We have previously written about six events that can trigger the need for a business valuation.  In each of these examples, the valuation will consider the dealership as a going concern or a continuing operation.  The valuation process considers normalization adjustments to both the balance sheet and the income statement.

For the balance sheet, normalization adjustments establish the fair market value of the tangible assets of the dealership and identify and bifurcate any excess or non-operating assets.  Non-operating assets are anything of value owned by the company that is not required to generate earnings from the core operations of the dealership.  Even if a dealer is considering a potential business sale, the other assets and liabilities not transferred in the proposed transaction still have value to the seller when considering the total value of operations.  These non-core assets would then be added back to the value of the dealership operations determined under the other valuation methods.  Many dealers also experienced heightened cash balances from forgiven PPP loans since the pandemic and heightened profitability in the past few years.  While these profits and funds tend to either be reinvested into the business or distributed to owners, we frequently find that auto dealerships will carry a cash balance exceeding the needs of core operations, which could but has not yet been distributed.

Working Capital on the Dealer Financial Statement

Cash (and contracts in transit) and inventory tend to be the largest components of working capital (current assets minus current liabilities) for auto dealers.  However, inventory is offset by floor-plan debt, requiring little actual upfront investment on the part of dealers.  Still, a certain level of working capital is required to maintain operations.  Most factory dealer financial statements list the dealership’s actual working capital, along with the manufacturer’s requirements or “guide” on the face of the dealership financial statement, as seen in the graphic below.

A proper business valuation should assess whether the dealership has adequate working capital or perhaps an excess or deficiency.  Comparisons to required working capital should not always be a rigid calculation.  An understanding of the auto dealer’s historical operating philosophy can assist in determining whether there is an excess or deficiency, as different sales strategies can require different working capital levels, regardless of factory requirements.  Often, the valuation date coincides with a certain event and may not be at year-end.  The balance sheet at the valuation date could represent an interim period and may reflect certain seasonality of operations; many dealers and business owners generally may hold more cash throughout the year and simply distribute for tax or other purposes right before year-end.  A proper working capital assessment should consider the sources and uses of cash, including anticipated distributions, capital expenditures, accrued and off-balance sheet liabilities, etc.  For many reasons, it may not be appropriate to simply take the $616,218 from above and call this amount a non-operating asset.

Case Study

So, how should the working capital of an auto dealership be assessed?  Let’s look at a case study of a recent project to determine the factors to consider.  Certain figures have been modified to improve the discussion and protect client information.

Consider a dealership with a date of valuation of September 30, 2023, compared to their typical calendar year-end.  In a review of historical financial statements and operational performance, the Company reported increasing cash totals, as seen below.

Click here to expand the image above

A quick review reveals that cash has increased by over $6 million since 2021 and $8 million since 2017 through the valuation date.  Would the entirety of this increase represent excess working capital?  Digging deeper, let’s examine the actual levels of working capital and working capital as a percentage of sales for the same company over the same historical period.  As shown above, working capital increased as a percentage of sales.  A rigid comparison of the latest period’s working capital to the prior period might indicate excess working capital either on the order of $2.7 million or 1% of sales.  However, we note that it is not significantly above prior periods as sales have increased along with working capital balances.

We can also look at the manufacturer’s requirement.  This dealership had a net worth requirement and the more traditional working capital requirement.  These simple figures indicate whether a dealership is properly capitalized, considering liquidity and solvency.

All of these financial calculations and cursory-level reviews of working capital and net worth fail to consider the specific assets and liabilities of the Company, the timing of the interim financial statements, and the anticipated uses of cash.  It is critical to interview the management to discuss these items and the operating level of cash and working capital needed for ongoing operations.

Importance of Management Interview

In this example, management indicated that the ongoing cash needed to facilitate day-to-day operations would approximate $5 million.  Deducting from the $14.7 million, would that indicate $9.7 million in excess cash based on comparison to the actual cash balance as of the valuation date?

Management also provided details of a related party note payable to one of its owners not readily identifiable on the dealer financial statement.  The note was a demand note that was callable at any time and was expected to be paid in the short term.  This is considered a non-operating liability, offsetting the excess cash.  Management also anticipated heightened capital expenditures for the fourth quarter in the amount of $325,000.  This type of information would be nearly impossible to discern by just analyzing the financials as this expenditure is an off-balance sheet item.  However, experienced valuation analysts in the auto dealer space know that the OEM has expectations about imaging, which requires capital investment.

After learning this information, we assessed working capital using three different methods.  First, we assessed working capital based on the manufacturer’s net worth because the Company can’t distribute excess cash to the level that would reduce equity below this figure.  This method resulted in an assessment of excess working capital of approximately $1.4 million, as seen below:

Next, we looked at the dealer’s working capital position compared to OEM requirements.  This method showed closer to $2.4 million in excess working capital.  While this shows the dealership may have ample liquidity to facilitate operations with less cash in the business, the excess cash cannot materially impair the required book value above.

The final assessment of working capital focuses directly on the cash and equivalents.  As discussed, management indicated that the Company had operational cash needs of $5 million.  Additional uses of cash prior to year-end included the likely repayment of the related party demand note and the cash required for the capital expenditures.  This method resulted in an assessment of working capital of approximately $1.3 million, compared to a rigid calculation of $9.6 million when only considering actual cashless operating level needs, as seen below:

Ultimately, we concluded the Company in this example had excess working capital in the form of approximately $1,350,000 in excess cash.  While there was more cash on the balance sheet than in historical periods, our other valuation methods assume appropriate investment in the business to sustain operations.  As such, we would be double counting value to add back too much cash without considering necessary improvements to the business to generate future profits.

This example highlighted a dealership with excess working capital reflected in excess cash.  Occasionally, an analysis might indicate excess working capital, but the Company’s cash is not elevated above a sufficient level to fund operations.  As discussed above, excess and non-operating assets could theoretically be distributed while not affecting the core operations of the dealership.  However, non-cash current assets, such as Accounts Receivable and Inventory, are either not readily distributable or doing so might jeopardize the core operations.  While selling down inventory will generate distributable cash, not investing the proper amount in inventory can inhibit future sales, as all dealers are well aware of the recent history of supply chain constraints.

Conclusions

Working capital and other normalization adjustments to the balance sheet are critical to the valuation of an auto dealership.  Identifying and assessing any excess or deficiency in working capital can lead directly to an increase or decrease in value.  Valuable data points to measure working capital include the requirements by the manufacturer and the Company’s actual historical cash and working capital balances, along with its current ratio and working capital as a percentage of sales.  None of these data points should be applied rigidly and should be viewed in the context of future sources and uses of cash, the presence of non-operating assets or liabilities, and the seasonality of an interim date of valuation.  Remaining PPP funds and prevailing industry conditions, including scarce inventory and heightened profitability, can pose additional challenges for current valuations.

The professionals of Mercer Capital’s Auto Team provide valuations of auto dealers for a variety of purposes.  Our valuations contemplate the necessary balance sheet and income statement adjustments and provide a broader view to determine the assumptions driving the valuation.  For a valuation of your auto dealership, contact a professional at Mercer Capital today.