Equipment financing: pay cash, borrow, or lease?

Most businesses buy equipment the same way they bought the last piece: cash if the account looks healthy, a dealer loan if it does not. That habit can cost more than the interest rate suggests. The right way to pay for a machine, a fleet, or a technology system depends on how long the asset lasts, how it earns, and what else the cash could be doing. A few questions settle most decisions.

The three basic paths

Every equipment purchase comes down to one of three choices.

• Pay cash. No interest and no paperwork. The cost is liquidity. Cash spent on equipment is cash not available for payroll, inventory, or an opportunity that shows up next quarter.
• Finance with a loan. The business owns the asset from day one. The lender usually takes a lien on the equipment itself, and the down payment is often modest.
• Lease. The business pays to use the asset for a set term. At the end, it may return it, renew, or buy it, depending on the lease type.

Match the financing to the life of the asset

The most useful rule is simple. The term of the financing should not outlast the useful life of the equipment.

A truck that runs for eight years can support a loan of five or six. A laptop fleet that will be obsolete in three years should not be paid for over five. When the debt outlives the asset, the business ends up paying for something it no longer uses, often while financing its replacement.

Equipment that holds value and lasts, such as heavy machinery or production lines, tends to suit ownership and a loan. Equipment that ages quickly or changes with technology, such as computers, medical devices, or software heavy systems, often suits a lease. The lessor carries the risk of what the asset is worth later.

Loans and leases are not the same

Equipment loans

The business holds title and keeps any value left at the end. Payments are usually fixed. Because the equipment secures the loan, lenders can be more flexible on credit than they would be for an unsecured line. Expect a personal guarantee from owners in many cases, particularly for smaller companies.

Leases

Leases come in two broad forms.

• Fair market value leases keep payments lower. At the end, the business can return the equipment or buy it at its market value then.
• Buyout leases, often called dollar buyout leases, work much like a loan. Payments are higher, and the business owns the asset for a nominal sum at the end.

Read the end of term language closely. Renewal notices, return conditions, and automatic extensions are where leases tend to surprise people.

Tax and accounting treatment differs between loans and lease types. It also changes over time. Your CPA should weigh in before you sign, not after.

When paying cash makes sense

Cash works well when the purchase is small relative to reserves, when the business has steady and predictable cash flow, and when there is no better use for the money.

Cash is a poor choice when it drains the reserve the business relies on for a slow season. It is also a poor choice when the company is about to seek a larger loan. Lenders look at liquidity. A business that just spent its cushion on equipment can look weaker on paper than one that financed the same purchase.

Think about the next financing, too

Equipment debt does not sit alone. A bank providing a line of credit or a term loan may hold a blanket lien on business assets. A separate equipment lender will need that lien carved out or subordinated. Some loan agreements also limit additional borrowing or require consent. Check existing covenants before you commit to a dealer program at the counter.

It helps to plan the year's capital needs together. Equipment, working capital, and any real estate financing all draw on the same credit profile.

To see how a new equipment payment fits alongside existing debt, try our debt sizing tool. If you are weighing a larger purchase or a broader financing plan, contact us to talk it through.

Thomas Capital Holdings is not a registered investment adviser and does not provide investment advice or recommend securities. Consult your own advisors about your situation.