Distress signs lenders should watch for as loan delinquencies rise

Automotive Industry

The automotive sector showed signs of difficulty in 2015 which continued into 2016. With loan delinquencies climbing, loan/portfolio performance risks are increasing for dealers, securitizers, and lenders in the industry. The risks to stakeholders offering auto financing have been mounting for years, as evidenced by Moody’s rating downgrade of Scotiabank in early 2016; and while auto loan sizes increased only modestly in 2015, previous year-over-year increases in excess of 20%—coupled with longer loan terms—remain cause for concern.

Given that the effect of low oil prices has contributed to job losses in Western Canada, the auto loan delinquency rates in this part of the country now far exceed the 2015 national average of 1.32%. In the fourth quarter of 2015, Alberta climbed nearly 35% year-over-year to a 2.4% delinquency rate, and Saskatchewan now more than doubles the national average, reporting at 2.7%. While similar metrics were seen in the 2009–2010 securitization market due to the financial crisis in these crude-reliant provinces (some rolling stock was parked for 2–3 years), oil was quick to rebound, and subsequently settled at near all-time highs. Now, however, the prognosis for Western Canada looks far more severe, with recent reports suggesting this recession is expected to last approximately two years.



Warning signs to watch for
The rise of loan delinquency is only one of the warning signs lenders and other stakeholders must monitor closely. Other key performance metrics and trends could also point to a company in distress: 
company at (or near) operating line authorized limit, or borrowing maximum per availability calculation;
  • increasing working capital requirements, aging accounts receivables, inventory mix (buildup of used vs. new), excessive, and/or aged, accounts payable;
  • significant CapEx spending; and/or;
  • management turnover, especially in the finance function. 
While these elements could indicate distress in companies across many sectors, we present below an in-depth list of red flags specific to the dealerships and automotive financing companies.

Warning signs for dealerships

Vehicles Sold Out-of-Trust (SOTs):
vehicles which have been sold, cash received, however the balance borrowed on the floor plan is not repaid within the required period (~2–7 days).

  • Fleet vehicles are usually allowed a longer repayment period (e.g. 30 days) due to volume and credit terms with the fleet service providers.
  • SOTs often occur from operational inefficiencies (dealers are not focused on—or do not have processes in place—to monitor collections), or liquidity constraints as funds received are being used to fund operations instead of repaying the floor plan.
  • Both are indicative of significant problems in the organization.
  • Vehicle audits—internal or external—are the first line of defence; clean audit results should also be viewed with skepticism; $1 of SOT is a significant warning sign/issue.
Used vehicle concentration: used vehicles have a higher risk profile than new vehicles.

  • Valuation of used vehicles is less easily determined than for new vehicles, and is subject to material changes.
  • Attention should be paid to an aging used vehicle fleet, despite the curtailments in place on margining. Increased concentration of used vehicles can be indicative of an issue such as increased trade-ins to drive new vehicle sales.
  • Overstated trade-in value may be concealed by not selling excess vehicles at auction.
  • Inventory may contain unsaleable vehicles.
  • Liquidity is significantly impacted by the decision to wholesale/monetize slow moving inventory vs. retail vehicle inventory (maximizing profit), tying up working capital.
  • Beware of re-aging in a multi-dealership scenario. As vehicles move between dealerships, the company may “re-age” the inventory in the system by applying the date of transfer, masking a valuation problem and increasing lender exposure.
  • Facility cap limits on used vehicles should be strictly adhered to.
  • Liens not paid off on trade-ins are an additional risk to lenders.

Leasing or CSA portfolios: usually non-core to the operations of the dealership/dealer group, growth and performance of these portfolios can be an additional indicator as to the health of the core business. A dealership may try to maintain vehicle sales by taking on debt at increased risk of default, pushing the performance problems down the line.

Expansion and dealership improvements: sources of financing to fund dealership capital expenditures, head office improvements, and purchases of additional dealerships should be examined. These activities should be funded through retained earnings, capital leases and mortgages; use of the dealership’s operating facility could be indicative of inability to generate sufficient profits or to obtain additional financing for growth. Additionally, beware of expansion for the sake of expansion and consider the following questions:

  • Execution risk – is the right management team in place?
  • Are overhead costs outpacing revenue/profit growth?
  • Are improvements required by the original equipment manufacturer (OEM)?

OEM relationship and banner: the specific banner and dependence on a specific banner within a dealership group should always be assessed and monitored (to avoid the impact of situations like that of Volkswagen). Additionally, correspondence with the OEM should be monitored to ensure the relationship is positive, and to gain insight into what capital investments are needed to meet the OEM requirements.

Indicators of distress in lease and conditional sales agreement
(“CSA”) Financing companies

Securitized portfolio: 

  • Perfect pay: any delay in collection from the customer can create a significant working capital requirement, as payment is required to the securitizer independent of collection of the customer receivable.
  • Defaults (Delinquencies and term loss): defaults in excess of historical trending erode profitability and cash needed to make required payments (perfect pay); this applies to leases or CSAs.
  • Early terminations: securitizers limit the number of early terminations permitted under the portfolio before imposing penalties.
  • Use of cash reserve: funding portfolio delinquency buy-outs of the securitizer’s facility with the cash reserve could indicate constrained liquidity (vs. using equity generated from earnings).
  • Cash reserve lock-up: resulting from breached covenants in the securitization agreement.
  • Changes to the securitization agreement: such as reduction in annual funding limits, increased cash reserve holdback or increases to the cash reserve ceiling (minimum cash reserve), are often indicative of increased risk in the securitized financing portfolio.
  • Event of termination (“EOT”): EOT can result if portfolio conditions further worsen, leading to an inability to securitize new deals, stalling operations or forcing loans into a self-funded portfolio. There is a risk of loss of control, should the securitizer decide to step in to monetize the assets in support of its security.
  • Taxes: cash taxes are sheltered as portfolios grow (tax depreciation greater than accounting depreciation), however when portfolios are in decline, cash taxes can be triggered when the company can least afford to pay them.
Changes in the securitized portfolio can have a significant impact on a company’s liquidity and profitability; free cash flow is usually tied up in the portfolio’s cash reserve. The release of cash (“waterfall”) from this reserve is a key success factor.

Self-funded portfolio:
  • Growth of these portfolios may be an early indicator of distress as this is paper that the securitizer was unwilling to accept (owing to credit risk, duration of paper, or the class of supporting assets).
The importance of working capital management

If working capital is not properly managed, liquidity constraints can be exacerbated in times of deteriorating performance and can shorten a company’s runway to turnaround or restructure. The following are common examples of where cash can get tied up in these businesses:

  • Contracts in transit (CITs) refer to the time it takes to get cash from the sale of vehicle from the customer or its lender. If funds are not collected prior to repayment of the floor plan facility, the company’s working capital will then be negatively impacted.
  • Lease residuals, such as CITs, can challenge working capital if unpaid by the customer at the time they are due to the bank (roughly 30 days after a sale), resulting in a duration mismatch.
  • Curtailments can cause a sudden reduction in borrowing availability, often as a result of:
  1. Aging – step-down in margining often begins after 90 days for used vehicles, and after 365 days for new vehicles; and/or
  2. ITCs – when vehicles are purchased from the OEM, the full value including GST/HST is eligible for borrowing purposes, but only until the sales tax return is remitted and ITCs are effectively “recovered” (roughly 45 days later).
  • Deferred units tie up liquidity as they act as a restriction to borrowing availability – even if unpaid, representing the vehicle units committed to with the OEM but not yet in possession of the dealer. With no immediate ability to monetize these assets, a high level of deferred units can constrain the business.
  • Trade-ins reduce the cash value received on the sale of a vehicle that could be used to repay the floor plan facility, while the borrowing availability generated from the trade-in is only a portion of the value (e.g. ~75%). In times of tight liquidity, excess used vehicles should be monetized to generate cash.
  • Parts on hand can tie up much needed cash, and can reduce funds due from OEMs (for manufacturer incentive rebates, etc.). Special attention should be paid to the OEM receivable balance: a high or growing balance can be indicative of disputes, failure to qualify for rebates, aged payables, etc.
Fraud risks in the automotive industry
Lenders and other stakeholders must also be skeptical of fraud in the automotive dealer and financing sector. Misrepresentation to lenders and even fraudulent behaviour have been uncovered in many organizations in this industry. As in all sectors, the propensity of destructive actions tends to increase in times of financial strain. Consider the possibility of the following:
  • withdrawal of capital by shareholders to support outside ventures, or for personal lifestyle;
  • playing the float (outstanding cheques in excess of liquidity);
  • financial statements management, as may be evidenced by difficulty in reconciling internal reporting to audited financials, or suspiciously strong sales performance for the season, category, or region, for example; and
  • lack of transparency or cooperation in communicating with lenders.
New vehicles
  • Company’s response to the vehicle audit: sold units are not paid off until SOT is revealed by a vehicle audit; need additional time to pay SOTs, or requests are made for advance notice of audits. (Misrepresentation of facts surrounding SOTs identified.)
  • Excessive number of vehicles on demonstration program, or demonstration vehicles unavailable for inspection when requested.
  • Phantom vehicles: vehicles on consignment unavailable for inspection, vehicles exchanged between dealers, vehicles on loan to customers.
  • Insufficient documentation to support ownership.
Used vehicles
  • Attempting to margin:
    non-existent units;
    wrecked units; and
    a unit belonging to an innocent third party.
  • Stripping margined inventory for parts.
  • Inadequate insurance in place.
Be vigilant
Early detection of profitability, liquidity and existence of assets issues is essential to preserving options available in order to restructure and/or support an operational turnaround. For this reason, continued vigilance is key for lenders and other stakeholders; this not only requires staying on top of the trends in performance, but in-depth knowledge and experience in the sector to interpret results and act early.

 Register to Richter’s publications


About Richter : Founded in Montreal in 1926, Richter is a licensed public accounting firm that provides assurance, tax and wealth management services, as well as financial advisory services in the areas of organizational restructuring and insolvency, business valuation, corporate finance, litigation support, and forensic accounting. Our commitment to excellence, our in-depth understanding of financial issues and our practical problem-solving methods have positioned us as one of the most important independent accounting, organizational advisory and consulting firms in the country. Richter has offices in both Toronto and Montreal. Follow us on LinkedIn, Facebook, and Twitter.


[1] http://www.cbc.ca/news/canada/calgary/td-economics-report-alberta-recession-gdp-forecast-1.3684056


Expert Showcase