Joseph A. Hardick, CPA, CCIFP, Dannible & McKee, LLP
When purchasing new construction equipment, one of the most important factors to consider is the financing option that works best for your needs. Paying in cash may be the most convenient and cost-effective option as it eliminates the concerns of long-term debt, high interest rates and debt-to-equity ratios. However, most construction companies opt for financing due to the lack of available funds.
There are three options available for financing equipment: short-term rental, lease, and loan. For our purposes, we will focus on the latter two. Although renting is a good choice for specialized equipment that’s only needed for a short period, it can be more expensive than taking out a loan or leasing. Renting is a suitable option here because there is no long-term commitment and maintenance is covered by the rental company.
Most companies, however, require long-term equipment availability. This is where leasing and financing are best suited. Both options have their pros and cons, so the best financing option will depend on how the equipment is being used.
Purchasing With a Loan
Obtaining a loan is the most common type of financing when acquiring equipment. It was particularly popular when there were low interest rates and fast tax depreciation options. With the rising rates, it is important to assess this option. Nevertheless, loans still offer many benefits, such as:
- It is the most cost-effective option in the long run.
- There are no usage restrictions.
- Payments can be customized to suit your needs.
- The equipment can be sold or traded at any time.
- Tax benefits such as Section 179 deduction or bonus depreciation are available.
Purchasing equipment with a loan also has some downsides, including:
- High initial cost and high down payments.
- Higher monthly interest and payment.
- Equipment can become outdated, potentially affecting resale value.
- A significant impact on cash flow.
Leasing Equipment
Leasing is another form of financing that has become increasingly popular recently. However, it’s important to note that the rising interest rates have also affected new leases. Recently, there have been significant changes in the rules involving leases, which could greatly impact your decision when acquiring new equipment. There are two types of leases: finance leases and operating leases, each with its own advantages and disadvantages.
A finance lease is similar to a loan, where it is a long-term commitment, and the equipment can be purchased at the end of the lease term. Several requirements must be met to qualify for a finance lease. The financial lease has the following characteristics:
- Fixed payment plan based on the equipment’s useful life and fair market value.
- Lower monthly interest and payment, but longer lease terms.
- The equipment might have usage restrictions.
- The option to buy at the end of the lease term, either at FMV or a predetermined price.
- A long-term commitment, sometimes can be longer than a loan.
An operating lease is any other lease that doesn’t qualify as a financial lease. An operating lease is like a rental for an extended period, where the equipment must be returned without the option to purchase it at the end of the lease term. The operating lease has the following characteristics:
- Flexible lease period.
- Requires the equipment to be returned at the end of the lease term.
- Does not impact the debt-to-equity ratio if it’s less than a year.
- Offers access to newer models and technology.
- Requires limited maintenance.
- Last for a short term, usually three years, but can be modified.
- Has higher monthly payments (flexibility comes at a cost!).
Summary
Making the right financial decision when purchasing equipment can greatly impact your profitability. The financial options available to you will depend on your specific situation, and there are many variables that need to be taken into consideration. However, if funds are readily available and the equipment is essential to your daily operations, paying in cash is the best option.
Contributing Author: Joseph A. Hardick, CPA, CCIFP, is a tax partner who has over 40 years of experience in all areas of individual and corporate income tax preparation and planning. Joe specializes in corporate tax and tax planning for manufacturing and construction companies.