We ask “Can it really make sense to borrow money to fund growth?” or is the Never Never only for people in dire financial straits?
My dear old father-in-law used to delight in telling me that he’d never bought anything he couldn’t afford:
“I’d never borrow money to buy anything – like a car for instance. I’d save until I could afford to buy it outright. That way I never got into trouble!” Millions of people like us who have grown up listening to the older generation peddling this holier-than-thou philosophy are secretly ridden with guilt. Because we financed the car, we financed the conservatory – hell, we even financed the three piece suite! And we’ve all used our credit cards to buy things we know full well we shouldn’t have bought. We do it all the time – and so does everyone else. Today, it’s become the norm to live today and pay tomorrow. And the problem with that, as any old-timer will tell you, is that you never know what’s going to happen tomorrow.
But there is another way of looking at this. Everything we finance has a finite useful life as far as we are concerned. Let’s take a car as an example. After three years, it’s time to change it – you’re going to sell it and start again. So if it costs £20,000 today, and it’s worth £8,000 in 3 years time, the capital cost of driving about in that car is £10.96 per day. Finding around £11 a day for our car doesn’t sound too bad, whereas finding a spare £20,000 in one hit is a different thing altogether. But let’s just assume that we could do that. If we were sensible, what we would do is buy the car and then every day put £10.96 into a piggy bank so that when three years were up we’d once again have twenty grand to be able to buy a new car. So in a sense we’re borrowing money from ourselves and paying it back over the lifetime of our ownership.
Actually, if we were being fair to our-selves, we’d pay ourselves back more than £10.96 pence a day. Because the £20,000 we used to buy the car was actually in a bank account earning us interest (or could have been), so we ought to give that back too.
So where’s the difference between borrowing the money to buy this car from ourselves or somebody else? In purely financial terms, very little! It’s all about interest rates, specifically the difference between the interest that’s PAID on savings and the interest that’s CHARGED on borrowings. In real terms, the daily cost of ownership (capital and interest) of a car financed by a third party is literally only a few pence more than it costs you to buy it outright. So STOP FEELING GUILTY!
Today it’s become the norm to live today and pay tomorrow. The problem is that you never quite know what’s going to happen tomorrow!
But the car was a domestic example. Everything changes again when we look at a commercial purchase.
The major difference between a domestic purchase and a commercial one is that the commercial purchase carries with it tax concessions.
Let’s take the hypothetical example of a cameraman (let’s call him Frank) who is using camera which costs £50,000 excluding VAT. He trades as a Limited Liability Company and up until this point he has been hiring this camera as and when he needs it. Let’s say he’s averaging 15 days work a month and the hire charge for his kit is £200 a day, so he’s been spending £200 x 15days = £3,000 a month ( or £36,000 a year) on hire. For the purposes of this example he has been passing on this cost to his clients with no uplift.
Frank has a number of options, but in this article I’m going to examine just three of them:
1. Buy a camera outright (assuming he has the funds)
Buy it on a 36 month Lease (or HP) agreement.
Continue hiring a camera as and when he needs it.
There are lots of rules and regulations surrounding tax concessions – it’s a complex area of tax law, but in order to stop your eyes glazing over completely, I’m going to assume that Her Majesty’s Revenue and Customs will allow Frank to write off the cost of his camera at the rate of 25% per annum. This is called Capital Allowance, and in my example it means that if Frank buys the camera his tax bill will be reduced by 25% x £50,000 (the cost of the camera excl VAT) x 21% (the corporation tax rate for companies making less than £300,000 profit a year) each year for 4 years.
Option 1 BUY IT OUTRIGHT
The first thing you have to get your head round is the fact that if Frank has money available to spend, it’s been earned and therefore it’s taxable. If he has earned £50,000 and he pays tax at 21%, he can expect a tax bill of £10,500. If he uses that £50,000 to buy a camera, he will effectively have that tax bill waived – but over 4 years.
So in Year 1, instead of paying £10,500 tax he will only pay £7,875, and in Years 2, 3 and 4 he will get a rebate of £2,625 a year, making the net tax bill relating to the £50,000 he used to buy the camera NIL.
The second thing to bear in mind is that Frank is only buying this camera because he has work for it to do. He charges his client £200 a day for the camera 15 days a month, 12 months a year. In total then, he charges his clients £36,000 a year for the camera which, after tax at 21% gives him a net annual rental income of £28,440. Once again, in order to keep things simple we’re going to ignore any VAT in this example and we are going to assume that Frank Ltd pays tax as it accumulates the liability (whereas in reality it would be paid in arrears). So in Year 1, Frank has paid out £50,000 on a camera, saved £2,625 on his tax bill and earned £28,440 after tax effectively renting out his camera. The net effect on his cash flow is therefore -£18,935.
In years 2, 3 and 4 he doesn’t have anything to pay out, so he simply saves £2,625 on his tax bill and earns £21,600 in camera rental each year, with a net effect on his cash flow of +£31,065.
At the end of the 4 year period the camera is still worth something – we’re going to assume 30% of its original cost.
Frank can therefore sell it for £15,000 but he will have to pay tax on that income (again, we assume, at 21%), so he will actually net £11,850.
We can see therefore that simply buy buying the camera outright and hiring it out 15 days a month for 4 years and then selling it, Frank is better off by a total of £86,110. (NB, this does not include whatever Frank charges to operate the camera.)
Option 2 FINANCE IT
If Frank doesn’t have £50K available or simply doesn’t wish to spend it in one lump, he could purchase the camera by way of a lease or HP agreement. Again, all leases are not the same, but whilst the fine details can vary (for instance relating to how interest is applied to the account or when VAT needs to be paid), the principle remains the same, and that’s what I am concerned with here.
For Frank’s £50,000 camera the Lease/HP costs would be around £1,575 per month (that’s £18,900 a year) for a 36 month agreement. That figure is made up of a capital repay-ment and interest. For the purposes of this example I am assuming that the interest element is £2,233 each year for 3 years. The HMRC rules relating to Capital Allowances still apply (saving Frank Ltd £2,625 in tax), but also loan interest is 100% allowable against tax too, saving Frank a further £469 a year in tax.
So in Years 1, 2 and 3 Frank has pays £18,900 in finance charges, saves £3,094 in tax and earns £28,440 in rental income. The net effect on his cash flow is therefore +£12,634 each year.
In Year 4 there is nothing more to pay to the finance company, so Frank saves £2,625 in tax (Capital Allowance) and earns £28,440 in rental income with a net effect on his cash flow of +£31,065.
So we can see that by financing the camera over 3 years, hiring it out 15 days a month for 4 years and then selling it, Frank is better off by a total of £80,817.
Using someone else’s money to buy his camera rather than his own makes Frank just 6% less money over the 4 year period, but the fact that his cash flow is positive at all times more than compensates (remember in Year 1 the outright purchase option goes cash negative by £50,000 on day one and takes over 18 months to climb back into the black ). Taking the finance option means that Frank Ltd has money available to get it through any unforeseen lean period, or to invest in other equipment that might produce a new revenue stream (like an edit suite for instance) or simply to earn interest.
Option 3 CONTINUE HIRING IT
If Frank continues to hire the camera, it remains the property of the hire company and so Frank Ltd cannot claim any tax allowances for it. It will spend £36,000 a year on hire charges and, because they are 100% tax- deductible, save himself £7,560 in tax (21% of £36,000) and earn £28,440 in net rental income. The net effect on Frank’s cash flow is therefore NIL.
This option is the most flexible of the three in that should anything go wrong Frank has no liabilities to the hire company to worry about, but in this instance on average it’s more than £20,000 a year less profitable than buying the camera using finance.
There are all sorts of reasons why people are reluctant to use finance to buy kit. The most prevalent is an emotional/moral reticence – a feeling that “I shouldn’t buy what I can’t afford”. I hope you’ll now see that this argument does not hold water. Almost every successful business on earth uses other people’s money to fund growth – that’s the whole reason why everyone has got in such a lather about the recent credit crunch! Lease or Hire Purchase of equipment is arguably the most sensible way to acquire your kit provided certain criteria are met, for example:
You have to have sufficient work to be able to afford the monthly repayments.
Those repayments should be equal to or less than the amount you would otherwise spend each month hiring your kit (in our example this equates to 8 days hire a month)
As we said earlier, not all leases are the same so it certainly pays to talk to an expert about the best options for your specific circumstances. Any broadcast and professional solutions provider (like Creativevideo or Mitcorp) would be pleased to assist.
The accountants amongst you will know that I have over-simplified things in this article. It is only looking at the tax implications of one part of Frank’s business – the costs and revenues directly related to the ownership of the camera (i.e. excluding the costs and revenues of actually operating the camera and any other activities that Frank may be involved in). I have made assumptions that will not always be the case. I have ignored the impact of VAT. I have made Frank pay his tax earlier than he would actually have to pay it. I have not accounted for the fact that until the end of the lease period Frank has a liability to the finance company etc. etc. But all this has been done in order to attempt to illustrate the benefits of ownership and the advantages and disadvantages of two different acquisition methods IN PRINCIPLE . I would advise you to seek professional advice from your accountant or financial advisor before committing yourself to any major purchase or finance agreement.