Get In The Drivers Seat Of Lending To Automobile Dealerships

Generating more than 20% of retail sales in1997, automotive retailing has established itselfas the largest retail trade sector in the U.S.

Approximately 19,500 automobile dealership locationsrepresent more than 40,000 franchised domestic andimport dealerships in this highly fragmented and largelyprivately held industry.1

The New Models Get AttentionSignificant change has come to automotive retailing.

Small mom-and-pop dealerships are quickly giving way tomega-dealers and public dealer groups—with 10 to morethan 50 dealerships—that achieve economies of scale andproduce revenues from $200 million to $2.2 billion. Theirhigh-growth strategies involve aggressively purchasingacquisition candidates throughout the country, seekingcontinued revenue growth, quick market penetration, andproduct line diversification.

Public dealer groups and private mega-dealers alikequickly accumulate critical mass, commanding reducedadvertising rates, lower supplier and vendor prices, andreduced financing costs. In addition to creating enor-mous competitive pressures for small dealerships, thesenew dealer structures have transformed traditional floorplan financing methods to include issuing equities,obtaining large credit facilities for inventory, workingcapital and acquisition financing, borrowing-based cer-tificates, and commercial paper conduits.

The recent industry revolution has allowed whatwas once an entrepreneurial business catered to by cap-tive and noncaptive auto finance institutions to becomea high-profile, high-dollar industry that attracts numer-ous commercial and investment banks. Competingbanks and auto finance companies have quickly pene-trated the market and, as a result, it is not uncommon tosee a dealership or dealer group with four or more

42 The Journal of Lending & Credit Risk Management November 1998

LENDING TO AUTO DEALERSHIPS

Identifying the various types of credit structures and their associated

risks is key to understanding and lending to automobile dealerships.

This article looks at issues and financial methodology pertinent to

automobile retailing. Next month, the author examines credit risk man-

agement issues for lenders to auto dealerships.

Get in the Driver’s Seat ofLending to Automobile Dealerships

by Erik Day

© 1998 by RMA. Day is dealer credit manager for World Omni Financial Corp. (WOFC), Deerfield Beach, Florida;before that, Day served as an account manager for Ford Motor Credit Company, Coral Springs, Florida. WOFC is asubsidiary of JM Family Enterprises, Inc., with more than $5 billion in annual revenues. Established in 1981 as thecaptive finance source for southeastern Toyota franchise dealers, WOFC currently manages more than $1 billion incommercial loans as a dedicated national auto finance company.

financing proposals to consider. Knowing this, dealershave negotiated from a position of strength with the var-ious financial institutions, driving down interest ratesand creating more flexible terms as the stakes increase.

Several years of a strong economy have fostered anenvironment focused on portfolio growth and not disci-plined lending. As a result, credit standards have slipped,leading to the OCC’s recently published concerns aboutcommercial lending in the banking community. It isimportant that the lender requires proper capitalization,prices according to actual risk, and implements financialcovenants. This is especially true of the automotive indus-try, which has afforded most dealerships continued rev-enue growth since 1991.

An Overview of the DealerDepending on the business model of the customer, a

financing request can present an array of needs andissues. The savvy lender first analyzes the big pictureand asks the types of questions that ultimately save timeand money. Next, the lender determines if the requestedcredit facility fits within the lending institution’s parame-ters and whether or not internal controls and resourcesexist to efficiently manage the associated risks.Following are some issues to consider when doing busi-ness with an automobile dealership.

Financing request. A traditional automobile dealer-ship typically seeks direct floor plan financing, and ifneeded, a mortgage and/or working capital loan. Largerdealer groups or public dealers may go the route of pri-vate credit facilities in which a finance company has theopportunity to become the lead agent or syndicatelender.

If it’s a traditional floor plan financing relationship,the lender ensures that the requested credit lines arewarranted by determining if the credit lines are com-mensurate with the inventory turn rates. This is done bycalculating the dealer’s 12-month rolling rate of travelfor new and used vehicles and multiplying it by theaverage cost of goods sold for new and used vehicles,respectively. This should provide a good guideline. Thelender must include a buffer to account for seasonalityand model build-outs. If the request is far above whatthe dealer warrants, a question should be raised.

If the dealer owns the real estate, it’s important tomake sure that the mortgage request appears logical andthat proper due diligence is performed, including anenvironmental study and MAI appraisal. This is an

important decision because of increased risks associatedwith real estate lending and the lower returns received ifborrowing costs are higher for mortgage loans. Also,because the real estate being lent against has a specificuse, it becomes difficult to sell the real estate for otherpurposes. The safest approach is to advance 80% of the“cost approach” appraised value. In the event of liquida-tion, word of a “fire sale” is spread amongst the dealerbody quickly, rapidly deteriorating the perceived marketvalue.

Capital loans can take many forms, but the collateralis generally the same. The best approach, whether using aborrowing-base certificate, revolver, or term note, is toidentify which assets are eligible—usually receivables,used vehicle equity, parts and accessories, and fixedassets (less leasehold improvements). Once this is done,the assets are scaled to account for receivable and inven-tory aging, as well as asset depreciation and a percentageof this amount is advanced. The dealer should be requiredto submit monthly schedules for use in monitoring thecollateral eligibility and loan-to-value. Although conser-vative, this method reduces a lender’s risk exposure andforces a dealership to manage its accounting operationsbetter.

Business overview. Consideration must be made asto how long the dealer or dealers have been in business,the marketplace in which they operate, and how the busi-ness is run. As with most businesses, longevity indicatesthe ability to withstand economic fluctuations. However,being in business a long time does not mean that a dealerhas been operating properly or is not exposed to unduerisks from changes in economic conditions, decliningproduct line demand, or even increased competition.

The lender also must understand how a particulardealer or dealer group operates. It is of utmost impor-tance for a public dealer group to report consistent earn-ings to both managers and shareholders. Financial infor-mation is fairly straightforward because the financialstatements must comply with Securities and ExchangeCommission requirements and are subject to publicscrutiny. There are, however, increased risks due to sig-nificant lending concentrations and the abundance offinancial data to analyze. Many lenders lookat the total group performance, but it’snecessary to get down to the individualdealership level to learn which dealersare the under-performers, their finan-cial contribution to the group, and the

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L e n d i n g t o A u t o m o b i l e D e a l e r s h i p s

risks that they present.Public dealer groups represent just 5% of the indus-

try; this means that most dealerships are privately held.Traditionally, privately held dealerships have concentrat-ed on generating as much cash flow as possible while atthe same time reporting minimal taxable income. Manyof these dealers operate as S corporations, managingcash earnings to minimize personal tax exposure. Someutilize management companies, which hold the majorityof cash and act as a pass-through for earnings generatedby the dealership. Others pad expenses, typicallythrough higher rent expense or management fees, asanother means of tax management. Whatever the case,the lender must make sure that there is a thoroughunderstanding of cash flow. The factory financial state-ments do not always tell the truth—positive or negative.If the sales volume is there but the bottom line doesn’tseem to add up, it’s necessary to investigate the opera-tions further or determine if the dealer principal is usingcash for other purposes, such as purchasing an addition-al dealership, real estate investments, or paying off notesheld by the prior owner.

Furthermore, the lender needs to understand how thedealer or dealer group derives the majority of its earn-ings. There are essentially five departments (new vehicle,used vehicle, service, parts and accessories, and bodyshop) from which to generate cash flow; the lendershould learn the dealership’s dependency upon any par-ticular department. For example, most dealers losemoney in the new vehicle department due to its low mar-gins, placing weighted importance on the other depart-ments. Also, if the dealer has declining customer reten-tion from increased competition or poor management,the back end or “fixed operations” also can experience adecline, reducing expense absorption and placing moreemphasis on the used vehicle department for profitability.Knowing this helps a lender to understand the customerbetter and allow for focused risk assessment.

Dealer principal(s). Many owners are hands-on andpossess numerous years of experience in the automotiveindustry. However, other dealers have what’s known asan “inactive” owner, typically relying on a general man-ager for overseeing the day-to-day operations. A lendermust be comfortable with the owner or general manag-er’s ability to run a dealership. The lender should besure to get a resume from the owner detailing his/herexperience and should find out what automotive associa-tions they belong to. Ideally, the owner is hands-on,

demonstrating a commitment to his/her business. If not,the lender should keep in mind that most fraud happenswith absentee ownership. If a dealership involves aninactive owner, the lender should obtain backgroundinformation on the general manager from the manufac-turer as well as references from other dealerships he/shehas worked at in the past.

The second part in analyzing the dealer principals isdetermining their ability to provide secondary financialsupport. For the most part, the majority of an owner’s networth is associated with the investment in the dealershipand, potentially, some real estate investments. It’s impor-tant to adjust the personal financial statement to get anaccurate depiction of an owner’s true liquidity or abilityto access capital for needed injection. Also, obtaining apersonal “continuing” guarantee from the owner shows acommitment to the business and provides a lender withmeans to pursue any deficiency balances in the event ofdefault.

Franchise mix. Diversification is key to offsettingmarket exposures. An automotive lender needs to be cog-nizant of the various franchises and their viability in theindustry as well as the immediate demographic market.Automotive manufacturers can contribute to increasedrisks from declining product demand, low product linemargins, franchise encroachment, such changing factorydirectives as requiring a particular franchise to be standalone as opposed to dualed with additional franchises, andthe inability to supply enough or the right mix of vehicleinventory.

To gain a better understanding of a dealer’s productlines and how the business fairs in the marketplace, alender can look at:• Manufacturer performance reports from the dealer

that indicate how the dealer or dealers are perform-ing in comparison to other dealerships in the imme-diate zone, region, or nation.

• Industry periodicals such as Automotive News2 pro-vide market data by franchise as well as overallindustry trends.

• Resources on the Internet can also assist a lender indetermining how many and what type of competingfranchises are within the dealers geographic region.

4. Demographic data from the various resources madeavailable on the Internet can help to determinewhether or not a viable customer base exists.

Processing days. In short, processing days are the



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number of days a dealer has before it is required to payoff a sold vehicle. Industry standard runs between threeand five days. However, many lenders have become laxin this area in order to sustain competitiveness in themarket place. Consequently, processing days have beenallotted at 10 or even 15 days, depending on geographicregion. Processing days are a key element in managingrisk, specifically, the dealer’s ability to “float” money.Often abused, unbeknownst to the lender, processingdays are a key element and first line of defense in spot-ting potential problems that may lead to what’s knownas a “Sold Out of Trust” situation. This means that thedealership has received the proceeds of the retail orlease contract and, instead of paying off the associatedliability, uses funds to satisfy other financial needs oreven diverts funds in fraudulent tactics.

A lender should keep in mind that in today’s mar-ketplace a dealer receives funding on retail/lease con-tracts within 48 hours. Deals that involve marginalcredit may take longer due to the numerous financesources and requirements needed to get subprime cus-tomers approved. However, dealers that take longerthan five days to pay off a vehicle that’s been sold gen-erally have the following problems:• The paperwork flow from the finance and insur-

ance (F&I) department to accounting is slow, caus-ing delayed processing and leading to “frozencash.”

• The dealer has a high volume of used car sales,which typically involves an extended approvalprocess for credit-challenged customers.

• Cash flow is tight and proceeds are used for opera-tional needs rather than paying off the sold collater-al.

The latter is most severe because the dealership is obvi-ously having liquidity problems.

Advance rates and curtailments. When providingfloor plan financing, the industry standard is to definespecific vehicle advance rates and require principle cur-tailments to maintain acceptable loan-to-value ratios.The following guidelines should be considered:• Advance 100% of dealer invoice on all new unti-

tled vehicles, which are then subject to monthlyprinciple curtailments in the following year so as todepreciate the vehicle when the new model yearbegins. All “prior year” models should be paid offor moved to the used vehicle floor plan line bySeptember to make way for the new models. A

lender can secure a repurchase agreement from themanufacturer that allows for financial recovery inthe event of default.

• Advance 80% of the National Automobile DealersAssociation (N.A.D.A.) trade-in value or BlackBook “clean”3 amount on all used vehicles that arereceived as trade-ins. Furthermore, depending onhow well the dealer manages the used vehicle inven-tory, it is common practice to require a principlereduction after 90 days and full pay-off after 120days. This forces the dealer to buy the right invento-ry and avoid taking higher losses than necessary.Also, in the event of default, sufficient loan-to-valuemargins exist to recoup losses by wholesaling thevehicles through an auction.

• Advance 100% of the purchase price on used vehi-cles purchased at a reputable auction. Although it isa higher advance rate, this trend has arisen due tothe large amount of lease turnbacks. These vehiclesshould be less than three or four years old and havea mileage limitation. Additionally, principle curtail-ments should be made as noted above to preserveproper loan to value ratios.

Fees. Lenders typically charge administrative feeson each vehicle placed on floor plan to offset expensesassociated with processing the paperwork. This practicealso helps to increase the yield. Fees generally run from$1-$3 per vehicle; because of increasing competition,however, many lenders have avoided charging them toretain a relationship or improve the chances in obtain-ing one.

Demos. Many dealers use demos for their man-agers and even to award top-performing sales associ-ates. However, a lender needs to keep this to a limit toavoid additional risk. Generally, limiting a dealer to 10or 20 demos, depending on the size of the dealership, isindustry standard. The main items to focus on are:• The dealer uses only new vehicles.• Mileage limitations are set (usually 5,000).• The policy is not abused so as to make it difficult

to see the collateral on inventory inspections.

Service loaners. Dealersmay loan vehicles to cus-tomers while their vehicle isbeing repaired or serviced. Ifthe dealer requires a line of


credit for this, make sure the vehicles are subject toprinciple curtailments to account for depreciation,implement mileage limitations, and inspect contractualdocumentation with the customer using the vehicle.

Fleet line. If the deal includes a fleet line, dealersrequire a delayed payment program allowing additionaltime, typically 20 days, to pay off vehicles that are soldto their fleet customers. A lender must ensure there areinternal controls to monitor this on a daily basis due tothe potential loss exposure. When the vehicle is sold, thecollateral is gone. To offset this risk, the lender shouldreceive an assignment of proceeds from all fleet cus-tomers and, depending on the fleet customer, determinethe financial viability of repayment in the event thedealer is in liquidation.

Rental cars. Many dealers now have a dealer rent-a-car (DRAC) operation. Once again, before going forwardwith a request that involves a DRAC line, a lendershould determine if the internal controls exist to monitorthis account. Typically, a 2% monthly principle curtail-ment is assessed to ensure the vehicles are depreciated tothe proper asset value. Also, a lender needs to ensure thatno fraudulent activity is taking place. This is mitigatedby proper audit procedures involving inspection of the“rental agreements,” noting the customer names, rentaldates, and vehicle information. Monthly monitoring iscrucial to ensuring that vehicles are being used properly.

The issues presented above should be used as aguideline or general thought process when doing busi-ness with a dealer or dealer group. Each transaction isdifferent and may involve additional risks. However,having a basic foundation from which to draw uponassists the lender in reducing risk and provides a greatercomfort level.

Financial AnalysisThere are approximately 24 different manufacturer

financial statements that a lender may need to analyze.The format across each manufacturer is generally thesame with a few exceptions that will be pointed out laterin this article. The financial statements are presented intwo parts—a balance sheet and a profit-and-loss state-ment (P&L). The P&L allows for further detail bybreaking out performance by department—new, used,service, body shop, and parts and service. A thoroughreview of dealership financial statements should include

analysis of operating trends, liquidity and leverageratios, and inventory management. Most dealerships aretoo small to warrant CPA audited statements. Even so,prudent analysis of either format should be paramount.

To begin, the lender should spread financial data onthe last two year-ends, the most recent year-to-date, and,if desired, the prior year interim period. With respect tothe year-end statements, the lender should be aware thatmost dealerships produce what’s known in the industryas a twelfth- and thirteenth-month financial statement.The thirteenth-month statement reflects the year-endadjustments, usually tax-related, such as LIFO and usedvehicle write-downs. However, some dealerships don’tproduce a thirteenth-month statement; instead, they postadjusting entries later in the following year, identifiedby a significant change in retained earnings. To avoidconfusion, the lender should try to get the thirteenth-month statement with a detailed breakout of the adjust-ing entries. This provides a more accurate picture of thedealership’s ability to generate cash flow since mostentries are noncash charges.

P&L StatementAnalysis of operating trends on a dealership

requires understanding the role of all the profit centers.Profit centers or departments are grouped into what’sknown as “front end” operations, which are the new andused vehicle departments, and “back end” or “fixed”operations, which include the service, body shop, andparts and accessories departments. Front end operationstypically produce the majority of a dealership’s salesmix, usually in excess of 80%. A good dealership, how-ever, should possess strong fixed operations so as tominimize reliance upon vehicle sales for profitabilityand to help absorb operating and overhead expenses.

Before analyzing operating trends of a dealership,it’s important for the lender to have a good knowledgeof how the departments operate. The following informa-tion is a departmental overview:

New vehicle department. New vehicles are some-thing of a commodity because the price, for the most part,is standardized throughout the dealer body. Consequently,competition forces very low margins. Most dealers relyon high-volume sales, factory-to-dealer incentives, andback end income (F&I or service contracts) to sustainprofitability in this department.

First, a lender should look for stable sales growth inthe new vehicle department, identify dependencies upon



a particular product line or model, if applicable, and beaware that some dealers may sign large fleet contracts,significantly increasing sales volume. If dealers signlarge fleet contracts, grosses in the department will prob-ably not increase materially due to the extremely lowmargins associated with fleet sales.

Second, the lender should look at the gross profitper new vehicle based on the front end sale and thendetermine the total gross profit per new vehicle. Indoing so, the lender should account for back end grossesgenerated from F&I or service contracts. The data arethen compared with similar dealerships in the lender’sportfolio or, for further analysis, the lender may usesuch industry data as the N.A.D.A. average dealershipprofile—published on a monthly basis. This analysisindicates how the dealership’s sales environment isdoing in conjunction with the F&I business unit. Theaverage dealership grosses around $1,200 per unit onthe front end sale and can generate anywhere from $300to $600 in back end grosses from the F&I business unit.However, front end and back end grosses can fluctuatedue to differing product lines and local competition.

Variances in how a dealership books its factoryincentives, as well as the changes required for reportingLIFO, can affect margins greatly, potentially skewingcomparisons if the financial statements present data dif-ferently. Some dealerships post factory incentives asgrosses in the new vehicle department while others postit as “other income.” In addition, prior to 1998, LIFOadjustments were made in the gross profit section of theapplicable department but are now required to be listedas additions or deductions to income. In the past, dealer-ships that had large LIFO adjustments were, in effect,understating gross profit. So if comparing two dealer-ships, the lender needs to make sure the numbers areconsistent.

Finally, the lender should analyze how well the deal-ership is managing its new vehicle inventory. Industrystandard is around 60 days, but this can fluctuate due tomanufacturer model build-outs and vehicle allocationissues. It is better to calculate the days’ supply of newvehicle inventory in units as opposed to dollars. Somedealers build a “pack” into the inventory value, whichmay simply be a fee collected by the owner upon sale.There could be additional assets in these accounts, all ofwhich will skew the data further. The lender also needsto back out any units designated as demos, service loan-ers, or rental vehicles to obtain an accurate measurement.

Used vehicle department. The used vehicle depart-ment, on average, is one of the more profitable depart-ments due to its ability to achieve higher margins.However, there are circumstances that deteriorate grosseson the front end sale. These situations occur from poortrade-in valuations, poor inventory purchasing, highreconditioning expenses, charge-backs fromrepossessions, and wholesale losses. As a result, the aver-age dealership generates around $1,300 on the front endwhile back end income can range from $300 to $800,depending on the dealership and its customer base. Backend income is higher in the used vehicle departmentbecause used vehicles may require extended warranties,attract subprime credit customers who pay higher interestrates, or involve various types of insurance for disabilitiesor payment preservation.

As in the new vehicle department, the lender shouldfirst look for stable sales volume and gross profits. Ifmargins decline or indicate a large variance from anoth-er comparison, the lender should focus on the contribut-ing factors outlined above. If, for example, the dealer-ship has a lot of C/D (subprime) paper, it may experi-ence a significant amount of charge-backs from repos-sessions. Dealers receive a split of the proceeds generat-ed by the F&I business unit, which is typically set at70% up front and the remaining 30% after six months orafter three payments are made by the customer. Uponsatisfaction, these “reserve” funds are paid to the dealer.However, if there is a high default rate, a dealer ischarged back this amount, offsetting grosses in thedepartment.

Also, if dealers are not buying the right mix or failto properly appraise trade-ins, they can experience largewholesale losses when the vehicles are sold at auction,further deteriorating grosses generated from retail sales.Once the vehicle is over the curb (sold), a dealershipmust do a lot more to preserve the gross profit.

As with the new vehicle department, the lendershould be aware of how LIFO adjustments are recordedin used vehicle inventory. This, too, can affect thedepartment’s total gross margin.

Finally, the lender should look at how well the usedvehicle inventory is managed. Again, the days’ supplyshould be around 45 days, if it’s astandard new vehicle franchisedealership. However, if it’s a“new car alternative” operationselling only used vehicles, thedays’ supply should be approxi-

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mately 60 days. It’s important that dealers turn theinventory quick enough to avoid aging issues that leadto declining grosses and additional cash flow outlaysfor principle reductions required by lenders.

Fixed operations. Fixed operations, on average,produce just 20% of a dealership’s sales. Due to grossmargins running in excess of 50%, however, fixed oper-ations can significantly offset operating and fixedexpenses, ultimately lowering the break-even point. Agood dealership should have overhead absorption ratesin excess of 50%, meaning that half the operating andfixed expenses are satisfied by the grosses generated inthe service, body shop, and parts and accessoriesdepartments. Furthermore, this illustrates that a dealer-ship is developing good customer retention rates. It’smuch easier to keep customer loyalty for future pur-chases if the vehicle is serviced or repaired at the origi-nal dealership.

As with the other departments, the lender shouldfirst look for positive trending sales and grosses fromfixed operations. If there are declines in performance,the dealer may have reduced advertising, changed man-agers, or experienced a lower sales volume that couldlead to a declining customer base.

Finally, the lender should ensure that parts andaccessories inventory is managed properly. A good ruleof thumb is for a dealer to have a one-and-a-half to twomonths’ supply. Some dealerships may do a lot ofwholesale business or have a body shop that requireshigher dollar levels than an average dealer, but theyshould still adhere to the same inventory turn rates.

Next steps. After analyzing the sales and grossprofit of the various departments, the next step is tolook at the expense structures and their effect on earn-ings.

Total expenses for a dealership should run 11-12%of total sales. If they are running far above this guide-line, a lender should look further to discover the reason.Expenses are broken down into three components—variable, operating, and overhead: • Variable expenses are associated with expenses

incurred from front end operations. A dealer canexperience problems in this area if sales associatesare paid overly high commissions or if inventorymanagement is poor. These translate, respectively,

into higher floor plan interest and excessive adver-tising costs. The industry standard is to pay salesassociates approximately 25% of the front endgross profit. The new and used vehicle departmentsfront end gross profit can be multiplied by 25% tosee if this amount is in line with the reportedexpenses. If not, the dealer may be paying too higha premium for sales associates. Floor plan interestshould run 0.50-0.65% of sales. If floor plan inter-est runs at a much higher rate, the dealer is carry-ing too much inventory, paying a high rate, orreceives what’s called “floor plan assistance” fromthe manufacturer—usually around $150 per newvehicle sold or 1.5% to 2.0% of the average newvehicle inventory value for the month. This money,rather than being posted as “other income,” issometimes posted as a credit to floor plan interestexpense. Consequently, it can produce a negativebalance in the account. These manufacturer pro-grams are not guaranteed, which should be a con-sideration if the lender compares similar dealer-ships or seeks to determine a conservative debtcoverage ratio. Advertising expenditures should run0.95-1.0% of sales; however, dealers can post cred-its to this expense if they receive co-op rebatesfrom the manufacturer. Also, some market areashave higher dealer concentrations requiring heavyadvertising to sustain customer volume.

• Operating expenses consist of personnel expensesand general expenditures associated with the costof doing business. The lender should focus on theowners’ salaries, other interest payable, and otherexpenses. Owners’ salaries should not approach thepoint of draining a major portion of earnings. Otherinterest payable may be money owed to a previousowner that holds a note or even a mortgage or capi-tal loan. Also, other expenses can be padded, suchas management fees paid to a holding company oreven document fees charged by the owner.Although decreasing the bottom-line performance,these other expenses can be factored in for cashflow purposes.

• Fixed expenses center around utilities and rent andequivalent expenditures. If the dealership leases thefacility from a third party, the only exposure is pay-ing rent above the market value. However, mostowners mortgage the property and lease the facility



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to the dealership entity. In doing so, it is very com-mon to charge excess rent as a means of extractingcash. The lender should be sure to factor this into acash flow analysis. After reviewing the primary components of the

P&L, the lender should focus on the profitability,determining whether or not core operations produce anoperating profit. If not, it’s due either to poor marginsor high expense structures. Also, depending on howthe dealer books incentive income, rebates, floor planassistance, and so forth, overall net profit can still bequite healthy. Profit margins should run 1.5-1.8% ofsales. Margins that run below this percentage do sobecause of poor operating trends or excess expensestaken out by the owner.

Balance SheetBalance sheet analysis should first consist of identi-

fying nonperforming assets or questionable accounts fol-lowed by liquidity and leverage ratio computations. It iscommon practice for dealership financial statements toinclude numerous nonperforming assets to meet the fran-chisor’s capital requirements. This also includes the useof off-balance sheet financing, which is very commonamong start-up operations.

The balance sheet items most commonly adjustedare as follows:• Vehicle, service, and parts receivables: Balances in

these accounts should be commensurate with thedealer’s sales volume. However, dealerships typi-cally include officer receivables, intercompanyreceivables, or employee receivables in theseaccounts. Furthermore, the lender should inquireabout aging receivables and get a copy of the deal-ership’s schedules.

• Used vehicle inventory: Be sure to get a copy ofthe dealership’s used vehicle aging report to seehow this inventory is managed and whether or notthe values on the books are commensurate with theN.A.D.A. wholesale trade-in value or anotherapplicable guide. If not, there is probably a lot ofwater in the inventory.

• Parts and accessories inventory: If the days’ supplyof inventory is high, the lender needs to inquireabout any parts and accessories more than 12months old. These are considered “obsolete” andshould be written off the books.

• Marketable securities: This account is usually a zerobalance. Some dealerships, however, use it as ameans to present goodwill or noncompete, falselyinflating the working capital.

• Pre-paid expenses: These assets are almost alwaysnonperforming and should be adjusted for a moreaccurate picture.

• Other nonautomotive investments: Again, theseassets usually do not relate to the core tradingassets of the dealership and should be adjusted.They typically include officer, employee, or inter-company receivables, goodwill, noncompete, orcapitalized expenses.

• Long-term debt: All factory financial statementsinclude a category for officer/owner debt. Somedealerships, however, choose not to present it in thespecified account. If the debt seems rather largeand there are no land and buildings as offsettingassets, chances are the debt is notes due to owners.This is a common practice since most dealershipsoperate as Sub-S corporations. Furthermore, if alender opts to obtain a “subordination agreement,”officer debt can be viewed as equity and factoredinto the leverage ratios.After making adjustments for intangibles and nonper-

forming assets, the lender should factor in any off-balancesheet financing. As noted before, many start-up dealerscreate a holding company to establish a borrower whilecollateralizing the loan with the assets of the dealership.This is done specifically to meet the franchise’s capitalrequirements. The money is then injected into the dealer-ship as paid-in-capital, effectively overstating the dealer-ship’s financial position.

Liquidity Ratios• Working capital as a percentage of guide: The

guide should be obtained from the financial state-ment. However, if the dealer neglects to present it,it can be obtained by contacting the market repre-sentative of the dealership’s applicable franchise.The dealership should possess 85-100% of the sug-gested guide.

• Current ratio: The dealershipshould possess a ratiobetween 1.15 and 1.40.Many dealerships presenttheir inventory on a LIFO basis,



understating the inventory assets. If this is true, thelender must add back 100% of LIFO Reserves intothe current assets. Although adding back 100% ofLIFO Reserves creates an unbalanced ratio calcula-tion, it gives a more accurate depiction of liquidity.

• Net cash to guide: A dealer should have enough netcash to cover 100% of its average month’s expens-es (guide). Many dealers choose to run operationsthin on cash to avoid exposure to embezzlementand other personnel risks. Consequently, the cash isput into other core trading assets, such as vehicleinventory, so that it’s available for use if needed.Net cash, an industry standard, is computed as fol-lows: [Cash in bank + Contracts in Transit +Vehicle Receivables (<30 days) + Holdback (<30days) + New & Used Inventory FIFO] - [VehicleLien Payoffs + Customer Deposits + Floor planpayables]. The lender should ensure that net cash,by itself, is positive. If it turns out to be a deficit,chances are the dealer is in a Sold Out Of Trustposition. This means that the dealer, probably tighton cash, has received the proceeds of sold (floorplanned) vehicles and, instead of paying off the lia-bility, has used the funds for other operational pur-poses. This is a telltale sign of major risk! Fur-thermore, the lender should see how much of thisNet Cash amount is due to used vehicle equity.Sometimes this can be overstated by inflated inven-tory values that stem from aging or “dealer packs.”On average, a dealer can access roughly 25% of theused car equity and readily convert it to cash bywholesaling the vehicle while at the same time notupsetting the mix of inventory in one of the mostintegral profit centers.

• EBITDA/Interest: A dealer should maintain a cov-erage ratio between 1.5 and 1.8. This ratio focusesmore on cash flow since many dealerships’ netprofit is usually understated because of aggressivetax adjustments that involve numerous noncashcharges to earnings. If the dealer receives floorplan assistance from the manufacturer and posts itas a credit to interest expense, the lender needs tofind out the amount of assistance received and backit out so as to obtain a conservative ratio. Thesetypes of incentive programs are not continual, sothe lender needs to be sure the dealer can generateenough cash if the assistance program stops.

Leverage Ratios• Debt to tangible net worth: An acceptable leverage

ratio should run between 3:1 and 5:1. Many lenderscompute this differently when underwriting com-mercial loans. However, the following format isrecommended when analyzing dealership financialstatements: [Total Liabilities - Subordinated Debt +40% of LIFO Reserves] / [Tangible Net Worth +Subordinated Debt + 60% of LIFO Reserves].Inclusion of subordinated debt should be discre-tionary, however, most Sub-S Corporations pullmoney out and put it back in as a note as a meansof managing tax issues.

• Net debt to tangible net worth: An acceptable ratioshould be 0.90 or less. This ratio is calculated thesame as above except floor plan liabilities arededucted from total liabilities. If the ratio is high,the dealership has a lot of nonfloor plan debt thatneeds to be investigated.

• Debt coverage: A dealer should possess a debt cov-erage ratio at or above 1.25. Simply stated, forevery dollar of debt, the dealer generates $1.25 incash. Again, this ratio may vary among lenders andindustries, but the following format is recommend-ed for automotive dealerships: [Net Profit +Interest Expense + Depreciation & Amortization +Rent or Mortgage + Change in LIFO (non-cashcharges)] / [Interest Expense + Actual Rent orMortgage (captures excess cash charges) + CurrentPortion Long Term Debt]. Also, if interest expenseis a credit balance due to the dealer posting floorplan assistance as an offset, back this portion out soas to obtain a more conservative number.

Due DiligenceThe final part of effectively mitigating risk expo-

sure on automobile dealerships is to perform properdue diligence before lending large amounts of money.This includes, but is not limited to, the following:• Book review of borrowers. This is not always

required but is recommended because of the highdollar amounts associated with these types of trans-actions.

• UCC-1 Searches at the state and county (if applica-ble) level on all borrowers. This assists in identify-ing any collateral issues or need forsubordination/inter-creditor agreements when tak-


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ing over a new relationship.• Personal credit investigation on the owners.• Background investigation on the dealers and own-

ers, which should include research on bankruptcies,tax liens, criminal charges, civil lawsuits, and assetownership.

• Trade creditor, depositing, and lending bank refer-ences, including a reference from the current floorplan source on historical audit performances.

• Repurchase agreements from the applicable manu-facturer(s), to provide an expeditious means to sellthe repossessed new vehicle inventory back to themanufacturer.

• Documentation including, but not limited to, cer-tificates of good standing, certified articles ofincorporation, copy of executed lease agreement(s)(if applicable), copy of franchise agreement(s), andinformation pertaining to real estate (if applicable)such as appraisal, environmental reports, and soforth.

ConclusionIf the underwriting process indicates an acceptable

credit risk based upon the financing request, and alender determines that it is willing to make the loan, theinformation in this article should provide a solid frame-work from which to progress to the loan documentationstage. Following these recommendations will help thelender feel more comfortable about doing business withautomobile dealerships.

To contact Day at WOFC, call 954-420-3359 or [email protected].

NOTES1 National Automobile Dealers Association; 19998 N.A.D.A. Data.

2 Automotive News is a publication of Crain Communications, Inc.

3 N.A.D.A. is a trademark of the National Automobile DealersAssociation. Black Book is a trademark of Hearst Business MediaCorporation.


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Get In The Drivers Seat Of Lending To Automobile Dealerships