Too many times how a company finances equipment is the last decision made. But it shouldn’t be.
“Often companies see they have a lot of unencumbered money on their balance sheet and decide they’ll use it to buy equipment outright,” says Jim Altman, middle market Pennsylvania regional executive, at Huntington Bank. “That’s often a mistake because they’re purchasing and funding a long-term asset with short-term funds when it’s better to line up long-term liability for the purchase of a long-term asset.”
He says the recent downturn should have been a lesson that being illiquid is detrimental. By keeping cash on their balance sheets, companies can avoid the pitfalls of the inevitable next cycle.
“Tying up cash in an equipment purchase also limits options for expansion, whether geographic, additional product offerings or acquisition of another company,” he says. “Equipment financing can preserve that liquidity for future opportunities.”
Smart Business spoke with Altman about financing an equipment purchase.
What should companies consider as they look to finance an equipment purchase?
Financing an equipment purchase is usually done by leasing, financing through a loan or buying it outright. To determine which is best, there are three considerations.
First are the economic factors. This deals with liquidity: trying to manage cash with lower payments, improve margins or reduce tax burden.
A second factor is purpose. How will the equipment be used? Is this for a long-term or short-term project?
The third factor is technological. Some equipment will be obsolete in 18 months — smartphones, for instance — while other technology, like plastic injection machines, have not changed significantly in many years. How long the technology is expected to last until it’s obsolete will impact how an equipment purchase is best financed.
What are the advantages and disadvantages of leasing instead of owning equipment?
Compared to ownership, payments are lower when leasing equipment since the company is essentially renting it for a prescribed term. This option generally gives companies flexibility, especially when acquiring specialized equipment for a short-term project.
Leasing is also advantageous when a project requires equipment with technology that will soon be obsolete.
A disadvantage to leasing is the lessee doesn’t get the depreciation benefits. There are, however, noncash deductions to the tax basis. The money doesn’t come out of pocket, but it will help reduce taxes overall.
Leasing also isn’t the best option when acquiring sustainable equipment that will be used for a long time.
What types of leases are available to companies that wish to lease equipment?
There are typically three lease options, through only two are used in business. There are operating/tax leases, capital or dollar out leases, and synthetic leases.
An operating/tax lease is completely off balance sheet — the monthly rent goes into profit and loss statements. The lessee is giving up some tax benefits, but hopefully the bank is providing tax benefits to the company that reduce its payments. Companies can ask their bank for operating treatment or a tax lease to establish rates and terms to get this benefit.
A capital lease, in some ways, acts like a loan. In this arrangement, the lessee gets all of the depreciation benefits associated with the equipment, but they must put it on balance sheet, which is public information. Those obligations might impair funded debt to earnings before interest, taxes and amortization, but the lessee is technically the owner of equipment.
Synthetic leases are not used much anymore. They set up a company to pass Generally Accepted Accounting Principles in terms of the depreciation rules in the tax code that differ from the Financial Accounting Standards Board 13 for treatment of operating leases. A company can purposely fail tax to take the depreciation, but this has fallen out of favor.
Equipment finance specialists, only available at certain banks, can help companies choose the best financing option for the situation. They’ll walk a company through the three fundamental questions and direct a company to the right choice.
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