By John Spader and David Spader
As published in RVBusiness September/October 2021
Fabulous. It’s really the only way to describe the financial results many of our clients have enjoyed this past year. Many struggling dealers have cured weak balance sheets while strong operators have gone from strength to strength. Higher turns and stronger profits have done for many what they haven’t been able to intentionally do for many years: reduced their debt-to-equity ratio to manageable levels.
In its simplest form, debt-to-equity is a measurement of how much of the lender’s money is invested in your business, versus how much of your own money is in the business. It may well be the most important ratio on your balance sheet; it’s a measure of financial strength, operational capabilities, and lasting power in case of a downturn in the market. Dealers with leverage ratios of 2.5:1 or less are fighting from a position of strength. They almost always have solid cash flow and profits, the most favorable floorplan terms, and extra reserves to take advantage of purchase opportunities.
When debt-to-equity gets above 5:1, the story can change quite a bit. Higher debt-to-equity ratios often result from lackluster profitability and rising inventory costs. They can also often occur during periods of growth, as dealers extend their resources to add locations or product lines. As the debt-to-equity ratio climbs, dealers become cash flow managers, lending terms become more strict, and growth opportunities cannot be pressed. The cure is strong net profit that builds equity, or an infusion of cash from ownership or other investors.
Right now, though, very few dealers have leverage issues. With inventory so scarce, turns are up. Where the pre-COVID average was hovering around 2 turns per year, many dealers are now in the 5 or even 6 turn range … constantly scrambling for new inventory. Since floorplan is almost always the most significant form of debt on a dealer’s balance sheet, it’s no wonder debt-to-equity ratios are so good!
None of this is sustainable, of course. The supply chain and manufacturer capacity will ultimately normalize. And as COVID subsides, the industry will again face competition for the leisure budgets of consumers … demand will return to some more manageable level.
When that happens, where will you be? What will your equity position look like in the post COVID world? Before you make that next acquisition or declare a big dividend, give some thought to what the business will need to maintain strength in a more normal market. Let’s look at a very simple analysis that only focuses on the leverage needs of new unit inventory financing.
The average dealers generates about 85% of their sales through unit sales, and about 90% of that is through new unit sales with nearly all of that inventory floorplanned. (Plug in whatever your actual numbers are.) So a $50,000,000 dealer has new unit sales something in the neighborhood of $38,000,000. Pull out industry average gross margins of around 13%; that leaves a cost of sales of $33,277,500.
So far so good. In COVID times, turning inventory 5 times would indicate an average inventory level of $6,655,500. To keep a leverage ratio of 2.5:1, this dealer would need to keep only $2,662,200 in equity in the company to manage this debt. But let’s say things get back to a more regular 2.5 turns? This would mean an average inventory of $13,311,000. In order to keep the same debt-to-equity ratio of 2.5 would require $5,324,400 in equity; literally twice as much.
This is a grossly simplified example, but it does illustrate an important point: there has been a lot of growth, both in raw unit sales and in inflationary cost increases of product. When turns slow down, dealers who have not been mindful of their equity position will find themselves over-extended, possibly dangerously so. Healthy sales growth requires commensurate profit and equity growth. To be sure you are prepared, project your future top-line sales numbers, then back into the needed equity to stay safely leveraged.