In business, there are three things you should always do without thinking. Firstly, manage your cash. Secondly, talk to your customers and thirdly, know your competitors. The reason why you never want to pay cash for heavy machinery is on account of this first rule – it is not a good way to manage your cash. In this blog, we will dig down into why it is THREE TIMES better to finance, lease, or rent heavy machinery than to dip into your cash pile. Reason 1: There are Better Uses for Your Cash
This happens more often than you think. In a moment of irrational exuberance, a business goes out and pays cash for a machine. A few months down the road they discover they are running a little dry on working capital and they have to go to their bankers, cap in hand, and ask for a loan. Given that the loan is not backed by an asset, the interest rate tends to be a lot higher than they would have been paying on the machine financing option. Businesses need to pay close attention to the preservation of their precious capital.
Reason 2: Protect Your Credit Lines
Credit makes the world go round and businesses should be obsessed about protecting their credit lines for when they need them. When you lease a new piece of machinery, you are availing yourself of a new source of credit and not drawing down on credit lines.
Reason 3: Other People’s Money is Powerful Driver of Investment Returns
Assume you run a plant hire business and you are eying a machine costing R500,000. You pay cash and rent it out for R100,000 per year net of costs and expenses. The return on investment is 20 percent (R100,000/R500,000).
Now, using your wily charms, you convince your local bank to finance the asset at an interest rate of 15 percent over 5 years. The banker requires you to put 10 percent down on the machine.
Let’s break down the numbers. The annual payment on the financing deal with the bank is approx. R128,500. Of this annual payment in the first year, almost R65,400 is allocated to paying down the capital balance while the interest payment is around R63,100. You still receive R100,000 in annual rental streams. We now minus the interest payments (not the principal payments because these are payments towards the ownership of the machine). Your net annual rent is R36,900. Your investment in the machine is the R50,000 deposit plus the principal payments (R65,400) which takes you to a total of R115,400. Your return on investment making use of the financing option is R36,900 divided by R115,400 is 32 percent.
This does not take into account the fact that the interest payments are tax-deductible. Assume a corporate tax rate of 30 percent. This means that your after-tax interest cost is lower. It is 70 percent (100 minus your 30 percent tax rate) of R63,100.
This is how the real calculation will look: Interest before tax: R63,100
Interest after tax: R44,170
Annual Rental before interest: R100,000
Annual Rental after interest: R55,830
Total Investment: R50,000 plus R65,400 (principal payments on finance deal in first year) = R115,400
Return on Investment: R55,830/ R115,400 = 48.4 percent
Your return on investment in year 2 gets a big kicker. When you calculate your return on investment, you do not need to take into account the $50,000 deposit which means that the denominator in the return calculation is smaller. Although you are paying more principal in the finance contract in year 2, you are also paying less interest. Let’s also assume that on account of the machine being 1 year older, the maintenance costs on the machine have increased and your total net annual rental excluding finance costs declines to R90,000.
This is how the numbers look: Interest before tax: R52,625
Interest after tax: R36,820
Annual Rental before interest: R90,000
Annual Rental after interest: R53,180
Total Investment: R75,840 (these are the total principal payments you will make in year 2)
Return on Investment: R53,180/ R75,840 = 70 percent
Summary
By not paying cash for the machine, you are achieving three very important objectives. Firstly, you are making your cash available for potentially more important destinations. Secondly, you are preserving your credit lines and thirdly you are more than doubling your return on investment over the medium term.
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