To Lease or to Finance: Is that Your Question?

Kathleen L. Powell and Curtis Ramsey

Independent Owner/Operators' Questions: What is the difference between leasing and financing?

While the terms "leasing" and "financing" are used interchangeably, they can mean drastically different contractual obligations.

First, straight financing is usually a simple loan: The buyer makes regularly-scheduled payments with a stated purchase option after the final payment. Banks are commonly used in this situation, and ownership at the contract's end is transferred to the buyer, usually for $1.

A lease is a contract of a slightly different form. First, the equipment's cost is not represented by the payments. Lease payments usually are significantly lower than loan payments - which allows the buyer to use the equipment for a lower monthly cost.

There are tax benefits to leasing, but ownership of the equipment is not $1.

Leasing is the best way to get equipment into the user's hands at the lowest possible monthly cost, helping keep the owner competitive.

This bottom-line approach allows many contractors to keep their overall bond costs lower because less overall debt is on their books.

Why should I use other people's money?

Cash is king.

Smart business owners know that using cash on depreciating assets is not a wise investment. Cash should be used on expansion and operating expenses.

The worst time seek a bank loan for operating capital and expansion is when the till is running low, and you really need it. Save your cash; it makes your balance sheet look much better.

If you have cash, you can always obtain debt. The reverse is next to impossible.

Additionally, interest rates are currently very low. Investing your cash into appreciating assets and investments, increasing your earning power while using "other people's money" to finance or lease your equipment is an intelligent move.

What are my competitors doing?

Owners' decision to finance or lease is based on the type of their equipment and on the company's net worth. Equipment factors include:

* If the equipment is in a variety of locations (containers or small balers, trucks), leasing will allow the owner to easily upgrade the equipment.

* The company will lease to keep monthly payments lower if the equipment is expensive (more than $200,000).

Certain factors in each company also affect their decisions. For example, expanding and profitable companies are opting for leases, no matter what the equipment is, so that the cash can be used for expansion and bank appeasement.

On the other hand, undercapitalized companies tend to finance, even if the equipment costs $500,000. They know that this equipment is vital and will outlast any future market lows. These companies are buying their future.

When should I finance? Lease?

As the owner, you and your accountant make the decision as to which method best deserves your business. However, if owners are operating under a specific contract or if they are expanding their business rapidly, a lease is usually the way to go. Leasing benefits include:

* You are not obligated to the equipment long-term. When the lease is up, you are free to find new, updated equipment for your next project. Or, if you choose, you may decide to purchase the equipment from the leasing company - usually at a bargain price.

* Your costs to operate the equipment are at a minimal exposure. Again, because it is a lease, the payments' value do not equal the initial equipment cost.

In other words, the equipment cost is being subsidized by an investor. This lower equipment payment costs allows maximum profit for the owner under the project contract.

* Rates on a true lease are below market rates. Without being too technical, it points to a lower monthly equipment payment.

* Leasing also can hide the true debt obligation on your balance sheet. You are only obligated to show the lease payment as a monthly expensed item, enhancing your tax position and debt ratios. So, when you need money from the bank, this lease obligation does not damage your debt ratios.

Financed contracts allows for:

* equipment payment over time;

* equipment ownership;

* equipment depreciation on the buyer's financial statements; and

* corresponding asset value shown on the buyer's financial statements.

What affects financing trends?

The equipment market is hot. New or used equipment doesn't stay available for long, so owners and finance companies must do their homework ahead of the application process.

* Both the finance company and owner must know the equipment specs and capabilities so that the approval time is cut to a minimum.

* Lenders want to see how the equipment will benefit the owner and how the operation will be cash flowed.

* Derogatory credit histories must be cleaned or have explanations prior to the application request.

* Lenders must be able to make a decision promptly and not take the traditional 10 days or more.

* With the availability of money in the economy, look around to find the best service with the most competitive rate.

* Deal with someone you like who comes with professional references.

Large Operators' Questions: Should I buy or lease?

This is the age-old question of capital expenditures. Today, the average new piece of equipment can cost as little as $25,000 for a forklift to more than $500,000 for a dirt haul truck.

Most operators' cash flows are predictable because they are governed by one or several contracts. Payments are predetermined by either a percentage of completion or on a per-unit basis. Therefore, the operator should have a reasonable idea of when to expect payment and how much each installment should be.

Given this, the operator should know exactly what can be afforded monthly. When weighing leasing versus buying, operators should ask:

* How much can I afford each month? Every operator should have a reasonable idea of the anticipated monthly cashflow available for debt service. As a rule of thumb, take the minimum amount expected to be received each month and subtract from that direct wages; fuel, oil and tires expense; average maintenance; insurance and any other direct operating expenses. This should leave the sufficient amount available to service lease or loan payments.

When borrowing money from a bank, the monthly payment must cover the bank's cost of funds and the amount needed to amortize your loan. This financed contract payment will not be the lowest monthly payment as compared to a true lease. The lease payment is typically lower than a loan payment. Assuming a longer term on a standard bank loan, the typical loan payment would generate lower monthly payments in most situations. However, a lease payment must cover the lessor's depreciation expense in addition to the lessor's cost of funds. Therefore, assuming a shorter lease term than a bank loan, the lease payment would generate a higher monthly payment.

* How much down payment can I afford? Most, if not all, lenders will require that some equity be invested. By definition, the lender will not have an ownership interest in the equipment. Therefore, the more the borrower has at risk mitigates the lender's loss exposure.

The lessor, conversely, retains an ownership interest in the equipment. Therefore, it will require less or sometimes no down payment by the lessee. In the event of default, the lessor simply repossesses the equipment and leases it to someone else.

* How long will I need this equipment/ how long is this contract? If the operator has entered into a 36-month or less service contract, chances are the equipment will have a longer life than the contract. Your questions should be: Do you want to own this equipment after the contract is over? Will you need this equipment in your on-going business?

If the equipment is needed in your normal course of business, then consider buying it. However, if this equipment is needed only for a specific contract and will not be used in the on-going business, then consider leasing. The rationale: Why would you want to own a seven-year old piece of equipment to operate a three-year contract? The depreciation expense in years four to seven will not be offset by income generated by the equipment.

* Is this equipment for a single purpose or could it be used in multiple applications? It makes more sense to purchase equipment with multiple applications which could be used on several different jobs. The depreciation expense would be offset by the cash flow of future contracts requiring the equipment's use. Special-use equipment with limited applications should be leased and returned at the contract's end.

* What is the expected useful life, given normal wear and tear? Whether you are buying new or used equipment, you should consider the equipment's expected useful life. If the equipment's life will exceed the contract life by 30 percent or more, consider purchasing. However, if the equipment life is less than 30 percent of the contract life, then consider leasing and returning the equipment at the contract's end.

* Am I going to want to own and maintain this equipment for the rest of its life? Maintenance varies dramatically between different types of equipment. Smaller units typically generate smaller maintenance bills - expenses which can be covered by normal cash flow.

The convenience of owning some equipment outweighs the monthly maintenance costs. However, large pieces of yellow iron can generate excessive amounts of regular maintenance per year - amounts which may not be covered by normal cash flow. Once the contract ends, will you be able to pay for an engine overhaul or a complete new undercarriage? Do you want to pay service-call repairs for idle equipment?

* Would I rather have more tax deductible expenses or reportable earnings? Companies with shareholders to keep happy or commercial banks to keep pacified may choose to own the equipment as generally accepted accounting principal's depreciation can be stretched over seven to 10 years, lowering annual depreciation expense and increasing current year earnings. However, smaller, privately-held companies that want to minimize taxable earnings may choose to lease because the entire lease payment is tax deductible, thereby lowering taxable earnings.

* What is my tax position/rate? The math is simple: Lease expense is 100 percent deductible, generating the most tax savings. Owning the equipment generates depreciation expense based on three- or five-year property, and only the interest expense portion of the monthly payment is tax deductible.

For companies with a low marginal tax rate or those that have low taxable income, owning the equipment should generate sufficient tax deductions through depreciation and interest expense. However, companies having the highest marginal tax rate or high taxable incomes, the lease payment, which is fully deductible, is the better answer.

Simple Credit: The ability to pay for purchases over time. It's what helps drive this economy at such a rapid expansion pace.

When you think about it, an equipment purchase bought under a financing or leasing umbrella hits a variety of businesses throughout the economy; benefiting many throughout the chain.

With a smaller business, equipment costs are generally so expensive that the initial cash outlay would put it out of business. Financing is there to assist. Not only does this generate a sale for the dealer that would not have happened otherwise, it allows the operator to use the equipment to generate revenue.

Further down the chain, the financing of that same equipment provides fee income for the financing company, benefiting others with revenue and income.

Even more important is the public effect: When the financing transaction is securitized and brought to Wall Street, it is represented under portfolios to be bought and sold for pension plans and mutual funds on the open securities market, benefiting even more individuals and investor groups far removed from the initial transaction.

The simple, initial equipment financing transaction has grown through the economy, providing income and revenue to hundreds in a ripple effect, keeping our economy strong and growing.

But, on the outside, the operator is deriving the most utility; he is the one gaining jobs, revenue from jobs that would otherwise have been turned away.