Funding Growth: Using Cash as a Filter for Smart Buying

Serious Stuff

Need new computers? Office equipment? A better car? The choices are bewildering. Deciding which model to purchase is tough enough. (Do I really need it? Will it pay for itself?) But deciding how to pay for it is even tougher.

Before making a decision, you need objective advice. But you won’t get it from a bank or a leasing company, and certainly not from a sales person. They are more interested in making the purchase easy than helping you make the right choice. The people making decisions about whether or not to grant you credit are not necessarily your friends.

Some Sobering Facts

It’s no accident that debt has increased 300% in the last twenty years (and that bankruptcies have increased 220%). Debt started to be marketed aggressively in the late 1970s as a way to more easily allow consumers to purchase cars, appliances and vacations. More recently, the process has spilled over into business use—a way for companies like yours to get much needed capital equipment faster and easier than waiting to pay cash for it.

All this sounds like debt is a good thing, made available by large philanthropic organizations like banks, credit card companies, and lease holding entities who carefully review our applications to see if they can help us.

The reality is a little different. Financial institutions are no longer just repositories, but also marketing machines. Debt is slickly and aggressively promoted. As a business (and personal) consumer, you’re encouraged to believe that you constantly need more items and services. And, big surprise, they can help you get them easily! (Irony: we’re so good at putting together these campaigns we tend to believe them ourselves!)

Actually, debt is just another product. It can be a good product—enabling the purchase of your home, for example. Or it can be a bad product, functioning like a drug that can result in a downward business spiral if you use it too often. (Often while a significant other in the background gets more and more nervous.)

How good or bad can it be? Well, in a recent survey of sixty clients on the effects of business indebtedness, we found that most of those making lots of money carried little or no long-term debt. How much of this prosperity was cause and how much was effect couldn’t always be determined. (Less money paid out in loan interest allows more profit, but profitable firms have the luxury of affording to pay cash for everything.)

One thing was evident, though: profitability and how principals view money are directly connected. (Businesses with two or more principals tend to adopt the view of the more conservative of the principals.) Moreover, communications firms that use a “cash availability filter” for purchasing are by and large more successful. 

Cash as a Filter

There are several methods (break-even analysis, pay-back analysis, internal rate of return, etc.) that can be used to more or less determine the affordability of any potential purchase. But as a general rule, “cash availability” works best for most smaller services companies. Here’s why:

• It puts the brake on growing too rapidly. Purchasing only what’s affordable today can keep your company from falling into the trap of expanding faster than your management capabilities. It necessitates prioritizing clients and assignments. By forcing you to focus on growth that’s affordable, it helps assure that you will expand in an orderly, sustainable, profitable way.

• It keeps you from overbuying. Individuals who purchase with cash are more likely to make considered decisions, and less likely to make emotional ones. This is especially relevant in small companies where the “purchasing agent” is also the owner. Studies show a significant increase in what’s purchased when credit or leasing is used instead of cash.

• It makes you less vulnerable to business downturns. When you lease equipment or take out a loan for it you are addressing a current need with money from an uncertain future. As long as business is good, monthly payments may not be a problem. But if business should take a downturn, they can be a major problem. The amount you owe on a loan for rapidly-depreciating equipment (e.g., computers) may be more than you can sell it for, even if you can find a buyer. And with leases you will probably be obligated for its full term, regardless of your later need or ability to pay. In fact, you can’t sell it. The result could be that your shiny and expensive new equipment will sit idly by, chewing up cash, while you are forced to lay off your most valuable assets—your firm’s employees. (Even worse, your valuable employees could go to work for a more financially conservative competitor.)

• You won’t ignore operational difficulties. These are all the business management issues that make it tough to pay cash in the first place. The more items you purchase on some form of installment, the easier it is to sweep management problems under the rug, the worse the problems become. When you pay cash, you’re forced to face up to the problems at the end of every month.

• You may qualify for tax savings. Depending on your situation, it may make tax sense to purchase equipment personally and lease it back to your company. (Your company must be incorporated to do this.) This moves money from the corporation to you personally without requiring you to pay FICA taxes on the disbursement. In this way, you get the advantages of a lease deduction while avoiding the traps of third-party leasing.

The Cost of Cash vs. Financing

A recent study done by The Wall Street Journal gives another example of why cash is usually a better way to obtain equipment—it reduces the cost. Here are their 3-year cost figures for a typical $20,000 item:

Cash cost: $20,000

Cash cost (3-year loss of interest included): $22,400

Loan cost (typical 3-year note with interest): $23,904

Lease cost (typical 3-year lease with 10% buyout option): $24,964

Although you may not consider paying out $20,000 in cash an option, the point is still valid: try to avoid paying anything but cash for most depreciating assets. The faster the item depreciates, the more important this advice is. (See definitions later in this white paper.)

This advice runs counter to the conventional leasing wisdom we hear so often, especially from salespeople: “New computer systems drop in value so fast, and the technology changes so rapidly, that you’re better off leasing, not owning.”

In fact, leasing a fast-depreciating asset is riskier because you are locked into a certain repayment price regardless of what happens to the item or its value. Trading up later to a newer model and extending the lease term can be a convenient benefit, but it is usually a very expensive one. When you trade up, your payments usually go up, and the more you do it, the farther you fall behind. (Our experience is that it is difficult for clients to get out of the cycle once they start.) And despite the rapid advances in technology, there’s usually little or no imperative to replace an item before it is paid for anyway. 

Finally, there is one other important consideration. Most smaller service businesses have little equity aside from the value of their fixed assets. If fixed assets depreciate as fast or faster than their monthly payments, no equity will ever be accumulated. In other words, you’ll never get ahead.

Personal Considerations

If your background has provided you with an appreciation of the importance of money management, you are fortunate. If like most of us it hasn’t, you need to develop it.

Try to resist the constant pressures to buy more than you need, before you need it. And before considering a purchase remember the “cash availability filter” and other criteria mentioned above.

Keep in mind that long-term success now depends as much on money management as ability in your field. I’m sure you can think of a competitor who did outstanding work...but went out of business anyway.

If you can’t afford to pay cash, something else is wrong. And by finding another non-cash means to fund the purchase, you’ll a) ignore the real issues and b) make it more difficult to change your firm down the road. You might decide to lease or borrow, but aim toward not being forced into it.