Leasing and asset financing—answers to some common questions
The right strategy allows your shop floor to keep pace with business growth
Four years ago, I transitioned my career from machinery sales to machinery leasing. The change has allowed me to continue a rewarding career in the machinery and manufacturing sector, to stay in touch with former clients, and meet new ones.
In the course of our discussions about leasing and equipment purchase, we usually cover some common questions. I thought it would be interesting to share some of these questions—and provide answers for other manufacturers who might be at a similar stage in their business.
Ken, why should I lease?
The textbook answer is “pay cash for assets that appreciate, and lease or finance assets which depreciate” but as we all know, real life rarely works on textbook answers so here are a few real-world replies to that question:
1). Comfortable monthly payments—With leasing, you have the ability to match monthly lease expenses directly to revenue, instead of dealing with a big cash outlay for a machinery purchase. The lease payment is usually (or ought to be) a small percentage of the monthly revenue generated by the equipment. For example, a $100,000 vertical machining centre would work out to be approximately $1,900 per month over five years but should generate a minimum of $12,000 to $14,000 per month in revenue.
2). Working capital is king—All businesses struggle with cash flow. Customers string you out on receivables, or you take a big order and need to purchase additional material, tooling or hire another operator. There’s no need to tie up valuable cash in expenditures that can be financed. Your cash is better used in places that can’t be financed, such as business development costs related to hiring an additional sales or applications manager, product development, or as a deposit to buy your current unit or manufacturing facility. People assume financing is for the guy who can’t write a cheque but my biggest clients are successful manufacturers who can write a cheque but choose to spend their money elsewhere.
3). Increased borrowing capacity—The typical leasing company isn’t looking to be your bank. In a perfect world, leasing companies complement the financing you already have in place. Most manufacturers use their bank for an operating line to cover short term needs, and use lease financing for long term debt. As a business owner, you should never use short-term financing such as an operating line to pay for a long-term asset such as manufacturing equipment.
4). Simple and convenient—Most of the inquiries I get are from manufacturers who have either just secured a contract and won some new business, or got more work from a good customer. In either case, time is of the essence and getting machinery or capital in place quickly is paramount. A well-organized leasing company has the ability to react within hours and at worst in a matter of a few days.
This type of response isn’t what most people experience with their banks or preferred lending institution. However simplicity and convenience extends far beyond quick responses, once a deal is signed and assuming the account remains in good standing (payments are made on time each month) you will never hear from us except during the holiday season when we send out gift baskets to our clients.
Doing business with a bank will mean monthly reporting from either your accounting department or bookkeeper, as well as yearly reviews. These additional costs, which can be significant, aren’t reflected in the rate they charge. I tell my customers that bankers are usually my best salesmen.
5. Fixed rate—This one doesn’t come up as much as it should but once you sign a lease, the monthly payment and interest rate are fixed. A bank or lending institution will rarely, if ever, fix a rate, so over a five-year period the customer is subject to interest rate fluctuations. We’re currently in a time of historically-low interest rates but the Canadian economy is the strongest it’s been in the last two years and showing signs of a significant period of growth. This will no doubt lead to increases in lending rates at some point in the future.
6. Tax write-off—Although I’m not an accountant, I can tell you 99 percent of my clients write off their lease payment 100 percent as an expense no different than tooling, material, wages, etc. That said, I always tell my clients to have a conversation with their accountant or bookkeeper before they proceed if this is a factor in their decision-making process.
Ken, you’re a charming, witty, and handsome guy but I have a great relationship with my bank manager and to be honest, your rates are just too high.
Well maybe that’s not exactly how the question is framed but let me answer each one of these separately.
The typical leasing company isn’t trying to replace a bank and I always ask my potential clients: “do you have only one customer?” Usually, the answer is “no.” So then why would you only have one lender?
A bank will look at a business and put a number against it and unless something changes in either direction, that number won’t change. In other words, there will be very little opportunity to finance growth with a bank because everyone knows growth doesn’t show up on financial statements until it has already occurred.
On a personal level, I can give you another example of why having one lender doesn’t make much sense. Our family business had a 40-year relationship with a chartered bank. At our height we had 45 employees and $40 million in sales. We had a $12 million letter of credit facility and a $1 million operating line which we never used because when business was good we able to cash flow our sales.
All we needed a bank for was to issue letters of credit to a Japanese machine tool manufacturer. A letter of credit is the only way an overseas supplier will release equipment beyond receiving the entire purchase price prior to shipment.
One day, our bank manager picked-up the phone to call my grandfather and the conversation went something like this: “We’re sorry Mr. Gross but we just don’t want to be in the manufacturing sector anymore. Thanks for the business.” The situation led to some tumultuous times for our business.
Higher rates / secured assets
A chartered bank gets its money from customers and the cost of funds is basically whatever they pay on deposits. If you have any money in the bank, you know it isn’t much—less than 0.5 percent. This allows them to put out cheap money but in order to secure their investments, they take far more than the equipment they’re funding as collateral.
They’ll insist on the guarantee of the owners, and put a general security agreement (GSA) in place, which basically means all the current and future assets of the company, including existing equipment and receivables are also secured to support the loan. In many instances, the owner’s personal residence and other property is also secured.
A private non-bank leasing company gets its money from a number of different places but it’s not a deposit-taking institution and therefore, has a higher cost of funds. However, the higher cost can be justified in a number of ways. First, leasing companies specialize in particular industries and have experts on staff with excellent knowledge of the assets they’re financing, and they will entertain deals banks won’t consider.
Second, in a normal transaction the only security is the asset itself. Plus, by leasing, there are additional savings by avoiding the necessary legal fees required to get a deal in place with a bank, as well as the ongoing monthly and yearly reporting requirements which also have hard costs associated with them.
When put in into real-world terms and to continue to use the $100,000 example, paying a three percent premium in interest rate works out to be $150 per month. If the difference between bringing in a new piece of equipment which will generate an additional $12,000 to $14,000 per month in revenue or not proceeding at all because your bank manager rejects the loan is predicated on not wanting to pay an additional $150 per month, then you have to take a moment to wonder why you’re in business in the first place.
Ken, can I pay-off early?
This is another question I get all the time. There’s no penalty to paying a lease off early but there isn’t a lot of benefit either. Mentally, I understand everyone wants to be debt free. Believe me, if I could pay off my mortgage tomorrow I would, but at the same time, if paying off my mortgage is going to cripple my ability to buy groceries or pay for gas, it probably doesn’t make a lot of sense.
From a tax standpoint, the lease is normally a tax-friendly solution so paying it off early will impact that benefit. I’ve written hundreds of leases in the last four years and the amount of customers that actually pay off early is less than two percent. Normally, the payment becomes part of the monthly overhead and because the equipment is generating so much additional revenue, it’s easily justified.
Usually, my customers tend to finish the lease and then start another one for a new piece because they’ve become accustomed to making the monthly payment.
Ken, what if I want to upgrade or raise some working capital?
If my customer finds after a few years, the 40 x 20 VMC is too small or inefficient and what they really need is a 60 x 30 or a horizontal, they just have to approach their selected vendor (dealer) and trade it in against the new piece. If the trade-in credit is less than what is owed, the difference is financed in the new lease. If the credit is more than what is owed, the savings reduce the amount financed and in turn reduces the monthly payment.
If the client is in growth mode but running short of working capital, we can actually raise money against the equipment because we know there’s available equity. To continue with the $100,000 example, we know a good piece of equipment will hold its value and after about three and a half years, the machine may still be worth close to $60,000 (assuming it’s been properly maintained) even though the amount owed against it might be closer to $40,000. This means we can easily get the client $20,000 in cash and re-write the lease.
The main point here is dealing with a private leasing company as opposed to the typical bank allows for more flexibility and many additional options.
The key take away is investing in good equipment, either in cash or with lease financing, is always a smart move since good equipment will always provide value to your business.
Ken Hurwitz is the Senior Account Manager with Blue Chip Leasing Corporation, an equipment finance company in Toronto. Ken has years of experience in the machine tool industry and now works to help all types of manufacturers either source or tap into their own capital to optimize their operations.
Contact Ken at (416) 614-5878 or via email at firstname.lastname@example.org
Learn more at www.bluechpleasing.com
This article is part of the Financial Management Success Centre.