Weighing up the cash v finance argument

Nigel Greenaway, Managing Director of JCB Finance Ltd, weighs up the pros and cons of cash v finance in equipment purchase. Formed in 1970 as the in-house finance arm of JC Bamford Excavators, JCB Finance Ltd, originally known as JCB Credit Ltd, has wide experience in the finance of all makes of construction, industrial and agricultural plant and equipment including the waste industry.

Historically, interest rates are still very low, even with August's 2004 increase to 4.75%. With rates so low should a business be using its own money to fund acquisitions or is borrowing a good idea? Often this question revolves around the question of cash or working capital. Lack of this commodity is what puts companies out of business.

Business growth and levels of confidence are generally good and the waste sector is expanding rapidly. It is in these circumstances that many companies expand at such a pace, only to find that their working capital has been gobbled up by paying cash for extra machinery and plant required to secure those extra contracts. If conditions begin to slow or payment for a contract fails to materialise, then cash flow can start to dry up. What would be learnt from this scenario and do today's low interest rates require a rethink about funding methods?

Purchasing options

Let us assume that two partnerships purchase identical machinery at £50,000 each, one paying cash and the other paying over three years on Fixed Rate Hire Purchase (HP). Both businesses are allowed to claim the 50% First Year Allowances (FYA). In addition the VAT is reclaimable in full within the first tax quarter for both cash and HP.

Parity so far, with both businesses claiming the same writing down allowances, therefore this part of the tax equation can largely be ignored. However, one can immediately see the appeal of applying the available tax writing down allowances against a £50,000 expenditure having only paid 12 monthly payments of £1,540 or a total of £18,480 in the first year. Paying £50,000 in cash on day one only gains the same tax benefits.

Even cash has its costs - could it be invested more profitably in other parts of the business and is tying up large portions of your working capital in machinery likely to leave you exposed if business activity dips? A good argument against paying cash is that you would not pay three years' wages in advance so why do the same for your plant? Let plant pay for itself from the income it generates for your business.

Interest questions

The real consideration is what interest would the business have gained if £50,000 had been left in a deposit account and what tax relief is available on the interest paid on the HP agreement? At one extreme, assume the partnerships are making high profits and are taxed at 40%. The partnership who leaves money on deposit can earn 2.5% interest, net of tax. It can also claim tax back on the interest paid on the HP agreement (figures below show the situation in the first year). The result - the HP agreement only costs £523 in net interest in the first year and there is still £50,000 in the bank. This amount could prove to be a crucial financial reserve. Some would argue that the £50,000 on deposit should be progressively reduced to pay the monthly HP payments. This would make the calculations far more complicated and ignores the fact that the machine is paying for itself through the income it generates for the business.

Alter the tax scenario above with a small to medium sized limited company, earning between £50,001-£300,000 in profits, paying a corporation tax rate of 19%. The interest earned net of tax would rise to about 3.25% but claiming tax back on interest paid would fall, as shown below. The result will still be an HP agreement that only costs £769 in net interest in the first year. These two scenarios represent the high and low taxation benefits so other businesses can pick their own tax rates that fall between these two points.

No short answer

There is no short answer to the question of using cash instead of external funding because no two businesses are exactly alike and movements in interest and tax rates will require constant reappraisals. The multitude of different tax rates, ranging from the current 10%, 19%, 22%, 23.75%, 30%, 32.75% and 40% also make a quick answer difficult.

You might conclude that these illustrations would not hold good when interest rates are high. However, the reverse is true because it is all proportionate. Higher interest rates mean higher deposit interest rates and consequently greater income plus the tax relief on HP interest paid is higher. This is a harder concept to rationalise because people naturally rebel against the thought of paying high interest rates. Ultimately your accountant will need to run the calculations to see what is best for your business coupled to a sound reason for investing in additional plant and machinery in the first place.

HP benefits

In summary, Hire Purchase agreements have the following benefits:

  • A business can claim the full writing down allowances - just as if cash had been paid.
  • Interest paid on an HP agreement can also be treated as a business expense in the profit and loss account - further reducing the tax bill.
  • VAT is fully reclaimable at the outset.
  • Fixed Rate HP protects a business against inflation and rising interest rates.
  • Variable Rate HP allows a business to enjoy savings from falling interest rates and there are no additional costs for early settlements or payments of lump sums.
  • Facilitates very accurate budgeting.
  • Preserves working capital - the life blood of any business. When considering the above points you can see why there is a strong argument to use competitively priced HP agreements instead of cash when Bank Base Rates are so low.

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