Determining franchise capital requirements

NOTE: The following article is from the collection of articles in our Automobile Dealership Buy/Sell Newsletters. The newsletter deals with the complex area of buying and selling automobile dealerships. Some of the material may not be up to date because of changes in the law from the date shown at the end of the article. This article is not to be taken as legal, accounting, tax, or other advice. You should consult your own professionals for such advice and for any updating of the information provided. 

If you plan to buy an automobile dealership, it is critical to understand that the better you intend to do, the more money you will need to do it.

Indeed, it is foolhardy to enter into a purchase believing that you will finance aggressive expansion through the profits of that expansion.

Until about a dozen years ago , dealers could obtain merchandise from manufacturers based entirely on the planning potential of their market area. If the statistics suggested that your dealership should sell 30 new cars a month, manufacturers would honor your request for the 30, whether you had the capital to handle the sale of them or not.

In the last decade, however, manufacturers have increasingly utilized the “turn and earn” approach in determining how much merchandise to provide dealers. That approach virtually mandates that dealers adopt a similar “performance orientation” in assessing the franchise capital requirements of their dealership.

When you are buying a dealership, the manufacturer’s business management representative may still use the planning potential, multiplied by a historical sales average, to make an initial determination of your franchise capital requirement (which includes working capital and the costs of fixed assets). This determination often is made without due regard for individual circumstances and thus results in initial capital requirements that leave prospective dealers, particularly newcomers, in despair. (Some disheartened potential dealers actually quit as a result, costing manufacturers extremely talented dealer candidates.)

But experienced dealers do not necessarily accept the manufacturers initial capital requirement determination because they understand that today manufacturers allow a wide array of variables to influence their decision making. If dealers present manufacturers with alternative ways to determine franchise capital requirements, the manufacturers will listen–as long as the alternatives are reasonable and presented non-confrontationally, (While they will consider these alternatives, they will not consider capital requirements that leave dealers undercapitalized.)

As a guide, manufacturers will estimate capital requirements at $1200 to $1500 per unit of expected volume, plus whatever fixed assets are purchased or contemplated. This is only a “ball park” estimate, however, because it does not take into consideration the nuances of a particular market or the particular strengths of the proposed operator.

The key to developing an alternate interpretation of the franchise capital requirement is to present the manufacturer with a comprehensive, reasonable analysis based on how the most significant items on the income statement and balance sheet will influence the needs of the dealership. The accompanying chart identifies many of these items, and offers examples of how each can impact on capital requirements.

In summary, an organization should be capitalized to produce liquidity and solvency, based upon the anticipated volume of business. It then becomes a question of the organization efficiently handling its assets so as to protect liquidity. In so doing, the result will be a better opportunity to maximize profit potential by not allowing frozen capital the opportunity of creeping into a balance sheet–thereby stifling profit opportunities. Economics is an unbending, hard, and sometimes cruel taskmaster, but if you capitalize correctly, and follow sound, prudent business management, your prospects of success will be greatly enhanced.

Notes:

1. CASH: A vital requirement. Even profitable dealership experience dips due to promotions, used car inventory fluctuations, etc. A reserve lets you weather the storm.
2. CONTRACTS IN TRANSIT. Contracts in transit sometimes strain dealership capital where risky financial practices are involved, like discounting of recourse paper, acceptance of one-pays, side loans (usually tough to make legal, and tougher to get financed in any event), poor spot delivery, etc.
3. CUSTOMER RECEIVABLES: Sometimes customer receivables do impact capital, as in the case of wholesale parts operations. If applicable, add two thirds of total monthly credit extended by the wholesale parts operation.
4. CAR OR VEHICLE ACCOUNT. Avoid this account absent formal delayed arrangements from flooring source.
5. NEW VEHICLES: Competent office staff can keep all new units on flooring if dealer trades or outright purchases are closely monitored. (Flooring switches by letter are generally permitted if the lender floors both dealers.) Follow the philosophy that the flooring check is released the day the deal is funded or no later than the number of days allotted by the flooring source. Don’t be lulled by an excessive number of days release privilege for it will lead one into some very bad habits.
6. DEMONSTRATORS: Curtailments and other reductions on demonstrators strain cash flow requiring corresponding capital contributions. Exact amount depends on number of units and turnaround practices.
7. USED VEHICLES: Probably one of the most abused issues affecting capital requirements in any dealer’s repertoire. Be forewarned, this asset can swell as if edema had set in, and with the same unhealthy results, unless you monitor supply closely. If really committed to turnover, an efficient operator can get by with a 20-day supply; target that level or risk committing yourself to an economic burial ground.
8. PARTS AND ACCESSORIES: Perhaps more than a 90-day supply if more than one manufacturer is represented. Beware of the ominous situation of allowing obsolescence to creep into the inventory, which will result in a limitation on your ability to maximize sales, costly write-offs and an unbalanced inventory.
9. WORK IN PROCESS: Exact number depends on the nature of work and whether a body shop operation is involved.
10. FACTORY RECEIVABLES: Allowance for holdbacks here is based on quarterly payment thereof. Likewise, the 30-day period for PDIs is based on their monthly settlement in the open account statement.
11. DUE FROM FINANCE COMPANIES: There are many variables in this account. The corresponding impact on capital depends on the basis of discount. Thus, no set formula will work–whether you use non-recourse, full recourse, reserve as earned, regular repurchase, reserve guarantee option, paid up front, or whatever. Theoretically, and in the interest of good business philosophy, non-recourse and payment of reserves up front with chargebacks paid as they occur is the best form of a capital requirement basis. Most manufacturers’ finance arms are set so that settlement is made monthly, requiring a 30-day supply of capital.
12. WARRANTY CLAIMS: The impact on capital is based on 30 day settlement periods, although issuance of single credits covering 15-30 days offsets the requirement to some degree. Avoid allowing account to become lopsided with overaged claims resulting in frozen capital.
13. REBATES OR INCENTIVES: Extreme diligence in following up is required to effect prompt collection. Remember, the manufacturer stands to gain if sloppiness creeps into this asset. Recent legislation in California will help to protect dealers in the future.
14. REQUIRED PRE-PAIDS: Six month’s worth of real estate taxes; one month’s worth of general insurance premiums, and one month to one year’s worth of premiums for health insurance and workers compensation insurance premiums depend entirely on the carrier selected.
15. PREPAID-OTHER: Naturally, there will be occasions when there will be obligatory purchases which can legitimately be spread over a period of time-not to exceed 12 months. However, too often this account becomes a dumping ground for deferred expenses to reflect a better operating result. This account should be kept at a minimum.
16. LEASE AND RENTAL VEHICLES: Generally speaking, leases and rentals are to be structured in such a manner that will not allow the building of equity, so no capital should be contemplated from this area of operations.
17. FIXED ASSETS: This area is rapidly increasing. The advent of computers has prompted manufacturer required purchases or diagnostic equipment, and computerized telephone systems are virtually required at any dealership. Thus, it is not usual to see a $600,000.00 investment for even a medium sized deal. In addition, leasehold and other improvements can be an area that would require funding. Naturally, if funding is not available from their vendors or predecessors, funding must be provided. Every attempt should be made to secure separate financing to minimize the impact on overall financial requirements, and don’t overlook the possibility of renting or leasing any or all of the fixed assets.
18. ACCOUNTS PAYABLE: An area that could be overlooked. This is on the plus side, for when the vendors or manufacturers take up to a month to pay you, the same holds true for the purchase you make. Therefore, subtract a one-month supply of purchases, with the exception of vehicles of course.

This article was written in 1994.