New phone systems, specialized machinery, software with a hefty price tag, bulldozers or fleet vans… sooner or later, many businesses need to invest in some form of equipment.
It’s a natural progression as a business grows and ages.
For many, the knee-jerk reaction is to use an “already available” line of credit or operating capital loan to buy the needed equipment. It’s sitting there pre-approved and waiting to be used, the interest rate is reasonable and it saves time… it seems like an easy answer.
While it may be as simple as writing a check, a line of credit might not be the best financing solution for new equipment purchases, however. It pays to think through alternatives and the long-term impact of each one.
Lack of a fixed term and interest rate
Line of credit loans can have very attractive interest rates, but typically it’s not a fixed rate. It can flex based on the market at the time you borrow against the line of credit, so a major purchase might lead to a higher payment than you expect.
It also can flex based on the amount borrowed. If you use it to purchase equipment then need to withdraw funds to cover a payroll shortfall that pushes you over the borrowing limit, for example, your interest rate could increase substantially.
Even a single late payment can have a serious impact, turning a once low-interest loan into an expensive liability with years of payments remaining before the new equipment is paid off.
The variable rate on a line of credit can be very different than a fixed term loan, where a late payment might result in a one-time fee but won’t impact the interest rate.
Not only are the terms less friendly for this kind of expensive purchase, but you’re giving up the “insurance” of having readily available funds to draw on for immediate needs.
Goodbye, safety cushion
Most open a line of credit to have funds available if needed, which can then be paid down and re-used as needed. Unlike a fixed term loan that is paid off then closed, a line of credit is designed to be flexible as business needs ebb and flow. It remains open. If you use it to finance high-ticket items like equipment, your safety cushion is no longer available for unexpected emergencies, such as a payroll shortfall or holiday inventory needs. It can take years to pay off the balance.
Plus, once you’ve borrowed against the line of credit to its limit, there’s no guarantee a bank will be willing to risk lending additional funds if you have an emergency. You’ve backed yourself into a corner.
Short-term loan vs. long-term depreciating asset
Lines of credit are intended to be a short-term solution to a financing need. They’re also intended to be paid off quickly, much like a credit card. Using it to pay for expensive items that require longer terms to pay off and depreciate slowly might not make financial sense.
As a general rule-of-thumb, it’s a good idea to match short-term financing resources to pay for short-term needs, and long-term resources to pay for long-term needs. Here’s an example. If you need $30,000 for equipment that would have an expected lifespan of five years—say a new set of computers for your team of 18 graphic designers–and your business revenue would require around the same length of time to pay off that balance, financing it through a separate fixed rate loan would be a much better option than using a line of credit.
Not only is the line of credit free for other things, but matching your cash flow to how long something is expected to benefit your business makes sense. It helps you manage your cash flow effectively without draining cash reserves to make a monthly payment or reaching your borrowing limit.
Should you consider leasing the equipment?
Financing options for equipment aren’t limited to an outright purchase. If a start-up or small business doesn’t have the creditworthiness or profit margin that a bank requires, if the equipment loan dollar amount is high enough to exhaust its borrowing capacity, or if the equipment will require replacement in less than three years due to obsolescence, leasing can be a solid choice.
It results in a less expensive monthly payment and can offer opportunities to purchase, return, exchange or renew the lease on equipment once the original term ends. It also has a completely different impact on your company financials. An equipment purchase shows up on your balance sheet and may have deductible interest, but a lease payment is likely to be 100% deductible as an operating expense. Smart business owners might consider speaking with their tax attorney or accountant before making a lease versus purchase decision, along with bankers and lenders.
Obtaining multiple quotes on a leasing arrangement is also wise from a down payment and term perspective. If considering a non-bank lender, terms can vary drastically due to a general lack of regulation in their industry (compared to banks), and shopping your purchase can be very enlightening.
It’s also helpful to discuss different lease formats, such as a capital lease versus an operating lease. Each has a different impact on your bottom line and balance sheet.
Questions to ask before you decide
According to William Sutton, president and CEO of the Equipment Leasing & Finance Association (ELFA), these ten questions can help you decide if a lease or purchase is your best option. While it’s not an exhaustive list and speaking to a banker is suggested, it’s a great place to begin.
- How long will the equipment be required?
- What is your monthly budget?
- Will the equipment become obsolete?
- Can it be used for other projects?
- How much cash is required upfront?
- Who receives the tax benefit?
- How will a working-capital facility be impacted?
- How flexible are the financing terms?
- Is additional equipment anticipated?
- Who can help determine the best option?
To get more information about equipment funding alternatives and right finance options that fit your specific needs, visit a Horizon Community Bank branch today, or call to make an appointment with one of our loan officers. We’re committed to your business success!