Increase Your Buying Leverage

Despite this year's gloomy predictions, some of you entrepreneurs are looking to add to your portfolio of stores. How would you like to use your buying leverage to increase your return on investment? Let's say you made 20% ($200,000) net profit on a dealership you bought for $1 million (there was a day when you could do that). But what if you invested $500,000 of your own money and borrowed the other

Despite this year's gloomy predictions, some of you entrepreneurs are looking to add to your portfolio of stores. How would you like to use your buying leverage to increase your return on investment?

Let's say you made 20% ($200,000) net profit on a dealership you bought for $1 million (there was a day when you could do that).

But what if you invested $500,000 of your own money and borrowed the other $500,000 (for the same $1 million total) and paid interest of $50,000? That would give you a cash-on-cash” return of 30%.

OK, now what if you invested $300,000 and borrowed $700,000 and paid $70,000 in interest? You would then have a cash-on-cash return of 43%.

Think about it this way. You actually have $1 million in cash and you invest it in a dealership and make the $200,000 (an OK return). But what if, instead of buying one dealership with your $1 million, you buy two dealerships by investing your $1 million and borrowing $1 million while paying interest of $100,000? In this scenario you would make $400,000 before paying interest of $100,000; leaving you a net after interest of $300,000 (a 30% return) rather than the $200,000 (a 20% return) in the first example.

By using leverage, you gain an extra $100,000 on the same investment of $1 million. To simplify, let's assume no principal amortization, so it would look like the graph at upper right. Not bad.

You get the point, but may be asking, “How much leverage may I have and still get factory approval?” That depends. See my column in the Dec. 2007 Ward's Dealer Business or go to http://wardsdealer.com/ar/auto_whats_succession_planning

Typically, the factories would like to see a “debt-to-equity” ratio of 1 to 1 or less. In other words, they would like you to invest at least as much of your own money in the dealership as you borrow.

That philosophy limits the amount of leverage you could use, but could there be a way to increase it.

It depends on a lot of things, but to simplify, let's assume that you borrow the money outside the dealership and the debt does not appear on the dealership's balance sheet.

Of course, the factories usually require a source-of-funds statement that details the origination of moneys put into the dealership at acquisition date. However, as long as those funds are derived from the financing of non-dealership owned tangible assets, you should be fine.

How much leverage should you use? Here are a couple of considerations. How “risk-tolerant” are you? The higher the leverage, the greater risk you are taking, unless only the assets being financed are used as security for the debt.

Another consideration would be the cash-on-cash return on investment compared with the interest cost of the borrowed funds.

Only you can determine how narrow a spread is acceptable to you vs. the risk.

And of course, as with any acquisition, a key factor in determining its viability, whether levered or not, is figuring out the cost and affordability of hiring the additional talented personnel you will require.

Approximately 650 to 850 dealerships change hands each year. I expect that number to increase in 2008, driven by an aging dealer body, a looming increase in the capital gains tax rate, slower new-vehicle sales, consolidation of over-dealered domestic points and ever-increasing facility demands by many manufacturers.

Now may be a good time to fuel your entrepreneurial drive by using leverage to increase your dealership holdings or to simply buy out a partner.

Don E. Ray is a CPA and a senior vice president at AutoStar. He can be reached at 901-907-0134.

Number of Stores Total Actual Cash Investment Debt Earnings Before Interest Interest Expense Earnings After Interest Cash on Cash ROI
1 1,000,000 1,000,000 200,000 200,000 20%
2 2,000,000 1,000,000 1,000,000 400,000 100,000 300,000 30%

Questions or comments about this column? Send us an e-mail at [email protected].

TAGS: Dealers Retail
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