What is equity engineering?

Equity engineering is a strategic approach to building a strong balance sheet, enabling your dealership to execute its plans for growth, diversification or extraction of wealth. Focusing on the income statement to build the highest net profit is profit engineering. Contrast that with making decisions and changes focused on a stronger balance sheet: that is equity engineering.

How does equity engineering relate to piloting with stability and security in turbulent times?

Dealerships with a strong balance sheet can focus on operations and strategic growth opportunities during the downcycle, fueling higher growth once the business cycle turns. Dealerships with a weak balance sheet end up focusing on the instability caused by those weaknesses.

Relationship between the balance sheet and income statement

How much equity is needed in a dealership?

Many OEMs and banks use a Debt:Equity ratio of 3:1 as the limit for minimum equity in the dealership. The example shows a dealership engineered with $2M of equity and $6M in debt to support $8M in assets and $20-24M in sales. Many dealers have lower Debt:Equity ratios and operate with more equity.

How is equity built organically?

Dealers build equity organically through net operating profits. If the dealership above had a 5% operating profit (EBIT) on $20M in sales, generating $1M, and, depending on taxes, $800,000 in net profit, that net profit is added to the balance sheet as equity, increasing the equity to $2.8M. At that point, the dealership could lower debt or increase assets. Increasing assets would permit faster organic growth. Or the profits could be distributed to the shareholders, leaving the equity at $2M. Equity engineering planning helps make that decision.

What measures show the most effective equity engineering?

There are 3 measures that I see dealers use most effectively to measure equity engineering: return on assets, return on equity, and Debt:Equity ratio.

• Return on Assets
  Return on Assets (ROA) measures the profit generated from the assets in the dealership.

ROA is calculated as:

Operating Profit (EBIT)
Total Assets

In the example shown, the dealership would have a 12.5% ROA with $1M in operating profit ($1M / $8M total assets) and a 20% ROA with $1.6M in operating profit ($1.6M/$8M).

• Return on Equity
  Return on Equity (ROE) shows what the equity in the business is earning. Debt load and profitability levels will have a significant impact on this number. As a result, determining desired return on equity goals will lead to decisions on debt and equity levels.

ROE is calculated as:

Operating Profit (EBIT)
Total Equity

In the example shown, if the dealership made $1M in net profit, the ROE would be 50% ($1M/$2M). If they made $1.6M, the ROE would be 80% ($1.6M/$2M).

• Debt:Equity Ratio
  The debt to equity ratio is a simple measure of the leverage of equity.

Debt:Equity is calculated as:

Total Debt
Total Equity

In the example above, the Debt:Equity ratio would be 3:1. ($6M total debt:$2M equity).

There are 3 primary drivers for the amount of leverage a dealership uses: manufacturer requirements, bank covenants and shareholder comfort. A Debt:Equity ratio of greater than 3 signals a potentially unstable dealership, as the risk for servicing debt increases. If the Debt:Equity ratio is less than 3 for a dealership, there is less risk in servicing debt; however, there may be growth opportunities missed, particularly if there is a Debt:Equity ratio of 1 or less.

• Equity Engineering Scenarios

Engaging in equity engineering during strategic planning will help ensure a dealership’s stability and sustainability:

Scenario 1: Growth requires additional equity

This scenario typically comes into play when a dealership is considering acquisition or greenfield expansion but there is not enough equity, or would be too much debt, for the assets required. Does the dealership take on more debt for growth, seek capital contributions from shareholders, or seek outside capital? In all three scenarios, what are the expected, best, and worst cases for growth, profit, and returns?

Scenario 2: An owner wants to take equity out of the business

As many dealer principals age, they are developing and executing succession plans. This could be selling the dealership, passing on shares to the next generation or selling shares to others in the dealership. Using outside capital to take some, or all, of their chips off the table, is a fourth option. Strategically engineering equity provides the current and future shareholders a plan for funding the buy-sell of shares, keeping a strong balance sheet and achieving growth goals. 

Scenario 3: A dealership has too many assets 

Disciplined asset management tends to weaken when profits are high, and equipment is selling — even when there are supply chain issues. Achieving optimal asset levels and turns involves both operational decisions and equity engineering. Strategically, does the dealership hold used units until the next season, sell them at auction, or turn those assets in other ways? We suggest guiding this operational decision by looking at the 3 key equity engineering measures. 

The Leadership Lesson: Incorporate equity engineering into your strategic planning process for a more stable and sustainable dealership.