Why is this important?

There are many different reasons to borrow and there are numerous finance options available. Choosing the best option to suit your needs can be difficult and confusing. Basing financial decisions on the most convenient or least time consuming course method may not be the most cost effective or suitable for your business.
Finance is also often chosen simply on the face value interest rate, based on the notion that the lowest rate provides the best option for any purpose. This is a common misconception. A number of other considerations including the real cost, not just the face value interest rate quoted, are important.

What to do

In considering the best choice of finance, it is important to match the method of financing with the purpose. Are you financing for:

• business expansion – growth, acquisition
• equipment finance
• IT software and services
• motor vehicles
• property finance – purchase, renovations, improvements
• working capital

Some of the most common types of finance available are:

• bank bills
• commercial hire purchase
• leasing
• overdraft
• rental
• term loans

Often business operators seek bank overdraft finance when they need finance because they have an existing relationship or an existing facility, which means it is quick and convenient compared to arranging a new loan. Overdraft finance is also generally considered to be a comparatively low cost form of finance.

When considering an overdraft, first consider the purpose of the finance and whether this method is best suited from a tax, depreciation and ownership perspective. These issues are covered in more detail below. Second, consider the real cost of the bank facility. The interest rate on an overdraft is not generally the real cost of the funds. This can only be calculated by taking into account the additional fees (such as facility fees, account fees, unused limit fees) that apply to the account.

It is not possible to give a comprehensive coverage of all the possible combinations of purposes and options, so a summary of just some of the more common situations is given here.

Equipment finance

Almost every business needs items of equipment ranging from industrial plant and machinery, computers, copiers, printers and other office equipment, furniture, telecom systems to motor vehicles – in fact, virtually any physical asset required in a business.

Some high-tech equipment represents a substantial investment and, for every item of capital expenditure, a decision needs to be made about how to fund the purchase. Even if the business has the option to pay cash, consideration should be given to whether this is the best business decision. There may be more effective ways of employing available cash reserves.

When considering whether to use finance or not, it is essential to first decide what the acquisition is intended to achieve.

Ownership or not

Does the business need to or wish to own the asset? The answer will depend partly on the effective life of the asset and how quickly it will become obsolete and need replacement.

For example, computer hardware now has a relatively short effective life and it may not make sense to own the asset in three years, if it is then obsolete and has little or no value. However, it may be better to acquire ownership on a three- or four-year finance contract for an item of equipment with an effective useful life of ten years.

To make an informed decision, it is useful to have a general understanding of the differences between the various methods of financing assets like office or manufacturing plant and equipment. These will usually fall into the following three categories:

On- or off-balance sheet

In an on-balance sheet transaction, the asset being financed is brought into the accounts of the borrower as an asset and depreciated in the same way as assets that are fully owned. Therefore, the advantage from a tax treatment angle is that both depreciation and interest on the finance can be written off against income.

With an off-balance sheet transaction, the asset remains on the books of the lender who can claim the depreciation. The borrower can only claim as tax deductions the interest or lease payments on the transaction as they are made.

Leasing

There are two different types of leasing agreements – finance leases and operating leases. In both cases the title is held by the financier, and the lessor pays a lease rental to use the goods. The difference between these two forms of finance is essentially the risk of ownership and accounting treatment of the transaction.

• Finance leases: The risk of ownership remains with the lessee (the borrower). The lease will have a fixed term and an agreed residual value at the end of that term. The lessee will guarantee the residual value so that, if the goods have depreciated to a lower figure, they are required to make up the difference. The lessor (the financier) can, and usually will, offer to sell the goods to the lessee for the residual value at the end of the contract term. The lease can be for any period of time and is only subject to the residual being no less than the depreciated value of the asset being financed. It is an on-balance sheet transaction but the lessee retains ownership and the ability to claim depreciation of the asset on their balance sheet. The lessor can only claim the lease payments as tax deductions, as they are paid.
• Operating leases: The risk of ownership remains with the lessor. An operating lease provides the lease payments as a tax deduction. An operating lease is an off-balance sheet transaction. However, it can only be for 75% of the estimated life of the equipment and provides no guarantee regarding the ownership of the equipment. (You may be able to purchase the equipment at the end of the term at fair market value – this figure however is not identified and could be 10%, 15% or 20% etc.)
• A rental agreement is similar to an operating lease. It overcomes many of the restrictions of the operating lease. Title of the equipment remains with the financier and there is generally no option to purchase at the end of the finance term. The financier will assign an undisclosed future value to the equipment and factor this into the rental payments, with the intention of being able to make a profit on the sale of the goods at the end of the term. In some instances, depending on the nature of the equipment, the financier will offer to sell the goods to the borrower at the end of the term.

Commercial hire purchase

Commercial hire purchase provides the user with depreciation and interest as deductions. It is an on-balance sheet transaction. At the end of the term the borrower obtains full title to the goods.

This can be a very effective method of finance for IT and high-tech equipment because it provides the same tax advantages as if the asset were purchased for cash without the initial capital outlay. The net tax benefit will often exceed the finance costs.

Options for lending finance

The financial position of each business will be different, so it is not possible to make a general rule about what lending product will best suit individual circumstances. This is why it is advisable to consult your accountant or financial adviser before entering into any transaction for major capital items.

By way of general guidance, some suitable options are suggested below:

• Working capital, business expansion or acquisitions: Overdraft or bank bill facility which provides for come and go finance, interest only on the amount used at any one time and the flexibility to vary the facility as needs change.
• Property purchase, renovations, additions for business purposes: Usually a fixed term mortgage that enables amortisation of a major capital expense over an extended period and provides the ability to deduct all borrowing costs, depreciation and property maintenance costs. If there is an option to lock in a fixed interest rate, this also needs to be considered in light of the prevailing rates and likely movements in the foreseeable future.
• Motor vehicles for business use: A finance lease or commercial hire purchase is generally the most suitable method for financing vehicles. If the vehicle is wholly for business use, the full cost of the finance can be claimed as a tax deduction. In the case of a lease, this is the monthly lease payment. For a commercial hire purchase contract, this is the interest component of the repayments, but depreciation on the vehicle can also be written off against income.
• Plant and equipment: The variables are numerous so the best choice will depend on the nature and cost of the equipment, its useful life and the depreciation rate allowed under the tax laws. An operating or finance lease, a rental or a commercial hire purchase contract would probably be the most effective option.
• IT equipment, software and services: Many businesses now rely heavily on complex, custom made IT systems. Finance for computer hardware is straightforward and generally readily available. Leasing or Commercial hire purchase is the most common method of financing these items. Rental is becoming a more popular method to avoid ownership of obsolete equipment. However, typically the major cost of an IT system is now the software licenses and services (implementation, training, maintenance, conversion, etc.) and there is a common misconception that these items cannot be financed because they are intangibles.  There are financiers who specialise in computer software and services and have products designed to maximise the tax advantages available.

In the course of making any decision regarding a major capital expense for your business it is wise to consider whether to obtain finance for the purchase and what the most effective form of finance would be in each particular instance. Seek professional advice to ensure that the decisions you make take into account all the implications with respect to the tax laws and your financial circumstances.

Where to go for help

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Ph: 02 9797 1777  Email: aiserv@bigpond.net.au Website: www.australianindustryservices.com.au

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