Kaitlyn H. Axenfeld, CPA/CFF, CFE, Dannible & McKee, LLP
As we move further from the height of the COVID-19 pandemic, we are seeing a drastic hike in interest rates. Over the past fourteen months, the prime rate has increased by 5.00% (3.25% in 2022 to 8.25% as of May 2023). Today’s high rates are expected to stay, if not continue to increase, which means financing is more expensive, and projects are less affordable. Interest rates should be evaluated and considered in all aspects of your business – the cost of equipment, estimating and bidding, cashflows and backlog.
When considering financing or leasing machinery and equipment, it is imperative to look at the interest rate implicit in leasing and financing agreements and compare the cash flow in the short and long term for all available financing and purchasing options. The days of 0% interest rates are gone. Implicit and stated interest rates for equipment financing now typically range from 7% to 20%.
For example, a contract that requires a piece of equipment that costs $500,000, leased or financed over five years with an interest rate of 10%, would require cash flows for interest payments of approximately $42,000 in the first year. It would be approximately $137,000 over the five years. While the average savings account earns 0.39% APY. The $500,000 of cash in a savings account, with compounded interest over the same five years, would earn approximately $16,000 in interest income. The cost of financing the equipment is almost $120,000. It is crucial to evaluate these decisions and consider the best use of available resources and the impact on short- and long-term operations and goals.
When estimating and planning jobs, it is also important to consider borrowing requirements and the impact of interest. As an example, $1,000,000 over five years with an interest rate of 3.25% would result in a monthly payment of approximately $18,000 with a total interest expense of approximately $85,000. This same loan with a rate of 8.25% would result in a monthly payment of approximately $20,000 with a total interest expense of approximately $223,000. In a little over a year, the cost of financing $1,000,000 changed drastically, with an increased monthly payment and interest over the period increasing $138,000. This is important to consider when planning and estimating jobs. What is the expected timing of purchases and outlays compared to billing the customer? Is there an option to bill for significant upfront costs? What is the timing of incurring costs and subsequently receiving billings? If cash flows are such that borrowings from a line of credit are unavoidable, interest expense would need to be considered into account to ensure coverage of capital outlays. Streamlining payments and billings will help ensure the project stays on track and decrease the chance of liens, delays and unnecessary interest and penalties.
Not only is the contractor affected by rising rates, but interest rates also impact the buying power of investors, businesses and property owners. It’s common to rely on short-term or long-term loans to pay for construction and improvement costs. Rising rates impact the availability and qualifications lenders use to evaluate financing. The overall scope of projects increases as costs increase, but the amount of funding may not. Over time, the number of new projects may start to decrease, and existing projects may be delayed due to higher financing costs. This could lead to increased competition as there are fewer available projects.
Rising rates have a significant impact on daily operations. To remain successful, contractors must ensure that projects are estimated using anticipated interest rates and that projects are profitable enough to cover any increased financing costs. With the uncertainty of continued rate increases, contractors have to re-evaluate their thoughts on financing, specifically cash flow stability as debt becomes more expensive and implement a cash management strategy to ensure the best use of resources during this time.
Dannible & McKee, LLP, is a public accounting firm with offices in Syracuse, Auburn, Binghamton and Schenectady, New York. The firm has specialized in providing tax, audit, accounting and advisory services since its inception in 1978. For more information on this topic, you may contact Kaitlyn at (315) 472-9127 or visit online at www.dmcpas.com.