Buying for Business: Making smart capital purchases

Final_Art2a Much has been said and written about the stalled U.S. economy. Many attribute the reluctance of small businesses to expand and add workers to an uncertain tax and regulatory climate. Others blame the failure of businesses to grow on the often debunked belief that financing is neither affordable nor available. Regardless of how valid the hurdles appear, however, those in the pond business may still need to make capital purchases.

Fortunately, there are tools that can help every pond business owner or manager decide whether or not to commit to capital purchases. Best of all, most deci- sion-making processes involve relatively simple analysis and often factor in economic uncertainty. Even in the best of times it can be difficult to decide whether to make capital purchases. Although there is no precise or standard definition, there are a number of mathematical formulas falling under the heading of “Cost Benefit Analysis” that are frequently used when deciding whether to purchase capital assets. These formulas usually summarize both the positive and the negative impacts of a particular transaction and then weigh them against each other.

THE COST OF OWNERSHIP:

To discover how much it costs to own any business asset, a Cost of Ownership analysis, better known as a Total Cost of Ownership, or TCO Analysis, is designed specifically to find the lifetime costs of acquiring, operating and changing something. TCO analysis often reveals large differences between the base price of some- thing and its long term cost.

Today, TCO analysis is used to support acquisition and planning decisions involving a wide range of assets that incur significant maintenance or operating costs over a long usable life. Total cost of ownership is used to support decisions involving computing systems, vehicles, buildings, equipment and machines, to name just a few.

TCO analysis is not a complete cost benefit analysis, however. TCO analysis ignores many business benefits that result, such as increased revenues, faster information access, improved competitiveness or improved quality of services. When TCO is the primary focus in supporting a decision, it is assumed that such benefits are more or less the same for all options and the choices differ only in cost.

RETURN ON INVESTMENT (ROI):

Everyone who makes an investment expects a return at some point. Someone who invests in an education, for example, may be doing so to have a good job in the future. A business and/or its owner usually invests to help the operation grow, expand or, in many cases, merely survive.

The easiest tool for analyzing a business investment is a computation of the Rate of Return (ROI) on that investment. An ROI analysis compares the magnitude and timing of investment gains directly with the magnitude and timing of investment costs. A high ROI means that investment gains compare favorably to investment costs.

One serious problem with using ROI as the sole basis for decision-making is that ROI by itself says nothing about the likelihood that expected returns and costs will be as predicted. After all, ROI by itself says nothing about the “risk” of an investment. ROI simply shows how returns compare to costs if the action or investment produces the results hoped for. For that reason, proper investment analysis should also measure the probabilities of different ROI outcomes. Wise pond professionals will consider both the ROI magnitude and the risks that go with it.

FINANCIAL JUSTIFICATION:

Financial justification analyzes whether or not an investment is justified — in financial terms. In other words, financial justification helps a pond professional decide whether or not to go forward with a proposed action. The results of a financial justification analysis address questions like these:

■ Does the proposed purchase represent the best use of funds?

■ Can the proposed new purchase be used to improve the pond operation’s financial position?

■ Will the proposed purchase, security, legal, accounting, or other service “pay for itself”?

Financial justification is distinguished from other types of analysis only by the special emphasis on financial decision criteria. Just which criteria determine justification in a particular situation depend heavily on the pond operation’s objectives and the current business situation.

PAYBACK PERIOD:

A basic analytic approach, often referred to as “net present value,” asks the question of how and how long it will take for the newly acquired equipment, services or business property to pay for itself. Quite simply, a factor equal to the operation’s cost of capital is applied to the expected cash flows from the new equipment, system, property or asset. Under this approach early returns from the investment are usually more valuable than later returns.

The net present value approach or some variation is generally the best method to analyze an investment. All cash flows are accounted for including any salvage value expected when the newly acquired business asset is eventually disposed of or sold, along with negative cash flows (e.g., high repair costs in later years of the property’s useful life).

The Payback Period Method has long been used for a quick, cheap and “dirty” analysis. In today’s current economic climate it can make sense since it inherently takes into account risk — particularly the risk several years out. It can be very useful for investments in fast-changing technology. A good example would be a piece of equipment that may be obsolete or where a significant upgrade should be available in a couple of years.

A Helping Hand from Taxes

Taxes obviously play a role in all capital purchases. Under our tax laws, businesses have long been entitled to deduct a reasonable allowance for the exhaustion, wear and tear of equipment and property used in a trade or business, or for property held for the production of income.

Recovering the cost of capital assets via annual depreciation deductions over what our lawmakers have set as its “useful life” has been augmented with alternative write-offs. Whether the Section 179 write-off that allows up to $500,000 in newly acquired equipment and other business property to be “expensed” and written off in the year acquired, or the so-called “bonus depreciation” allowance allowing 50 percent of capital purchases to be written off will continue after the 2013 tax year is debatable at this time. While they continue, they result in significantly smaller cash outlays for the capital purchases for every profitable pond business.

Buy/Lease Conundrum

A garden pond professional short on cash might also want to consider leasing rather than buying. Leasing offers real advantages, including reduced cash outflows. A short list of leasing advantages includes:

■ Conventional bank loans usually require more money up front than leasing.

■ Leasing generally requires only one or two payments up front in lieu of the substantial down payments often required to purchase equipment.

■ Unlike some financing options, leasing offers 100% financing. That means a pond business can acquire essential operating equipment and begin using it immediately to generate revenues with no money down.

Financing, Not Brain Surgery

Interest rates remain close to their historical lows but financing for many businesses continues to be elusive. One problem: lower interest rates have trans- lated into lenders and investors being more selective. However, often thought of as a lender of last resort, the U.S. government is actually an excellent source for a wide variety of economical financing.

Some government loans, particularly those of the Small Business Administration (SBA), have less stringent requirements for owner’s equity and collateral. In addition, many SBA loans are for smaller sums than most banks are willing to lend.

7(a) LOANS:

The biggest and most popular SBA loan program is the 7(a) Loan Guarantee Program for eligible borrowers that can be used for many business purposes, including real estate, equipment, working capital or inventory. While borrowers must apply through a participating bank or lending institution, the SBA guarantees up to $750,000 or 75 percent of the total amount, whichever is less. For loans under $100,000, the guarantee usually tops out at 80 percent of the total loan.

504 Loan Program:

At the top end of the SBA loan size spectrum are the 504 Loan Programs that provide long-term, fixed-rate loans for financing fixed assets, usually real estate and equipment. 504 loans of up to $750,000 are usually made through Certified Development Companies (CDCs) — nonprofit intermediaries that work with the SBA, banks and businesses looking for financing.

Capital Purchases:

As already mentioned, every pond professional will face situations where there is no need for a formal analysis … although generally, the numbers should be run before deciding whether a capital purchase is warranted. Sometimes, particularly with changes in technology, the savings are obvious. However, no business property, equipment or asset should be replaced just because it has failed. After all, it may no longer be needed or the technology may have changed.

Information about the ratios and formulas used in formal analysis is widely available on the Internet and in print. There are even widely-distributed software programs that quickly perform this analysis. Not too surprisingly, however, the assistance of a qualified professional is highly recommended when deciding on any capital purchase.

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