Property, plant or equipment is often expensive. As a consequence, businesses consider a variety of different funding methods in order to identify the most appropriate method for the circumstances.
Traditionally, businesses try to match the length of the funding method chosen with the useful life of the asset. By doing so, the financial cost of the asset is matched against the benefits of having the use of the asset. This approach will also tend to reduce the impact of the purchase on the business’ cash position.
Examples of funding methods
Cash purchases refer to assets bought using money held in the business’ bank account or using cash. This method is most commonly used to purchase small value items as most businesses do not have large cash balances from which to buy high-value assets.
Purchases using standard credit terms
This method refers to purchases of property, plant or equipment from suppliers who offer short periods of credit, in the same way that businesses buy inventory on credit terms. Like cash purchases, this method tends to be used when purchasing small value items as payment for the asset is only delayed for a short period of time (e.g. a month).
Many businesses will take out a loan to assist them when buying non-current assets. Loans may be from a bank or similar financial organisation, or could be from other sources such as loans from the business’ directors or from family members.
Loans can be very flexible; they can be taken out for small amounts and for large and the repayment term can also be negotiated to suit a borrower’s needs (though banks will not offer a loan with a repayment term that is longer than the useful life of the asset being bought with the loan).
Hire purchase agreements
Many businesses use hire purchase (“HP”) agreements to acquire assets. Under a hire purchase agreement, the HP company will acquire the asset and provide it to the business in return for regular payments over the term of the agreement (typically 1 to 5 years in length). Provided that all the payments are made, ownership of the asset will be transferred to the business at the end of the agreement.
HP is most commonly used to purchase small to medium value assets such as computers, cars and equipment and is often offered as an option by the seller of the asset.
Leases are similar to HP agreements in that the use of an asset is received for a period in return for a series of regular payments. One of the differences however, is that ownership of the asset often does not pass the business at the end of the lease agreement (although lease agreements can sometimes allow for this).
Leases are often used by business to acquire the use of medium to large value assets such as plant and equipment and land and buildings.
A part-exchange occurs when a business pays for a new asset, at least in part, by trading in an existing asset that they own. This method is very common when businesses purchase vehicles as they often have an older vehicle that is being replaced and therefore needs to be disposed of at the same time.
Using more than one funding method
It is very common that a business will use more than one funding method to purchase an item of property, plant and equipment. For example, many banks will not lend more than 60% of the value of commercial property, meaning that a business will have to obtain some funding from another source to pay for the remainder of the cost. Similarly, a business buying a machine on hire purchase will typically have to pay a deposit using funds from its bank account with the remainder being paid under the HP agreement.