The most frequent reason to use lease financing in business is to retain as much cash for operations as possible while enjoying the benefits of the financed product (i.e. equipment and/or software). Having served as turnaround CFO and commercial financing consultant, I have seen opportunities missed by purchasing long use assets with cash. For example, companies have used operating cash for technology and equipment purchases only to subsequently find they are short on cash for operating activities such as payroll and vendor payments.
But before pursuing lease financing, do a business assessment. That is, know your numbers and know the value of the financing for you.
Lease finance underwriters (Lessors) generally use these following 7 criterions to evaluate financing requests:
1. Your personal credit score. You are considered “A+” credit risk if you have a 725 or better score. (See Credit Repair: How to Improve Your Credit Score). If you’re a private business owner with less than seven years in business you will likely have to personally guarantee (PG) the lease. There are exceptions. No PG’s are required for non-profit or government entities and sometimes for VC backed companies.
2. Average monthly bank balance for the latest three months.
3. Time in business. How long your business has been operating can be a significant impact on approval and cost of funds.
4. Type of collateral. Since lessors only place liens on equipment financed, collateral types known as hard or soft collateral will drive availability of lessors.
5. Dun & Bradstreet (D&B) Paydex. The Paydex is the credit score for a business. 80+ is considered an excellent score. (A Guide to D&B’s U.S. Ratings and Scores).
6. Debt service coverage ratio (DSCR). Your DSCR is a measure of the cash available to make current debt payments including principal & interest on loans plus lease payments from net operating income (NOI). A ratio of one or greater indicates the ability to service added lease payments. (What is a Debt Service Coverage Ratio)
7. Profitability. Although profitability is a vital measurement of business success, it does not limit a business’s ability to obtain equipment financing. In fact, there are specialty lessors that focus on businesses that are profit challenged.
After you’ve assessed your credit profile, the next step is to know what type of lease agreement fits your needs. There are 4 points that should drive your decision.
1. How long of a lease term do you want? Terms generally range from 24-60 months and sometimes up to 84 for hard collateral.
2. When would you like the lease to start? If the equipment/software is income generating, you may be able to request a delayed start such as 90 days.
3. How much do you want or must pay down? The usual amount is the 1st and last payments upfront, that’s about 5% of the total equipment cost.
4. What purchase option should you select? Now, this can be a tricky decision and will play out to your benefit or detriment at tax time and at the end of the lease.
There are 3 purchase options (PO):
a. Fair Market Value (FMV). FMV is a “tax lease” meaning you can write off every payment on your taxes. You agree to pay the fair market value of the equipment at the end of the lease.
b. $1.00 PO. One dollar out means exactly as it sounds. You pay $1.00 at the end of the lease and you own the equipment. This is a capital lease that has to be depreciated over the term of the lease which usually matches IRS and accounting rules.
c. Fixed percentage (FP). For example, say 10% of the original equipment cost.
When planning equipment, software and SaaS implementations consider all of the benefits of lease financing. 4 come to mind for me:
1. “Cash is King”! Conserving as much cash as possible for operations.
2. Matching outgoing cash with incoming cash. Buying equipment for cash when I can allocate the cost over 3-5 years is like paying an employee 3-5 years ahead.
3. How is the financing going to help me execute my strategic plans? This is the value of the financing suggested above. Just as there is a need for cash to make payrolls and pay vendors you may need additional equipment/software to achieve strategic initiatives.
4. Section 179 of the Internal Revenue Code. This allows you to write-off all equipment in the year of purchase up to a certain amount. This changes annually so please check with your tax advisor. (Section 179 Education).
Using a balance of lease financing, internal funds, equity and bank financing is a strategic move that informed corporate CFO’s use consistently. The next time that you are buying a long-term asset, consider all of your options, including lease financing.
Please leave your thoughts in the comments section below as knowledge gained and shared is how we all grow personally and professionally.
About the Author:
Julius has served as a turnaround and consulting CFO to health care entities in Michigan, Florida, Georgia, and Illinois. He has arranged credit lines, equipment leasing, purchase order financing and bridge loans for companies across many industries. He began his accounting career at “Big Four” accounting firms where he was a Senior Auditor, giving him a wide variety of industry exposure.