Chalk it up to simple economic realities, but a capital expenditure requires quite a bit of forethought these days. Should you buy the equipment you need with cash, or should you take out a loan or lease the equipment you need?
These are the questions business owners are asking now that the economy is showing signs of improvement.
“If you are a business having difficulty raising capital, one consideration may be an SBA equipment loan, as it provides 100 percent financing with terms up to 10 years, whereas banks typically require a 20 percent down payment for a conventional loan,” says Gabe Makhlouf, first vice president in commercial lending at First State Bank. “Another option would be to tap into the equity in existing equipment to obtain 100 percent financing. There are types of equipment, such as computer hardware, software, restaurant equipment and office furniture, that are difficult to finance, and leasing may be the best alternative. In these cases, the leasing company is the owner of the equipment and assumes the risk of obsolescence or later marketability in a limited market.”
Smart Business spoke with Makhlouf about what you should consider before your next equipment purchase.
What should business owners consider when determining how to finance equipment purchases?
Many factors come into play, such as types of equipment and its useful life, economic conditions, tax consequences or advantages, and the company’s current financial condition. Questions to ask include, how long are you keeping the equipment? Can you utilize the tax benefits? If cash flow is an issue, is 100 percent financing more attractive via a lease or SBA loan than a conventional term loan where a 20 percent down payment may be required?
What are the advantages of purchasing equipment rather than leasing?
Although there are many individual advantages to purchasing equipment with cash or a loan versus leasing, these advantages can be placed into the following categories.
- Long equipment life. Companies tend to keep equipment around longer than they have in the past. When you get that initial piece of equipment and make your decision on financing, think long term and make sure you understand its value to your business. If the equipment you are purchasing does not have an obsolescence risk, has a lifespan of 15 to 20 years and you want to keep the machine, you are better off purchasing, as you will own the equipment long beyond its depreciable life.
- Tax benefits. There are tax benefits associated with new equipment acquisition and ownership. If your business has seen production and profitability increase, you could take optimum advantage of those benefits. In the past few years, government programs have been created to help jumpstart the economy, which allowed 50 to 100 percent depreciation for equipment in the year that equipment was placed into service. If you lease, it may be possible to pass bonus depreciation on to the lessor and do a true lease because you could receive a lower payment structure. The lessor would take the depreciation benefits and then pass those back to you in the form of a lower rate. Make sure you understand the tax ramifications of your equipment financing by consulting your CPA.
- Payments based on current cash flow. With a loan, you know exactly what your monthly payments will be and they usually remain the same throughout the term of the loan. Your loan payment is based on your current cash flow. With leasing, you need to be careful not to fall in the trap of initial lower payments that progressively increase. Oftentimes, this method is factoring in future performance that may not materialize to step up payments. With conventional financing, payments are based on current cash flow and rarely factor in future performance.
- Refinancing available. If your lease rates were set during a time when your company wasn’t performing as well as it is now, your rates may be higher than what you could obtain today. Most leases implement prepayment penalties that can render prepaying the lease almost impossible, as they require that all future full lease payments be made in order to fully pay the lease. When compared to conventional financing, companies can prepay equipment loans that are variable rate-based without incurring a prepayment penalty; even fixed rate loans have a preset and predetermined prepayment penalty that decreases with the life of the loan.
Should business owners consider purchasing used equipment?
In this recovering economy, many companies that have delayed equipment purchases may think they can easily purchase used equipment. However, that has proven difficult, as inventory is limited and, consequently, prices have risen. As a result, many companies are shifting toward buying new equipment as the cost and benefits outweigh buying used.
Should businesses purchase equipment with cash?
You may believe that if you have the cash available to acquire necessary new equipment, you should pay with cash, because it is less expensive than financing the equipment through a bank or equipment finance company. But it is important to ensure that your business remains liquid and has plenty of cash available to manage through any setbacks. A business can fail because of a shortage of cash, even while showing accounting profit. Also, the greatest opportunities to grow and expand often appear in times of market turmoil, and it takes cash to take advantage of those opportunities.
Where can a business turn for help?
Talk to your banker about a financing solution that optimizes your cash flow while meeting your accounting and tax objectives and your business needs. Interest rates are low and lenders are eager to help in this area.
Gabe Makhlouf is first vice president, commercial lending, First State Bank. Reach him at (586) 445-4856 or firstname.lastname@example.org.