Publications: Equipment Financing: More Options Than You May Think

This article was adapted from Mr. Levenstein’s presentation to the Packaging Machinery Manufacturers’ Institute Solution ’99 conference at Pack Expo Las Vegas.

According to the U.S. Department of Commerce, U.S. businesses spent more than $600 billion for equipment in 1998.

The chosen method of financing equipment acquisition affects a company’s cash flow, taxes and earnings. The following discussion will provide an overview of equipment finance and a growing trend in the area known as equipment life-cycle management.

The needs and goals of your company will determine the appropriate option for financing equipment. The following factors should be considered: the company’s (1) size, (2) stage of growth, (3) cash flow situation, (4) balance sheet, (5) tax needs and (6) need to report earnings.

The basic methods of acquiring equipment are variations of the use of (1) cash and loans and (2) leasing.

(1) Cash and Loans. Cash and loans should be used to acquire packaging equipment which will have an extended period of use (generally in excess of five years) and where flexibility to modify the equipment is a forecasted requirement of the business plan. Purchasing equipment with available cash may be the least expensive choice. However, before this option is chosen, the overall effect on the company must be evaluated, because improper management of cash flow will cause financial hardship. Also, cash flow will be considered by lenders when determining the amount of credit to be extended to a borrower.

Cash is available to a company from operations, borrowings or capital infusions. Focusing for a moment on capital contributions, capital may be obtained from (i) existing shareholders, (ii) new investors by means of a private placement or an equity fund, or (iii) an initial or secondary public offering.

The price of securities is based on the company’s valuation. This is determined by the financial performance of the company, comparing the company with other companies in the same industry and analyzing current investment trends.

Borrowing is another popular option for financing equipment purchases. Fixed-rate loans are the most popular because they have a predictable payment schedule. Skipped payment plans are sometimes offered, which allow the borrower to skip paying the first payment for a specified period of time. There are also deferred payment plans under which the borrower only pays interest on the loan for a fixed period of time.

Another financing option available for small and mid-sized manufacturers may be public finance programs which provide equipment financing at low interest rates. These programs involve the issuance of corporate bonds disguised as municipal bonds. The interest on the bonds is earned free of income tax, which accounts for the low interest rates.

In order to qualify, a company must meet certain requirements. Companies may also qualify for other tax-exempt financing directly or indirectly from federal, state or local government entities.

(2) Leases. According to the U.S. Department of Commerce, 80 percent of U.S. companies lease some or all of their production equipment. The benefits of a lease financing structure are as follows:

• Little or no up-front cash/outlay is required.
• Certain leases are not recorded on a balance sheet as an asset or liability, so the company’s debt-to-equity and earnings-to-fixed assets ratios are not adversely affected. Nonetheless, bankers and other commercial lenders may still consider lease obligations when evaluating the credit worthiness of a borrower.
• Tax benefits are generated because lease payments are generally deductible as long as the transaction is not deemed to be a conditional purchase.
• It is easier for the company to maintain up-to-date equipment and reduce the burden of owning obsolete equipment.
• Leases can be tailored to match the needs of the company to address contemplated growth. Payments can be structured to match cash flow through deferred rental payments, cyclical rental payments, unequal periodic rental periods and balloon payments.

The disadvantages to the lease option are:

• Most lease terms cannot be terminated before the initial term is complete. However, some leases contain a “cancellation clause” which allows the lessee to return the equipment prior to the expiration of the basic lease.
• The lessee does not establish equity in the equipment.
• Lease payments may be greater than payments would be under other methods of financing when the potential tax benefits are not considered, and most leases require the lessee to remit all property taxes, if any.

Leases have different structures including operating leases, sale-leasebacks, capital leases and synthetic leases.

Operating Leases. Certain packaging equipment has a forecasted use of less than 5 years. This occurs when equipment is acquired for a designated short-term project, a new product launch, to manage short-term capacity fluctuations or for the introduction of new technology which provides increased performance. As products and related packaging requirements change or their customer mix changes, companies must maintain the agility to modify the equipment used to satisfy the requirements of their customers. The operating lease is the product of choice when flexibility is required.

During the term of the lease, the customer only pays for use of the equipment rather than paying for 100% of the equipment cost. This is possible since the lessor is responsible for remarketing the equipment at lease maturity. The projected equipment value at the end of the lease term (usually referred to as “lease maturity”) is imputed into the customer’s cost of use of the equipment over the term of the lease. The balance is the cost to the customer for use of the equipment over the term of the lease and is typically referred to as the “present value.”

The customer’s portion may be paid in a single lump sum payment or amortized with interest over the term of the lease in periodic payments. The single payment operating lease structure option is often preferred since the customer is not required to make additional payments during the term of the lease. This is important to customers that are concerned about the cyclical nature of their business.

Other customers select this single payment structure to avoid any interest expense when leasing the equipment.

From an accounting perspective, the lease payments are recorded as an expense on the income statement without a corresponding asset or liability. This off-balance sheet feature of the operating lease improves the company’s financial ratios, such as the debt to equity and return on assets ratios.

During the term of the lease the customer has quiet enjoyment and use of the equipment. Also, the customer typically retains flexibility to modify the lease agreement during the lease term to upgrade the equipment, add additional features, extend the lease or terminate the agreement. At lease maturity, the customer typically has the option to return the equipment to the lessor with no further obligation; renew the lease for an additional period of time; or to purchase the equipment.

When the equipment is returned, the lessor assumes the risk and cost associated with remarketing the equipment.

Sale-Leaseback Product. The sale-leaseback product is an often-overlooked financial product. It is useful when previously purchased equipment is forecasted to be surplus within a 5-year period of time. This could happen with a pending technology change, a change in the business plan or recognition of surplus capacity.

The sale-leaseback structure converts the value of the equipment into immediate working capital for the company while allowing the company continued use of the equipment. Further, this structure simultaneously transfers the impending risk and cost of remarketing to the leasing company.

In a sale-leaseback transaction, the equipment is purchased by the leasing company for cash and leased back to the customer for an agreed upon term and rental expense. The cash payment can be made directly to the company, or it can be used as a full or partial payment for new equipment that the company is acquiring in order to lease it to the customer. The sale-leaseback can also be structured as an operating lease. When this occurs, the transaction is recorded off-balance sheet and retains all features of the operating lease.

Capital Lease. This is the leasing method of choice in the packaging industry. Under a capital lease or finance lease, the equipment is recorded as an asset and the obligation for payment is a liability. Finance leases (also called non-tax leases) are more like a flexible loan and require less money up-front. These leases are treated as loans for tax purposes. A finance lease is very similar to a bank loan but usually permits higher leverage. The lessee receives title to the equipment after paying a certain amount. The lessee also receives the tax benefit of depreciation.

Synthetic Lease. Another type of lease is a synthetic lease, or off-balance sheet loan. This is a complex structure which avoids recording the debt or asset on the balance sheet (other than in footnotes) yet allows the lessee to be considered owner and borrower with respect to the lease obligation, thereby retaining the tax benefits.

Structure of Lease Arrangements. Leasing structures provide varying payment schedules and options. One option allows customers the use of the equipment for a specified period of time with an option to purchase at lease termination for the equipment’s fair market value. The business also has the option of extending the lease or returning the equipment at the end of the original lease term. Another plan includes a predetermined purchase price, extension and return option. If at the end of the lease term, the business opts to extend the lease, a second predetermined purchase option may be provided or the equipment may be returned. The advantage of this structure is that the guess-work of negotiating a lease extension or purchase price is eliminated.
Some vendors have implemented an “equipment rotation” plan, which allows customers who sign a long term lease (such as five years) with the right to cancel the lease after a certain period of time (often two years) so that capital may be used for new or different equipment.

Equipment manufacturers also provide equipment funding/financing. There are several benefits of financing equipment through manufacturers. They understand the value of the equipment and can be extremely flexible and creative when it comes to financing arrangements in order to further a transaction.

Equipment Life-Cycle Management

Equipment life-cycle management is a strategy that packaging companies can employ to improve their competitiveness in the manufacturing market. Equipment life-cycle management is defined as the methodology and timing for the acquisition, use and disposition of capital equipment. This process starts during the initial planning for the acquisition of equipment and ends with the disposition of the equipment when it becomes surplus. The methodology involves several distinct steps over the equipment’s life-cycle, including:

1. Assessment of existing equipment for functionality and projected time period of use;
2. Assessment of equipment to be acquired:
   • Review the business plan to analyze equipment requirements and limiting factors;
   • Financial alternatives for equipment acquisition (cash, loan, loan equivalent or lease);
   • Balance sheet issues and equipment control issues for partnerships and joint ventures;
   • Strategies to upgrade or replace existing equipment as business conditions change; and,
   • Disposition strategies once the equipment becomes surplus.

The goal of life-cycle management is to optimize the profitability of the company while maintaining operational flexibility and reducing the risk of equipment use. Once the equipment analysis is completed, the planning should shift to which type of finance product should be used to acquire the equipment. Similar to the production model where different types of technologies are employed to package a product, companies should use a mix and match financial strategy for blending the use of cash, loan, operating lease and sale/leaseback products to acquire and finance the packaging equipment.

Remarketing Surplus Equipment. The final segment in the equipment life cycle is the remarketing of packaging equipment which has become surplus. One solution for companies is to remarket the equipment directly to other end-users of equipment to receive retail value. The seller of equipment typically will need to recondition and reconfigure the equipment to the new buyer’s specifications. The used equipment buyer will typically require that the seller provide installment and warranty for the equipment.

Another technique used to address the retail market is the consignment of the equipment to a third party. The company retains title to the surplus equipment and the third party assumes the remarketing, reconfiguration, installation and warranty obligations for a fee.

The remarketing solution employed by the company will depend upon the amount of time, energy and resources the company elects to allocate to this activity.

There are many variations on the basic themes of cash/loans and leasing. You need to evaluate your company’s needs in order to determine which option is best for you.

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