Understanding Equipment Financing

When businesses aim to grow or maintain their operations, capital expenditures (CAPEX) play a critical role in the acquisition of equipment and fixed assets. These assets are essential to the ongoing operations and long-term success of many companies. However, the acquisition of such assets often requires substantial upfront capital. This is where equipment financing comes into play.

In this article, we will explore the key components of equipment financing, types of equipment loans and leases, their implications on financial statements, and how lenders assess risk when offering financing.  We will break down how financing impacts businesses across industries and why understanding equipment finance is essential for corporate growth.

The Importance of Equipment Financing

Equipment financing allows businesses to acquire the necessary machinery and equipment without needing to pay the full price upfront. Instead, they can finance the purchase through loans or leases and pay it off over time. This type of financing is crucial for businesses that want to grow their fixed assets while maintaining liquidity.

For many industries, such as construction, manufacturing, and transportation, access to equipment is essential for daily operations. Without the ability to finance equipment, businesses may face limitations in expanding their operations, improving efficiency, or even maintaining competitiveness in the market.

In addition to meeting operational needs, equipment financing provides flexibility in how businesses manage their cash flow. Instead of using large amounts of working capital to purchase assets outright, they can spread out the payments over time, allowing them to retain cash reserves for other important investments.

Sources of Equipment Financing

There are various sources of equipment financing, and the choice of lender often depends on the lifecycle stage of the business and the industry in which it operates. The most common sources include:

1. Commercial Banks: Larger financial institutions that provide loans to established companies with strong financial records. Banks typically offer favorable interest rates but may have stricter credit requirements.
2. Community Banks and Credit Unions: These are often smaller, regional lenders with a focus on local businesses. They may offer more flexible terms but might not have the capacity to finance large-scale equipment purchases.
3. Equipment Finance Firms: Specialized lenders that focus solely on financing equipment purchases. They may cater to specific industries, such as transportation or manufacturing, and have faster turnaround times for loan approvals compared to traditional banks.
4. Supplier Financing: In this model, the equipment supplier offers financing directly to the buyer. Supplier financing allows companies to purchase equipment from a trusted source while deferring payment over time.

Each of these financing sources has its own underwriting criteria, interest rates, and terms, which means businesses should carefully evaluate their options to determine the best fit for their needs.

Types of Equipment Financing: Term Loans vs. Leases

When it comes to financing equipment, businesses generally have two options: term loans or leases.

1. Term Loans

A term loan is a traditional financing option where the borrower receives the full amount of the loan upfront and repays it in installments over a set period. The term loan is secured by the equipment being purchased, meaning the lender can repossess the equipment if the borrower defaults on the loan.

Key features of term loans:

• Fixed or variable interest rates
• Amortization over several years (typically 3–7 years)
• Borrowers own the equipment outright after the loan is fully repaid
• Equipment serves as collateral, reducing risk for lenders

Term loans are particularly suited for businesses with strong financial profiles that want to purchase equipment outright and spread the cost over time. Additionally, because the equipment is considered a company asset, it appears on the balance sheet and may be depreciated for tax purposes.

2. Leases

Equipment leases come in two primary forms: capital leases and operating leases.

• Capital Lease (Finance Lease): A capital lease is similar to a loan in that the lessee effectively owns the equipment and records it as an asset on the balance sheet. At the end of the lease, the lessee often has the option to purchase the equipment at a reduced price or nominal value. This type of lease is suitable for businesses that want long-term use of the equipment and plan to own it at the end of the lease term.
• Operating Lease: An operating lease is closer to a rental agreement. The lessee uses the equipment for a specified period, but at the end of the lease, the equipment is returned to the lessor. This lease is not recorded as an asset on the lessee’s balance sheet, which can make the company’s financials look more favorable. Operating leases are commonly used for assets that are frequently upgraded or replaced.

Key considerations for leases:

• Lower upfront costs compared to term loans
• Flexibility in upgrading to newer equipment
• Operating leases keep the company’s debt levels lower, which may improve key financial ratios

Adjusting Financial Statements for Leases

Leases can have a significant impact on a company’s financial statements. The distinction between capital leases and operating leases is crucial for financial analysis. Capital leases are considered assets and liabilities on the balance sheet, while operating leases may not appear directly.

Recent changes in accounting standards—such as the 2019 IFRS (International Financial Reporting Standards) and 2018 US GAAP (Generally Accepted Accounting Principles) updates—require companies to include operating leases on the balance sheet. This change has increased transparency but also necessitated adjustments in how companies report and assess their financial health.

When adjusting financial statements for operating leases, analysts must:

1. Adjust the Balance Sheet: Add the present value of future lease payments to both assets and liabilities, ensuring that the full lease obligation is reflected.
2. Reconstruct the Income Statement: Add lease payments back to EBITDA to give a more accurate reflection of operating cash flow.
3. Recalculate Lending Ratios: Key lending ratios, such as debt-to-equity and interest coverage, must be recalculated to ensure an accurate picture of the company’s financial standing.

Equipment Finance Risk Management

Lenders providing equipment finance must carefully evaluate risk factors before extending credit to a business. The loss given default (LGD) is one of the key measures that lenders use to assess risk in equipment finance. LGD estimates how much of the principal loan amount the lender is likely to recover in the event of a default.

There are several factors that influence LGD in equipment financing:

1. Loan-to-Value (LTV) Ratio: The LTV ratio represents the amount of the loan compared to the value of the equipment being financed. A lower LTV ratio reduces the lender’s risk by ensuring that the collateral (the equipment) is worth more than the loan amount. Term loans generally have LTV ratios of around 75%, whereas leases can have LTV ratios as high as 100%.
2. Asset Liquidity: The more liquid or easily sellable an asset is, the higher the recovery rate in case of default. Generic, high-demand equipment is easier to resell, which reduces LGD.
3. Security Registration: Lenders register liens on financed equipment to ensure that they have a legal claim on the assets in case of default. The lien protects the lender by providing a clear path to seize and sell the equipment if necessary.
4. Lessee’s Creditworthiness: The borrower’s financial health is also an essential factor in risk management. Companies with strong cash flow and a history of responsible borrowing are more likely to secure favorable terms.

Public Security Registrations and Perfecting Security

In equipment finance, the lender’s ability to claim collateral in the event of default depends on the proper registration of the security interest. Different jurisdictions have their own methods for recording liens on assets:

• Uniform Commercial Code (UCC) in the U.S.: A UCC filing is a public registration that gives lenders a legal claim on specific equipment in case of default. This ensures that the equipment cannot be used as collateral for another loan without the lender’s knowledge.
• Personal Property Security Act (PPSA) in Canada: Similar to the UCC, PPSA filings record the lender’s claim on equipment financed by the borrower, protecting the lender’s interests.

Properly registering and perfecting security interests ensures that lenders can recover their assets in the event of non-payment, which reduces risk.

Sale-and-Leaseback: Freeing Up Capital

One common strategy used by businesses to free up capital is sale-and-leaseback financing. In this arrangement, a business sells an asset (such as equipment) to a lender and then leases it back, allowing the company to continue using the equipment while gaining immediate cash.

This type of transaction is particularly helpful for companies that need to improve liquidity, whether to invest in growth initiatives or cover near-term liabilities. The sale-and-leaseback approach also allows businesses to avoid taking on additional debt, which can improve financial ratios and make the company more attractive to investors.

When to Consider Sale-and-Leasebacks in an LBO

Sale-and-leaseback transactions are particularly useful in LBOs when the company has substantial, underutilized assets that can be monetized without disrupting operations. For example, if a target company owns valuable real estate or equipment, these assets can be sold to raise cash, while the company continues to use them through a lease arrangement.

This strategy can also be effective in industries where assets are essential but ownership is not, such as logistics, manufacturing, or transportation. By converting ownership of these assets into a lease structure, the acquirer can optimize the financial structure of the deal, reduce initial capital outlay, and improve liquidity.

Conclusion

Equipment financing is an essential tool that allows businesses to acquire the machinery and assets they need to grow without straining their cash flow. Whether through term loans, capital leases, or operating leases, companies have a variety of options to fund their capital expenditures while keeping debt levels manageable.

For lenders, understanding the risks and rewards associated with different types of equipment financing is key to structuring deals that benefit both parties. Factors like Loan-to-Value ratios, loss given default, and proper security registration all play crucial roles in the lending process.

By choosing the right type of financing and structuring deals effectively, businesses can acquire the equipment they need to remain competitive and innovative in their industries.

However, determining the most advantageous financing option, structuring deals, and properly managing debt and cash flow all require a clear understanding of both the financial health of a company and its long-term goals. This is where Business Valuation Advisors can assist.

At Business Valuation Advisors, we specialize in providing businesses with comprehensive financial advisory services. Whether you’re looking to finance new equipment, structure sale-and-leaseback deals, or ensure accurate balance sheet adjustments for leases, our expert team is here to guide you. We ensure that the financial choices you make today align with your long-term objectives, allowing you to maintain liquidity, manage debt, and improve operational efficiency.

If you’re preparing for an equipment financing decision, or if you want to understand how such decisions can impact your overall valuation and business health, we can help you navigate these complexities. 

Visit www.valuationadvisor.com to learn more about how our team can provide expert financial guidance tailored to your business needs. Let us help you make informed financial decisions that support your growth and strategic objectives.