agreements on debts owed to the U.S. Government (see 14-307). In all audit situations, auditors should be alert to conditions which may indicate unfavorable or adverse financial conditions or other circumstances which could impede a contractor’s ability to perform on Government contracts (see 2-306.1c).
c. Early detection of contractors in financial distress allows maximum flexibility for the Government to:
- (1) avoid loss of critical products or services,
- (2) increase or decrease interim financing,
- (3) protect Government property and inventory with subordination agreement and
prompt removal of completed items,
- (4) increase or decrease volume of workload to the contractor,
- (5) alert the contractor of Government concerns so extraordinary actions can be taken early,
- (6) develop alternative sources, and
- (7) avoid financial loss.
d. Early detection of contractors in financial distress allows maximum financial flexibility for the contractor to consider extraordinary management actions such as:
- (1) liquidating assets by reducing excess plant and equipment,
- (2) borrowing money, expanding lines of credit or restructuring debt,
- (3) reducing or delaying capital expenditures,
- (4) increasing ownership equity,
- (5) eliminating unprofitable product lines,
- (6) eliminating or subleasing of equipment and idle space, and
- (7) reducing and reorganizing the workforce.
e. The request for a financial capability audit places emphasis on evaluating the contractor's current financial condition and trends, near-term cash flows, and ability to obtain funds outside the normal course of operations. While the evaluation of historical financial data during the financial condition risk assessment can indicate unfavorable or adverse financial conditions, the audit focus is on the contractor's ability to maintain future cash flows to sustain performance on Government contracts.
f. In considering contractor financial capability, the auditor will encounter several terms (including terms with specific legal meaning) that are commonly used by financial analysts. Some of these terms, which will be used throughout this section, are listed below.
- (1) Bankruptcy. A legal recognition of the state of insolvency, initiated for the benefit of creditors with unpaid and unsecured debts. Voluntary bankruptcy involves an assignment of assets by the debtor for the benefit of the creditors, while involuntary bankruptcy is initiated by an unsecured creditor.
- (2) Business Failure. An entity's inability to succeed in selling its products or services, meet its obligations, and/or earn a satisfactory rate of return. A business failure may not lead to bankruptcy because the owners may choose to terminate or sell the business.
- (3) Cash Management Plan. A corporation’s procedures for monitoring, analyzing, and managing its business’ cash flows.
- (4) Cash Sweep. The automatic transfer of cash into a centralized bank account by the entities of multi-segmented corporations to assist the parent company in the management of the cash needs of the entire corporation.
- (5) Default. The failure to do something required by duty or law. The term is normally used in context of the failure to meet the conditions of a contract.
- (6) Financial Capability. The prospective financial status of a contractor based on historical and forecasted financial data of the contractor.
- (7) Financial Condition. The current financial status of a contractor based on historical financial data of the contractor.
- (8) Financial Distress. A condition of being under financial pressure (caused by difficulty in meeting ongoing cash obligations) which may require extraordinary management actions to obtain additional funds outside the course of ordinary operations. “Extraordinary management actions” include the ability to borrow from a variety of sources, to raise equity capital, to sell and redeploy assets, and to adjust the level and the direction of operations in order to meet changing circumstances. Financial distress can be brought on by circumstances such as reduced cash flows from operations, customer payment defaults, excessive debt and related interest expense,
competition in the marketplace, adverse legal actions, and changing business environment or economics.
- (9) Financial Flexibility. An entity’s ability to take effective actions to control amounts and timing of cash flows so it can respond to unexpected needs and opportunities.
- (10) Guaranty. A legal agreement by one party to assume the debt or perform an obligation of a second party in the event of the second party’s default. Parent companies may execute a guaranty to ensure contract performance continues regardless of the default by one or more of its subsidiaries.
- (11) Insolvency. Insolvency occurs when an entity cannot pay obligations as they come due. Insolvency may be a temporary condition resulting from a mismatch between cash inflows and cash outflows. Insolvency in the context of bankruptcy occurs when an entity's financial condition is such that total liabilities exceed the fair market value of assets.
- (12) Liquidation. Liquidation is the process of closing a business entity, including selling assets, paying liabilities, and returning the residual to its owners. Partial liquidation would occur when an entity is involved in the piecemeal sale of a significant percentage of its assets.
- (13) Long-term. Being in effect for more than one year.
- (14) Near-term. Being in effect for up to one year.
- (15) Off-Balance Sheet Arrangements. Off-balance sheet arrangements involve, but are not limited to, unconsolidated, non-independent, limited purpose entities, often referred to as structured finance or special purpose entities. These entities may be in the form of corporations, partnerships, limited liability companies, trusts, structured finance entities or other types of agreements, relationships or understandings. These
entities may be used to provide financing, liquidity, market risk or credit support, or involve leasing, hedging, and/or research and development services.
- (16) Related Party Transactions. Related party transactions are business arrangements between two or more parties if one party controls or can significantly influence the other. Examples of related party transactions include transactions between:
- (a) a parent company and its subsidiaries,
- (b) subsidiaries of a common parent,
- (c) an enterprise and trusts for the benefit of employees, such as pension and profit-sharing trusts that are managed by or under the trusteeship of the enterprise’s management, *(d) an enterprise and its principal owners, management, or members of their immediate families, and
- (e) affiliates.
14-302 Responsibilities
a. DFARS 232.072 requires the contracting officer to make a determination of financial responsibility and provides suggested policies and procedures for making this evaluation.
As such, the Defense Contract Management Agency (DCMA) established its Financial Capability Group (FCG) to perform all financial analysis for the Department including preaward financial analysis (see 5-202), post award financial surveillance (see 5-203), and the monitoring of contracts receiving financing payments (i.e. progress payments, see 14-203). Buying activities that require financial capability reviews in relation to a contractor’s bid on a specific solicitation (preaward) should submit requests to the contracting officer...
14-303 Financial Capability Detailed Risk Assessment Procedures
d. Trend Analysis of Key Financial Statement Ratios
(1) Financial statements provide a primary indication of a contractor's financial condition. The ratio analysis concept is that as a business deteriorates so too will the key ratios. At contractor locations where the majority of these ratios are experiencing a negative or unfavorable trend, the auditor will normally perform a financial capability audit. The analysis of key financial ratios is an important consideration when evaluating a contractor’s financial condition; however, they must be used with care. General rules of thumb regarding acceptable ratios should be avoided.
| Ratio | Formula | Description |
|---|---|---|
| Current Ratio | Current Assets/Current Liabilities | This ratio measures a company's ability to pay its short-term liabilities from short-term assets. |
| Quick Ratio | Liquid Assets/Current Liabilities | This ratio measures a company's ability to pay off its short-term obligations from assets readily convertible to cash. |
| Return on Investment(ROI) | Net Income/Total Assets | This ratio is a measure of economic performance and is used as an indicator of management’s effectiveness, a measure of a company's ability to earn a satisfactory return on
investment, and a method of projecting earnings. |
| Debt to Equity Ratio | Total Debt/ Stockholders Equity | This ratio assists in determining the relative size of the claims of creditors compared to the claims of owners. High levels of debt can restrict management and increase risk to owners. |
| Capital Turnover Ratio | Working Capital (Current Assets - Current Liabilities)/Total Assets | This ratio measures the net liquid assets of the company relative to its total capitalization. Ordinarily a firm experiencing
consistent operating losses will have shrinking current assets in relation to total assets |
| Cash Flow to Debt | Cash Flow (Net Income + Depreciation + Depletion + Amortization)/Total Debt | This ratio is an indicator of the adequacy of available funds to satisfy debt obligations. |
| Cash Flow to Sales | Cash from Operations/Sales | This ratio shows the percentage of each sales dollar realized as cash from operations. |
| Debt Coverage | Total Debt/Cash from Operations | This ratio estimates how many years it will take to retire all debt at the current level of cash from operations |
