Financing capital expenditures
by Wim-Kees van Hout, SVP / Relationship Banker, Scott Valley Bank
As the economy continues its (mostly) gradual recovery, more and more business owners are looking at replacing old or investing in completely new machinery. Since many business owners have deferred such capital expenditures until the clouds over the economic landscape lifted somewhat, there is a palpable increase in equipment and machinery purchases over the past 12 months, which appears likely to continue. What is the best way for you as a business owner to cover the cost of such capital expenditure?
The cheapest way to cover the cost is to fund the equipment purchase out of the business’s cash flow. At least, that’s what people often think. However, depending on the equipment, its cost and how quickly it generates new cash flow, it may actually not be wise to take funds out of current cash as this may cause cash flow tightness later in the business cycle. In particular, it is almost never a good idea to take funds out of a line of credit to purchase capital equipment, as you are by definition reducing the cash available to support the business’s working capital. It is a little like using a credit card to buy a new car: such mismatching of a long-term asset purchase with a short-term financing liability frequently leads to cash flow shortages and worse further down the road. A good rule of thumb is that, if the purchase cost is big enough to be capitalized under your business’s existing capitalization policy, it is probably big enough to be financed with term financing.
Term financing comes in different flavors and may have different features added on:
- The first determination is if you want to borrow the funds under a loan structure, or lease the equipment.
- a.Under a true (often referred to as “operating”) lease, the bank will own the equipment and you will have the use of it. These types of arrangements can be good if you cannot use the depreciation of the new asset for whatever reason; for instance, if you are a non-profit (both the intentional and the unintentional -and hopefully temporary- kind!) or if your CPA determines you are better served by a lease. You are in fact passing on the depreciation benefit to the bank and will get a lower rate in return.
- b.Under a term loan (or financing lease), the depreciation stays with the company as owner of the equipment and no such benefit is passed on to the bank, so these rates will be a little higher than under the operating lease.
- Typical terms for both leases and loans are 3 to 5 years to pay off the debt (with leases commonly having one final, larger payment known as a residual), usually with monthly payment amounts the same each month for ease of use and accounting. The repayment schedule should fit in with the projected rate at which the equipment will repay for itself.
- Both a term loan and a lease can be structured with an initial ramp-up (or “drawdown”) period of 3 to typically 6 months maximum when only interest is payable: this helps for instance when a business owner knows they will buy additional equipment within the next 3 to 6 months, but has not yet determined exactly the type or cost of the equipment, or when it will be bought. By building in a drawdown period, you are not having to service debt for equipment you have not yet bought – and in fact you may never have to service that additional amount: if you do not locate the equipment you would like to buy, you simply end up using a lower overall loan or lease amount than the total amount approved. Another benefit of this drawdown period can be that bigger amounts in loans/leases may end up being relatively cheaper financing than smaller amounts, so it may work in your favor to gross up the financing to cover all your funding needs over a period of time instead of funding equipment purchases one by one.
- If your business or organization has a different frequency than a typical monthly cash flow, sometimes repayment terms for the loans can be adjusted to suit your particular cash flow cycle: some businesses receive big quarterly revenue checks and loans may be structured with quarterly principal payments instead of monthly ones to reflect that quarterly cycle.
- Finally, even at the smaller end of the scale it is a good idea to pay attention: having found a large number of unexpectedly high rates on small outside leases among our clients (like the “single app” leases that your office manager might sign for a copier), Scott Valley Bank has made an effort to pre-approve most of our business clients for the bank’s “QuickLease” program, which allows you to purchase even small office equipment with not just ease, but especially with peace of mind, knowing that your own bank is a straightforward and trustworthy partner who will not engage in misleading marketing or communication using very low, but demonstrably incorrect, teaser rates.
If you are contemplating a capital asset purchase this year, talk to your banker and review what type of financing and what features are the best in your particular case.