ASSET FINANCE – AN EXPLANATION
The Basic Premise
Unless you or your business is in the enviable position of being cash rich, you will inevitably need to raise finance to purchase new equipment and expand. It is the same for all businesses and even countries (although generally countries don’t approach Asset Finance Lenders). Some asset finance products are treated from a tax perspective in a unique way so even businesses that are cash rich often find it more tax efficient to take advantage of an Asset Finance facility. More on that later.
Business borrowing tends to be generally for two purposes: cashflow and equipment acquisition. The preservation of positive cashflow is an absolute must to maintain a successful, profitable business and there are numerous avenues available to Customers to help them.
We are more focused with helping Customers when it comes to the acquisition of fixed assets for the business that are essential to generate income and hopefully, profit.
When it comes to financing equipment for the business, the most common forms of borrowing are:
- Bank Loan
- Finance Lease
- Hire Purchase
- Commercial Loan
We will now explain these products and the pros and cons to each. We’ll also briefly touch on other forms of borrowing.
Bank Loan
All businesses maintain a bank account to enable them to trade. To pay for goods and services, to enable their customers to pay for the goods and services it sells to them and for all manner of other essential day-to-day transactional requirements.
Banks too offer lending facilities, overdrafts, loans and a range of credit facilities all caveated with the much-used phase in global finance – “subject to status”.
It is fair to say, that many businesses use their bank for every credit requirement including funding the purchase of new equipment. Often, the business will have an all-encompassing facility that helps the Customer to preserve a positive cashflow as well enabling it to purchase, stock, raw materials and equipment.
These facilities are secured. The bank will take a legal charge over the business and often other security in the form of land and/or buildings to protect its interest. It will often demand that the owners of the business provide their personal guarantees. (more on personal guarantees later)
The limit of the facility will be finite so businesses that chose to solely finance their operations solely with its bank must be 100% certain that it can service the debt and that there will be no unforeseen circumstances that would put the business and therefore the facility, under pressure and risk of foreclosure.
We find that many SMEs like to not put all their financing options into one basket. Indeed, similar to how many people have different saving instruments, we find that many businesses like to spread their borrowing requirements around a number of providers who can often offer products that the banks don’t and some of these products can even provide the Customer with unique tax advantages,
Let’s look a little closer at these products.
Finance Lease
Legal Status –
In law, a Finance Lease is effectively an Hire or Rental Agreement for a fixed term, it is not technically an interest bearing facility like a Loan or Hire Purchase contract. The Customer chooses the equipment supplier and specification then the Lender purchases the equipment on their behalf and hires the equipment to them for a fixed term.
The Customer does not own the equipment so the periodic rentals paid by the Customer qualifies these rentals an operating expense and these can be deducted from taxable profits as a genuine trading expense effectively reducing the tax paid. As it is treated as an operating expense, the rentals attract VAT which can be reclaimed for VAT registered businesses.
End of The Fixed (Primary) Period of Hire –
There are 2 variations of Finance Lease agreement. There is firstly a Fixed Term agreement where the agreement automatically terminates on payment of the final rental. There is also a Minimum Term agreement where at the end of the Primary Rental Term, the agreement automatically goes into a Secondary Rental period.
With a Minimum Term agreement the secondary rental period is generally 1 month’s rental per annum, however such agreements do not enter this secondary rental period if the customer provides sufficient notice to the Lender that it wishes to terminate the agreement.
The most common form of a Minimum Term agreement is in the mobile phone world where the user agrees to a minimum period contract and this carries on beyond the term unless the user has upgraded their phone or does so at the end of the Minimum Period.
Ownership of the Equipment at the end of a Lease –
Generally, Lenders will agree to the transfer of title (ownership) for the payment of one month’s rental.
It is worth noting that the Lender cannot agree the sale in advance of the end of the primary period because this would change the legal status of the agreement from a “hire” agreement to a “purchase” agreement. This would affect the tax treatment of the agreement.
The transfer of title is not enacted directly with the Lender. To preserve the “hire” status the Lender legally needs to invoice a nominated third party (generally the Broker) for the payment for transfer of title. The broker would then duly invoice the Customer and, once paid the customer would have full ownership.
TIPS:
- Establish with the broker if you are committing your business to a Fixed Term of Minimum Term agreement.
- Always try to establish what the broker’s policy is in respect of transfer of title to your business – some brokers have been known to increase this amount substantially, we do not!
Tax Treatment –
This is very important as it is unique to a lease.
As mentioned, the rentals are treated as a business expense, which are fully offset against the profit of the business that effectively reduces the company’s corporation tax liability.
Another advantage that a Finance Lease provides, when compared with a Hire Purchase contract, is that the equipment can be fully expensed over the period of the Lease. By comparison with Hire Purchase, only the interest portion of the repayment is expensed with an allowance for depreciation on the remaining capital balance. The depreciation on the asset would be over a greater period taking much longer to claim the tax reductions.
Ultimately with Hire Purchase when the machine is fully depreciated the tax saved would be the same as Finance Lease it just takes longer to achieve.
ADVANTAGES
- Fixed monthly repayments – The payments are fixed and never vary
- Pay as you earn – Pay for the equipment from the revenue it generates
- Preservation of cashflow – Cash can be more efficiently deployed elsewhere in the business
- Tax Advantageous – All repayments are 100% offset against pre-tax profit
DISADVANGE
- Early full settlement of a finance lease is not generally recommended. If you wish to settle your Finance Lease early, then the settlement figure would be the remaining repayments. Some Lenders offer an early settlement discount, but they are not obliged to and it is unlikely to be more than 4% to 5%.
Hire Purchase
Legal Status –
In law, a Finance Lease is effectively an Hire or Rental Agreement for a fixed term, it is not technically an interest bearing facility like a Loan or Hire Purchase contract. The Customer chooses the equipment supplier and specification then the Lender purchases the equipment on their behalf and hires the equipment to them for a fixed term.
The Customer does not own the equipment so the periodic rentals paid by the Customer qualifies these rentals an operating expense and these can be deducted from taxable profits as a genuine trading expense effectively reducing the tax paid. As it is treated as an operating expense, the rentals attract VAT which can be reclaimed for VAT registered businesses.
End of The Fixed (Primary) Period of Hire –
There are 2 variations of Finance Lease agreement. There is firstly a Fixed Term agreement where the agreement automatically terminates on payment of the final rental. There is also a Minimum Term agreement where at the end of the Primary Rental Term, the agreement automatically goes into a Secondary Rental period.
With a Minimum Term agreement the secondary rental period is generally 1 month’s rental per annum, however such agreements do not enter this secondary rental period if the customer provides sufficient notice to the Lender that it wishes to terminate the agreement.
The most common form of a Minimum Term agreement is in the mobile phone world where the user agrees to a minimum period contract and this carries on beyond the term unless the user has upgraded their phone or does so at the end of the Minimum Period.
Ownership of the Equipment at the end of a Lease –
Generally, Lenders will agree to the transfer of title (ownership) for the payment of one month’s rental.
It is worth noting that the Lender cannot agree the sale in advance of the end of the primary period because this would change the legal status of the agreement from a “hire” agreement to a “purchase” agreement. This would affect the tax treatment of the agreement.
The transfer of title is not enacted directly with the Lender. To preserve the “hire” status the Lender legally needs to invoice a nominated third party (generally the Broker) for the payment for transfer of title. The broker would then duly invoice the Customer and, once paid the customer would have full ownership.
TIPS:
- Establish with the broker if you are committing your business to a Fixed Term of Minimum Term agreement.
- Always try to establish what the broker’s policy is in respect of transfer of title to your business – some brokers have been known to increase this amount substantially, we do not!
Tax Treatment –
This is very important as it is unique to a lease.
As mentioned, the rentals are treated as a business expense, which are fully offset against the profit of the business that effectively reduces the company’s corporation tax liability.
Another advantage that a Finance Lease provides, when compared with a Hire Purchase contract, is that the equipment can be fully expensed over the period of the Lease. By comparison with Hire Purchase, only the interest portion of the repayment is expensed with an allowance for depreciation on the remaining capital balance. The depreciation on the asset would be over a greater period taking much longer to claim the tax reductions.
Ultimately with Hire Purchase when the machine is fully depreciated the tax saved would be the same as Finance Lease it just takes longer to achieve.
ADVANTAGES
- Fixed monthly repayments – The payments are fixed and never vary
- Pay as you earn – Pay for the equipment from the revenue it generates
- Preservation of cashflow – Cash can be more efficiently deployed elsewhere in the business
- Tax Advantageous – All repayments are 100% offset against pre-tax profit
DISADVANGE
Early full settlement of a finance lease is not generally recommended. If you wish to settle your Finance Lease early, then the settlement figure would be the remaining repayments. Some Lenders offer an early settlement discount, but they are not obliged to and it is unlikely to be more than 4% to 5%.
Other Sources of Funding
The Bank
As we’ve already explained, this is the source of most business’s ‘go-to’ source of finance. Banks tend to offer the lowest interest rates but care always needs to be taken to include all the fees and remember that bank facilities are normally allied to variable interest rates, can be ‘called-in’ at short notice, often require high levels of asset collateral and personal indemnification. Bank lending is necessary in the economy but in our opinion is best to assist with working capital which flexes with the demands of the business and to cover any short term demands for cash to supress any circumstances beyond your control.
The Family Silver
By far the cheapest form of borrowing with flexible repayment terms and with some luck (and love) you might not ever need to pay it back! Caution though, family members might thin the world of you and want to help you in any ways they can, but they don’t always make for the best business partners.
Crowd Funding
A relatively recent way to borrow money. Some businesses have used crowd funding very successfully, but often it is not the simple solution that people often believe. The principal of lots of people personally lending a small amount works for some businesses and organisations
Crowd funding platforms are very selective as to which businesses they select to offer to their investors. Both the platform owner and its investors are expecting a reasonable return on their investment so this method of finance does tend to be more expensive than other options. They also prefer to see established businesses that can demonstrate at least two to three successful trading and in their opinion, businesses that have a ‘good story’ to advertise.
Commercial Loan
Commercial loans are available from many Lenders that sit outside the banking sector. They tend to be fairly easy to arrange and can sit alongside your bank relationship and other Lenders that may have financed your capital equipment. Ideally, similar to your banking facilities, a commercial loan is best used to fund working capital or project-based expenses such as ground works, general maintenance or other non-tangible assets.
Considerations
Whatever type of finance you use please don’t get hung up about the interest rate– It’s not the interest rate that is important it’s the monthly cost.
All Lenders vary in what interest rate they charge but that’s because they all differ as to what type of customer they want to contract with. Not all Lenders will lend to new starts or businesses established less than 3 years, others will have a minimum level at which they will lend and some Lenders will not work with businesses trading in sectors they don’t like.
So, ask yourself…
- Can your business afford to pay the fee every month, winter and summer alike?
- Can taking out finance help your business grow?
- Can taking out finance ultimately generate more profit?
If the answer isn’t yes to ALL three of these questions, then … DON’T DO IT!
If the answer is YES, then we suggest the following checks you should make before you proceed.
- Ensure that your broker is authorised and registered with the Financial Conduct Authority
- You are clear as how they will handle your finance application and how they will work with you throughout the life of your contract
- If you are providing personal information, be clear on how they will handle your personal data and your rights
- Ask to see their policy on Treating Customers Fairly, and
- in the event of dissatisfaction with any aspect of their service, you should have a clear understanding on what they will do to put things right and what rights you have if you are not 100% satisfied with their final resolution.
At GTF Event Equipment Finance, at the start of our relationship with you, you will be provided with:
- Our Letter of Engagement – In clear and concise English, providing you with our terms of business and confirmation of instructions for you to us
- Where relevant, our Suitability Letter – a statement as to what product/s we have suggested to you and how we have arrived at our suggestion
- Our Privacy Policy – Detailing how we will treat and handle your personal data
- You will be given a copy of our Treating Our Customers Fairly Policy as we feel it is imperative that our relationship is built on honesty, openness and fairness
- We will also ensure that you are given our Complaints Policy – We hope that it is never needed but we understand that sometimes there could be a reason to make a formal complaint so we believe it is important that you understand what we will do to put things right and advise what your rights are should you feel we have not done so.
Requirements for a Successful Finance Application
This process may to some seem a little long winded, but a good broker will be able to help and keep you informed at every step.
Not all the information listed here will be required for every application and of course, in the case of a new start or recently established business, not all of it will be available.
However, if you think about it logically the information you provide is all the Lender has to judge and evaluate you or your business to then decide whether they think that you are a good or bad risk.
Remember that you will be confident in your business ability to flourish and prosper but if you don’t give us all the relevant information (some of which will be in your head) then this may lead the Lender to decline your application.
So what’s needed?
Personal information
You, and all directors/partners, will need to provide a copy of a valid passport or driving licence and recent utility bill. The Lender will need to know and verify who you are. This is important as it helps to prevent identity fraud and prevent instances of money laundering.
Company Financial Statements
The company’s most recent filed accounts and also management accounts if the annual accounts are over 6 months old.
Bank Statements
Three months’ recent statements – Lenders are not specifically looking at the bank balance they are interested in how you operate the bank account. A clean bank account with no overdraft breeches or returned cheques demonstrates a business under control.
Business Plan
This is the thing that most people get stressed about and can come in all formats from a single page to “War and Peace”. The important thing about business plans is to communicate to the Lender your vision and why borrowing their money will help your business grow. It should show that you have considered the key elements of the project; competition, costs, overheads and the most important, how sales will be delivered.
Financial Plan
A basic financial model showing income and expenditure. The main purpose of the projection is to show that you have thought about the project and to prove affordability. Lenders obviously want to see that you will be making a good profit and you can pay them back the money you want to borrow.
Other Information
This can be vary from CV’s for directors to business tenancy agreements and will vary between different assets and businesses. We will advise you of what will be needed for your finance application.
Always remember – the more comfortable you can make the Lender feel about your business – the more likely you are to receive an approved application.
Finally, a word on Supporting – Personal Guarantees
In most cases a personal or directors guarantee of an SME will be required.
People are averse to signing them for obvious reasons but think about it from the Lender’s perspective.
Unlike the bank who will have security over all the business assets and probably some personal ones as well. By contrast the asset finance Lender only has security over their asset, which the moment you take delivery is immediately second hand and worth less than they paid for it. The Lender then takes it on trust that you will manage your business effectively, they have no control over how you run your business or even ask to review your accounts.
By comparison with a bank that generally has surplus security and reviews its position and can withdraw funding if they choose, the Asset Finance Lender is taking a far greater risk so they rely on a personal guarantee.
In this respect the guarantee is to focus your mind upon making sure that they are repaid and remember that the guarantee reduces with every payment you make. The guarantee is only ever for the outstanding balance of the finance after the equipment is sold.
