Purchasing Equipment vs. Usage-based Equipment Financing: What Should You Do?
Updated: Nov 12, 2019
The short answer is that it depends on the business's objectives. Usage-based equipment financing can be a good alternative for those who don't have a lot of capital or who frequently exchange their machinery due to trends. Buying equipment is better suited for those businesses who are established or intend to use that specific equipment in the long-run.
Since it's situation-dependent, determining whether one should purchase or finance equipment with the help of a financial institution is an in-depth decision that takes a lot of consideration.
That's why I'm going over this topic alongside a point system so that I can break down each method alongside a head-to-head analysis.
Round 1: Business Objectives
To continue the conversation of business objectives, the first thing an equipment user must identify is their primary business goals, both short-term and long-term.
When is a business is thriving and needs to maintain its longevity, it's probably a good time to purchase new equipment. Decision-makers might also want to consider buying when it’s time to replace old equipment, or their business needs to take advantage of the latest industry technologies.
Basically, if buying won't impact the business or instill any unknown market risks that typically arise with expansions, then purchasing is the right way to go.
If decision-makers plan to expand rapidly in the upcoming years and need to invest heavily in new equipment to grow production capacity, then try to avoid direct purchases. As an alternative, consider a financing route.
Also, if the company is facing a strong market demand for its products in the short-run, but it's uncertain if this demand will persist over the long-run, then acquiring new equipment may not be the best solution to catch the temporary trend.
Equipment users typically try to avoid this high level of uncertainty since there’s no promise of any long-term market commitment.
In this case, pay-per-use financing can be the right option to absorb the benefits of spontaneous high market demand without taking upon the entire financial risk immediately, since repayment rates adjust to the equipment's per-unit production.
Every company faces different short-term and long-term goals, therefore, there is no clear advantage for purchasing or UBF, and thus, both get the point.
Score - Purchasing | 1:1 | UBF
Round 2: Financial Situation & Effects on Financial Statements
The next question equipment users ask themselves is:
What’s my current financial state? And how will an investment in new equipment affect my balance sheet and PnL statement?
By analyzing their financial statements, equipment buyers are better situated to tell how much of financial risk their company can bare at the moment.
Buying equipment out-right opens a door into an enormous up-front investment hurdle; that’s why companies, who are directly purchasing, must have enough cash available.
Machine buyers typically try to avoid this financial commitment for various reasons, such as the immediate cash-out burdens, balance sheet explosions, depreciation challenges, tax disadvantages, and significant PnL effects, to name a few.
Besides the effects on one's financial statements and overall company wellbeing, the equipment buyer must absorb other costs like opportunity costs or take the cost of equity under consideration to fully understand what a direct purchase will look like.
On the other hand, pay-per-use inspired financing introduces zero to little initial investment for machine buyers as payment is pegged to periodic unit production. So there will not be immediate cash out for equipment users if they finance it via usage-based financing.
Aside from eliminating massive investment hurdles, usage-based financing enables possible off-balance-sheet effects (also possible under IFRS 16) and cash flow optimization by transforming capital expenditures (CAPEX) to operational expenditures (OPEX) to positively impact financial statements.
Other UBF related costs include interest rate fees, but this is typical of any other type of loan or leasing structure.
UBF's total expense depends on the overall performance of the financed equipment.
Minimum and maximum forecasts are made to better determine the financing contract's beginning costs. Rest assured, the costs associated between lower and upper parameters cannot be exceeded.
And as a side note, unlike traditional equipment rentals, UBF does not fall trap to the typical rental disadvantage of paying a fixed amount even when machines are not in use for that exact rental period.
Every company must judge its own situation of whether or not they have the financial power and stability to purchase equipment.
But even if they have the financial means to do so, they still have to mitigate other potential adverse effects on their financial statements when investing.
In this case, UBF can be an option to treat these investments as neutral in terms of the impact it has on financial statements.
Due to the fair treatment of financial statements and no applicable costs, this round goes to usage-based financing.
Score - Purchasing | 1 : 2 | UBF
Round 3: Impact on Cash Flow
With purchasing equipment, buyers risk not being able to quickly spread the upfront costs to coincide with money coming into the business.
As a result, the purchaser undergoes various cash flow challenges like the difficulty of scaling quickly without burning tons of money.
There lies another scenario where too much money is spent during the ramp-up phase when the equipment user is stuck and cannot produce any valuable output with its new machinery.
Rather than deploying cash to purchase new equipment, however, buyers can leverage pay-per-use financing to enable a more flexible and scalable operation since installments are generated variable to equipment utilization.
In other words, buyers can minimize their burn rate during ramp-up phases and economic downtimes to improve cash flow.
Again, I’ll need to give the point to usage-based financing due to the ease of operation scalability, burn rate minimization during ramp-up phases, payment flexibility, and the corresponding cash flow improvements.
Score: Purchasing | 1 : 3 | UBF
Round 4: Ownership
Who will own the equipment?
While I did briefly discuss the question of ownership in round two and its relating balance sheet effects, I want to dive a little deeper into this subject.
When purchasing equipment without any external money, the company owns 100% of the machine.