Before Acquiring Equipment, Study Options Carefully
There are options contractors should consider when upgrading their equipment cache during times of economic recovery.
As billions of dollars in stimulus funds continue to flow to the states for construction of highways, bridges, transit lines, aviation centers and rail projects, more than a few contractors are in a quandary. Still shell-shocked from the economic carnage of 2008, many contractors know they need to upgrade their equipment to compete, but yet find it difficult to climb out again on a financial limb.
Moreover, they do not know whether they should purchase, lease or rent equipment. That has long been a source of confusion — and subject of debate — for all contractors, but particularly for small and mid-size companies. In the past, before the current economic travails began, there were a few rules of thumb about buying versus leasing. Those rules no longer apply very well. With sources of credit tighter than ever and construction volume rising and falling like the stock market, it’s nearly impossible for contractors to predict the future.
To help with the decision, let’s look at a few of the advantages and disadvantages of purchasing, leasing and renting equipment. First let’s look at equipment purchases.
Contractors who purchase equipment have always enjoyed various benefits, including the tax advantage of deducting depreciation, stronger physical assets and the ability to recoup expenses by selling used equipment. Until 2007, the majority of contractors expected to meet 86% of their needs with purchased equipment, according to CIT Construction’s 2007 Construction Industry Forecast.
Although dependable statistics for the past 12 months are hard to find, it’s safe to say that fewer contractors are buying new equipment. Still, it’s an appealing choice because purchased equipment helps build equity and can last up to 20 years.
In addition, Section 1201 of the 2009 American Recovery and Reinvestment Act allows first-year depreciation of 50% of the purchase cost by extending for one year the depreciation bonus created by the 2008 Economic Stimulus Act. Contractors may not claim the bonus if a purchase contract existed prior to Jan. 1, but they may be eligible for the 2008 depreciation bonus.
There are disadvantages to owning equipment as well. New equipment requires maintenance, servicing and insurance. In addition, sales taxes must be paid. Perhaps the biggest drawback is the reduction of cash. An outright cash purchase — with funds provided from working capital — is usually the least costly method of acquiring equipment because it eliminates service fees, interest charges and expenses. But this also substitutes a fixed asset (equipment) for liquid asset (cash), therefore weakening the balance sheet. Bankers and sureties don’t like to see a weakened balance sheet.
Leasing is another option that has been gaining popularity for quite a while. As opposed to renting, which normally is a short-term strategy, leases usually cover a two to three-year period. The top advantage of leasing is that it frees capital that can be used to expand the business. It also allows a contractor to build reserves against unforeseen declines in volume and to take advantage of trade discounts. Another advantage is that leasing does not affect financial ratios, particularly the working-capital ratio. Leasing also works as a hedge against inflation.
Leasing has drawbacks, however. One of those is that there are many different types of lease agreements, which continues to cause confusion. Some agreements require the contractor to pay for maintenance, others do not. Some allow for future ownership, others do not. The biggest drawback, however, is that operating leases do nothing to bolster assets and build equity, which is keenly important to lenders. (Capital leases —- those that provide for future ownership — are required to go on the balance sheet.)
Another disadvantage is that there isn’t always a local lease market for all types of equipment, particularly highway heavy machinery. When availability is limited, costs go up. Another drawback is that leasing precludes contractors from being able to benefit from the resale market, which traditionally has been strong in the construction sector.
Now let’s look at equipment rental. As opposed to multi-year lease agreements, rental contracts last only a matter weeks or even days. In general, the type of equipment rented is more industry specific than geography-based. Scissor lifts, booms, forklifts and skid-steers are the most rented pieces of equipment, according to industry reports. A lot of backhoes, aerial equipment and forklifts are rented as well.
A key consideration in determining whether to rent is the nature and length of a construction project. Renting is a popular option for a contractor who has a large job but isn’t sure that the company’s workload will remain the same once the project is finished. A company’s size also determines whether it rents or purchases. Smaller companies that employ 25 to 100 workers tend to rent equipment most often.
By the way, many companies rent equipment simply as a way to test drive it before entering into a purchase agreement.
Essentially these are the options for acquiring equipment — purchase, lease or rental agreements. Each has its place. Historically the decision has been based on a contractor’s size, specialty, market area, capitalization and debt load, and growth. That hasn’t changed. What has changed is that rules of thumb relating to those criteria have changed a lot. For example, it used to be that small contractors without substantial cash flow should always lease their equipment and use the surplus capital for expansion or to retire debt. But it also used to be a lot easier to borrow money. Today, bankers want to see hard assets before providing loans or lines of credit.
Conversely, large contractors with maintenance barns full of equipment may now want to think about reducing capacity to improve liquidity.
With assistance from professionals, deciding how to acquire equipment can be fairly simple. But with tax laws constantly changing and equipment costs still high, contractors need to solicit input from accountants and other advisers. In the construction industry, equipment management can mean the difference between success and failure.