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New jobs often bring new equipment needs, and that means putting pencil to paper and matching the productive capacity of the machine to whatever mountain needs moving. But there is one more calculation you have to make before you buy that machine.
The type of financing you choose can have a bigger impact on your profits than any of the productivity variables.
Cash has just about disappeared as a means of acquiring equipment, says Mark Killpack, executive vice president of CIT Equipment Finance, and for good reason. If a company is making 15 percent net profit on its capital and only pays 6 or 7 percent to finance or lease equipment, it would be losing money by tying up working capital in high-dollar cash purchases.
Loan, lease or rent: making the best choice
“The mix between leasing and straight loans has changed in the past three years,” says Tom Meredith, director for the Construction Equipment Group at CitiCapital. “In a low interest rate environment, loans become more attractive. With rates edging back up, leasing should be on the upswing,” he says.
But macro-economic conditions aside, there are a lot of micro-economic calculations you need to make – cash flow, business goals, tax status and utilization – before you can choose the right finance package.
A loan, or conventional financing with a series of fixed payments, may be the least expensive method depending on your business’s financial situation and tax status. Financing gives you the same depreciation benefit of a cash purchase but frees up working capital. You have to pay interest on the loan, but you can deduct your interest payments from your pre-tax income, and inflation tends to shrink the real cost of your payments over time. So the interest is not as expensive as it initially seems. The payments remaining on a loan are considered corporate liabilities, however, and as such will reduce your bonding capacity.
Some leases are considered operating expenses by the IRS and the payments can be deducted from your pre-tax corporate income. “The most important thing leasing does is help contractors manage their cash flow better,” says Jim Galecki, manager of market development for John Deere Credit. “Monthly payments on a lease are significantly less than they are on a loan. And for contractors, that’s the key to the industry today – managing cash flow. If you can save $1,000 a month on your cash flow, you can use that money to drive other parts of your business.” A lot of times, contractors don’t look at the time value of their money. But when you consider the time value of your money, there are times when a lease can be cheaper than even a zero percent loan, he says.
And a leased piece of equipment is not considered a liability like a loan you’re paying on, so you have more bonding capacity. “The decision will generally be to pay a premium in interest in order to acquire more bonding capacity,” says Charlie Sanders, president of Sanders Consulting Associates.
An operating lease is basically a long-term rental. At the end of the contract, the equipment is returned to the lessor or the contractor has the option to purchase the equipment at the “fair market value” – essentially the same price you would pay if you were buying it on the used equipment marketplace. These are typically used to acquire specialized types of equipment that the contractor is unlikely to need after the lease period is over or when contractors want to keep the newest equipment on hand to avoid technological obsolescence.
A finance lease, sometimes called a capital lease, has what is called a “bargain purchase” option that lets you buy the equipment at the end of the lease at a price lower than the fair market value. Each payment contains both interest and principal. If you decide to purchase the machine at the end of the lease, you can pay off the balance of what is owed in a final balloon payment or in some cases the finance company can convert your equity into a down payment and you can take out a loan to pay off the balance at a lower interest rate than the original lease. A lease-purchase agreement spells out what you will pay for the machine at the end of the lease and may contain an early-buy-out option that lets you convert the lease to a loan sometime before the lease is set to expire, typically six to 12 months.
A master lease is an agreement between the leasing company and the contractor. It sets out all the details and agreements covering numerous pieces of equipment and additional future acquisitions in one document. Then when you want to add a piece of equipment to the lease, you only have to attach a schedule to the master lease. Master leases also enable you to acquire equipment from different OEMs and dealers and used equipment all under one umbrella contract.
“We use master leases almost exclusively where we can,” Killpack says. “You don’t have to go through the whole process every time your equipment needs change.”
Rental, on the surface, is the most expensive way to use a machine, but also needs to be compared against the total cost of financing. Don’t forget with rental, you don’t pay taxes, fees, maintenance or any of the other costs associated with ownership. And nothing is more expensive than sitting on a machine you don’t need or can’t use – a problem you’ll never have with rental.
Utilization and rules of thumb
Deciding between a loan, lease or rental requires the help of your accountant and fairly sophisticated financial analysis of your tax status, cash flow and internal rates of return. (If your business manager or your accountant is not familiar with these formulas, check out Charlie Sanders’ book listed in the resources box at the end of this article.) But utilization rates usually play the biggest role in determining which financing alternative to choose.
If you’re going to be using the machine more than 75 percent of the time and you know it will be a key machine in your fleet for years to come, a conventional loan may be the best way to go, assuming it fits your tax, cash flow and bonding requirements. If you’re not sure you’ll need or have the right mix of work for the machine three or four years hence, a lease can keep you from getting saddled with unwanted iron.
If you have between 60 and 75 percent utilization, you probably need to consider renting or leasing, Sanders says, although for specialty equipment or places like Alaska or Minnesota that get fewer working days a year, a 50 percent utilization rate may be acceptable. The higher the utilization, the more sense it makes to lease, but again, the final decision may rest on your company’s financials.
Anytime equipment can’t generate 50 to 60 percent utilization, or for any machine you’ll use less than six continuous months, rental is usually the best option.
Captive and independent sources of leases
To promote the purchase of their equipment, many of today’s manufacturers offer in-house financing and leasing through their dealers, sometimes called “captive” financing.
“If the manufacturer wants to move backhoes, a captive will create a program to move backhoes,” Galecki says. In most cases this means below market interest rates for designated new machines. “Your captive finance companies will also probably take an aggressive residual position,” he says. “Because of the relationship we have with our dealers and our remarketing network we know we are going to realize a higher resell price. We have dealers wanting to buy units back from us so we can pass that benefit on to the customer in terms of a lower monthly payment.”
OEM-based programs also have the benefit of offering uniform rates across the country, so a company with multi-state operations can get the same deal from that manufacturer regardless of the territory, Galecki says. Independent finance companies (those not affiliated with a
manufacturer), in general, are more favorably disposed to options such as conversions of leases to loans and leases on used equipment.
Another strength of the bank-owned, independent finance companies, Meredith says, is their ability to provide a full range of banking services including working capital loans, cash management services, checking accounts, demand deposit accounts and foreign exchange services. “There are economies of scale and you can leverage that,” Meredith says. “If we have larger loans from strong credits it gives us the ability to get more aggressive on the pricing.”
Qualifying for a lease
As with any dealings with a bank or financial institution, you need to present a good case for yourself. Killpack recommends you come to the meeting with a credit information sheet on your business and all pertinent information including federal ID number, social security number, trade references and bank contact information. If you’ve been in business less than three years, be prepared to discuss your experience and give references. Even if you have bad credit, acknowledge it rather than try to hide it, he says.
“We will make credit decisions up to $250,000 from what we call a person’s willingness to pay, which basically means no financial information is required,” Killpack says. What we are looking at is payment history. When you get above $250,000 we look not only at his willingness to pay, but his capacity to pay. That’s where a financial statement is required.”
Additionally, Killpack advises that you come prepared to discuss your motivation for the lease or loan. “Why are you buying this piece of equipment?” he asks. “Is it because it’s shiny and yellow or does it have a use? Those who can tell me why they are buying it almost without exception get financed. But it has to make economic sense and not be just an emotional purchase.”
For startup companies and smaller companies it is especially important to come to the table with a strong business plan, Meredith says. “We need to know what they’re going to do, how they’re going to do it and when they’re going to do it,” he says.
Choosing a leasing company
Meredith urges contractors shopping for a finance company to look first at that company’s financial stability and commitment to the industry. “In the past three years, the industry has gone through a pretty severe downturn and some finance companies weren’t there to help. You want a company that will be there in the good times and the bad times.”
The finance company’s size is also worth consideration. “Do they have the ability to grow with you?” Meredith says. “If you take out a $1-million contract with them this year, will they be able to provide a $5-million package in a few years as you become more successful?”
And especially if you intend to lease, your finance company should have a broad range of experience and knowledge regarding the equipment.
Sanders also urges contractors to look for a company with a solid financial track record – something you can check with a Dun & Bradstreet rating and from current customers and peers. The company should also have a good reputation for integrity and fair dealing and have adequate staff to supply timely non-financial services if this is what you need, he says.