What it means
A captive finance company sits inside a corporate group as a separate lending entity with its own balance sheet. Its customers are the parent's customers, and its loan book is built almost entirely from purchases of the parent's goods.
Many captives also fund the dealers who hold stock, an arrangement known as floor plan financing. The reason groups bother is that a captive turns a single sale into a stream of interest income lasting years.
It also puts credit approval inside the group, so fewer sales collapse because an outside lender said no. In several large manufacturers the finance arm quietly contributes more profit than the factories do.
Managers watch two headline numbers. Penetration rate is the share of the parent's sales financed in house, and net interest margin is the gap between what the captive pays for its own funding and what it charges customers.
A rising penetration rate can signal a healthy sales machine or a group buying volume with cheap credit, and the loss rate on the book tells you which. The important nuance is that a captive is a bank in all but name, so it carries banking risks.
Funding markets can tighten, and a downturn hits the sales side and the loan book at the same moment. Rating agencies and investors therefore look at the captive's accounts separately from the manufacturing business.
In practice
Real-world examples.
Example
A tractor manufacturer's finance arm offers 0% for 36 months on a $90,000 combine harvester during the autumn selling season. The factory funds the discount out of its own margin, the captive books the loan at a normal rate, and the sale closes in a quarter when the dealer would otherwise have missed target.
Example
A furniture retailer sets up a small captive to offer 12 month instalment plans in store. Average order value rises from $1,400 to $2,100 because shoppers buy the sofa and the rug together, and the captive earns interest on the plan for a year afterwards.
Example
A commercial truck maker uses its captive to provide floor plan lines to 200 dealers, financing the vehicles sitting on their forecourts. When freight demand drops the captive tightens those lines, and the parent immediately sees factory orders slow.
Formula
Calculation
Penetration rate = units financed by the captive / total units the parent sold. Net interest income = average loan book x (lending rate - funding rate).
A machinery maker sells 20,000 units in a year and its captive finances 12,000 of them, so the penetration rate is 12,000 / 20,000 = 60%. The captive's average loan book over the year is $300,000,000. It charges borrowers 8% and funds itself at 4%, a spread of 4%, so net interest income = $300,000,000 x 4% = $12,000,000. Credit losses run at 1% of the book, which is $300,000,000 x 1% = $3,000,000, and running costs are $2,000,000. Pre-tax profit = $12,000,000 - $3,000,000 - $2,000,000 = $7,000,000.Case study
Seen in the real world.
Northmoor Tractor Works is an illustrative, entirely fictional maker of mid-sized agricultural machinery. Bank appetite for farm lending had thinned, and roughly one order in five was collapsing at the credit stage, so the board set up Northmoor Financial Services with $60,000,000 of group equity.
Within three years the captive was financing 55% of unit sales and carrying a $240,000,000 loan book at a four point spread. Group profit rose, but so did the risk profile, and when grain prices fell arrears climbed and the captive had to raise its loss provision sharply.
The lesson the fictional board drew was to report the two businesses separately and set a hard ceiling on penetration. Sales targets could no longer be met by loosening credit, because the finance arm now had its own approval standards and its own profit target to defend.
Watch out
Common mistakes.
- Treating the captive's interest income as if it were manufacturing profit, which flatters the operating margin of the core business.
- Assuming a high penetration rate is always good news, when it can mean the group is subsidising credit simply to shift stock.
- Ignoring the captive's funding profile, so nobody notices that long dated loans are being funded with short term borrowing.
Questions
People also ask.
Does a captive finance company need a lending licence?
It normally needs some form of lending or consumer credit authorisation, and the exact requirement depends on the country and the type of customer being financed.
Why do captives offer 0% deals?
The parent pays the captive a subsidy, known as subvention, so the finance arm still earns a market return while the customer sees a headline rate of zero.
Is a captive the same as a bank owned by the group?
Not quite, because a captive usually funds itself in wholesale markets rather than by taking retail deposits, although the credit risks it runs look very similar.
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