WHICH CAPITAL FINANCING OPTION IS RIGHT FOR YOUR BUSINESS?

For businesses thinking about financing an equipment purchase, there is good news. The resurgence in manufacturing means that more lenders are supporting this sector. Interest rates remain low, and with more capital in the market, more financing options are available. Potential buyers with good credit are enjoying flexibility through longer terms, often with no money down.

Companies that couldn’t secure loans a few years ago are starting to have financing options open up to them, even if the terms are not the best. This is a significant change from 2010, when very few options were available for these buyers.

PAY CASH OR FINANCE?

There are two ways to pay for equipment: with cash or through various financing vehicles. Paying cash enables a business to own the equipment immediately upon payment. The company can amortize the cost of the equipment over its economic depreciable life. However, purchasing equipment up front can also reduce the purchaser’s availability of cash for other investments, such as plant expansions or improvements, marketing or purchasing future equipment.

The ability to pay cash is unique to each customer. True cash buyers are few and far between. Typically, only 25 percent of all capital equipment transactions are done through cash. Capital financing is a much more common approach, accounting for 75 percent of all equipment investments. It’s easier to finance machine tool equipment than inventory or an acquisition, so people tend to save their cash for those other investments. Capital financing also enables a company to better match the monthly cash flow being generated from the equipment to the obligation of the monthly payment due under the financing vehicle.

There are two primary ways to finance machine tool equipment: through a traditional loan or by leasing the equipment.

With a traditional loan, the borrower is immediately the legal owner of the equipment and uses it as security or collateral to borrow the funds to pay the seller. The borrower then pays monthly principal and interest payments to the lender until the loan is fully repaid.

Leasing equipment is an alternative capital acquisition strategy that can lower the operating cost of high-performance equipment. Of all the financing options, leasing offers the most flexibility to meet a company’s unique capital expenditure needs. In leasing equipment versus buying, the lessee (the company paying the lease) is paying only for the value of the machine being consumed during the lease term. The asset continues to have a “residual value” after the term of the lease, which the lessee is not required to pay for unless he or she decides to purchase the asset at the end of the lease term. Typically, the better the quality of the equipment being leased, the higher the residual value will be on that equipment and, as such, less of the value is paid for during the lease term.

Leasing gives businesses the opportunity to match incoming and outgoing cash flows. Usually if a term loan is handled through a bank, the bank will require a down payment of 10 to 15 percent, which is paid up front. In the monthly payment under a term loan, borrowers pay either even consecutive monthly installments of principal and interest (mortgage style) or even principal payments with interest added on top of the principal (which means the monthly payments are higher at the beginning of the lease versus monthly payments toward the end of the lease). In either scenario, the payments required by the loan do not offer any flexibility that may be needed to match anticipated changes in the purchaser’s cyclical cash flows, such as seasonality.

The monthly payment under a lease is more like a mortgage—the same payment is due each month throughout the lease term. This amount, however, can be tailored to accommodate for anticipated changes in a customer’s cash flows due to seasonality, adjustments in contractual output or other issues.

With a lease, borrowers can usually finance up to 110 percent of the acquisition price, 100 percent of the equipment cost, plus 10 percent of soft costs such as tooling, rigging, shipping or installation. In some circumstances, lease terms allow for upfront payments to be deferred, giving companies the flexibility to defer making payments until the machines start producing and generate additional revenues needed to make the monthly lease payment. This option again provides better opportunity to match cash flows.

LEASING OPTIONS

There are two main classifications of leases:

A capital lease is very similar to a term loan. The asset and lease liability are carried on the company’s balance sheet, with monthly depreciation and interest expense being recorded. In a capital lease, the company is typically paying for the entire cost of the machine through the lease term (including any bargain purchase option at the end of the lease term) and, as such, owns it at the end, just like a traditional loan.

An operating lease is an agreement to use or rent the machine over a specified period of time. The monthly payment obligation is expensed in the lessee’s operations and shows up only on the profit and loss statement. An operating lease usually gives a company the lowest monthly payment obligation, as the company is paying only for the value of the equipment being used during the term of the lease. The value of the equipment at the end of the term is the most compelling cost driver for determining the monthly payment obligation. However, at the end of the operating lease, the lessee does not own the equipment, but instead has the option to either pay the then fair-market value to purchase it, return the equipment to the lessor or extend the lease. For situations where a manufacturer’s production contract may not be extended beyond the initial term of the lease and the equipment may no longer be needed, this option can be helpful as businesses decide what to do next.

In the manufacturing industry, our experience has been that approximately 65 to 75 percent of businesses choose a capital lease over an operating lease; however, each business’ financial situation is different. It is important for purchasers to work with a capital services organization that can make recommendations based on a company’s current and projected financial situation while taking into consideration their asset management strategy. This approach requires collaboration between the lessee and lessor so the lessor can gain an understanding of the lessee’s goals and objectives relative to their equipment purchase needs and its impact on the success of the business. Choosing a capital financing group that understands the manufacturing industry is typically the best scenario.

FINANCING A HIGH-PERFORMANCE MACHINE TOOL

Many businesses think they cannot afford a high-performance machine, but don’t realize that it can be a better value over time, especially when financed correctly. While the initial purchase price might be higher for a high-performance machine, the residual value typically is also higher at the end of the lease term than a lower quality machine.

Using a car analogy, someone has the choice to either lease a $50,000 high-performance car or lease a lower cost $30,000 car over the same period of time, such as three years. Due to the nature of the lease, the monthly payment requirement is primarily driven by the value of the car utilized (depreciated) during the lease term. The more value remaining at the end of the lease, the less the lessee is required to pay during the lease term relative to its original cost. The value of the higher cost car at the end of the three-year lease is 60 percent of its original value ($30,000), while the value of the lower cost car is 40 percent of its original value ($12,000). Using the higher cost car for the three years was effectively $20,000 versus the $18,000 cost to use the lower cost car over the same period.

It is also important to remember that purchasing the machine itself is only part of the equation. It does not include the cost of operating and maintaining the machine. It’s important to weigh the entire return on investment (ROI) for the capital equipment purchase, including operating costs, cycle time, tool life, part quality and equipment maintenance. A high-performance machine typically produces more parts faster, with less downtime, while a cheaper solution can result in higher part costs, shorter tool life, increased scrap, unplanned downtime and higher maintenance costs.

Finding a financing solution that meets your unique business needs is the most important factor in determining which financing vehicle you should use to grow your business.

ABOUT THE AUTHOR:

As manager of Makino’s Capital Services, Tom Scherpenberg works with manufacturers to deliver customized financing solutions to keep their business running efficiently and profitably. His 30 years of experience in the financing industry demonstrates a deep understanding of the market and the unique needs of manufacturers. For questions or financing recommendations, email [email protected].