- Anthony Roberts/
- January 2019/
Getting the capital structure right is crucial.
Don’t make your life any harder than it has to be.
Getting the mix of debt, equity and asset finance right, or in other words, optimising your capital structure, will make a substantial, and potentially critical, difference to the success of your business.
We work closely with many different businesses - helping them navigate the different types of asset finance structures available; choose which will be most suitable for them; and understand how making the right financing choices are central to a successful business strategy.
Cash is king in business, but particularly in small and medium sized businesses. Most business owners report that cash flow is the issue most likely to keep them up at night, and rightly so. It’s the issue most likely to determine the success or failure of your business.
That’s why the capital structure, or how you fund your business is so important. From equipment, to working capital, to funding future acquisitions and growth, you will need money to succeed.
Yet many business owners don’t have the time to develop a thorough understanding of the different options available, and don’t realise that the decisions they make could have significant consequences for their business.
The fact is that if you don’t match your finance decisions to your business structure and strategy, you could be selling yourself, and your business, short.
First up, a couple of asset finance terms explained.
A finance lease allows you to pay for an asset over time. At the end of a finance lease, you will own the asset. This kind of lease appears on your balance sheet and the payments you make will cover the full cost of the asset, because broadly speaking, you will be in the same position as if you had actually purchased the asset outright. Some finance leases include running costs and some will have a balloon payment at the end.
An operating lease allows you to pay for the use of an asset over time, but does not convey ownership at the end of the lease. This kind of lease does not appear on your balance sheet and payments are treated as an expense in your P&L. An operating lease is often used for assets which have a residual value at the end of the lease, or are likely to become obsolete quickly. Most operating leases include running costs.
Rule 1: Keep your options open. Choose a capital structure which supports, not hinders, your growth.
Most small and medium businesses go straight to their bank when they need new equipment, and most will be offered a finance lease when they do.
A finance lease is often the cheapest and easiest option, for the bank, but that doesn’t necessarily make it the best option for you. But it doesn’t make it the wrong choice either.
What’s important when you are looking at options, is to keep in mind some important considerations.
Banks will only lend so much. Keep your debt (and equity) for expansion, not depreciating assets.
Since the credit crisis, banks have been subjected to strict regulations. These have significantly impacted who they will lend to, what they will accept as collateral and how much they will lend.
If you choose a specialist asset finance provider to purchase the equipment you need, you will keep your line of credit with the bank open. And preserve your capacity to borrow in the future. If you use up the total amount the bank is willing to lend you to purchase equipment, when you need bank debt for other purposes, like expansion, you may be refused.
At the same time, buying equipment with your equity rather than borrowing might not be the best idea either. Preserving your equity for the highest possible returns, returns to shareholders or yourself as the owner of the business, is generally a much better use of cash. Using equity for depreciating assets, isn’t the best return on your capital.
And bear in mind that when you borrow from a bank, they will usually require some form of security over your business, where asset financiers typically only secure to the asset itself. This leaves more control in your hands.
Focus on where your business is going, rather than short-term payment schedules
Sometimes a vanilla loan may appear to be simpler and less expensive than asset finance. But make sure you also think about the total cost of the debt and the impact it will have on your business strategy. In particular, consider the following before making a decision.
- Three years down the track, where do you see your business. Where are you heading and what assets will you need to get there over the next few years?
- What is the effective life of the asset you need, is it technology-based, likely to become obsolete in the short to medium term, when will you want to upgrade? The answers to these questions can reveal the kind of finance structure which will suit you best.
- If you are likely to need the asset for 10-15 years, and it’s central to your business, then owning the asset at the end of the finance period makes sense. Here, a finance lease might be the best option.
- If the asset is tied to a particular customer (which you may or may not retain), or its effective life is 4-8 years rather than 10-15 years, then the flexibility to hand the asset back via an operating lease, might make more sense.
- What do you plan to do with the asset? If it is material to the future of your business, then as you grow, you may need it to produce an equity return. In this case, a rental, in the form of an operating lease, rather than a purchase (outright or through a finance lease) is a good option. Because you don’t actually own the asset, you don’t need to absorb depreciation, but instead will have a quarterly expense to offset against the revenue that the asset generates.
- Think about residual cost. Ownership can seem important, but it isn’t necessarily the best option from a financial point of view. If what you own is an asset that is rapidly depreciating, then any value in the asset can be illusory. Simply leasing equipment in order to make money from it could be a better option.
Rule 2: Work with a partner who understands your business. And the kind of equipment you need.
Businesses range from the simple to the complex, and in the same way, the equipment they need ranges from the simple (a car for example) to complex (like cutting-edge machinery or technology) which is used by only a few.
It takes time to understand a business, so choose a partner willing to take that time – to come to your business, to talk to you about your business strategy, to understand the equipment you need - so that you can work together come up with a capital structure which will help you achieve your goals.
There are a number of things to look for in an asset finance provide:
- A financier who takes the time to understand your business – from your future strategy and plans, to the way you use the equipment you need, and when it will need upgrading.
- A financier that isn’t afraid to have the difficult conversations so has an honest and open conversation about the end of the lease, not just the beginning. What happens at the end, are you likely to need to hand back the equipment or not, what happens if you need to hand back early, all the sometimes tricky questions it’s easy to gloss over.
- A financier that is happy to look at your capital structure overall, and give honest advice about the best ways to finance equipment, and your future requirements.