Financing options

When your business needs money, normally your first thought is to go to a commercial bank and apply for a commercial loan. However, there are other options besides a commercial loan. Sometimes these options become an option because the bank isn’t ready to extend you credit.

Leasing is an option to finance equipment. According to Kyle Gilliam, president of Arvest Bank’s leasing division, leasing has several advantages for businesses when compared to a commercial loan. First, a lease lets you finance 100% of the cost of your equipment, no down payment required. In a growing business with large demands on cash, this is a definite advantage. Gilliam said other advantages include flexible payment terms, preservation of existing lines of credit, possibly a lower cost of money, quick turnaround, and even a faster tax write off.

A lease can be created that allows you to make your payments either monthly, quarterly, or annually. For example, a farmer might want to schedule his payment annually to coincide with when he harvests his crops, when cash is at its peak. Another payment arrangement may be where lease payments are scheduled to be low on the front end and high on the back end of a lease. This type of flexible payment schedule would be helpful for a fast growing business that needed equipment to grow their sales but the sales growth was going to be steady, but not immediate.

It is common for banks to finance a business customer’s needs through a line of credit. A line a credit is a loan where the business borrows and repays money as cash flow permits rather than on a fixed payment schedule. The amount the bank allows the business to borrow is generally tied to a percentage of its accounts receivable balance and a percentage of its inventory value. Many businesses will use their line of credit for all financing needs, including the purchase of equipment. By leasing equipment a business could preserve the line of credit for other cash flow needs.

It is possible, when considering your payments over the life of a lease versus a loan, that it is cheaper to lease your equipment rather than to buy and borrow. When you lease your equipment you don’t actually own the equipment. Since you don’t own the equipment the lessor will depreciate the cost of the equipment on their tax return resulting in tax savings. Sometimes, part of this tax savings can be passed on to you.

Every business likes a fast tax write off — at least profitable businesses do. Depending on your industry, the Internal Revenue Code tells you how many years you have to depreciate your equipment. For example, equipment used in drilling natural gas wells is required to be depreciated over seven years. If you borrowed money to buy drilling equipment and paid the loan off over four years, you still have to depreciate the equipment over seven years. However, if you leased this equipment over four years, you would deduct the cost in four years. This hasn’t been important to many small businesses with Code Section 179 allowing businesses to expense equipment up to a limit of $250,000. For 2009 and 2010, the limit on expensing equipment under Section 179 is $125,000. However, beginning in 2011, the amount of equipment allowed to expense drops to $25,000. Leasing may be more advantageous for income tax purposes for some businesses beginning in 2011. (As always when discussing taxes, there isn’t enough space or time to cover all the rules and requirements. If you are interested in leasing equipment, consult a CPA, such as myself.)

Leasing equipment through a bank generally subjects you to the same lending standards you would find in a commercial loan division. However, if banks have made “other” financing options your only option, they exist.

If your credit history prevents you from borrowing money or leasing equipment through a bank, you might learn that equipment dealers, in order to move their equipment, will lease or arrange to lease you their equipment. Equipment manufacturers or dealers are motivated by the profit made from their equipment as well as the yield made from a lease.

Another way to finance your business when a commercial bank won’t give you a loan is factoring. Factoring is when you sell your accounts receivable to a “factor” at a discount. In the past twenty-five years, I’ve only had one client factor their accounts receivable. It was expensive.

If memory serves me, my client’s agreement with the factoring company was that the company would invoice their customer and send the invoice to the factor. The factor would immediately deposit 70% of the invoice amount into the company’s bank account. The company’s customer was instructed to pay the invoice by sending payment to the factor. When the customer paid the factor for the invoice, usually in about 30 to 40 days, the factor would pay the company another 27% to complete the purchase of the initial invoice or accounts receivable. The factor required the company to buy back any accounts receivable that was not paid by their customer within 90 days. The factor only paid 70% of the face value of the invoice and used the other 27% as a reserve for the company to buy back any invoice that wasn’t collected within 90 days. These details might not be exact since it was a few years ago when this arrangement was in force. But it is illustrative of how factoring works. I do remember that the cost to the company was equivalent to a loan with an interest rate in excess of 30%. The end result, the company folded. Part of the reason it failed was the cost of financing the business. I’m not saying that factoring is in itself bad. It just wasn’t good for this particular company. If you ever factor your receivables, make sure you understand your agreement and how much it will cost.

Many a small business has started using credit cards as a significant source of financing. As with any credit card, the attraction is easy credit and low minimum payments. You get sucked in with offers of a zero percent interest rate for the first year and then 8.9% for life, or until you’re a day late with the first payment. Then the interest rate becomes something absurd like 199%. Everybody understands credit cards and their costs, but still they will always be a source of funds for smaller businesses.

Your vendors are a source of financing although only for a short time. If your vendor lets you establish an account, you are in affect borrowing money from this vendor, usually interest free. You can increase your cash flow by extending the number of days you wait to pay your bill. However if you abuse this arrangement, your vendor has a number of options from reducing your credit amount or totally eliminating your credit, to charging you a financing or late charge, or just increasing the price at which they sell you products or services.

Banks are not your only business financing option. Their just usually your cheapest. There are lots of “non-traditional” financing sources. You can find them with Google. Make sure you read the fine print.

(Although every effort is made to provide you accurate and timely information, it is general in nature and not meant to be specific to your facts and circumstances. Consult a qualified professional to discuss your particular case.)

David Potts is a certified public accountant also accredited in business valuation. Owner of Potts & Company, Certified Public Accountants for more than 25 years, his practice focuses on small and medium size businesses and their owners in the areas of taxation, accounting and bookkeeping, business valuation and business advisory services. He is a Fort Smith native and a graduate of the University of Arkansas. You can follow his blog at ThePottsReport.com.