Written by: Martin Anderson | Farm Business Consultant | 0439 150 458
With forward 3–5-year interest rates higher than the variable (approximately 2%) and farm balance sheets typically exceptionally strong is it time to rethink the use of equipment finance? This has been a common discussion topic during annual reviews this year as clients ponder how best to finance the purchase of operating plant and equipment.
Before we explore your options though be clear on your financial position but most of all remember a) is it a good investment and b) debt is debt!
Historically use of equipment finance (i.e. chattel mortgage) has been a ‘no brainer’ given low (often discounted) forward rates and the fact that such finance sees the loan secured against the item not the farm itself therefore keeping potentially valuable farm borrowing capacity at its maximum.
This position has changed quite dramatically though, given the recent dynamics in the interest rate market, with upward market movement in fixed rates for short, medium & longer terms, followed by rapid and regular RBA interest rate increases. Additionally, many farmers have recorded 2-5 years of strong profit results which mean there are significant funds available within their accounts or lending facility limits, that won’t necessarily be fully utilised this coming season. On top of this land values have skyrocketed meaning general farm borrowing capacity has increased substantially.
So, given the above what is right for you?
For the benefit of this article, it is assumed that you’ve already done the necessary due diligence, sought advice, undertaken an appropriate cost benefit analysis, etc around whether the plant and equipment purchase is the right decision, for the business at this time. Initially it’s important to understand why equipment finance has typically been the obvious funding choice for farm businesses:
- The loan is secured against the item which keeps the borrowing capacity of the business freed of that capital purchase amount until it’s been repaid, which can be important in case that freed up borrowing capacity is needed to fund future (poor) seasons.
- A good way to fix rates, when this is appealing. The last few years this has been the case, although in the current rapidly rising interest rate market this may not be as appealing now.
- Discipline – to help manage the annual cost of plant & machinery ownership a ‘HP’ schedule has been a great way of doing this (i.e. keeping annual HP total to max 10% of average income). Paying ‘cash’ can see businesses lose this discipline, and this despite better seasons, is still very important now.
With the above key points in mind though, the following are some other considerations when deciding whether to use equipment finance or not.
The size of the capital purchase. It goes without saying that a purchase of a ute or other smaller items for say $50,000 to $100,000 are not going to have the same impact as the cost of a new header, SP sprayer, tractor, etc in the range of $500K to $1.2m.
Finance all or a portion on Equipment Finance, HP, Finance Lease, etc. Remember to consider discussions with your accountant to take into account any taxation implications or strategies. Fund via your available cash flow. This may be very relevant if there is a significant differential between the interest rate that you are likely to pay on your overdraft or short-term funding versus what you can currently get. Long term fixed interest rates (including for equipment finance) have potentially doubled or more in the past 18 months.
Remember to consider how long you may likely carry the extra capital cost and/or debt for on your account. Particularly if this could adversely impact your peak debt levels later in the season or even in subsequent years, leaving you without sufficient cash to fund the year to year operational and overhead expenditures. If the latter is the case, it could be worth considering options such as:
- Paying an initial larger up-front deposit (i.e. 20% to 50%, or more) and then funding the remainder on equipment finance over shorter terms of 1, 2 or 3 years, which are also likely to have lower interest rates than 4, 5 or 6 years for example.
- Pay for the item out of your initial available cashflow, and then where your financier allows, you can look at funding a larger portion via equipment finance later. Some financers allow 60 – 90 days after purchase.
However other financiers will allow new and relatively new gear to be funded up to 12 months or longer after purchase. Please note that this may most likely be on the proviso that the appropriate amount of depreciated value is factored in, for example an item that is maybe 12 months old, at least 20% or greater is paid by the owner and 80% or less is funded via finance. As such it may be subject to an appropriate valuation of the specific equipment.
This method can be particularly useful, if you’ve had a very good couple of years and are unlikely to see any cashflow pressure on your lending limits until late in the year, or you need to see how this current season is playing out. However, don’t forget to speak with your lender to understand what is possible for them to offer.
Another important consideration is to think about and factor in future cash rate rises that may impact what your overdraft or short-term funding costs may be in the next 6 to 12 months. Recent market indications have shown that the spread between cash/short term rates to long term rates has narrowed significantly. Given the rapid RBA cash rate increases since May 2022 (3.25% in 10 months), this is not surprising really. However, the known unknown is how much higher is the RBA going to go, and what other domestic & global issues may influence it versus the longer-term rate market over the next few months?
Bottom line (unless you don’t have any working capital or term loan debts) is that the funds are borrowed whether that be on overdraft or equipment finance. So, in terms of what suits best then it depends on the business. If borrowing capacity is stretched then generally equipment finance would be the preference, as the cost of funds is not the primary issue. However, if borrowing capacity is not stretched and even if
large cash reserves being held, then not financing or only partially financing is very legitimate. However, remember to be disciplined, if using cash/overdraft to fund equipment then use your plant investment to your average farm income ratio to help measure and keep discipline (maximum of 1:1).