Sales Make it Happen
By Terry Winders, CLP
Both leasing and financing may have the same mark-up (interest) for the funding source, but the impact of the " True Cost" on the business depends on all these issues and matching them to the complete list of wants and needs of the business.
When considering how best to finance equipment, many business owners and managers are faced with a broad range of wants and needs. If you ask them, which is the most important "want" or "need," they will usually select interest rate. What they really mean is what is " the cost of financing."
The question that needs to be answered to help your customer is: What is the true cost of financing? Is it interest expense or cash expense? And then is it book expense, tax expense or maybe is it matching expenses to revenue?
True cost has many answers depending on what the customer is trying to accomplish. An answer to this question will put you on the road to creating the proper financing package for your customer.
There are four parts to True Cost:
- Cash expense,
- Book expense,
- Tax expense,
- Term of use.
To the average business manager the control of the expense and its timing is almost as important as the expense itself. The True Cost takes into account many different aspects. It depends on how they manage their business, when they take expenses and what results they want to show to their stockholders, suppliers, creditors, or bankers. This, for the most part, depends on how they arrive at, or control revenues and expense.
The appearance of true cost in traditional financing looks easy because financing provides an interest rate cost and a purchase price to be depreciated over time.
"When and How the expense is taken"
The timing of the expense is dependent on accounting rules that depreciate the purchase price on a straight line basis over the assumed average term of use. This expense usually does not coincide with the financing that creates a cash cost by requiring a down payment and a short term of financing. Thereby the cash required to pay for the equipment is greater that the book expense because they are on different terms. Therefore the cash cost is larger than the assumed interest and depreciation because of the drop in equity to offset the excess cash cost. This is sometimes referred to as "opportunity cost."
The expense for tax is accelerated; however, it is usually over a different term than the book depreciation and is no longer tied to the actual term of use. Therefore true cost is a mixture of when and how the expense is taken.
The True Cost of Leasing is different than the True Cost of financing because of both tangible and non-tangible issues.
The tangible issues are:
- The cash requirements to pay the rent connected to the type of lease for expense purposes;
- The term of lease as it relates to how long the equipment will be of "use" to the business (lessee), and;
- The adjustment of the rent to take into account cash cost for maintenance, insurance, or seasonal revenue flow.
Some of the non-tangible issues are:
- Control of expense timing;
- The time delay prior to the beginning of rent to allow equipment to become productive before the expense begins;
- The control of the expense by arranging irregular rent to coincide with cash revenues, so no line of credit from the bank with additional interest is required for cash shortfalls;
- The matching of expense and cash cost;
- No capital investment or down payment required and;
- 6) Off balance sheet approach when following accounting rules.
Leases that meet operating classification for accounting and can be expensed for income tax put everything in tandem. If the term of the lease is equal to the term of the equipment use, then a True Cost can be assumed because the expense is properly placed over the term of use with a structure that controls the timing of the rental payments. If the lessee wants a level cost over the term then level rents are offered. However, if the lessee wants to increase the rentals in the beginning when there are no maintenance costs and reduce rentals in the future when maintenance cost materialize or to reduce them in the beginning until revenue is received in the future, they both can be accomplished by adjusting the rent to control the cost.
In addition to preserving cash flow and other lines of credit, whether the company is a large corporation or entrepreneur, what is the effect of the cost, when it is recorded and placed on the income statement and the tax return is an important factor to consider.
Leasing offers the best method to control costs and support the lessee's need to present it in the financial records to show the company's best results.
Terry Winders, CLP
Lease training and Consulting