The hidden dangers of concentration risk
Many business owners are blissfully unaware that financing equipment through their existing bank usually has that equipment debt “bootstrapped” to any other securities the bank may hold (such as properties and other owned assets within the business). This bootstrapping typically comes in two forms:-
- Cross Collateralisation Clauses (which sees all debt with the bank secured by all security held by the bank)
- General Security Agreements (GSA) which is the new term for the old Fixed and Floating Charges or Registered Equitable Mortgages (REM). Which means the bank owns all assets of the business under this GSA.
Typically the banks do not go out of their way to tell business owners about these overarching securities, however it is most often the reality and a simple company search will tell a business owner if a GSA is in place over their business.
Finally, the sleeping dragon in this situation most often rears its head when a business looks to change banks and the outgoing bank insists upon all equipment finance being paid out and the penalties incurred on contracts which are early to mid-term at that point. As an indication of those penalties, the cost to terminate a $1 million equipment loan which is one year into a five year transaction is typically in the order of $40,000.
In a world where there are a dozen or so competitive banks and financiers keen to finance equipment in its own right without this bootstrapping, a company’s existing bank is probably the worst place to have their equipment debt.
The existing bank does have a role to play in funding working capital such as overdrafts as well as property based requirements and under these circumstances, the bank having the benefit of property equity via mortgages over properties is completely relevant and commercially acceptable.
The provision of a GSA to a bank should only ever be granted by a business as a last resort as it is in effect the granting of a mortgage to the bank over the entire company.
Spreading the risk
Many businesses spread their equipment debt across 3 or 4 financiers as this creates a stable platform of supportive lenders for future growth as well as creating competition between those financiers to ensure competitive structures and rates are provided. This can be done by the client or through the use of a capable finance broker.
Remember, these lenders have no other asset as hard security other than the equipment they have financed.
The true effect of interest rates
In this increasingly competitive environment where business owners are constantly squeezed on margins, any saving in expenses is beneficial.
Based on a simple $1 million debt over a five year term, the following is worth noting:-
- At 5.5% the payments are $19,100 p/m
- At 4.5% the payments are $18,645 p/m
The difference of $455 p/m over the 60 month term is $27,300.
To put this into perspective, where a business has a net profit margin of 5%, an additional $546,000 in turnover is required to offset this additional $27,300 cost, so attention to the cost of finance is always a worthwhile exercise.
Dispelling the myths
Refinancing existing equipment debts towards the latter part of the existing contracts (in the last 12 – 18 months) can be done through an increasing number of financiers. There are minimal penalties involved to do so at this later stage, the current interest rates would typically be around 2% less than the initial debt and the refinancing of those existing debts on long-term assets will usually substantially reduce the existing monthly commitments and in doing so free up cash flow which can cover in part the cost of additional equipment.
Equipment finance can be written with payments monthly in arrears to allow a 30 day payment delay to assist cash flow. The cost differential between monthly in advance and a monthly in arrears is minuscule.
Example on $1milion over 5 years:-
- Monthly in advance $18,573 p/m
- Monthly in arrears $18,645 p/m
Used equipment including private sales can easily be financed, saving businesses significant dollars on the cost of equipment. Care does need to be taken around ensuring clear title on private sale assets, including company searches on the vendor to ensure there is no dedicated debt on the asset or overarching GSA by their bank. A simple PPSR search will show up on any interests held on those assets being sold.
Major refurbishments of existing plant can also be financed on a term equipment debt, no different to repowering the engines of an aircraft where the value of the aircraft is substantially increased through this process.
Choosing the right structure (CHP V Chattel Mortgage)
Beware of the pitfalls of Ad Valorem Stamp Duty which has been abolished in all states except NSW. Those businesses in NSW can incur this unnecessary stamp duty expense through the use of a Chattel Mortgage instead of Commercial Hire Purchase (CHP).
Stamp duty on a $1 million machine under chattel mortgage is $3,941 (add this to the cost shown above in interest rates and the dollars are starting to add up).
This cost is not incurred through CHP and although there is GST payable on the interest component of CHP, the GST is a refundable expense.
Choosing the right term and residual/balloon
Business owners should ensure that the term and residual/balloon they would like on their long-term assets is the structure that suits them and not what the bank dictates.
The same applies to deposits and GST.
There are many competitive lenders out there so business owners should shop around until they get the right structure.
Being forced to pay off a $1mil asset (which has a 10 year plus lifespan) over five years at $18,645 p/m maybe too heavy on cash flow.
Perhaps a 5 year term with a 40% balloon at $12,865 p/m followed by the refinancing of that $400,000 balloon over a subsequent 5 years at $7,460 p/m is a better outcome.