Equipment leasing basics.

Would you hire a worker and, on his first day on the job, pay him his entire wages for the next year? Then why pay fully for the delivery and installation of a machine when its cost can be covered over a multiyear period? Leasing can be the answer to that question.

Today in the U.S., commercial leasing accounts for more capital equipment acquisitions than corporate bonds, equity or commercial bank debt, and in 1995, 80% of all U.S. companies leased equipment. Due to the fact that casting manufacture requires major commitments to equipment, leasing is slowly becoming a common form of capital in the foundry industry. Molding machines, sand systems, furnaces, CAD/CAM systems, computers, environmental equipment and other machinery can all be leased for a foundry operation.

Leasing Defined and Applied

Essentially, a lease is a financial and legal transaction whereby a fixed asset is owned by one party (the lessor) and used by another party (the lessee), who pays a fee for its use (rent). The lessor assumes all the risks of ownership; he incurs asset depreciation expense, technological obsolescence hazards, lost interest earnings on other investment alternatives, and default losses. The rents should therefore recover most of these costs, with the balance coming from special tax benefits or an anticipated gain on equipment resale at lease end.

The foundry, as lessee, uses the equipment for the specified term of the lease, generates revenue from its use, and pays the rent as it goes along. In many instances, leasing provides 100% financing--including freight and installation charges--without a down payment, though certain leases may require a 1015% deposit.

After the original lease term expires, the foundry's obligations are completed. If the foundry now feels that ownership is attractive or practical, it can offer to purchase the equipment outright, or even negotiate a short-term rental continuation. In either circumstance, the lessor will probably be open to discussing these options, since they have a familiar, ready and willing customer. It is simply a matter of setting a price, under the principal of "fair market value."

Foundry equipment may literally have no market salvage value. Or it may have the value of 100% of its original selling price (especially in a period of high inflation). To comply with IRS guidelines, appraisals of the equipment may be needed to arrive at fair market value.

Setting the price isn't an exact science, and both the lessee and the lessor are exposed to potential risks. If the foundry had assumed a price lower than fair market value, it may have overpaid on the monthly rent. If the lessor assumed a higher purchase estimate, it has taken an immediate loss on income. For your protection, three leasing rules are vital:

1. Know Your Lessor--Your leasing firm should be financially healthy, knowledgeable of foundries, and have a reputation for high business ethics. There are several times during the course of a lease where your relationship with the lessor can save time and money by minimizing potential disagreements.

2. Evaluate Leasing Economics on an After-tax Basis--The rent payments you make are treated as an operating expense, so you're not allowed any depreciation allowances. Expensing the rentals will create a slightly better savings than depreciation on 3-4 year leases.

3. Negotiate the Lease For Your Best Tax Benefit--Most leases are written as either an operating lease or a capital lease. This designation has practical implications for your foundry. First, by classifying a lease as an operating lease, you remove the heavy debt load foundries usually carry from your balance sheet. Taken to the logical extreme, if all your equipment were under an operating lease, the only debt you'd show would be for land/buildings (assuming they were mortgaged).

The second benefit of an operating lease is that it may allow you to acquire equipment without violating any restrictive financial covenants like those found in Industrial Revenue Bonds (IRBs). An IRB usually restricts the amount of debt a business can incur, and may restrict the amount of cash used for new equipment purchases. Since an operating lease is not debt, and it tends to carry lower monthly payments than capital leases, it is sometimes the only way a firm can get the equipment it needs.

Freeing Up Cash Flow

To maximize the benefits of leasing, good cash flow management requires you to apply time value concepts to your receipts and disbursements of cash. Match the term of the financing to the life of the asset financed. You can't help but improve the amount of cash that remains in your business by applying time-value-of-money techniques to analyzing your leases and equipment justifications. You also avoid decisions based on misleading information.

For example, assume you bought a molding machine for $100,000 in cash and two months later the price of scrap significantly increased. How would you obtain the necessary inventory if there were no cash or bank credit left?

Also, the rate of inflation affecting foundries runs 2-4% a year. If your lease remains fixed for five years, it's easy to see how you've retained additional cash for the business.

The rules highlighted here should help you to understand the potential value of leasing to your business. To get started, begin gathering information from equipment vendors, local leasing representatives and trade associations. You should look for leasing firms that provide: precise, proper documentation; all types of leases; support programs during the lease; and cost/benefit analysis and assistance.

Remember, the value of foundry equipment lies in its use, not necessarily in its ownership. Future profits will come from employing new, efficient and increasingly high-tech equipment. Leasing is a practical way to acquire that technology.