Article by Darlene Menzies, CEO of Finfind
There are a number of reasons why growing businesses may need to raise finance, from bridging a temporary cash flow situation to a more long-term need like funding a major expansion. Research from over 5000 businesses applying for finance reveals that the top eight reasons for raising capital are:
- Purchasing equipment and machinery
- Funding business expansion
- Working capital / cash flow assistance
- Franchise funding
- Buying a building
- Funding a contract
- Property development
- Import financing
Let us look at the considerations for raising finance to buy equipment or machinery.
Buying Equipment or Machinery
When exploring the finance options to fund the purchase of equipment or machinery, the cost of the equipment or machinery you are wanting to buy will help guide your choice of funding. For smaller capital outlays, amounts under R50,000, it is often easier to fund these via credit card facilities, business overdrafts or term loans. Larger capital spends are best funded by dedicated asset funders or funding facilities provided by the equipment/machinery manufacturer.
There are a number of lenders that provide asset funding and due to the range of equipment or machinery that can be used in business. Many of these lenders specialise in financing for specific sectors or specific products. Some specialise in areas of expensive capital equipment while others may work in sectors where equipment redundancy is high – each has tailored their financing offering to suit the type of equipment or machinery, and the market needs. Many specialist asset funders have formed partnerships with equipment or machinery suppliers and will facilitate the purchase at preferential rates and often also offer additional services that can be very helpful.
What asset funding options are there?
Depending on the type of equipment or machinery you require, you have a few options as far as asset funding is concerned. There are three basic ways formal asset financiers structure their loans – financing for an outright purchase, rental agreements or leasing options. It is important to understand which finance option suits your specific business need.
- Financing an outright purchase of the equipment or machinery you need is done via aprime-linked loan from a lender where you then pay them back in equal instalments, over an agreed period plus interest. The period can vary from twelve months to more than five years depending on the life of the asset. The duration of the loan is usually equated to the lifespan of the asset – for example, IT equipment is depreciated over three years and so a shorter-term loan would apply. While you’re paying off the loan, the lender owns the asset, in the event that you can’t pay back the loan the lender has the legal right to sell the asset to recover the outstanding money. You can’t sell the asset without the lender’s consent. Once you’ve paid back the loan to the lender, the ownership of the asset reverts back to you. When you buy an asset outright, the maintenance and ongoing running cost are your responsibility.
- Renting is typically suited to situations where the equipment or machinery is only required for temporary use or where the use of expensive equipment or machinery is only needed for short periods. Rental prices can be high as the company that rents the equipment to you has to recover their costs and make a profit. Renting is a great option where you need a very expensive piece of equipment (i.e. a crane) for a relatively short period of time. In cases like this, there is no need to buy the asset or even lease it for several years, so a short rental is appropriate even though it might be at a higher price.Rentals work well in industries that are rapidly evolving technology wise i.e. computer equipment. In some industries assets become outdated within one or two years, and a lease could leave you holding outdated assets for five or ten year terms. Rental costs are always expensed on the income statement for both accounting and tax purposes.
- Leasing is a contract to rent an asset for a set period of time and for set payment terms. Leases often comes with many conditions in terms of the allowed use of the asset and sometimes even required maintenance terms. A typical lease is often long term, ranging from one year to as many as ten years. Significant penalties can be incurred by either party, the lessor (owner of the asset) or the lessee (user of the asset), in the event that either party violates the lease. It is also not uncommon for the asset to revert to the lessee at the end of the lease automatically or for what is termed a ‘bargain purchase option’ where the asset can be bought for significantly less than it is worth. This means that once the lease runs its course you have effectively bought the asset, though when considering the lease payments often for far more than it was actually worth.From an accounting and tax perspective leases typically fall into two main categories, operating leases and capital leases. If the lease terms meet certain criteria the lease will be considered capital, including:
- the value of the lease payments makes up most of the fair market value of the asset,
- the life of the lease makes up most of the effective useful life of the asset, and
- there is a bargain purchase option.
Capital leases require you to record the leased asset as a fixed asset on your financial statements and also record the lease obligation as a liability. Over time the value of the asset is amortized and the lease obligation decreases through payments made. An operating lease has no such requirement and you can simply expense the lease payments each time they are made, for accounting and tax purposes.
The decision to lease vs. rent really depends on what you need. If the asset is integral to your business and you need it there all the time, then leasing is your best option. The security and guarantee provided by a lease is important, and it ensures your business has what it needs. For short term periods where you don’t need an asset in your business year-round then renting is likely a better option. Renting may cost more over that short term period but the total cost to you will be lower since you won’t have the asset for many years.
What factors should you consider?
When it comes to choosing a funding option to finance an asset, it is always advisable to do a proper financial analysis prior to making your decision. For example, while owning an asset will add to the value of your business and the interest portion of the repayments, the depreciation, maintenance and running costs are tax deductible, it will require a large cash outlay upfront which can impact significantly on your cash flow. When lenders assess the merits of an asset loan application, they will expect you to provide sufficient proof that the business can afford the equipment.
Asset funders are quite particular about the type of equipment or machinery they are prepared to fund. The first thing to consider is whether the equipment or machinery has a good resale value. Items that are highly specialised and cannot easily be sold will incur a higher rate of collateral which adds to your costs. If the equipment or machinery has a good resale value then the collateral amounts required are lower or, in some cases, the equipment or machinery itself can be used as collateral.
Before making a final decision on the purchase, it is worth considering buying second-hand equipment. Obviously the type of equipment will impact this decision, but if you are in the construction or manufacturing sectors then good second-hand equipment may be a much more cost effective option. However, you need to consider that lenders don’t typically fund the purchase of second-hand equipment and machinery. The lenders are loaning you money to buy equipment or machinery and if you don’t pay back the loan, they need to make sure the asset has a high resale value. This is unlikely to happen with second-hand machinery although there are some types of equipment and machinery that still has a good resale value even if they are second-hand.
What do asset funders require from you?
The type of equipment and machinery needed by the business will dictate the process to be followed to apply for asset funding. Highly specialised equipment or machinery is best handled by specialist asset funders or direct enquiries to the manufacturer. Most manufacturers of capital intensive equipment or machinery have formed partnerships with selected lenders and they can help you understand what funding options are available to you and will guide you through the application process. Likewise, specialist asset funders have formed procurement partnerships and they will discuss the relevant options and assist with the application process.
For other types of equipment or machinery you will be expected to provide quotations that detail the type of equipment or machinery and the landed costs.
In general, there are three steps to be followed to finalise asset funding. Due to the work the lender must do in order to evaluate the loan application, an administration fee may be charged. If cessation documents are required to seed collateral to the lender for the duration of the loan, then the cost of drawing up these documents will be for your account.
Step 1: Evaluate the value of the asset. Factors to take into account are the lifespan of the asset, its total value, its resale value and the size of the market that might buy the asset should it need to be sold to recover outstanding debts.
Step 2: Evaluate the business risk involved in lending finance to your company. For example, lenders will want to know the amount of available collateral (a requirement unless the asset you are buying can be used as collateral). Typical forms of collateral are property, cash, shares and policies that have a value greater than the cost of the asset. They also want to know that the business can afford the repayments, so you will be required to submit financial statements that show the value of your business (balance sheet), trading history of your business (management accounts), bank statements which will show them how you manage your money, company registration documents, and a list of personal assets and liabilities. Lastly they will evaluate the risk of lending money to you. In this case your credit rating will be checked. A poor credit rating will not sit well with lenders as it indicates that you may default on repayments.
Step 3: The financial offer will be prepared based on the assessments outlined above. The interest rate charged and final amount offered will be determined by your risk profile. The higher the risk, the higher the interest charges.