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Turning collection headaches into profit opportunities. (Balance Sheet Management).

Setting up a joint venture between a manufacturer and a finance company can be a real boon for a company with large volumes of receivables weighing down its balance sheet.

The economic downturn has made it more important than ever for financial executives to protect their organizations against bad credit risks. Those who need to be on special alert include manufacturers selling to dealers of products particularly sensitive to swings in the economy, such as consumer durables, power sports, outdoor power, farm equipment, furniture and musical instruments.

As more dealers fall past due on their payments or even go bankrupt, their suppliers can suffer significant chargeoffs. Fortunately, companies with large amounts of receivables can dramatically improve their balance sheets by partnering with a financial services firm to create a joint venture -- a separate company that oversees and jointly manages the credit and collection processes. The manufacturer becomes a profit partner in the venture, able to use the finance company partner's people, sophisticated systems and capital. The entire arrangement can be transparent to the manufacturer's customers.

The joint venture offers a fresh approach to healthier balance sheets and the ability for manufacturers to grow their business. To enter into a joint venture, the manufacturer contributes equity based on a percentage of the net receivables held by the venture.

For purposes of illustration, let's assume that the manufacturer and the finance company each put in 7.5 percent of the total receivables. The manufacturer has $100 million in receivables. The venture takes the $100 million off the manufacturer's books and, in return, requires an investment in the venture of $7.5 million. It then gives the manufacturer $92.5 million in cash. As the receivables grow, the manufacturer contributes proportionately greater equity. But if receivables decline, the need for equity falls, and the manufacturer gets money back.

Although the equity contribution is virtually equal, the recommended ownership split for the venture is at least 51 percent for the finance company, with the remainder for the supplier. This enables the venture to operate on a balance sheet separate from the manufacturer's, but still gives the manufacturer a 50/50 voice in election of board directors and other decisions in the venture's control.

The joint venture is a low-cost alternative to securitization, another widely publicized method of outsourced financing. In securitization, the manufacturer sells receivables into a securitization conduit. The loans are repackaged and sold as securities, which entitle the owner to some or all of the repayments on the loan. To protect the securitization vehicle from loss, the manufacturer often is required to contribute additional collateral equaling as much as 30 to 40 cents on each dollar of receivables, compared with the estimated 7.5 cents for the venture equity requirement.

Cash Finds Many Good Uses

Virtually any manufacturer partner in a joint venture can find enough good uses for the cash to more than justify its equity investment. As a financial executive, you may choose to reduce debt and improve your balance sheet's debt-to-equity ratio. You may buy back your company's stock or may invest in your plant, acquisitions or new product and services introductions.

The venture helps the manufacturer retain its existing dealers or attract new ones by addressing virtually all their financial needs, using the programs available through the financing partner. These may include inventory financing, open account financing, extended billing on display merchandise, asset-based loans and enlarged and dedicated credit lines to meet seasonal marketing needs.

In attracting new dealers, the ability to deliver affordable financing is often essential to induce a dealer to switch its product line. It's often cost prohibitive for the dealer to replace the display merchandise of its existing supplier with the goods of a new one. While the manufacturer alone might be unable to finance this new inventory, the venture should be able to do so.

Collections Made More Effective

For the venture to profit, collections must be as effective as possible. A state-of-the art collection system allows the finance company partner to collect faster and more thoroughly from dealers than the manufacturer can alone. That system would ensure that follow-up on past dues is immediate and if necessary worldwide.

This early warning system is especially critical if a debtor is in real financial difficulty. Making an early call can result in getting some or all of the debt back, while creditors who move slowly may end up getting little or nothing of what is owed them.

On a brighter note, this close monitoring often leads to rehabilitation of a struggling dealer through means such as reducing its credit line and inventory to a more manageable level, or putting product in warehouses that the finance company controls, instead of on the dealer's floor to remain unsold. If these measures fail, the venture can step out of its relationship with the dealer or help to arrange different financing.

The venture also gives the manufacturer additional income and savings pportunities, such as:

* The manufacturer's equity share of the interest on dealers' or distributors' loans, which would be paid entirely to the finance company in a conventional inventory financing arrangement, and other financing options such as asset-based loans and factoring.

* Savings from renegotiating discount agreements with dealers.

* Income from sales to dealers of products and services of the finance company partner. For example, venture partners can profit from premiums for insurance and fees for retail credit cards that the finance company can sell to their dealers.

How do these benefits work in the real world? A major appliance manufacturer has consolidated its financing with a finance company as its venture partner instead of the four firms it used before. It has lowered its inventory financing costs and now realizes half of the profits from the venture. And it has used the finance entity's resources to grow its business through various programs introduced to its dealers.

What to Look for In a Finance Partner

How should you go about entering a joint venture? First, find the right financing company partner. Look for one that that can provide:

* A state-of-the-art portfolio control, billing and collection system with demonstrated results. Make sure the financing company has licensing agreements with manufacturers of the computer hardware and software for state-of-the-art collection. And look for e-commerce capabilities, which can speed collections by enabling dealers to pay online.

* Seasoned finance professionals with joint venture experience and an established and proven infrastructure. A finance company with experience in joint ventures can provide a standard set of legal documents for review in setting up the venture as a partnership or a limited liability corporation.

* Knowledge and expertise in the organization's industry.

* A strong debt rating, which will enable the financial firm partner to raise cash on behalf of the venture faster and at lower interest rates than the manufacturer can.

Once it has found a potential partner that meets these criteria, the manufacturer should make sure it has realistic expectations and a meeting of the minds with the potential partner. This means that the manufacturer can't look at the venture as a way to take on higher-risk accounts than it would be willing to handle on its own.

Too many manufacturers give in to the urge to "ship product" to dealers with little or no concern about their ability to pay on time. The joint venture often benefits the manufacturer by providing a more disciplined approach to credit decisions.

Historical loss rates are priced into the venture, with both partners providing input into the credit decisions. However, in extraordinary circumstances, the manufacturing partner can have a credit enhancement option on accounts that the venture cannot credit approve. The venture would still manage the deal with the credit enhancement.

The partners need to agree on targeted pre-tax profit returns. The results are accounted for by the financial company, which should have the in-house tax and finance experience to produce the required venture management and audit reports.

Take Steps to Make the Venture Productive

A number of additional advance steps need to be taken to make sure the venture is as productive as possible, such as a functional design group that integrates the venture into the manufacturer's organization. It's important to win support of the manufacturer's existing credit department -- and that may mean setting up the venture offices at the manufacturer's facilities. Typically, half of the venture's employees are from the manufacturer's credit department and half from the partnering finance company. The manufacturer's staff members retain their existing benefits, seniority and pension eligibility. Top management positions should also be split between the partners.

Getting the manufacturer's business unit managers on board is also critical. Often their budgets are not charged for the cost of carrying their receivables under the existing financing arrangement, such as an open account system. If the managers will be charged under the new venture's accounting, this needs to be considered in setting their goals and compensation.

It's also essential to get the manufacturer's bank to approve the venture as part of its covenant with the company. The auditors of both parties must also be in agreement with the proposed accounting, and there must be full disclosure; the venture cannot be perceived as an Enron-type partnership.

The venture is a self-contained finance company. However, its structure must be flexible enough to allow it to outsource functions to the most efficient and cost-effective suppliers.

In short, taking manufacturers out of the collection business allows them to focus on what they do best, build high-quality products and sell them to paying customers. The joint venture approach to managing receivables can turn a nagging headache into a profit opportunity and a tool to add value for investors and customers alike.

RELATED ARTICLE: Venture Gives Welcome Jolt to Snowmobile Maker's Earnings

Polaris Industries, Inc., the world's largest snowmobile manufacturer, says it realizes roughly $12.5 million in additional annual pre-tax earnings, or 9 percent of its total, by outsourcing a majority of its accounts receivable function to a joint venture it created with Transamerica Distribution Finance (TDF).

The additional income is generated by Polaris' 50 percent share of the loan interest collected from its 1,700 dealers in the United States. Before the two companies entered into the joint venture -- called Polaris Acceptance -- all of this income went to TDF, which had provided inventory financing to Polaris dealers for more than 10 years before the joint venture was formed in 1996.

Mike Malone, Polaris vice president/finance and chief financial officer, says that the joint venture puts Polaris closer to its dealers by increasing its visibility in financing their products. Yet, Polaris can concentrate on its competencies -- making and selling quality products -- because it uses the expertise and technology in credit and collection management of its joint venture partner

"We wanted to offer more financial services to our customers, while relying on experts in the industry and their strong debt rating to mitigate the risks," Malone says. "It's in our best interest to ship product to the dealer and have it sell to consumers quickly. When that doesn't happen, we often have to offer discounts, issue rebates and incur other selling costs that burden our income statement. Now we offset those costs by sharing in the joint venture's financing income.

"We could have mitigated some of our risk through securitizing the receivables, but we'd be obligated to perform all the credit functions. We don't care to get into all that," Malone adds.

In 2000, the receivables of Polaris' parts, garments and accessories (PG&A) business were moved off Polaris' balance sheet and on to that of the joint venture. PG&A provides about 14 percent. or $200 million, of Polaris' total revenues.

Malone says that, unlike the notorious off-balance sheet arrangements in the Enron debacle, "Polaris Acceptance is a straightforward partnership that's consolidated on Transamerica's balance sheet and is accounted for as an unconsolidated subsidiary on one line in Polaris' balance sheet and income statement."

Malone observes. "The Financial Accounting Standards Board's generally accepted accounting principles require that an off-balance sheet partnership must have a 3 percent investment from an outside partner. In this case, the investment is 50 percent for both partners."

Both partners have equal representation on the Polaris Acceptance board of directors, agreeing on programs, pricing, services, partnership structure, return on investment targets and risk tolerances on new accounts. Both companies' auditors agreed on proposed accounting practices.

The partnership is housed at Polaris' Minneapolis headquarters, and the staff of 23 is headed by Tom Orluck, an executive transferred from Transamerica. Each partner contributed employees to the joint venture and shares costs equally. The workers transferred from the parent companies retain their original benefits, seniority and pension eligibility.

The joint venture uses dealer Web-based systems for much of its communications.

"Dealers like the ability to arrange financing, make payments and view their account status on-line," says Malone. As the company introduces new products -- such as a line of Victory motorcycles in 1998 -- Polaris Acceptance also finances those receivables.

After seeing the joint venture thrive in the last few volatile years, Malone concludes: "It's effective when the economy's going great, and our growth is substantial. But we've also found it to be effective when growth is more modest, and the economy is tougher."

John E. Peak is senior vice president and chief financial officer at Transamerica Distribution Finance, a provider of customized financing solutions, business inventory financing and asset-based lending. He can be reached at 847.747.7821 or
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Author:Peak, John E.
Publication:Financial Executive
Article Type:Column
Geographic Code:1USA
Date:Sep 1, 2002
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