Innovative approaches to funding help shops and plants acquire the technology they need.
Article
From:
12/1/2003
Modern Machine Shop, Chris Lyle
In recent years, many machine shops have experienced a significant decline in sales; compression of margins; increased competition; exportation of machining and manufacturing demand; difficulty in obtaining working capital and acquisition financing resulting in operating losses; and an erosion in tangible net worth. Those shops that have remained profitable and experienced upward trends have several common characteristics: experienced and disciplined management, a diverse customer base, no significant customer concentrations, proper leverage and stringent cash flow management.
A challenge all equipment buyers experience is determining the best means to fund an equipment acquisition: cash/equity, a bank revolving line of credit or an equipment loan. Equipment financing is especially difficult during lean economic periods, when a prudent businessperson needs to monitor and forecast cash flow needs and availability to remain solvent.
All three acquisition payment methods entail both advantages and disadvantages. Cash purchasing is simple, requires no third party intervention and alleviates a buyer from future debt/rental payments—yet a cash purchase may adversely affect a company’s solvency. Using a bank working line of credit availability is another simple funding method that requires no third party intervention. The bank line of credit financing method typically offers a competitive, variable rate loan, yet it may adversely affect a company’s access to funds needed for operational growth, cause business flow interruptions and impact daily working capital requirements. Leasing has become the most common method of funding equipment needs.
The Changing Equipment Finance Marketplace
The equipment finance marketplace has changed considerably in the last decade. As a result of consolidation, industry specialization and contraction of capital markets, machine tool buyers are left with fewer options to find financing sources in the traditional bank and finance marketplace. This has led to the growth of captive finance companies owned and operated by either a manufacturer or a distributor. Captive vendor finance companies provide finance products and services exclusively to their parent companies’ customers. Most progressive manufacturers and some of the more prosperous distributors are providing equipment financing as an extension of their selling services in order to promote acquisition.
Captive vendor finance companies provide convenient, creative and alternative finance solutions to equipment buyers. These companies offer distinct advantages over banks, finance companies and brokers. They have an understanding of the industry and equipment, the intended use of the equipment, customer credit profiles and the specific customer equipment applications. Furthermore, captives are able to offer a variety of finance products tailored to meet specific customer needs.
Reviewing Options
Many different finance options are now available. These include a loan, capital lease, finance lease, operating lease, off-balance sheet lease, tax lease, non-tax lease, promissory note/security agreement, skip payments, step-up or step-down payments, and many others. The variety of product options can often be confusing. To simplify the process, buyers should consider two financial concerns prior to selecting a finance product—tax appetite (the need for depreciation deductions to reduce actual tax paid) and cash flow.
If the buyer seeks the depreciation benefits of ownership, a non-tax lease, lease purchase, finance lease, loan or capital lease may be the product needed. Conversely, if the buyer has no tax appetite, prior or current losses, restrictive loan covenants regarding increased borrowing/leverage, or need for short-term utilization, then a tax lease, operating lease or off-balance sheet lease may be the product needed.
Once the lease product has been identified, the term and payment structure can be developed to meet the borrower’s cash flow needs. Other features of the lease such as rate, down payments, balloon payments, deferrals, commencement terms, prepayment penalties and guarantees are then typically negotiated based on the customer’s credit strength and specific needs.
“Skip payments” and flexible credit acceptance programs for equipment acquisitions on an application-only basis are in very high demand. A skip payment structure provides a payment deferral of 30, 60, 90 or even 180 days, allowing a customer to generate cash from the use of the equipment. The application-only credit approach provides a quick and easy way to fund the purchase of new equipment up to $250,000, without financial statement disclosure, based upon a buyer’s historic payment performance and character.
How One Builder Gets Creative With Leases
The majority of Makino’s lease structures are boilerplate 60-month term, lease purchase agreements with ownership transfer at lease expiration for $1.00. However, the company has also been asked to provide a few creative lease and rental scenarios.
Recently, for example, the company was asked to deliver machines to a tier one automotive supplier seeking temporary use of horizontal machining centers to qualify for a Production Part Approval Process (PPAP). This industry standard verifies that statistical methods and process controls have been implemented and have been proven effective. The machines had to be in place to receive this approval. If successful with the PPAP and contract award, the machine shop sought a long-term lease or a fixed purchase price option. If unsuccessful, the customer wanted to return the machinery without further obligation.
To accommodate the customer, Makino agreed to a sell price and set up a short-term rental allowing the customer to perform the PPAP. At expiration of the rental period, the customer was given the option of returning the equipment with no obligation, purchasing the equipment at the fixed price with a portion of the rental payment credited toward the purchase or opting to continue to lease the equipment.
In other cases, Makino has offered to refinance existing assets to lower a customer’s overall monthly payment obligations and incremental debt rate; facilitate like-kind exchanges or trade-ins; assist in the refinance of working capital lines of credit; and ship consignment machines into the customer’s plant while awaiting the delivery of a custom-engineered manufacturing solution. These examples show how the machine tool builder is trying to play the role of financial partner that banks no longer fill. The builder’s understanding of machine tools, the industry and customers’ needs put the builder in a position to create innovative funding options.
Investigating Solutions
Funding the acquisition of machine tools is always an urgent issue. For a number of companies, distinguishing themselves in the marketplace with exceptional machine tools provides an edge that is vital to their survival. Meeting their cash flow goals and determining short- and long-term acquisition funding solutions are essential. The health and growth of the machine tool user and the machine tool builder are mutually dependent. Programs such as machine tool financing allow a builder not only to support the user, but also to build a competitive and supportive marketplace.
About the author: Chris Lyle is the customer finance manager at Makino in Mason, Ohio. He can be reached at (800) 552-3288, or at chris.lyle@makino.com.
Tax Depreciation And Cut
After the terrorist acts on 9/11, Congress passed a tax relief act allowing companies that purchase a new machine to depreciate 30 percent of its value immediately. The remaining book value would be subject to depreciation according the asset class the machine falls into (as defined by the Modified Accelerated Cost Recovery System) and as allowed by IRS guidelines. Additionally, the act permits a company to reach back 5 years (as opposed to 3 years) for a tax refund.
In order to stimulate the economy this year, Congress passed President Bush’s jobs and economic growth tax relief bill, which contains a new 50 percent expensing allowance for machine tools and other equipment ordered between 5/06/03 and 12/31/04 and placed in service by 12/31/04. This increases the temporary 30 percent expensing allowance enacted in 2002.
Furthermore, small businesses (those with equipment purchases of all kinds that do not exceed $400,000) are permitted to depreciate the first $100,000 of an acquisition. They can then depreciate 50 percent of the remaining basis of the machine and apply MACRS depreciation as allowed by IRS guidelines to the remaining value. In other words, a qualifying small business that purchases a $100,000 machine can expense the entire value in the first year. A $200,000 machine could qualify for a $157,000 first year deduction (78.5 percent of the asset); a $300,000 machine could qualify for a $214,000 first year deduction (71.3 percent of the asset).
The tax incentive does not apply to the purchase of used machinery. This stimulates factory production and provides a persuasive, economic argument against purchasing used machinery versus new technology. In some cases, the tax savings/refund will offset the expenses associated with operating the machine for the first year. Keep in mind that the incentive is targeting small businesses. A cash refund may be received in the spring tax return for acquisition activity in the previous calendar year.
What’s The Right Financing Program For You?
A closer look at various financing programs shows that each has merits worth considering. Some of the most popular are reviewed here.
Capital Lease/Lease Purchase Program
Buyers select a lease purchase or a capital lease product if their long-term objective is to own the equipment, obtain the tax benefits associated with ownership and seek 100 percent financing. In a capital lease/lease purchase, the lessee enjoys the benefits of ownership and receives the depreciation benefits while the lessor retains a security interest in the equipment. Lease purchases are designed with end-of-term options or with guaranteed sales prices. Capital leases provide the following additional benefits:
A shop canpreserve its credit lines so that they are available for other needs.
Sales and use tax are paid during the term of the lease rather than upfront, as is customary with an outright purchase.
Payments can be matched to revenues by setting up a payment schedule that lets the shop pay for equipment with the revenue it generates.
Lease-end options are flexible. At the end of the term, the shop has two options.
It can purchase the equipment at a predetermined percentage of the original cost, typically for $1.00 or 10 percent of the original cost, as a so-called “balloon payment”; or
It can continue leasing the equipment at a predetermined percentage of the original cost.
Loan
A traditional loan (sometimes documented as a note and security agreement) is typically a bank product requiring a down payment of 10 to 20 percent. For tax purposes, a loan is treated the same as a capital lease. The customer owns the equipment and receives the tax benefits of depreciation and interest deduction. In most cases, the equipment itself acts as collateral. Loans provide the following benefits:
The borrower conserves cash by financing a portion of the purchase price, including sales tax.
Payments can be matched to revenues by setting up a payment schedule that allows the shop to pay for equipment with the revenue it generates.
Fixed or variable rate payments may be available.
Balloon payment options, which give the buyer a reduced monthly payment but a final payment representing some agreed-upon percentage of the original cost, may be available.
A borrower has the option of selecting either a fixed or variable interest rate. Advantages and disadvantages must be weighed. The variable rate transaction offers a lower incremental borrowing rate resulting in a lower monthly payment but carries the uncertainty of interest rate fluctuations. A fixed rate will carry a higher rate, resulting in a higher monthly payment when compared to variable rate transactions. However, the fixed rate structure offers the certainty that payments will remain the same during the term of the loan.
A variable rate product is indexed to float on a monthly, quarterly or annual basis. This provides the renter the opportunity to pay interest on a short-term rate, but to amortize it over a 5- or 7-year period. The variable rate is typically chosen when the renter believes that rates will remain low or continue to fall. Conversely, a fixed rate is typically chosen when the renter believes that rates are at an all-time low and wants to lock in the selection. This allows a shop to anticipate its budget, monthly principal and interest costs during the term of the loan.
Rental Programs
A shop may request a rental agreement for temporary use of equipment, typically for a minimum term of 12 months, for strategic rather than economic reasons. Renting is extremely expensive because the customer bears the cost associated with the front-end depreciation and utilization for the asset. However, renting may be the best option in some cases because it provides a short-term solution while avoiding the burdens of long-term ownership.
In addition, rental agreements normally provide an opportunity to purchase the equipment or renew the agreement upon its expiration. The accounting and tax treatment of renting a machine is the same as an operating lease or tax lease. There are two types of rental programs.
Rent-to-own agreements are ideally suited for those who think they might want to eventually buy the equipment. This option often features low buyout purchase options, flexible rental renewal options and easy return options.
Month-to-month programs offer convenience and simplicity if the shop has no plans to buy the equipment at the end of the original rental period.
A rental agreement provides the following benefits:
It helps to avoid obsolescence. Renting can be a flexible way to manage technological change and economic uncertainty.
It helps avoid capital budgeting constraints. When divisional or corporate capital budget limits are imposed, a rental agreement often allows companies to obtain needed equipment without the challenges of seeking a capital budget “exception.” Payments can be structured to remain part of an operation budget and can be treated as a periodic expense.
Flexible Payment Structures
It is worth noting that flexible payment structures are a hallmark of many captive vendor finance companies. The installation of a new machine tool often interrupts business processes. Builders are repeatedly asked to provide 30-, 60-, 90- or even 180-day skip payment plans to accommodate the business interruption or cash flow interruption. Captive vendor finance companies are able to provide this option, whereas traditional banks typically will not. Flexible payment structures help companies maintain a positive cash flow, among other benefits. Shops and plants that want to acquire a new machine tool should look at flexible payment structures. They make it possible for the shop or plant to afford the purchase when it would be otherwise unattainable.
