Alex Tabatabai is Co-founder of Fernbank Partners (http://www.fernbankpartners.com). In this video he talks about how to decide whether to lease or buy for capital assets.
- Calculate future cash flow potential
- Compare upfront investment
- Seek a healthy margin between income & costs
- Factor in useful life & residual value
- Conservatively estimate asset value for distressed situations
- Evaluate potential tax incentives
In almost every small business there’s decisions to be made with regards to capital assets. When to acquire them? What prices to pay for them? Whether to lease or buy them? And this basically boils down to what that asset is going to do for you from a cash flow standpoint. What income and revenue will it generate for the business? And what is the cost of this equipment and you want a nice margin between that. You want an arbitrage essentially.
So you’re looking at this capital asset for productive purposes. If you’re buying it, you’re making an upfront payment or you’re financing it so you’ll be making a reoccurring installment payments and a lease is a variation of that too. May be the payments are lower from month or quarter to quarter because you’re not paying for the residual amount at the end of it.
So I would set aside any biases one may have about leasing or buying. A lot times our parents or other people have told us things and it’s just a cold hard calculation. What do you expect to earn from that asset and what do you pay for that asset and just match those. It’s just matching cash flows. Now very important thing is to make sure to have a healthy margin of safety between the income that capital asset brings in and you’re cost of acquisition, your payments, whether you bought it or lease it. For example if this piece of equipment, these capital asset brings your business $100 of income every month and the lease payment is $50 a month, that’s a nice $50 margin of safety and so if you hit tough times or revenues unexpectedly drop to let’s say $60 a month, you can still cover the financing cost of the equipment.
However if your business is earning $100 because of that capital asset and your lease payment is $90 a month, I would be very scared because if you have some unexpected drop in revenue now you can’t make your lease payment and if you can’t make your payments they come and take the equipment away and that’s very detrimental to your business. So it’s very important to be disciplined and have a margin of safety with regards to matching those cash flows and also it’s important to think about the useful life of this asset. What is its residual value? There’s tax calculations for this. There’s financial calculations for this. Use your common sense. How long do you really expect to use it? What do you think you can sell it for when you’re done using it and trying to calculate the residual value, really think about distressed situations if you know we had a recessionary period of time or a depression, how much can this asset be sold for in a distressed situation. How liquid is the market for this asset? Some things are very bespoke and there are not many buyers out there for them. So it’s very hard to have a decent residual value and there’s also tax benefits. There are in the Federal Tax Code, many benefits to take depreciation, bonus depreciation upfront and these usually do not mirror the actual economic realities but they’re incentives to encourage business owners to purchase assets. So there are two sets of calculations that should be done and there are some real economic tax benefits which should be considered.
Make sure there’s a good margin of safety between what that capital assets earns for you and what you have to pay for it and just see if it’s beneficial to your business over the long term.