March 23, 2007 | General

Equipment Purchasing And Leasing

BioCycle March 2007, Vol. 48, No. 3, p. 18
Understanding how to buy equipment for composting sites and options regarding purchase vs. lease can have significant impacts on your bottom line.
Craig Coker

PURCHASING (or leasing) equipment for use in manufacturing compost (and/or soil products) can be one of the riskiest decisions compost managers must make. The obvious risks of equipment acquisition (i.e. paying too much, higher than expected operating costs, not having the cash flow to cover payments, etc.) are augmented by risks such as machines not able to keep up with the increased materials handling demands as the facility grows, equipment not being the right type for particular types of wastes, or equipment not being able to withstand the harsh gritty corrosive environment it must operate in. Each of these “forward-looking” factors should be carefully defined as you are making an acquisition decision for a machine with a five to eight year life (maybe longer).
There are literally dozens of equipment vendors for each major type of equipment needed in a composting facility and it can be difficult to “separate the wheat from the chaff” when evaluating product claims by various vendors. One of the first steps in the evaluation process should be to assemble an evaluation team. This team should be cross-functional, with its members having an understanding of maintenance, operations, engineering and financial issues. This team, which could have both internal and external (i.e. consultants) members, should go through a step-wise evaluation process: Prepare a vendor comparison matrix; Prepare a vendor rating matrix; Prepare a vendor cost matrix; and Negotiate and execute an agreement.
These matrices can be assembled using spreadsheet software programs. The key advantage of a matrix is to arrange all the information in a clear comparative format. The comparison matrix simply lists all the desired features of the equipment down the vertical column and the responses from each vendor across the horizontal rows. Table 1 illustrates this concept for an evaluation of front-end loaders:
A vendor rating matrix is a weighted-matrix evaluation technique, where weights (numerical values) are assigned to different evaluation factors to represent the relative importance of that factor to the evaluation team. This “weighting factor” is multiplied by the rating score for each particular item to arrive at a “weighted score”. The rating score can be subjective, for example 1 is inadequate, 2 is below requirements, 3 is adequate, 4 is exceeds requirements, and 5 is excellent. The various weighted scores are then summed across all of the evaluation factors for each vendor. Table 2 illustrates this concept for a trommel screen vendor.
Developing rating scores for each parameter of importance from each vendor will require the most work by the evaluation team. This will require speaking with (or, preferably, visiting) owners (and operators) of similar equipment at other facilities about their experiences with the equipment, possibly arranging for an on-site demonstration of the equipment at your facility, possibly visiting the manufacturer’s factory, and careful review of all pertinent owner’s manuals and maintenance manuals for the equipment. Be sure to have your on-site people take numerous digital photographs of the equipment (including close-ups of various features); this will facilitate the teams’ rating evaluation back in your offices.
A vendor cost matrix is simply a side-by-side comparison of each vendor’s cost proposal, which should include the base cost and all optional costs, on line item by line item basis and should also include support costs like shipping, installation and training. Try to get actual maintenance costs from other users of the same equipment rather than relying on vendors’ estimates.
Keep in mind that these various evaluation matrices contain confidential information provided by each vendor and your evaluation team should respect that confidentiality. While the evaluation process discussed thus far has focused on new equipment, this same procedure applies equally well to used equipment.
Most equipment vendors will want a 20 percent down payment and the balance due either right before shipping or right at delivery. If you’re buying equipment made overseas, you’ll need to deal with currency fluctuations as well as with import and customs regulations that can affect the transaction (some financing sources won’t pay the balance due until the machine is in the U.S. and some foreign equipment vendors won’t ship without final payment).
Some believe that if you can pay cash for equipment, you should (as opposed to borrowing money to finance the purchase). Whether to pay cash or borrow funds requires consideration of both working capital and debt-to-equity considerations. Investing cash in equipment can reduce working capital (a measure of liquidity), and complicate your ability to finance day-to-day operations (payroll, receivables, etc.). Using long-term debt to finance equipment purchase will raise the debt-to-equity ratio (the ratio between total liabilities and total net worth) which raises fixed overhead costs. These measures may also be stipulated or controlled in other financial relationships (such as a facility construction loan), so be sure to review any possible limitations in your other loan documents.
There are also tax considerations in equipment purchasing. A portion of the cost of the equipment can be recovered each year through defined annual tax depreciation percentages; and loan interest payments (but not capital payments) can be added to operating costs (and thus, reduce taxable income). Should you sell the equipment at some point in the future, that sale is considered a “taxable event” and the gain/loss on tax book value is reported with taxable income.
Financing equipment purchase is much like buying any big-ticket item: you’ll need anywhere from 10 percent to 20 percent down (or more) and loan terms tend to be in the three-to-seven year range. Just like buying an automobile, financing an equipment purchase through a bank will result in the bank being designated as lien holder on the title to the equipment and will likely require the bank to be named an additional insured on your insurance policies. A few equipment companies offer financing, but most will expect you to come up with your own financing.
Leasing equipment is an option if it is important to maintain high levels of liquid working capital (such as during winter months in northerly climates), or if scarce financial resources can be put to better use, or if increasing the debt-to-equity ratio is ill-advised. Equipment leases are more often “capital” leases (lease-to-own agreements) rather than “operating leases” (such as a lease for a temporary equipment rental). Capital leases run 3-5 years and normally have a “balloon” payment at the end equal to the residual value of the equipment. How the residual value is calculated varies from manufacturer to manufacturer. “The folks at Backhus [windrow turners] use expected wear and tear, expected operating hours, and depreciation to figure residual value,” said Lyndell Pate, President of N40, LLC, the North American representative for Backhus, “They don’t take market value into consideration.” Pate noted that some lessors will limit the number of allowed operating hours during the lease period to raise the machine’s residual value.
Capital leases are generally not renewable; the manufacturer expects the lessee to take ownership of the equipment at the end of the lease period with payment of the balloon amount due (which itself can be financed by outside sources). Some manufacturers will assist in trading in the leased equipment on a more current model and allow the lessee to roll over the balloon payment of the first lease as a down payment on a new model’s lease. The lessor (often a financing entity separate and distinct from the equipment manufacturer) will purchase the equipment on behalf of the lessor after the first lease payment has been made, and will retain title to the equipment during the lease period. The amount of the payment under a lease will depend on the lessee’s credit history, the lease term, the residual value, the capital cost amortization schedule, and the lessor’s cost of money.
Capital leases will affect the balance sheet as the leased equipment is an asset and the remaining lease commitments are liabilities. Operating leases have no effect on the balance sheet. Neither type of lease has any effect on working capital, but capital leases do affect the debt-to-equity ratio.
The principal advantage to leasing is that you get access to equipment that can improve profitability, without significant impact to your working capital. The need to conserve cash and maintain an acceptable debt-to-equity ratio means leasing is often the only alternative available to companies that are leveraged (i.e. using others’ monies) and growing rapidly.
The various factors affecting a lease versus purchase decision are complex. Various issues to consider include:
o Fixed overhead costs – monthly loan and lease payments must be made whether or not the equipment is used. As fixed overhead costs go up, there is a tendency to focus on cash flow (taking in more tip fee material and/or selling more product) instead of earnings (net profits).
o Working capital – using cash to purchase equipment has a negative impact on working capital (which is usually in short supply) and can cause the need to use debt (like revolving lines of credit) to cover short-term operating needs (i.e. buying bulking agent).
o Debt-to-equity – even if there is enough cash flow to cover debt, most financial institutions have limits on acceptable debt-to-equity ratios. Keeping this ratio low will result in lower debt financing rates.
o Residual market value – if the residual market value is set too high, the final balloon payment under a lease can exceed an appraised fair market value (essentially a negative equity).
o The fine print – some lease agreements can have difficult terms in the event of default, “excessive wear and tear” (which can be contentious to define), or usage above a predetermined number of hours.
o Taxes and financial statements – tax issues can be very complex; operating leases are deducted as normal operating expenses; capital leases (like loans) are limited to deducting only the interest portion of the lease payment plus the allowed depreciation.
Craig Coker is a Principal in the firm of Coker Composting & Consulting in Roanoke, Virginia, who specializes in providing technical and managerial support to the composting industry in the areas of planning, permitting, design, operations and compost sales and marketing.
Checklist & Definitions, page 21
A large, lump-sum payment scheduled at the end of a series of considerably smaller periodic payments. A balloon payment may be included in the payment schedule for a loan, lease, or other stream of payments.
Also called a finance lease, a capital lease is similar to a loan, with lessees building equity in equipment as they make each payment. Because of this, lessees account for the asset as a conditional sale and must depreciate the equipment as a capital asset. Simultaneously, the present value of the firm lease payments appear as a liability on the lessee’s balance sheet.
A measure of a company’s financial leverage. Debt/equity ratio is equal to long-term debt divided by common shareholders’ equity. Typically the data from the prior fiscal year is used in the calculation. Investing in a company with a higher debt/equity ratio may be riskier, especially in times of rising interest rates, due to the additional interest that has to be paid out for the debt.
A tax deduction representing a reasonable allowance for exhaustion, wear and tear, and obsolescence, that is taken by the owner of the equipment and by which the cost of the equipment is allocated over time. Depreciation decreases the company’s balance sheet assets and is also recorded as an operating expense for each period. Various methods of depreciation are used which alter the number of periods over which the cost is allocated and the amount expensed each period.
The party to a lease agreement who is obligated to pay the rentals to the lessor and is entitled to use and possess the leased equipment during the lease term.
The party to a lease agreement who has legal or tax title to the equipment (in the case of a true tax lease), grants the lessee the right to use the equipment for the lease term and is entitled to receive the rental payments.
For financial reporting purposes, Financial Accounting Standards Board (FASB) defines an operating lease as one that does not meet the criteria of a capital lease. This means that the asset and corresponding liability are viewed as “off balance sheet” and the entire monthly payment is expensed or treated as a budget item. As viewed by the lessor, an operating lease describes a short-term lease (compared to the asset’s expected useful life) in which the total of payments received by the lessor do not cover the cost that the lessor paid to acquire the asset.
The book value that the lessor depreciates a piece of equipment down to during the lease term, typically based on an estimate of the future value, less a safety margin.
Current assets minus current liabilities. Working capital measures how much in liquid assets a company has available to build its business. The number can be positive or negative, depending on how much debt the company is carrying. In general, companies that have a lot of working capital will be more successful since they can expand and improve their operations. Companies with negative working capital may lack the funds necessary for growth.

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