EQUIPMENT FINANCING By Mike Reiner
Businesses run on cash flow. The #1 reason businesses fail is because they run out of capital. Your business needs equipment to operate and turn a profit. Whether you’re a new start-up, replacing technologically or functionally obsolete equipment, upgrading or expanding, equipment acquisition will be a necessity for your continued success. Without giving up control or ownership of your business to outside investors, there are two main ways to acquire new or used equipment and technology …cash or finance.
Cash is easy. If you can afford it, paying cash is usually the least expensive way to go in the long run. In the short-term however, cash flow and day-to-day operations are more important. The question is, can you really afford it? Will saving a little interest today cost you more to borrow in the future because your financial ratios (liquidity and credit) aren’t as strong? Do you have enough cash reserves for unexpected emergencies? A minimum of 6-9 months of operating capital is a good rule of thumb.
For most companies, paying cash for major equipment purchases does not make good business sense and is simply not an option, so let’s look at the three main forms of financing in more detail; revolving debt (credit cards), installment debt (bank loan), and lease.
Credit card companies don’t care what you buy, why you need it, or how you’re going to use it. If you have a credit card, you’re already pre-approved. There are two things to be concerned about when using credit cards; 1) Total exposure, 2) Variable rates. Using a credit card for small purchases under $5,000 is an excellent short-term financing option. Small balances can be paid off quickly, and won’t use up too much of your available credit. In most cases, however, the cost of the equipment we’re talking about will be significantly higher than $5,000.
‘Exposure’ is the percent of available credit you have used. For example, if you have a card with a $10,000 limit and you’ve used $8,000, your total exposure is 80%. Your revolving availability is 20%. This ratio affects your credit and future borrowing. Revolving debt over 25%, considered “overexposed”, affects how lenders view your risk as a borrower and may limit your ability to borrow at the most competitive rates. It lowers your personal credit score, affecting both business and personal financing. Everyone from car dealers, banks, mortgage companies, insurance companies and credit unions use this as a risk indicator to determine if they’ll approve you and for what terms. Many employers will also check credit before hiring someone to see how they handle their personal responsibilities.
Credit cards, like bank loans, are variable rate. Even if you have a fixed low introductory rate, make sure you understand the fine print on the back of your agreement. The rate can be raised at any time, for any reason, even if you’ve made all your payments on time! Average credit card rates in the US are usually higher than bank loans and leases. For long-term major equipment purchases over $5,000 credit card debt may end up costing you more than you expected.
Everyone knows how important it is to maintain a good credit score if you have any intention of borrowing money, but it’s not just a matter of paying your bills on time. Here’s a general depiction of how credit scores are determined.
Additionally, lenders will also consider your industry experience, the type of equipment, where the equipment will be located, why it’s needed, and how it will be used to reduce expenses or increase revenue for the business.
Banks offer many different types of loans; secured, unsecured, interest only, home equity, credit lines, …etc. These “bank loans” are fairly uniform from customer to customer, offer competitive interest rates and several different payment plans. These are the “Pros” of bank loans and if you have an established relationship with a local bank, good credit (both personal and business), and strong financials then you should have no problem qualifying for a business bank loan.
Banks can’t fit a square peg in a round hole. They make most of their decisions based on documented business financial history. It can be difficult for new businesses to provide the loan officer with tax returns, W-2’s, bank statements, collateral, personal financial statements, co-signers, etc. You may need to hire an accountant and get appraisals, and obviously this takes a great deal of time and slows the approval.
Bank loans typically require a 20% down payment or more, they don’t provide 100% financing, and usually don’t cover things like taxes, shipping, installation, licenses or maintenance plans. If your objective is to conserve capital, additional out of pocket expenses like these can cost 40%-50% very quickly. Also, if you have to personally guaranty, it will be reported on your credit report which has the same effect as revolving or credit card debt…increases your exposure and lowers your score.
Most loans will require collateral unless you’re a very strong client. Usually this will be a ‘blanket lien’, meaning they will file UCC-1’s on all your business assets. Other common collateral can be in the form of a home or automobile, land and commercial buildings, CD, savings or investment accounts. Your collateral reduces the risk of the bank in making the loan, and places more risk of borrowing on you, the buyer. There is no easy way to get a 1:1 relationship between the collateral and your equipment, you can’t repossess half a building, so often times the banks ask for a lot more collateral than what you’re borrowing. This is called “over-collateralizing”, and since you effectively lose control of the asset until the loan obligation is satisfied (you can’t sell it), it’s typically not worth the cost when other options are available. Blanket liens also make it very difficult to borrow more money at competitive rates from other banks should you need to because you have nothing to secure it.
Like credit cards, bank loans are usually variable rate, which means the bank can increase your payments at any time for any reason, or call the note, requiring payment in full if they get concerned about the economy or your ability to make payments. Even if the loan says “fixed rate”, make sure to ask if there’s any situation in which the rate can be increased.
The loan officer will typically require updated financial statements from you or your accountant biannually, and can ask to review your books at any time. Many business owners simply find bank covenants too restrictive and time consuming for the marginal interest savings they offer.
Lease companies work with all types of credit, from new start-up businesses to Fortune 500 companies. It’s estimated that nearly 80% of businesses lease some or all of their business equipment. This accounts for several hundred billion dollars in equipment each year. Most leases are unsecured, and for under $100,000, they’re approved “Application Only”. This means tax returns and financial statements are generally not required. The obvious advantage is that leases are easier to qualify for and can be completed in a matter of hours as opposed to weeks or months.
Remember, you don’t have to own the equipment in order to use it. The equipment doesn’t know who owns it, it works the same either way. But don’t let the word “lease” confuse you, you always have the option of keeping the equipment at the end of the term if you still want it, you don’t have to return it.
The “Cons” of leasing are that all this speed, freedom and flexibility will cost you more in the long run than cash or bank financing if you decide to keep the equipment for its entire useful life instead of replacing or upgrading in 3 to 5 years.
If structured correctly as an Operating or “True” tax lease, you may be able to fully expense your payments each month as an operating expense just like rent. All businesses are different, therefore you should always consult your tax advisor on how to depreciate or write-off your equipment to minimize your tax liability and maximize your profit.
As a general rule, most equipment and technology you purchase for your business can be depreciated on the balance sheet using various accounting methods like MACRS, straight line, double declining balance, etc. In certain circumstances under IRS Section 179 qualifying equipment may be fully depreciated in the same year it was installed. This may be a significant advantage of financing over a cash purchase, because you can write-off the full amount of the equipment without paying for it.
Currently for 2010, qualifying businesses can write-off the first $250,000 in equipment purchases, and take an additional “Bonus Depreciation” of 20% of the amount over $250,000 up to program limits.
If tax implications are a major factor in your decision to acquire new equipment, you’ll definitely want to discuss all options with your tax advisor before making a decision.
Mike Reiner has specialized in capital equipment financing since 1997, and funded over 1000 equipment leases. His company First Pacific Funding focuses primarily on automotive, construction, high-tech and medical equipment. He can be reached directly at 1-888-335-3381 to discuss any future equipment leasing needs or for more information.