By Dan Furman
Across all industries, using credit is a standard practice. This is especially true for manufacturers, distributors, and other related entities – the need for new machinery, vehicles, and upgrades is constant and a key component to staying efficient and competitive.
For 2023, the economic climate can be tumultuous. With higher rates, inflation, supply chain issues, and talk of possible recession, it’s important that companies get the very best value on their financing and leasing deals.
What follows is a quick look at the current economic climate, and then a few best practices for financing and leasing equipment within this unique economy.
How high will interest rates go?
This is the #1 question asked by borrowers. And the answer is a vague “nobody knows.” To address inflation, the Federal Reserve raised rates repeatedly in 2022, including an unprecedented four consecutive 75 basis point increases.
However, inflation, while slowing a bit, is still increasing (the slow supply chain is not helping). While the Federal Reserve has indicated future 75 basis point increases might not be in the cards, they are still concerned, and have made statements that smaller increases are still likely.
Indeed, most experts are confident rates will continue rising in 2023, and then enter a sustained period of stagnation (neither going up or down) to ensure inflation has ended.
Best practices for financing and leasing
Since higher/rising rates are likely here for the foreseeable future, there are a few specific considerations that can help companies who are using credit. These best practices may seem rudimentary but can save a company from future pitfalls.
Best Practice: Waiting out rates is counter-productive
If a company is waiting for lower rates, they will likely wait a very long time. As stated earlier, the Federal Reserve is still quite concerned with inflation.
Unless they can wait years, a company putting off replacing or upgrading necessary equipment will almost certainly pay a higher rate than they would now. In addition, waiting can give an opening to competitors, especially in the case of production.
Here’s an anecdote that illustrates this: In March 2022, a client of ours was in the process of choosing between two models of a specific machine. During their deliberation, they inadvertently missed a rate increase. This caused them to consider canceling the deal. Their exact words were “we lost out”, solely because the rate was higher.
However, after some discussion, they realized they truly needed the machine. They financed it at the higher rate. Fast forward to now: there have been many rate increases since, but they are locked into a March 2022 rate. In essence, they didn’t “lose” – they won! That very situation is likely to continue deep into 2023.
Best Practice: Choosing the best loan or lease type
To keep it simple, we’ll discuss to most common finance and lease structures: an EFA (Equipment Financing Agreement) and an Operating Lease.
For most small to mid-sized businesses, a fixed-rate EFA is the most advantageous. An EFA is like a traditional loan, with predictable monthly payments and a defined term (note: a company should always insist on a fixed rate EFA since it shelters against future rate increases.)
Equipment purchased with an EFA is considered an asset and appears on the balance sheet (e.g., the company owns it). This means a full Section 179 Deduction may be taken, which is a very attractive benefit.
Now let’s look at an Operating Lease. Using this type of lease means the equipment is not an asset and remains off the balance sheet. This also means Section 179 cannot be utilized.
While it sounds like an Operating Lease may be undesirable due to the Section 179 factor, there are certain circumstances where a company may prefer it. One such circumstance is the company is public, and new assets need approval from the Board (which could be time consuming). An Operating Lease keeps the equipment from being an asset so it can be acquired quickly without board approval. Another reason is the company may be seeking investors, and fewer assets make it more attractive. Finally, some companies are forced to lease to prevent breaking bank covenants by keeping debt-to-equity ratios in check (more on this in the next section).
These scenarios excepted, most companies will realize more benefits utilizing a fixed-rate EFA when acquiring equipment.
Best Practice: Be aware of loan covenants and restrictions
Many loans will come with several covenants and restrictions (this is especially true with almost all bank loans.)
The most common covenant is a Blanket Lien, which puts a lien on all company assets, present and future. This prevents a company from selling any assets without bank approval.
Another common covenant is requiring a minimum bank balance (usually 80% of a loan’s value). This ties up a company’s cash – the bank balance cannot fall under the minimum.
Lastly, the most impactful covenant is requalifying for the loan annually. In short, this means a company cannot have a down year, or take on more assets/debt than the bank is comfortable with (hence being forced to lease). If a company cannot requalify, the bank can call in the entire loan immediately (and with the blanket lien and minimum balance, this can be easily enforced).
The best practice is to be 100% clear on all loan covenants and restrictions, and ensure they are both understood and tolerable. In many cases, these covenants can be avoided at the cost of an extra point or two of interest, which may be preferable even in a higher-rate environment.
Manufacturers, distributors, machine shops, and other industry professionals will always need credit to stay efficient and competitive. And by employing a few best practices, companies can get the best value from their lenders even in today’s higher rate environment.
About the author
Dan Furman is the Vice President of Strategy at Crest Capital, which provides small and mid-sized companies financing for new and used equipment, vehicles, and software, as well as offering equipment sellers a simple and risk-free financing program. Visit them online at www.crestcapital.com.
All views expressed in this article are those of the author and do not necessarily represent the policy or position of Crest Capital and its affiliates. These views are also opinion – always speak to your accountant or tax professional before engaging in any financial contract or tax matter.