The Effect Manufacturer Capital Policies Have on Your Balance Sheet

February 15, 2011

The following article was written by Greg Gilmore, the founder and president of The Apex Group, Inc. located in Houston, TX. The Apex Group is a firm that specializes in supporting ownership and market representation activities on behalf of the franchised automotive dealer.

General Motors has recently changed their accounting policy, which actually eases some financial burden on new dealerships and existing dealers.

Starting a new dealership often requires an automotive franchise buyer to spend significant time and money negotiating the demands of sellers, manufacturers, floor-plan providers, mortgage bankers and other capital sources. One of the most difficult challenges in gaining the approval of an ownership change is navigating the capital policies of automotive manufacturers. There are basically two components to the capital policies of every automotive manufacturer. The first relates to the amount of debt that is allowed on the dealership balance sheet and the second concerns the amount of working capital that is required of the dealer. If factory thresholds are not met and the new dealership balance sheet is not acceptable to the manufacturer, the transaction will be turned down upon submission.

The manufacturer’s net working capital calculation is a key component of the new dealership owner’s franchise application. The calculation varies significantly among manufacturers. Basically, manufacturers fall into two categories when it comes to working capital requirements for a new dealership. The first group provides a standard at the onset of the application process that is based on planning volume or historical market share information. Typically, these manufacturers have a set dollar amount allocated per new vehicle projected. There is typically no negotiation when it comes to the requirement and the standard is provided upon delivery of the manufacturer’s document checklist. The second group provides a working capital standard based upon the new owner’s forward forecast. The requirement is typically provided in the middle of the application process and after the forecast has been reviewed by the manufacturer. With this group of manufacturers, working capital formulas and calculations vary among franchises. Additionally, the level of guidance and the amount of manufacturer input on the actual forecast varies among franchises. If you are purchasing a dealership that represents a manufacturer where the working capital guide is based upon the applicant’s forecast, its important to seek guidance from someone who understands manufacturer’s calculation before submitting your forecast. It could mean the difference of hundreds of thousands of dollars in start up capital. After the first year of operation, both groups of manufacturers typically use the past 12 months of historical performance to revise the working capital requirement.

The second group of key capital polices concerns the amount of debt allowed to be held on the dealership entity. General Motors has recently changed their accounting policy, which actually eases some cash equity burden on new dealerships and existing dealers. In summary, GM is allowing their dealers to borrow additional funds to meet their working capital requirements. While they are not changing their overall debt to equity policy of 42.5% maximum debt, they are allowing their dealers to count more debt towards their actual working capital calculation. This in turns allows for greater flexibility when it comes to capitalizing a new dealership. General Motors has always utilized a unique policy to the industry, which classifies debt as “qualified” or “unqualified” as it pertains to a dealer’s actual net working capital calculation. Historically, to qualify debt towards a dealer’s actual working capital, the debt had to be classified as an owners/officers note and could only be 50% of the dealer’s working capital standard. In other words, any money owed directly from the dealership to a traditional financial institution could not be counted in the dealer’s actual working capital calculation. As of February 1st, 2011, GM is allowing 100% of the working capital requirement to be borrowed and “qualified” towards the dealer’s actual working capital. The debt still has to be qualified as an owners/officers note but by allowing the dealer 50% more debt as it relates to the dealer’s working capital requirement, I would expect to see more debt on GM dealership balance sheets going forward.

Even with the recent capital policy revision, General Motors’ current policy of 42.5% maximum debt still is one of the strictest debt to equity policies in the industry. However, the most stringent debt to equity policy in the industry based on my experience is Ford Motor Company’s policy. While Ford allows its dealer’s to borrow 50% of working capital and fixed assets combined, the company requires its dealers to pay for any goodwill or blue-sky with a total cash equity contribution. Depending on the level of goodwill involved, this can require a significant portion of the dealership purchase price to be in the form of cash. This has not been a major issue over the past two years, as Ford goodwill values have been lower than in the past. However, as Ford continues to improve market share and shareholder value, I would expect goodwill valuations to increase in line with their industry success. If you are planning on purchasing a Ford dealership in the near future, it is important to understand that Ford Motor Company expects you to purchase all goodwill exclusively with cash.

Besides Ford and General Motors, most automotive manufacturers have a 1:1 debt to equity policy. In other words, borrowed capital may not exceed owned capital in the capitalization of a dealership. Of course there are exceptions to this policy among franchises. In addition, manufacturers do not want their debt to equity policy to reach the maximum threshold. This is especially true during a proposed ownership change or a buy-sell transaction. If an application is submitted with a balance sheet that pencils the maximum amount of debt allowed by the manufacturer, the approval process will be difficult for the new owner. A good rule of thumb is to maintain 80% or less of the maximum debt allowed.

Capital policies among the manufacturers follow a common thread. Manufacturers desire a strong cash position with their new dealers so as to meet the challenges of a volatile economy along with opportunity to borrow for future facility upgrades and expansion. As business picks up and manufacturers renew their push for facility renovations in the coming months, expect further scrutiny and possible capital policy modifications with respect to franchised dealership balance sheets.

 

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