Would you risk going into long-term debt to almost guarantee business expansion, and therefore profit?
Asset financing is a vital lifeline for many small businesses. From new cafes that require expensive industrial washers, to oil giants who want better drills but need to preserve cash flow. Leasing the equipment from lenders can be a much more cost-effective option. So let’s discuss equipment financing, and help you decide whether this is the right SME finance option for you.
What is Equipment Lease Financing?
Equipment lease financing allows small businesses to acquire machinery without limiting their own cashflow. A small business owner can approach a lender and get access to equipment financing instead of using working capital to access the business equipment.
Equipment financing refers to high-value machinery costing anywhere from $1,000 to $10 million. Loan companies chose to offer this service to recoup the cost back at an inflated rate. Alternatively, small businesses may need the equipment to grow and scale, but can’t afford to purchase it outright. Equipment financing allows business owners to spread the cost.
Types of Asset Financing for Equipment
There are a range of different finance options that could be used when dealing with equipment financing. In particular, there are 4 types of equipment loan used time and time again in the industry. These are:
- Hire Purchase
- Operating Lease
- Finance Lease
- Specialist Purpose
A hire purchase consists of the borrowing company owning the piece of equipment after the loan period is up. It therefore appears on both the assets and liabilities sheets during the period of the loan, as it is owned but money is still owed.
An operating lease is typically used when the borrowing company will not require the equipment for the entirety of its lifespan. The small business only requires the asset for a few years before it can be returned without being particularly depreciated. In this case, the lender retains full ownership of the equipment and covers maintenance costs during the loan period.
At the end of the loan period for a financial lease, the financier typically sells the asset to the small business. Having said that, the equipment will appear on the balance sheets of the borrowing party from the beginning.
Specialist purpose comes into use when the asset or small business is in a specific niche or industry. In this case, it is recommended that the source of finance also comes from inside the industry so that the lender has expertise and can be aware of industry-related costs.
How does equipment financing work?
Much like other forms of funding, equipment financing is a form of asset finance. This means that borrowers will hold a liability but retain full control of the shares in their company. An alternative option would be equity financing, but this sacrifices some of the shares (and thus the decision-making powers), as well as limiting potential profits.
Here is how equipment financing works:
- The lender will purchase the required equipment and will agree to insure and maintain it.
- The business owner will agree to lease the equipment from the company for a set period of time. This is usually between 1 and 7 years to account for the interest rate on the initial outlay purchase.
- The business owner then pays consistently over the agreed usage period and may be able to acquire the equipment at the end, depending on the type of asset finance deal entered into.
One of the most popular industries for equipment financing is agriculture. Farmers and producers rely on high-value equipment in order to make their processes more efficient, therefore leading to a higher output and turnover. But, it is not always realistic or justifiable to commit their own cash flow to the machinery.
Another business type utilising specialised asset finance is transport and private haul. These companies use asset loans to purchase trucks and lorries, as well as heavy lifting equipment, and agree to pay back their loan in increments over the following years. At the end, the businesses will either own the vehicles or have the option to buy them through the finance lease.
Benefits of Equipment Leasing
There are many advantages of equipment leasing for the small business in question. Firstly, the reduced upfront cost leads can improve cash flow. Not only does this leverage higher profits, but means that owners can diversify their outgoings. For example, the extra cash could be used to hire more staff to then produce a higher outlay. This may also lead to better tax efficiency.
Due to the nature of the loan, in most cases, the equipment financier is responsible for the ongoing costs and maintenance of the machinery. However, it also depends on the type of equipment and type of business. This makes it a stable and low-risk investment for the business owner.
Plus, businesses that may struggle to qualify for other types of finance should find equipment financing easier to attain. Owners have access to this new line of credit fairly easily, and little security is required against the loan. This is therefore a great option for newer businesses or businesses with very small cash flow but a strong strategy.
Disadvantages of Equipment Leasing
Of course, one of the most obvious drawbacks of equipment leasing is that the lender owns the equipment in most cases. This lack of ownership is a reminder that accidents are not covered under the insurance, for example. It could make your business liable for added and unexpected expenses.
Plus, depending on the cost of the equipment, you are likely entering into a long-term loan commitment. The lack of flexibility means that you must make sure you can pay back the principle amount and cover the interest rates, no matter the financial state of your company.
How do you qualify for equipment financing?
Business equipment financing is authorised and regulated by the financial conduct authority. There is a criteria for assessing equipment finance needs known as “DIMS”. All applications for equipment would be reviewed against this standard, however, it is fairly flexible. DIMS stands for:
- Durable
- Identifiable
- Movable
- Saleable
The other qualification for equipment financing is your ability to provide collateral for the loan. Lenders will look for hard assets to provide security. These include things like cash and property, and hold the majority of the business’ monetary worth. Alternatively, soft assets such as staff members, software or websites, are not a reliable source of collateral.
If the business cannot afford to repay the loan, the lender would need to seize hard assets in order to recoup the funds. This is why soft assets are not considered enough to offset an equipment finance loan.
So, is equipment financing right for you?
Asset financing sounds like an attractive deal but comes with a few catches to be carefully considered. But, it’s an incredibly popular option, with around half of companies getting help to finance their new equipment purchases in 2019.
Still, if you’re looking for other forms of R&D funding, there are plenty of finance options. Why not check out our resources on property financing or revenue-based finance? The great range of models out there means you can go into a new agreement with the knowledge to be confident in your decisions.
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