If you own a well-established automobile dealership and have a strong credit rating; it is likely that you are carrying floor-plan debt that you rarely think anything about. Based on history, one may assume that the debt being carried is secured by specific automobiles included in the inventory of new and used vehicles. Be warned that this may not be a valid assumption.
Since the start of the COVID-19 pandemic, automobile sales (and margins) have skyrocketed, and inventory is difficult to obtain. As a result, certain lenders have grown lax on their underwriting of these loans.
Prior to the pandemic, it was common for dealerships to obtain funding for specific automobiles. The dealer would provide basic information such as the year, make, model and vehicle identification number and request a loan for a specific automobile. The lender in turn would loan the money to the dealer collateralizing that specific automobile.
Since the pandemic, dealerships have been flushed with cash, resulting in many dealerships achieving profit margins on both new and used vehicles – more than their historical results. Of course, lenders have been happy to continue to provide based on the dealerships’ newfound riches. This trend is problematic because some lenders are not practicing the same level of diligence that they applied prior to the pandemic. Some lenders require nothing more than a request for additional funding, anticipating that there will be sufficient cash flow from which to make payment. Such shortcuts in diligence may increase the risks for adverse outcomes, including losses due to fraud. Lenders may want to review a few simple steps that are common to virtually all automobile dealerships that help avoid this problematic trend:
- Vehicles Are Large Ticket Items, Generally With Thin Profit Margins –These two statements are factual and not subject to debate. Preferences and tastes change as outside factors such as fuel prices change. Take for example pick-up trucks and full-size sport utility vehicles. Does anyone think that those vehicles will have the same appeal when fuel is over $5.00 per gallon as when it was $2.50 per gallon? Is it fair to assume that the profit margin on those unsold vehicles will decrease as fuel prices increase? Whether it’s a once-in-a-lifetime event like the COVID pandemic or an unforeseen humanitarian crisis like the Ukrainian invasion, there are many ways that the business environment affecting demand and supply of automobiles can be influenced and impacted.
- Include an Analysis of the Balance Sheets and Income Statements of the Dealership To Determine Its Financial Strength – Whether your role is that of debtor or creditor, there are commonalities to the necessary analysis to minimize the risk associated with debt. It is desirable to assess the dealership’s liquidity and calculate the working capital. It may also prove beneficial to calculate certain ratios such as the current and quick ratios. Additionally, focusing on the income statement, a profitability assessment is beneficial, such as the gross profit margin and the operating profit margin. Mundane steps such as taking a physical inventory, surprise audits on behalf of the lender, and observing appropriate documentation when it is required, should not be forgotten or overlooked.
- Determine Receivables Turnover and Inventory Turnover To Determine if They Are Supported by the Sales Level – For lenders, floor-plan lending risks can be minimized by following regulatory guidelines and guidance such as the Office of the Comptroller of the Currency (OCC) – Comptroller’s Handbook on Floor-Plan Lending, which segregates risk by the following categories:
- Credit Risk
- Operational Risk
- Compliance Risk
- Strategic Risk
- Reputational Risk
Mitigation of risk can include policies, processes, personnel, and control systems.
- Performing Physical Inventories To Ensure That All Vehicles Are Accounted For – Such a simple step, but vital. A simple example of this is reviewing the age of a used vehicle.This is obligatory as it may indicate that certain older vehicles should be monetized by sending them to auction. Along with ensuring that rebates are being collected in a timely fashion, as they often comprise a significant portion of revenue and can be overlooked.
In conclusion, it is imperative that creditors and debtors carefully review their policies and procedures and institute steps such as the ones mentioned in this article, to ensure that the use of debt is maximized by both.
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For more information on this topic, please contact a member of Withum’s Dealership Services team.
