Leasing manufacturing equipment changes your balance sheet

After a successful tradeshow like the Canadian Manufacturing Technology Show (CMTS), which was held last month in Toronto, many manufacturers begin to seriously think about adding new technology their shop floor.

In some cases, visiting the show will validate their need for a purchase, but in many others, manufacturers see something unexpected that will increase both their business’s capacity and its efficiency and want to purchase it. Either way, they need capital.

How Much Can I Borrow?

As a lender, one of the first questions I typically get asked is about how much money I can secure for a client. The reality is that the transaction size is limited only by the borrower’s finances. The amount of funds a bank or leasing company has available is limitless; it is the equity box of the borrower that determines how much money is available.

A review of working capital and cash flow is performed to determine if the borrower can pay their current loans and expenses before any new debt is added. The borrower’s debt-to-equity ratio also is examined. A high debt-to-equity ratio indicates that more creditor financing (leases and loans) is being used than investor financing (owner funding) to finance the company’s assets. Last, retained earnings, which are the profits retained by the company and not paid out as dividends, and tangible net worth, the sum of all the tangible assets (cash, equipment, property) less any liabilities also are evaluated.

All of this information is found within the borrower’s financial statements and corporate tax returns. It is always best to have all financial information prepared by a chartered professional accountant (CPA) as opposed to a tax service, which many people use because they are less expensive.

The difference in the quality of the work is significant and a well-prepared statement provides much more comfort to potential lenders. Also, internally prepared reports—or interim statements—for the current financial year also may be required if the statement or tax return is more than six months old.

Next, a lender uses some sort of commercial reporting service, the most common being Equifax and Dun & Bradstreet (D&B), that provide detailed reports on a company’s borrowing and payment history. PayNet is another service used by lenders—specifically in the leasing industry—because it records payment histories for previous lease transactions.

Personal credit reports are also reviewed when the application includes a personal guarantee of the owner.

These reports provide a significant amount of information on the borrower, including the number of trades, how much credit they have been extended by either credit card companies or their bank, and most importantly, their repayment history. These reports also provide information about any legal or collection issues.

It is always a good idea for borrowers to know the information that appears on their credit report, particularly if there have been any financial problems, so it can be addressed early with a potential lender.

Leases on Balance Sheets

Another question I get quite often is about how a lease is accounted for from a financial statement perspective.

When a piece of equipment is bought outright, either using cash or a bank loan, the buyer takes immediate ownership, and the equipment becomes an asset on their balance sheet.

From a taxation perspective, the benefits of ownership allow the company to depreciate the asset, which is a fancy way of reducing earnings and paying less in taxes. However, if the purchase happens near the end of the year, the tax savings are minimized if the Canada Revenue Agency (CRA) doesn’t allow a full year’s depreciation to be taken.

There are many nuances to CRA’s rules, which is another reason why a professional accountant should be retained. I always advise clients to talk with their financial adviser before making equipment purchases to ensure there is clarity about how the purchase will be handled from an accounting perspective.

Many manufacturers prefer a lease transaction called an operating lease. Equipment leases fall into two main categories: capital leases and operating leases. Capital leases are treated similar to an outright purchase of the equipment or bank loan. An operating lease is different. It is a contract that allows for the use of the equipment but does not convey any ownership rights. The leasing company maintains ownership while the lease transaction is active.

The equipment is not put on the books as an asset but instead accounted for as a rental expense in what is known as off-balance sheet financing.

Operating leases also have tax incentives; however, they do not appear on the balance sheet as an asset or a liability. An additional benefit leasing—both capital and operating leases—is how GST/HST is handled. Even though most businesses get all paid-out GST/HST back, when equipment is purchased or if the funds are borrowed from a bank, the federal and provincial taxes are either paid in cash or must be borrowed (and in turn, interest paid). When the equipment is leased, the leasing company pays the taxes upfront because it is taking ownership, and the borrower only pays GST/HST on each payment, which has a positive effect on cash flow.

The point here is that every business, large or small, at some point requires a lender when they want to add manufacturing equipment to its floor. It’s important to know what options are available, and it is equally important to have a discussion with your accountant or business adviser before making any equipment purchases.

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