Banks versus leasing companies: Know the difference

This year marks my 12th anniversary in the equipment finance world. Even though all the changes to the world in the last two years have presented new and unanticipated challenges to the manufacturing industry, it has, for the most part, been on a very long run of both prosperity and growth.

This means manufacturers have had a constant need for equipment. It also means that borrowers have a constant need for financing.

I’m often asked by potential borrowers why their banks don’t seem interested in their business.

Buying the latest technology can be a very expensive proposition, and even though good equipment, when maintained properly, will run in a plant for more than a decade, it can be difficult for a typical bank to understand the real value of these assets.

At my office we have underwriters who have come from the chartered banking world, and I have heard many firsthand accounts of how banks typically review assets. Essentially, they look at every asset, whether it’s a machine tool or anything else, as one from which they can recover about 20 per cent of the value if the borrower defaults.

This means the borrower is judged based on a risk of 80 per cent of the transaction value and approved or declined accordingly.

How Banks Differ From Leasing Companies

When a leasing company with expertise in equipment looks at the same transaction, it knows that the recovery value for a machine tool is much higher than 20 per cent and, therefore, it is more likely to approve a transaction because the perceived risk is significantly smaller.

Even with that being said, my largest and most successful clients all have well-established banking relationships with large operating lines, which they properly use for short-term debt management, such as receivables and operational costs like buying tooling and material. They use equipment leasing companies as a complement to their bank and avoid using bank lines and working capital for long-term needs like machinery and equipment.

This type of financing theory allows these owners to reinvest in their business, where the return is much higher. One example of where cash is best used is product development; something which cannot be financed, but where the return can be enormous.

Leasing: An Example

One client of mine, a leading innovator in the medical industry, leases all its equipment, which allows it to reinvest profits back into the business to develop new products.

Leasing also allows for flexibility. When a new piece of equipment is purchased, it usually takes time to install, set up, program, and debug before it generates parts and revenue. However, regardless of whether the equipment is purchased outright or if a bank loan is involved, equipment is paid for upon delivery.

A leasing company can offer a program that defers payments for a few months, so they don’t commence until the machine is up and running and, most importantly, generating revenue.

This flexibility is also found when a customer needs to come up with a deposit before being approved for financing. A competent leasing company can structure the transaction so the deposit is paid over the first six to 12 months of the lease to relieve any additional stress on working capital.

Why Rates Are Different

One major difference between banks and leasing companies are the rates.

When a bank reviews a financing application, it first evaluates its exit strategy. Using a mortgage as an example, most banks have cheap rates (maybe 2 or 3 per cent). The reasoning is quite simple: A mortgage is a very long-term transaction, usually 20 years or more. Because the interest is compounded, even very low rates produce substantial interest and, in turn, profit for the bank.

More important, the bank also holds equity in the home from the first day, so in the event of default, the property is sold and the bank gets all its money back.

Leasing companies focus on commercial business assets.

For example, a $100,000 transaction for a machine tool isn’t a risk of $100,000 because even if the deal goes bad in the first year (when the fewest payments have been made) and the equipment is repossessed, a minimum of 50 to 60 per cent of the original value will be recovered.

A leasing company looks at the risk in the transaction as being the difference between the selling price when the machine was new and the recovered amount when it’s resold.

Keep in mind that new equipment depreciates the moment it is installed, and because the equipment itself is the collateral for the transaction, leasing companies face a riskier transaction than the typical bank does. This is one reason rates aren’t the same.

A leasing company not owned by a bank does business in an entirely different space and secures its funding from large institutions.

I believe that our recent history of low interest rates has led to an inflationary market, and it is just a matter of time before the Bank of Canada raises the prime rate. I expect this will happen sometime later this year, which will increase the cost of doing business at a bank. It is very important to keep in mind one of the benefits of arranging a lease and paying a small premium is that the interest rate is locked at the time the deal is funded.

It’s important to note that financing options exist beyond traditional banks which, if properly sourced, are a complement to existing funding and can provide additional flexibility.

Ken Hurwitz is vice-president of Equilease Corp., 416-499-2449, ken@equilease.com, www.equilease.com.