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There are three main
types of equipment financers: commercial banks, commercial finance
companies, and the financial subsidiaries of equipment manufacturers.
These sources account for more than 90% of available financing for
equipment purchases. The remainder is provided by community development
organizations, government agencies, and companies whose primary
business is leasing.
Commercial Banks
The primary type of loan
made by a commercial bank is the short-term, unsecured business
loan. Larger commercial banks make some term loans for periods up
to 12 years. Since commercial banks are limited to how much they
can lend to a single borrower (measured as a percentage of the bank's
capital and surplus), loans might not be available from commercial
banks–even to credit-worthy borrowers. Often a commercial bank
will syndicate a large loan by forming a credit group made up of
a number of other banks, with each bank providing a certain percentage
of the total loan. Commercial bank term loans establish a working
relationship between the borrower and the bank. While this can provide
valuable advice and information, it also requires that the borrower
divulge confidential information while adhering to restrictive provisions
of the loan agreement.
The AmSouth Bank is a
commercial bank with extensive experience in financing the purchase
of construction equipment. AmSouth offers a wide range of loan services
to equipment operators, including a check-accessible line of credit
that allows the borrower to write checks up to $100,000, with no
need to apply for a loan each time, and working-capital loans for
short-term needs, such as carrying accounts receivable and inventory
or for financing transportation, manufacturing, or computer equipment.
Commercial Finance
Companies
A commercial finance
company is a financial institution without a bank charter that makes
loans secured with accounts receivables. Commercial finance companies
do not make unsecured loans, so borrowers in need of short-term
and/or unsecured loans rely on commercial banks.
Orix Financial Services
(OFS) is one such commercial financing company. OFS offers specific
financing arrangements and lines of credit directly to equipment
purchasers that enable the client to acquire equipment as needed.
Used equipment can be utilized as collateral to refinance existing
debt to stretch out payments to better match cash flows and enhance
the borrower's capital position. This in turn can result in
an increased bond rating (an important factor in the construction
industry) and thereby create opportunities for additional business.
The company has also formed a Portfolio Management Group that has
the ability to manage finance companies for equipment manufacturers
of large vendors of construction equipment. OFS provides the systems,
personnel, and administrative support to operate these financial
subsidiaries.
Equipment Manufacturer
Financing
Most major equipment
manufacturers also provide financing to customers purchasing their
equipment. In return for providing the convenience of "one-stop
shopping" and the resultant reduction in paperwork load to
the purchaser, the equipment manufacturer can develop a second source
of income by making the financial arrangements.
One of the best examples
of a manufacturer offering financial services is the Caterpillar
Corporation. Its subsidiary, the Caterpillar Financial Services
Corporation, offers financing and leasing services for every market
Caterpillar serves: agriculture, construction, forestry, lift trucks,
marine, mining, quarry and aggregate, paving, waste disposal, engines,
and power generation. It offers a wide range of financial plans;
for example:
- Installment Loans–enabling
customers with a down payment or trade-in to acquire equipment
and structure payments over time.
- Operating Leases–providing
off—balance-sheet solutions for customers to lease used equipment
for a stated term, then return the machine, extend the lease,
or purchase the equipment.
- Finance Leases–giving
customers the option and benefits of owning equipment under lease.
- Working-Capital
Loans–providing Cat customers the option of using their
Cat equipment as collateral to obtain financing for other business
needs.
- Governmental Lease/Purchase
Plans–offering low interest rates and flexible terms
to qualified state and local government agencies in the United
States.
Cat Financial works with
the customer to put together payment plans and financial structures
that meet their specific business needs–including monthly,
quarterly, semiannual, annual, and seasonal payments. It understands
Caterpillar products and the industries they support. It also provides
customers convenient, one-stop shopping; a fast credit turnaround;
and user-friendly documentation. Cat Financial reported record revenues
of $1.42 billion in 2000, a $236 million increase from 1999. New
retail financing business reached $5.6 billion.
What Do They Want?
It should come as no
surprise that banks and other lending institutions are in business
to make money. The first rule in making money is to not lose it
in the first place. Therefore, banks place great emphasis on reducing
risk or compensating for risk with collateral and restrictive provisions
on the borrower. When applying to a bank for a line of credit, a
commercial short-term loan, or an equipment loan, many of the same
basic lending principles apply. The most fundamental characteristics
a prospective lender will want to examine are:
- credit history of
the borrower,
- cash-flow history
and projections for the business,
- collateral available
to secure the loan,
- character of the borrower,
- loan documentation
that includes business and personal financial statements, income-tax
returns, and frequently a business plan, which essentially sums
up and provides evidence for the first four items listed.
The first three of these
criteria are largely objective data (although interpretation of
the numbers can be subjective). The fourth item, the borrower's
character, allows the lender to make a more subjective assessment
of the business's market appeal and the business savvy of its
operators. In assessing whether to finance a small business, lenders
are often willing to consider individual factors that represent
strengths or weaknesses for a loan.
Loan Types and Terms
Loans can be long term
(lasting more than one year) or short term, secured (requiring collateral
from the borrower) or unsecured. Typically, short-term loans are
unsecured, whereas long-term loans require collateral. Affecting
the valuation of the loan are the subsequent depreciation expenses
on the purchased equipment (and the resultant tax advantages) and
the cost of capital that reflects the inherent risk of the operator's
firm and its business.
Cost of Capital
The cost of capital is
the rate of return an operator must earn on its investments and
equipment for the market value (the present value of the company's
expected earnings) of the firm to remain unchanged. In other words,
the value of the firm's anticipated profits, modified by perceived
risk, determine its cost of capital. There are two types of risk:
business risk and financial risk. Business risk is determined (or
more accurately, guessed at) from the projects accepted by the firm.
Projects with a perceived high risk will result in high cost of
capital to the operator. Business risk can be considered external
to the firm. Financial risk is related to the firm's financial
structure (interest, debt, taxes, and so on). Businesses with a
higher proportion of fixed-cost financing will be considered less
risky and will be able to obtain capital at a lower cost. Financial
risk can be considered internal to the operator's firm.
Long-Term Financing
Long-term financing is
defined as any loan with terms lasting longer than one year. Most
long-term debt instruments have maturities between five and 10 years.
Equipment loans tend to be about five years in length. Standard
loan provisions, imposed on the borrower to ensure that it continues
to exist and operate (i.e., reduce risk of default to the lender)
are as follows:
- Maintenance of satisfactory
accounting records in accordance with generally accepted accounting
principles that allow the lender to easily read and interpret
these records so as to ascertain the financial health of the lender.
- Rendering of financial
statements to the lender at specified dates so as to provide the
lender with an accurate assessment of the borrower's current
financial health.
- Payment of taxes and
other liabilities when due so that other claims on the borrower's
cash do not result in default on the loan payments to the lender.
- Repair and maintenance
so as to ensure that the borrower is not letting his equipment
and other assets deteriorate to the point where their fair market
value is negligible. This provides a degree of insurance to the
lender that, if the worse happens, the lender can still recoup
most or all of the outstanding balance on the loan by the liquidation
of these assets.
- Borrowers are usually
prevented from the sale of accounts receivable as this could result
in a future liquidity crunch, preventing the borrower from meeting
his loan payments.
In addition to these
standard provisions, the lender usually imposes certain restrictive
provisions on the borrower. Again, this is done to reduce the risk
to the lender against default of the loan. These can include requiring
the borrower to maintain a minimum level of working capital, prohibition
against the liquidation of fixed assets, limits on future borrowing,
prohibition against entering into a lease, and such management restrictions
as maintaining certain key employees.
There are essentially
two sources of long-term financing, externally generated term loans
extended from lending institutions to the operator, and internally
marketed bonds that indicate the operator has borrowed an amount
of money that it intends to repay. This article will focus on the
relationships between lending institutions and operators borrowing
money to purchase equipment.
Short-Term Financing
Short-term financing
is defined as loans with terms lasting less than one year. It is
most appropriate for the support of a firm's current assets
(cash, securities, accounts receivables, and inventory). Short-term
financing is generally not suited to most major equipment purchases,
as construction equipment represents a significant market cost and
has an operational lifetime measured in five to 10 years. However,
short-term financing can be used to purchase less-expensive items,
such as specialty tools and smaller pieces of equipment (e.g., a
Bobcat). Unsecured (no collateral needed) short-term financing can
be obtained from a variety of sources: purchasing items on open
account, which allows the use of accounts payable as a form of financing;
accruals or liabilities for services received for which payment
is not yet made; notes and lines of credit; promissory notes such
as commercial paper; revolving credit agreements (the credit card
in your wallet is such an agreement); customer advances in which
payment arrives before the firm provides good or services; and a
private loan from the firm's owners and stockholders. Secured
short-term financing requires collateral, such as the pledging of
accounts receivable, inventory, stocks, or bonds. Major assets,
such as land, plant, and equipment, are typically used to secure
long-term loans.
Notes
A note is a paper representing
a single payment or installment loan received by the bank. A note
usually represents a single payment, unsecured, short-term loan.
Notes differ from a line of credit in that the borrower does not
believe his need for capital will continue. The length of the loan,
its maturity date when the payment comes due, and the interest rate
charged by the lender are set by the agreement. Interest rates can
be fixed or floating and are derived from the perceived risk of
the loan. Most notes have a maturity of 30-90 days. If an operator
has a sure, secure cash flow during this period (in the form of
a contract for work performed for a major project, for example),
a note can provide much-needed financial flexibility. A note can
be used to purchase the equipment for the project or to fill in
the gaps in the operator's equipment fleet with specialty equipment
needed for the job. Once the job is completed and payment made to
the operator, the cash from the job can then be used to pay off
the note. Naturally this tactic involves some risk, especially if
major disagreements between the owner and the contractor result
in cash payments being tied up for the term of the dispute.
Lines of Credit
A line of credit is an
agreement between a commercial bank and the equipment operator that
allows the operator to borrow the amount of unsecured short-term
loans the bank will make available during a given time period (typically
one year). The amount of the line is the maximum amount the operator
can owe the bank at any point in time. The operator requires no
collateral. This is not a guaranteed loan, and actual loan amounts
may be reduced if the bank currently lacks sufficient funds for
making the loan. From the bank's point of view, lines of credit
simplify operations because they eliminate the need to examine the
credit worthiness of the borrower each time the operator borrows
money. To ensure that the operator's credit rating is maintained,
the bank usually places operating and/or financial constraints on
the operator as part of the agreement. Lines of credit are subject
to renewal and can be terminated by either party at will.
Collateral
Collateral is required
for all secured loans, and most equipment loans will be secured
by the lender. Collateral usually consists of assets such as equipment
or land that are described in a security agreement attached to the
loan. Under the security agreement, the borrower agrees to forfeit
to the lender the assets described as collateral in case he forfeits
on his loan payments. Lenders always require collateral from potential
borrowers that they consider to be risky. Often, for lenders whose
clientele includes such inherently risky businesses as construction,
collateral is often required even of firms that are considered safe.
Several factors determine
what type of asset is considered to be acceptable collateral. These
include the life of the collateral, the activity of the collateral,
the percentage advance, and the loan's interest rate and fees.
Lenders prefer to tie the lifetime of the collateral to the term
of the loan. For short-term loans, these include current assets
such as accounts receivables, inventories, and so on. For long-term
loans, fixed assets such as land are preferred. The activity of
the collateral is the speed at which it can be liquidated and converted
into cash. Liquid current assets (having average ages less than
180 days) are preferred. Once an acceptable collateral is identified,
the lender determines what percent of its value he is willing to
lend against. Typically the lender advances a loan amount equal
to 30-90% of the collateral's book value. Interest rates charged
on secured loans are typically higher than those imposed
on unsecured (no collateral) short-term loans. This might be surprising
until you realize that what matters to the lender are risk and its
perceived risk, which sets the rates. A high-risk borrower, no matter
the collateral, is not preferred to a lower-risk borrower.
Depreciation
Owners of nonfixed assets
(most everything except land) are allowed to charge a portion of
the purchase price of the asset as expenses on their annual income
statements. These expenses are the depreciation on the asset or
piece of equipment. The tax code allows for both straight-line depreciation
and an accelerated cost recovery system (ACRS). Under the ACRS,
larger depreciation expenses can be taken earlier in the lifetime
of the equipment, except for the first year. Generally speaking,
the shorter the depreciable life, the quicker the cash flow generated
by the depreciation expenses.
The percentage of the
cost of equipment allowed under each method varies with the total
lifetime of the equipment, as shown in the following table:
| Table
1. Percentage of the Cost of Equipment Allowed |
|
Year
|
3-Year
ACRS
|
3-Year
Straight Line
|
5-Year
ACRS
|
5-Year
Straight Line
|
10-Year
ACRS
|
10-Year
Straight Line
|
|
1
|
25%
|
33%
|
15%
|
20%
|
8%
|
10%
|
|
2
|
38%
|
33%
|
22%
|
20%
|
14%
|
10%
|
|
3
|
37%
|
33%
|
21%
|
20%
|
12%
|
10%
|
|
4
|
|
|
21%
|
20%
|
10%
|
10%
|
|
5
|
|
|
21%
|
20%
|
10%
|
10%
|
|
6
|
|
|
|
|
10%
|
10%
|
|
7
|
|
|
|
|
9%
|
10%
|
|
8
|
|
|
|
|
9%
|
10%
|
|
9
|
|
|
|
|
9%
|
10%
|
|
10
|
|
|
|
|
9%
|
10%
|
Note that the depreciable
lifetime of equipment is not the same as its operating lifetime.
Tax law has established acceptable depreciation lifetimes for equipment
and vehicles, which are subject to change. Autos, light-duty trucks,
lab equipment, and special tools have depreciable lifetimes of three
years. All other equipment (including heavy-duty trucks and construction
equipment) has a depreciable lifetime of five years.
Advantages of Borrowing
The advantages of borrowing
are those that occur with ownership of the equipment. The owner
can realize depreciation expenses that can be deducted from the
operator's financial statement, resulting in a tax shield for
his company. The amount of this tax shield depends on the chosen
depreciation schedule and the current tax rate on earned income.
The interest portion of the annual loan payments can also be deducted
in the same fashion. The owner also retains the salvage value of
the equipment, even if only as scrap. Though this might not be a
significant source of future income, the right to sell the equipment
helps the operator offload equipment when it has become obsolete.
The owner is also free to make improvements on the equipment, including
upgrades to its electronics system and computer controls.
Disadvantages of Borrowing
Ownership entails changes
to the operator's financial ratios, increasing both his assets
and liabilities. Cash allocated to current and future loan payments
cannot be used for other purchases and effectively reduces the operator's
liquidity. Most long-term loans require the operator to provide
a down payment upfront, usually equal to 5-10% of the purchase price,
which can be a significant out-of-pocket expense. Ownership provides
no bankruptcy protection, as creditors would have claim to the total
amount of the unpaid financing. Owners might be stuck with an obsolete
piece of equipment and find it difficult to sell. Large, long-term
loans typically come with restrictive covenants that influence how
the operator runs his company. Loan payments, though they can be
refinanced, are rigidly set and inflexible. And finally, the operator
almost always has to put up collateral to secure the loan.
Obsolescence of Emissions
Controls and Electronic Equipment
The potential dangers
of obsolescence to an equipment operator should not be overstated.
The iron and power-plant technology of construction equipment have
not changed that much in the past few decades. However, two areas
are subject to more rapid change. The first is the emissions-control
systems of the trucks and off-road equipment in the operator's
fleet. With coming changes in local and national diesel-engine emissions
standards, an operator might be forced into an expensive upgrade
or be unable to find a local market for his now-obsolete equipment.
Advances in software and electronic hardware, instead of regulatory
change, drive the second possible source of obsolescence. For example,
the software package operating a dozer's global positioning
guidance system will change much more rapidly than, say, its blade
configuration (which we can confidently predict won't change
at all). Fortunately for the owner, this can be a relatively inexpensive
(if often frustrating) upgrade.
Summary and Conclusions
Financing for the purchase
of construction equipment can be obtained from commercial banks,
commercial finance companies, and the finance subsidiaries of the
equipment manufacturers themselves. Their first concern will be
to minimize their risk against loan default by requiring collateral
or restrictive covenants. The financing can be long or short term,
secured or unsecured, depending on the needs and perceived risks
of the borrower. Flexible financing instruments, such as notes and
lines of credit, are available, as are loans specifically designed
for equipment purchases. The financial advantages provided by depreciation
expenses, interest-payment deductions, the ability to upgrade, and
salvage values are offset to some degree by the risk of obsolescence,
the need to provide collateral, reduced liquidity, and restrictive
covenants.
But as the saying goes:
There's no such thing as a free lunch.
Daniel P. Duffy, P.E.,
is a professional environmental engineer in Cincinnati, OH, and
a frequent contributor to Forester Communications publications.
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