Calculating ROI

In capital-equipment-intensive industries, such as recycling, businesses are continually challenged to effectively plan capital equipment expenditures to improve productivity, maximize return on investment (ROI) and maintain strong cash flow. The analysis extends to asset management, asset useful life, tax treatment, financial ratios and covenants.

Among the first questions every business must answer is how it will pay for the equipment. If the business is able to purchase the equipment out of cash, it might look at the ROI as the stream of cash flow received from the project over the cash expense. If the business uses a lease or loan to acquire the equipment, it might simply look at the monthly cash flow generated by the asset, less the monthly payment on the loan or lease. For a small-ticket purchase, that may be sufficient. For large-ticket equipment purchases costing hundreds of thousands or millions of dollars, the analysis is more complex.

Businesses acquire capital equipment with the expectation that it will increase revenue or reduce expenses. In the simplest analysis, businesses use leasing and financing to acquire large-ticket capital equipment because they can pay for the asset out of the improved cash flow they generate. The ROI is clear because management can easily tie the changes in cash flow to the asset. However, how a business pays for a large-ticket project can have a larger impact on the business and ROI.

Businesses will choose to pay cash if they feel they are more than sufficiently liquid, have concerns about debt or feel they don’t have the time to secure outside financing. When using cash, some secondary factors must be considered when calculating ROI. Often, with large-ticket equipment purchases, there is a considerable lag time before the asset is running optimally. During that time, cash is essentially tied up in the project, and there may be significant opportunity costs, or investment opportunities a company misses because its cash is tied up in the equipment project. Should the business experience a short-term liquidity crunch requiring additional borrowing or affecting trade discounts, this would have to be factored into the ultimate ROI analysis.

Cash flow issues can be further compounded on large-ticket equipment acquisitions if there is a long lead-time delivery, progress payments are required and cash is tied up in an asset that will not be installed for months. Businesses have to decide if that is the best use of their cash.

A large cash outlay also can have significant balance sheet considerations. By converting a short-term asset, such as cash, to a long-term asset, such as equipment, you are negatively affecting liquidity ratios on the balance sheet. This can have a negative impact on current and future borrowing capabilities and interest rates. Changes in these borrowing abilities must be factored into the overall investment.

Additionally, any cash purchase limits the tax write off available to the business to depreciation only. This is an especially important current consideration in light of the new bonus depreciation rules enacted by Congress in February 2008. Instead of the usual first year of depreciation for a five- or seven-year modified accelerated cash recovery system (MACRS) property of 20 percent and 14.29 percent, respectively, for all purchases secured between Jan. 1, 2008, and Dec. 31, 2008, the depreciation will be 60 percent and 57.15 percent, respectively. Some corporations cannot use such a large deduction and would do better to monetize the deductions through lower rates in a tax lease.

Many businesses use their revolving lines of credit like cash to pay for large-ticket equipment purchases. Using the revolver is quick and easy, and the business is comfortable with the interest rate. However, as stated above, a revolving line of credit is a short-term liquidity vehicle and is subject to many of the same considerations as cash. Also, finance executives should seriously consider the effects of the recent liquidity crisis on renewal of secured lending facilities—the less in borrowings on such facilities, the more leverage the borrower has during renewal negotiations. Furthermore, businesses must consider that the longer-term fixed rates available on equipment financing often can be lower than revolving lines of credit.

Equipment leases and loans are popular because of the flexibility and structure they provide to maximize cash flow and ROI. From a cash-flow perspective, leases and loans provide a number of advantages. The initial cash outlay for the business on a lease is typically one or two monthly payments. On a bank loan, it may be a deposit of 10 percent or 20 percent of the loan amount. If progress payments are required by the vendor, an equipment leasing company will usually make those payments for the customer, further enhancing cash flow.

Equipment financing and bank loans are accounted for on the balance sheet, and the business will typically use depreciation and interest as a tax deduction to further increase ROI. However, this additional debt may have negative consequences for the business. When adding new debt impacts to existing loan covenants, it can result in an increased rate on other financial instruments, such as the company’s revolving line of credit. Other increased costs tied to this equipment financing need to be factored into the ROI.

When leverage is a particular concern, the business would want to consider an equipment leasing structure that qualifies as off balance sheet for generally accepted accounting principals (GAAP) accounting purposes. If the equipment lease meets certain criteria, the business may be able to keep the lease off the balance sheet entirely, as the lease payments are classified as an operating expense. In this case, balance sheet ratios are not affected.

Off-balance-sheet consideration is a function of adhering to GAAP and the rules of Financial Accounting Standards Board (FASB). Whether a lease qualifies as an operating expense for GAAP does not directly affect tax treatment. However, it is typical for GAAP operating leases to also qualify as tax leases. This may further improve the ROI by allowing the business to write off 100 percent of the monthly payment for tax purposes. Businesses receive an additional benefit if other costs, such as shipping, maintenance and training and other project-related expenses, are bundled into the lease payment.

The financing structure should be tied as much as possible to an asset’s useful life, which affects overall ROI. Economic useful life is established in the tax code for the purposes of classifying different assets and establishing depreciation guidelines. Most machinery in a recycling yard has a five- or seven-year MACRS. Actual useful life is simply how long the business plans to use the equipment. This might be 10 or 20 years for the same piece of equipment.

When a company is considering a major capital equipment acquisition, such as a baler, material handling equipment or even IT equipment, it needs to consider a number of factors when projecting ROI. Given the size of the investment, useful life of the asset and impact on cash flow, equipment acquisition can have a major impact on the financial health of the business and must be carefully evaluated.

The author is senior vice president of sales and marketing for CG Commercial Financial, Newport Beach, Calif., and can be contacted at jon.albin@gccommercial or at (800) 303-4006.