Use your year-end for financial reflection

It is very important for any business owner who is contemplating a year-end acquisition to have a conversation with their accountant before any purchase order is issued.

Even though we are coming to the end of 2023, there is still business to discuss.

The market has been quite busy since the Canadian Manufacturing Technology Show, which was held in September. Manufacturers are now working quickly to get financing approvals in place so they can have equipment on their floor before the end of the year.

Because this is a common year-end occurrence, it’s relevant to talk about year-end purchases and how they are handled on your company’s financial statements.

Before we get into the accounting discussion, I do think the end of a financial year provides a good opportunity to examine business operations, review active borrowing transactions, and potentially review your situation with new lenders.

Most of the clients that I work with tend to have their financial year-end coincide with the end of the calendar year, which puts them in a very good position to know their final sales and profitability numbers.

For a busy shop that has been financing or leasing machinery, it is a good time to review how the equipment has performed, seek out bottlenecks, discuss growth opportunities, and begin thinking about next year’s needs. When business is good and there are strong sales numbers on your financial statements, it is a very good time to look at expanding your operating lines or get financial approvals in place for additional equipment, even if there is not an immediate need.

Use Your Operating Line Wisely

An operating line, essentially a business line of credit, is something only a bank can provide, and it is extremely useful when a busy shop has clients that take 90 or 120 days to pay but have tooling and material suppliers that are looking for immediate payment. It is also a financial tool that is best to negotiate when your financial statements are strong. The same can be said when applying for a new lease, even if the equipment isn’t needed immediately or not readily available. A lease approval is typically good for 90 days and can be easily extended.

Account For Your Accounting

From an accounting perspective, one big question I get is “How is a purchase handled from a financial perspective?” When a piece of equipment is bought outright—either in cash, a bank loan, or a line of credit—the buyer takes immediate ownership, and the equipment becomes an asset on their balance sheet.

A standard balance sheet has three parts: assets, liabilities, and ownership equity. The difference between the assets and the liabilities is known as equity or the net worth of the company.

From a taxation perspective, the benefit of ownership allows the company to depreciate the asset, which is a fancy way of reducing earnings and paying less tax, hence the motivation to get the purchase on the books by the end of the year.

However, if the purchase happens near the end of the financial year, the tax savings could be minimal because the Canada Revenue Agency may not allow the full year’s depreciation to be taken. In reality, it is very important for any business owner who is contemplating a year-end acquisition to have a conversation with their accountant before any purchase order is issued. This is a very good piece of advice anytime a large investment is being considered.

Another method to handle the transaction is setting up an operating lease. Accountants classify equipment leases into two main categories: capital leases and operating leases. Capital leases are treated similar to an outright purchase or bank loan. Operating leases are contracts that allow for the use of an asset but do not convey rights of ownership of the asset. The funding institution maintains ownership.

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 have very appealing tax incentives because the payment is expensed like any other cost, such as tooling, material, and labour. Therefore, the operating income and the entity’s profitability are reduced by the full amount of the payments, which results in tax savings.

Another ancillary benefit of an operating lease is that no additional assets or liabilities are recorded on the balance sheet. And last, manufacturers that are doing significant borrowing from their bank, whether it is in the form of a loan or an operating line, have financial covenants that must be maintained. These are ratios that the borrower is required to stay above or below, such as debt-to-equity or interest coverage. There also are restrictions on debt levels and minimum working capital requirements.

If equipment is added in the form of a capital lease, meaning both the asset and liability is noted on balance sheet, it can easily throw off these ratios and result in the entity no longer complying with the banking agreement.

For these reasons, it’s extremely important to engage your accountant or financial adviser before making large purchases. They are the experts who are best equipped to provide both a short- and long-term strategy for handling investments from an accounting perspective.

Lastly on a personal note, I want to thank Joe Thompson and Canadian Metalworking for once again making this space available to me. Whether you came across my column just this month or have been reading it for years, it is my hope that you have enjoyed reading it as much as I have enjoyed sharing my experiences within the Canadian manufacturing industry.

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