How and Why Lenders Can Transform Auto Dealership Financial Due Diligence

Mark A. Blosser, CPA
How and Why Lenders Can Transform Auto Dealership Financial Due Diligence

With relatively flat sales trends, continued margin compression, complex manufacturer incentive programs, and rising interest rates, today’s automobile dealerships face an array of new financial pressures.

In view of these concerns, prudent lenders should consider enhancing their use of financial due diligence to monitor how well their dealership clients are managing these issues. In addition to providing better visibility into their clients’ financial stability, lenders’ use of enhanced due diligence also can benefit dealers by offering insights into risks and adverse practices they might not have recognized on their own.

Dealers’ evolving challenges – why lenders should take notice

Many of the financial pressures dealers currently face stem from external economic developments beyond the control of individual dealers or the industry as a whole. For example, although recent Federal Reserve commentary suggests interest rates might be stabilizing for a while, the increases of the past few years have had a significant effect on many dealers, particularly when manufacturers’ interest assistance programs have not kept pace.

High inventory levels and rising wages within dealerships have added to the pressures, but one of the leading contributors to many dealerships’ financial situation has been manufacturers’ continued use of volume incentives, particularly stair-step programs that require dealers to achieve ever-increasing volume levels in order to qualify for the quarterly bonuses that many have come to depend on to maintain adequate cash flow.

Coming at a time of relatively flat or slightly declining volumes across the industry, these incentives have tended to put an even tighter squeeze on margins. In addition, the generally improved quality of new cars in recent years contributes to lower sales volumes while also keeping a lid on service department revenues.

The effects of these incentives can be seen in the trend lines for certain important financial performance metrics, as tracked by Crowe among dealer peer groups. For example, overall dealership profitability, measured as net income as a percent of total revenue, has declined noticeably since 2015, particularly among domestic dealers. Concurrent with this trend, the average gross margin per new vehicle also has declined, while an ever-increasing share of dealers’ net income has come from the category of other income, which includes income from manufacturer incentive programs.

The value of due diligence

In spite of the changing financial pressures their clients face, it appears many lenders are not performing financial due diligence on a regular or consistent basis. For example, in a recent Crowe webinar, executives from a variety of lending organizations were asked when their organizations performed in-depth financial due diligence on their automotive dealer clients. As shown in Exhibit 1, only one-third (34%) of the participants said they perform due diligence regularly as part of the annual renewal process.

Exhibit 1: Lender due diligence practices

Exhibit 1: Lender due diligence practices
Source: Online survey of Crowe webinar participants, Feb. 21, 2019

The largest group of respondents (39%) reported they perform due diligence only when establishing new relationships. Another 26% reported they do so when customers are deemed to be at risk. By limiting their use of financial due diligence to only new clients or those at risk, these lenders are depriving themselves of a broad range of potentially valuable information.

For example, in-depth due diligence can help uncover adjustments designed to plug cash or net worth accounts, uncollectible receivables, or inventory that is overvalued because it was not purchased correctly or it has aged. Due diligence also can reveal if shareholder or related-party receivables and payables are recorded incorrectly on the balance sheet or buried within other accounts and not clearly visible on the factory financial statement. Such errors, whether deliberate or accidental, can directly affect the working capital reported on the financial statements. They also can skew other critical financial ratios that lenders use to judge a dealer’s financial stability and creditworthiness.

Effective due diligence also can help uncover selling out of trust (SOT) situations, in which the proceeds of a retail sale are improperly used to cover other expenses rather than repaying the floorplan lender that financed the inventory. 2018 has seen a noticeable increase in SOT investigations.

Critical areas of review

While all areas of dealer operations should be reviewed, several areas of a dealership’s financial statements merit particularly close scrutiny, including questioning how a line-item entry was determined. Digging deeper into financial statement entries often can reveal especially important information that might not be apparent in an initial review or by looking at the factory financial statement. A few common examples include:

  • Journals. Even if the cash balance on the balance sheet seems reasonable, it is wise to review the cash and general journal entries to look for unexplained entries that tend to increase cash with offsetting adjustments to other accounts.
  • Owners’ receivables. There have been instances in which owners’ notes were hidden within parts and service receivables. If they remain undetected, the notes will be included incorrectly in the lender’s working capital analysis when they actually might need to be moved to a long-term asset. Such hidden receivables can be discovered only by reviewing the detailed schedules that are used to compile the financial statement.
  • Aged contracts in transit (CIT). Here again, the net balance for contracts in transit often appears reasonable and does not raise any red flags. But digging into the CIT schedule can reveal contracts that are aged well past the typical 30 days and therefore should be judged as uncollectible. Such an adjustment would have a direct impact on working capital.
  • Used vehicle valuation. Consistently overvaluing used vehicle values can lead to drastically inflated inventory values. Financial due diligence should include an analysis of the vehicle values, in which the general ledger cost shown for each used vehicle is compared to a book value.
  • Floorplan liability without inventory. One balance sheet ratio that many lenders watch closely is the ratio between floorplan liability and new vehicle inventory value. Comparing these ratios alone, however, does not tell the full story. It is useful to look at the floorplan schedules themselves, to detect any floorplan balances that do not have a corresponding inventory item in stock. In addition, the vehicle sale dates and payoff dates can be identified along with the gap between these two dates. This information can be highly valuable in revealing possible SOT situations.
  • Year-end adjustments in accounts payable. Another valuable financial due diligence practice is a review of individual trade payable accounts. Such a review can reveal unusual adjustments in which expenses that should have been posted to the income statement or retained earnings are instead hidden within various trade accounts. Again, this practice can skew the working capital calculation.

These examples are by no means a complete or exhaustive list of items to review, but they do give an indication of the type and significance of the disparities that can be uncovered through effective financial due diligence.

Using technology to enhance financial due diligence

When webinar participants were asked why they did not perform deeper financial due diligence on a regular basis, they offered a variety of reasons, with lack of time and resources as their top concerns. Fully half of the respondents cited all the listed constraints for holding them back (Exhibit 2).

Exhibit 2: Why lenders fail to perform due diligence consistently

Exhibit 2: Why lenders fail to perform due diligence consistently
Source: Online survey of Crowe webinar participants, Feb. 21, 2019. Numbers might not equal 100 percent due to rounding.

Fortunately, new technology can help lenders address virtually all these perceived limitations. For example, today’s advanced electronic collateral analysis software makes it possible to minimize or even eliminate much of the time-consuming fieldwork that limits lenders’ capacity to perform due diligence on a broader scale. By using electronic data extraction and report delivery capabilities, lenders can perform a complete collateral and working capital analysis remotely, without the need for extensive on-site interviews and reviews that can be burdensome to lender and dealer personnel alike. What’s more, this technology now makes it possible to complete this analysis in a matter of just a few days, rather than weeks.

In addition to its obvious benefits to lending organizations, such rapid, in-depth analysis delivers value to the dealerships concerned. When dealers learn how the analytic tools associated with financial due diligence can alert them to previously unrecognized risks or practices, their initial resistance often fades quickly. In many instances, dealers have become enthusiastic supporters of the effort, realizing it can help them anticipate new and unexpected financial issues they might encounter as they adapt their business models in response to evolving manufacturer pressures and changing consumer preferences.

Such transformative technical capabilities, which can streamline the due diligence process, are likely to continue spreading through the lending industry. At the same time, the worrisome trends in dealers’ financial performance metrics are also likely to persist for some years – and in fact are likely to accelerate.

If and when that happens, the need to perform financial due diligence on a recurring basis will become even more evident, and the potential benefits to all concerned will become even more obvious. In such an environment, investments in technology that enable financial due diligence to be carried out efficiently and with minimal disruption to the client can be recognized as a prudent step and a sound business practice.

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Mark Blosser - Large
Mark A. Blosser
Partner, Financial Services Credit Leader