As another year closes BHPH operators must focus on how to make next year better! The answers can’t be found in their year-end financial statements or even by reviewing unit sales numbers.
This article will discuss what every operator should evaluate in order to improve performance and profitability as follows:
1. 1. Indicators that your installment contracts portfolio needs a “tune up”!
2. 2. Proactive ways to improve portfolio performance by using metrics as your guide.
3. 3. The proper accounting for bad debt losses and why charging off those losses should not be deferred.
4. 4. Is your business model designed for success or failure?
5. 5. What you can learn from your losses so you do not repeat them!
Here are some indicators that your installment portfolio needs a “tune up”:
1. 1.Your receivables are increasing but your collections are decreasing.
2. 2. You are selling more vehicles but your portfolio is not growing at the same rate.
3. 3. Your bad debt losses are increasing and you don’t know why!
4. 4. Your portfolio is more than 50% liquidated and you aren’t replacing the “run off” with new originations.
5. 5. Your portfolio performance is worse than the NABD industry benchmarks which are available at www.subanalytics.com.
Hoping that next year will get better is not a prudent strategy. Waiting for the competition to decline or disappear isn’t the answer either! You must take a proactive approach to improving your internal portfolio performance and not depend on the competition declining.
The first step is to develop portfolio metrics: static pool, loss/liquidation, and default rates which are needed so you can compare your performance with your peers and identify performance trends. Here is what you can learn from the aforementioned metric calculations:
· - Net Static Pool Rates – measures the frequency and severity of your bad debt losses after recoveries (in dollars) over the life of pools of installment receivables. (This is your performance report card!)
· - Net Loss/Liquidation Rates – measures the pace of losses in your portfolio (after recoveries) in dollars before pools of receivables are fully amortized. This measurement is important for projecting cash flow, anticipating future losses, and in identifying changing trends.
· - Default Rates – measures the frequency of bad debt losses in units (not dollars) over the life of your installment portfolio. This metric is used to measure volatility and portfolio quality.
If you don’t have these metrics your access to capital to fund portfolio growth will be severely limited. Capital providers use the aforementioned metrics to evaluate credit risk and to project loan repayment. You can’t expect to borrow millions of dollars without these portfolio barometers.
The next step is to charge-off your bad debts when losses become known. Bed debts in BHPH are not like wine; they don’t get better with age. When customers become delinquent 60-90 days their ability to “catch up” is unlikely. It is important that delinquent debt be charged off when it is identified so that losses can be mitigated and the appropriate collection action can be taken. If a charged-off account is subsequently collected the recovery should be recorded when received. A timely and consistent charge-off policy provides a realistic picture of your portfolio performance and helps you avoid financial surprises. These bad debt charge-offs are deductible for federal tax purposes so your corresponding tax liability is reduced.
Your business model dictates your BHPH success! You must evaluate your business model periodically for cash efficiency. That means determining the cash return (ROI) on your portfolio investment. You would not make other investments without first considering their ROI and the same holds true for building a BHPH portfolio. These calculations require the use of static pool and loss/liquidation metrics needed to project future cash flow, after bad debts and recoveries. Such projections are used to identify capital needs and predict future financial performance.
A new Credit Loss Measurement Standard passed by the AICPA in June 2016 will require you to reserve for future bad debt losses. You must determine how this new standard will affect your loan covenants and borrowing relationship as soon as possible. Metrics are needed to estimate future losses and to adjust your reserve for bad debts in your financial statements.
Those who do not make portfolio adjustments periodically cannot expect better results. The BHPH industry must regain market share by learning from their bad debt losses and not repeating them. Do not enter another year without “looking under the hood” of your own portfolio! The more you learn, the more you will earn! Good Luck!
Kenneth Shilson, CPA is President of Subprime Analytics which uses data mining to perform computerized portfolio analysis for operators and capital providers to the subprime auto industry.