to rent or buy – that is the question

by | Nov 25, 2021

Capital budgeting and cash flow management is a wholistic process. This means that the whole cash cycle needs to be considered when making capital investment financing decisions. The financing decision you choose can impact the organization and investment time horizon cash flow result in several ways.

In this article we will look at how to finance assets that do not directly generate revenue for the business. This will include items like motor vehicles, computer equipment, solar installations, furniture, etc.

Financing options include surplus cash, available overdraft, instalment sale agreements (finance leases), or operating rentals.

The assertion I will be making is that many businesses do not fully understand the full benefit of an operating rental relative to the other financing methods.

In most finance lease agreements, the asset is purchased in the name of the company but remains assigned to the financing company as security. The asset is therefore recorded on the balance sheet along with the associated lease liability. Depreciation and interest will flow through the income statement.

In contrast, true operating rentals are structured such that the asset is owned, licensed, insured and maintained by the rental company. Rental payments are simply processed through the income statement, i.e. it is pure off-balance sheet finance. The IFRS 16 accounting standard does change this accounting treatment but at present those companies that apply IFRS for SMEs are not impacted.

The table below illustrates some of the key considerations and benefits of renting versus an instalment sale agreement (ISA) when it comes to motor vehicles.

Rental

Instalment sale agreement

Purchasing
Rental companies typically purchase large volumes of vehicles and are therefore able to negotiate substantial discounts at time of purchase. This will affect the rental pricing.

The rental company will arrange all purchase administration.

Without the relative discount negotiating strength the effective amount required to be financed will be higher.

The lessee will be responsible for all purchase administration such as arranging finance, insurance, maintenance plans and licensing.

Insurance
Again, the rental company has greater negotiating power with respect to the cost of insurance. You may have less premium negotiation strength.
You will not be subject to annual insurance premium increases. You will be subject to insurance premium increases; particularly should you have to claim against the policy.
Should you have an accident, the rental company will be responsible for the entire process of getting you back on the road again. Should you have an accident, you will be responsible for submitting and administering the insurance claim. Should the vehicle be written off, you will have to handle obtaining a replacement vehicle and refinancing the replacement with the finance company.
Deposits
Generally, no upfront deposit is required. The financing company may require an upfront deposit that can be up to 20% of the purchase price of the vehicle.
Security
Typically no additional securities are required by the rental company. The bank may require additional security which may affect your ability to raise finance for other purposes.
Residuals
No residual payments are required at the end of the rental period You might negotiate a residual or balloon payment at the end of the term of the ISA to reduce the monthly instalment amount. Banks will typically accept up to a 30% residual.

However, this will increase the amount of interest that you pay over the term.

You will also need to plan for the residual payment that might put a strain on your cash flow.

Resale value uncertainty
The rental company will forecast the expected resale value at the end of the rental period and build this into the rental amount.

At the end of the term, you will simply hand the vehicle back to the rental company.

You are at risk of the resale value being less than the residual lease payment and the amount you included in your capital budgeting calculation.

You will also have the hassle of selling the vehicle yourself.

Interest rate risk
Monthly rental payments are typically fixed over the term of the rental. The rental company will absorb any interest rate increases. Most ISA’s in South Africa are variable rate meaning should interest rates rise, so too will your monthly instalment.
Cash flow predictability
With the monthly rental payments being fixed with no residual payment required you have a clear view of your cash flow requirements. Based on many of the factors listed above you may need to regularly re-adjust your cash flow and funding requirements for the rest of the business.
This covers most of the factors to consider when choosing between financing options. However, a very important aspect that is either not done at all or misses out a key element is the capital budgeting calculation; determining the true cost or return on capital over the finance period.

When a capital budgeting calculation for purchasing a delivery vehicle is performed it typically goes as follows:

Clearly, this shows that despite all the relative advantages referred to above, the rental option works out to be more expensive based on the assumptions made.
However, this fails to consider the alternative deployment of the ISA deposit in revenue generating assets, such as stock.

You might find that your finance company doesn’t require an upfront deposit. However, when you do want to grow your working capital sometime during the term of the ISA, you may find the bank less willing to provide finance because of the extra gearing sitting on your balance sheet. As you will see. the rental option is a way you can mitigate this risk.

Based on a margin of 40% and a stock turn of 4 the rental cash flow would be radically transformed as follows:

So, by performing a wholistic capital budgeting calculation you can see that the rental option becomes a lot more attractive.

Should the deposit required increase to 20% the situation changes even further because the rental cash flow actually becomes positive. This surplus cash flow can then be re-invested and the multiplier effect kicks in. Remember the beauty of compound interest? The same principle applies so that, based on the assumptions included here you could grow your cash position from the deposit amount of approximately R80,000 to almost R1 million in just 5 years. That’s a significant internal rate of return compared to a negative internal rate of return when purchasing your vehicle using an ISA.

Furthermore, by growing your inventory and equity you should be able to secure additional bank finance for working capital to accelerate your growing business even further.

These calculations may seem complex and every business’ circumstances are different. If you need assistance in making the right decision for your business, contact waurentals for expert advice.

1 Comment

  1. LUKAS SNETLER

    Very interesting reading and very meaningful. Excellent work David, well done on a Wau document!!!

    Reply

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