Lease Equipment to Build Your Bottom Line
Comparing the numbers reveals an advantage to leasing.
BY CRAIG S. LEVINE

"If it appreciates, buy it. If it depreciates, lease it."

The above quote, attributed to the late oil billionaire J. Paul Getty, alludes to the fact that revenue is generated by using equipment, not by owning it. Another saying, "A dollar today is worth more than a dollar tomorrow," points to the inflationary effects on money, and that it needs to work for you. Optimally, any business welcomes immediate cash inflows and will attempt to delay cash outflows. When acquiring equipment for business, these key points are a central theme when making the lease financing decision.

The reasons for acquiring equipment for a business fall primarily into two categories:

• revenue generation

• cost reduction

Changes to revenues or costs are caused by using equipment, not through the passive ownership of it. Therefore, given that equipment depreciates with use and time, the expenditure of capital for it should entail critical analysis. The decision to acquire equipment stems from a need the business has identified, such as for replacement, market expansion or cost efficiencies. Whatever the reason, the need is there. The next step is how to acquire it. Two primary options for acquiring equipment exist: paying with cash out-of-pocket or through financing.

Paying Cash

A practice may decide to pay cash in full by saving the funds needed or by using current reserves. If the company has to save the funds to make the purchase, real time is lost for revenue generation or cost reduction. Competitors may already have the equipment, thereby improving their profit margins and gaining a larger market share while you are gathering resources. The practice may think it is reducing risk by not incurring debt, but the risk of not having the cash later may be far greater. Depending on the time it takes to recoup the investment, a cash shortfall could be critical if there is a severe downturn in the business. Also, if demand for the company's services increases more than expected, there are no extra funds available to obtain additional equipment or employees.

By using cash to pay for equipment, the practice is giving away assets it could use to grow its own business. The company has substantially traded a potentially appreciating asset for a depreciating asset when it may not need to make that choice. Also, paying cash for major equipment purchases reverses the preferred cash flow theme by causing an immediate cash outflow and delaying cash inflows until revenue generation builds with clients.

Financing

Financing is a broad category which includes loans and leases. This option permits the practice to obtain the equipment it needs without depleting a substantial amount of cash resources. By strategically leveraging the acquisition, the practice stays ahead of the curve on net cash and market share, while weathering any downturns and being able to take full advantage of business upturns.

When deciding among financing options, the practice should consider the terms of the options (not just the interest rate) and the timing of cash flows from using the equipment. The following are key questions to consider when choosing among financing options:

► How large a payment is required at closing? The smaller the better to delay cash outflow.

► Are the payments fixed and predictable?

► How much will be due at the end of the term?

► What is the overall cost of financing?

Why Lease?

Leasing is a method of financing equipment acquisitions that provides predictability and flexibility to a business that other financing methods such as loans are not able to provide. General attributes of leases are:

► faster credit process

► wider credit criteria

► low initial payment (small payment in advance)

► choice of term length (usually 24 to 60 months)

► choice of end-of-term option (the lessor usually canpurchase, re-lease, or return)

► choice of payment structure to match business cycle

► capital conservation

► tax benefits

► credit line conservation.

When comparing leases to loans, practices have a tendency to compare interest rates, which should not be the only consideration. The practice must look at the whole picture to determine a true cost comparison. For example, the bank loan may require 20% down, a variable rate after the first 6 months and a balloon payment at the end which may need to be refinanced at higher rates. Also, tax aspects and the time value of money come into play. Another important aspect to consider is that leases, more than any other type of financing, can have payments structured to benefit the company. Put differently, practices must conform to the structure of a loan whereas a lease can conform to the business cycle of the practice.

Lease payments can be structured to match the seasonal cash flow of the business operation. Therefore, by looking only at the interest rate, a company may be eliminating options that could give it an edge over the competition.

Acquiring equipment is a necessary component of a medical practice. It is also one of the things that the practice has a high degree of control over. The method of equipment acquisition directly affects the net cash position of a practice. In this article, assume you wish to acquire a LASIK system for $350,000. What method of acquisition offers the most advantages to the practice?

Arriving at True Cost

We can begin with some basic assumptions:

Equipment cost:   $350,000

Cash available:   $350,000

Interest rate on savings:   4%

Interest rate on capital lease:    7.25%

Monthly payment: (on    $6,971.78

60-month capital lease)    (100% financing)

Class life:    5 years

Depreciation schedule:   2004 IRS-approved General Depreciation System (GDS) 200%; half-year Modified Accelerated Cost Recovery System (MACRS) double-declining balance

Tax rate:   35%

Desired rate of return:    10%

Monthly payment: (on 60-month tax lease)    $6,750.87

Next, it is important to explain the factors behind these assumptions. You might want to discuss these factors with your accountant or financial adviser if you find the mathematics a bit daunting.

Simplified assumptions. If you noticed on the assumptions, no mention was made about the revenues and operating costs of the equipment. It is irrelevant in this analysis because the profitability of the equipment is the same regardless of the option. Adding it provides no additional information to the decision.

Cash-available options. For this analysis, we will assume that you have the cash to purchase the equipment outright. Therefore, there are two alternatives, spend the cash or save it for future needs. In this case, we will be conservative and assume that the cash will be left in a money market account paying 4%. Over the 5-year period, the two options would result in the following:

Desired rate of return. For the rest of the analysis, a desired rate of return must be used to factor in the time value of money. Consider this rate to be the return you need to make the investment worthwhile. In other words, if you could achieve a rate of return of 10% or more in some other investment, then you would put it there instead of the equipment. Another way to look at it is if the cost of borrowing money is 7%, then the return needs to cover that cost plus add some profitability. Each practice has a different rate of return it needs. In this case, we will use 10%.

Present value of the capital lease. A capital lease is essentially a purchase agreement and treated similarly like a loan. The capital lease in the analysis assumes 100% financing (no down payment), 60 months at 7.25%. The total monthly payment is $6,971.78. For tax purposes, only the interest is deductible, the principal is recovered through depreciation which will be addressed later. Cash outflow on the capital lease includes principal and the after-tax portion of interest. We then apply the desired rate of return using present value factors at 10% over 60 periods (found in any financial or accounting text). The present value of the capital lease is $307,948, or $42,051 lower than the cash purchase option, plus you would have $427,248 (at 4% annual interest on your $350,000) at the end of 5 years.

Present value of the tax lease. A tax lease (or operating lease) is essentially a rental agreement. The majority of tax leases provide 100% financing. For this analysis, the term is 60 months and allows the practice to return, purchase or re-lease the equipment at the end of the period. We will assume that at the end of the period, the equipment will be returned so that the practice can upgrade to a newer system. The monthly lease payment is $6,750.87 for this term and size of transaction. A tax lease payment is considered a rental payment and therefore fully deductible. Taking the after-tax number (which computes to $4,388 after subtracting 35% for taxes) and applying the present value factors, the resulting present value of the tax lease is $206,525. Before comparing this number to the other two options, depreciation needs to be calculated.

Present value of depreciation. Depreciation allows the practice to recoup its investment in equipment by providing a tax deduction. It is a noncash expense that reduces the taxes paid out. Depreciation can be used for the cash purchase and capital lease options, but not for a tax lease. We will assume that the double-declining balance method is used to recoup as much as possible in the early years. For this analysis, we will try to simplify. Because depreciation essentially adds cash back by reducing taxes, provided the practice is profitable, we will receive a cash benefit of 35% of the depreciation expense. Table 1 at top right provides an example of present value calculation for the depreciation, which is a once-a-year expense and therefore uses factors for 10% over 5 periods:

Comparison Summary. Adding the positive depreciation benefit to the negative expense yields the net cash expense. It can be seen from Table 2 that the cash purchase option is the most expensive. The tax lease is the least expensive and provides flexibility at the end for equipment disposal or ownership. The capital lease and tax lease options also offer the savings cushion to take advantage of new opportunities or sustain downturns in the economy. An interesting point of the analysis is to perform sensitivity studies. For example, keeping all things the same except the interest on the capital lease, the borrowing rate could be increased to almost 15.4% before the capital lease expense would equal the cash purchase expense. In the case of the tax lease, the payment could increase to the monthly payment of the capital lease of about $6,970 to equal the same net cash expense but provides the flexibility of returning, purchasing, or re-leasing. To be equivalent in net cash expense to the cash purchase, the tax lease payment would need to increase to about $8,340 and yet still provide the savings cushion and termination flexibility.

The Leasing Advantage

The above analysis should help to provide a framework for deciding which method of financing to use toward your next equipment acquisition. Seek the assistance of your accountant or financial consultant to compare cash purchase, bank loans and various capital and operating lease structures. Regardless of assumptions, you will probably find that the cash purchase option is the least desirable and places a strain on your budget and the ability to compete. Leases provide an affordable way to maintain your edge with reduced risk.

Remember, equipment depreciates with use and time so financing the acquisition is preferable in order to maintain cash reserves. This keeps you ahead of the curve. Avoid the tendency to look only at the interest rate; doing so puts the company at risk by not looking at the full picture. Instead, examine all the benefits of a lease, from payment structure to tax advantages to timing and minimum cash outlay.

Craig S. Levine, founder and president of Seabrook Capital, Inc., Friendswood, Texas, is a member of the National Association of Equipment Lease Brokers. Seabrook Capital serves the equipment financing needs of businesses primarily in the dental and medical industries. Craig can be reached by phone at (800) 237- 5589, by e-mail at craigsl@swbell.net or through his company's Web site at www.seabrookcapital.com