Revealing hidden costs
- April 26, 2012
What is the true cost of financing machinery and equipment?
by Daniel Wittlin and Adrian Isaacs
When looking to get a bank loan to finance machinery many companies only consider the rate of interest quoted by their bank.
There are a number of other factors to consider. In this article, we are going to elaborate on three of these: The hidden costs of financing; Consider the small print – the General Security Agreement; Perception of Debt.
Before reviewing these items, a brief recap of some of the key differences between financing and leasing is important. Financing is a loan and the manufacturer (or borrower) holds title to the asset. The bank quotes a rate of interest along with various terms to be considered. With leasing, the lessor takes title to the asset and charges a monthly “rental” type payment. At the end of the lease, the company can purchase the equipment; usually it’s a predetermined percentage of the original equipment cost or for a nominal value, depending on who you lease with.
Hidden costs of financing
In addition to the actual rate of interest to be paid when obtaining a bank loan to finance the purchase of machinery, there are many other hidden or indirect costs that need to be considered:
Legal fees: Banks often have comprehensive loan agreements which may require preparation or review by a lawyer. Based on a lawyer’s hourly rates, this could be sizeable costs to the loan. Plus, the manufacturer may also be responsible for the banks legal fees, if any.
Requirement to prepare ongoing financial statements during the term of the loan: Banks often require an annual audit or review engagement level financial statements done by an external firm of Chartered Accountants. These types of engagements typically cost from $5,000 per year and up, depending on the size and complexity of the business.
Costs of generating and reporting ongoing financial information: Banks require ongoing financial reporting during the term of the loan, which can include: providing monthly or quarterly financial statements and Accounts Receivable information. The manufacturer should consider the costs for the time required for internal staff to generate this information.
Costs to do the accounting for setting up the asset and loan on the books: There are costs for the company’s controller or bookkeeper to do all of the accounting for the financing, including the time to: track the asset on a fixed asset register, compute the annual depreciation and amortization, record the liability to the bank, account for the monthly loan payments between principal and interest, and reconcile the amount owing to the bank.
Costs for income tax preparation: Our external accountant needs to track the asset by tax class and then compute the annual Capital Cost Allowances allowed by CRA.
The Small Print – General Security Agreements
It’s important to be aware there is often terminology or language in the Loan Agreement which will give the bank a charge over all of the assets of the manufacturer; even if you are just financing one machine. This type of agreement is called a General Security Agreement (“GSA”) and almost every company that has an operating line of credit with a bank has signed one.
In the event of default, it gives the bank the ability to seize and sell off the majority of the assets of the manufacturer to repay the loan
including accountant’s receivable, equipment and inventory. Whereas typically, the leasing company’s only security is the machine they leased.
Perception of Debt
Another factor for manufacturers to consider is that when they finance equipment, the amount they borrow appears on their financials as debt.
If the business is seeking to raise funds generally, the existence of these types of loans can be negatively perceived. Often the amount on your operating line of credit is negatively impacted by your equipment loan, reducing the financing available to the company. Every lender has a limit in how much they can finance a client.
Manufacturers should evaluate leasing their capital equipment as a viable alternative to financing with their bank. If we have learned anything from the past few years it’s that anything can change at any time. Leasing is also an easy way to spread your financing needs to multiple sources, while allowing you to keep a strong relationship with your bank by having your operating line with them. The total cost for leasing vs. bank loans in today’s market are similar and usually the leasing company will finance a higher amount against the machines with less security. This is not to say that solid banking relationship is not a cornerstone to a successful company, it is. But just like you wouldn’t want your entire business reliant on one customer, so too should be your philosophy with your business’s finances.
Once you have evaluated all of the pros and cons of loan vs. lease, leasing is a viable solution for manufacturers. SMT
Daniel Wittlin is president & CEO and Adrian Isaacs, CA is a vice president of Enable Capital Corp., Toronto. www.enablecapitalcorp.com