It isn’t just a matter of determining whether to lease or own; funding your fleet involves a great deal more analysis and research, and choosing the best method is an important fleet manager responsibility.
That said, determining whether to own or lease company vehicles is a good starting point in the process; either buy them, or lease them from a fleet lessor (or other sources). Each of the above, however, contains further questions that need to be answered, as both offer several options.
Buy or Lease?
For long-term use, either by assigned drivers or pool use, companies have two basic choices: They can own their vehicles or lease them.
Fleet managers have a role in the analysis, and in most companies they are subject matter experts providing the assumptions and data (i.e., vehicle cost, projected residual value, lease rate factors, etc.) to someone who will create the actual financial model. It is a good idea, however, for the fleet manager to at least have a basic understanding of that process and what it represents.
In its simplest terms, the financial analysis of the lease versus own dilemma is a comparison of the present value of the net after tax cash flows of both options. There are certain tax benefits to both, and since one of them (leasing) involves payments made over a period of time, the flows must be compared using the present value of both.
The cash flows of an owned fleet are relatively simple; there is an outflow of cash on the first day the vehicle is purchased, followed by the tax benefit of accelerated depreciation over time, with the final cash inflow when the vehicle is sold (on which tax must be paid). The cash flows generated by a lease will depend upon whether or not the lease is a capital or operating lease (this question will ultimately be answered for all leases once the new accounting rules, currently in process, slated to be implemented sometime in 2018).
For an operating lease, the monthly payments are expensed, that is, each month they are treated as an expense in the same manner as are other categories of expense, such as salaries, benefits, the cost of goods sold, etc. Taxable revenues are reduced by deductible expenses to a net pretax revenue; the company’s tax rate is applied to this revenue, resulting in net after tax income. Operating lease payments are reduced by applying this tax rate. For example, a $500 lease payment, for a company in a 20% tax bracket, becomes a $400 net after tax cash flow.
For a capital lease, the vehicle is treated for accounting purposes as an owned asset on the company balance sheet. The value of the asset on the left side, the lease obligation as a liability on the right side, and any difference will increase or reduce net worth. The asset is reduced each month by depreciation (at a rate chosen by the company), and the lease obligation is reduced as payments are made.
Now this is an oversimplification of the analysis, however again, it isn’t usually the fleet manager creating the model; he or she will provide vehicle pricing, lease payment factors, residual values, etc. to the company treasurer or finance manager. Either way — leasing or ownership — vehicles are funded.
There are only two ways a company can fund vehicle purchases:
- Cash from operations.
- Borrowing from a bank or other funding institution.
Within the second option, borrowing, are subcategories:
- Direct loans, which borrow the value of the purchase in the form of individual loans.
- Draw from an overall line of credit (one which is opened by the company for any use).
- Draw from a line of credit dedicated to vehicle purchases.
Purchasing vehicles using cash from operations carries a cost, called an “opportunity cost,” equal to the company’s net after tax profit margin. For example, that margin is 5%, which would be the opportunity cost; by foregoing the reinvestment of cash back into the company, the opportunity to earn that 5% return is lost, and becomes the cost of using cash. The decision on whether or not to use cash from operations becomes a relatively simple one: if the opportunity cost is less than the cost of borrowing, it is more cost effective to pay cash. If it is greater, it’s better to borrow funds. There may be, of course, other considerations, but from a pure cost perspective, the lower cost of funds wins out.
The company must, of course, have sufficient cash on hand to make vehicle purchases. Also, bank lines of credit are more often used to fill gaps in cash flow, where needed for payroll, paying suppliers, and other such operating expenses that will usually take precedence over replacing company vehicles, an action that can be put off for some period of time.
If borrowing is the most cost efficient way to fund fleet vehicles, a line of credit provides the most flexible source of funds. Most manufacturers, in addition to banks, offer their fleet customers lines of credit, from which payment can be drawn when new or replacement vehicles are needed. Larger companies usually have what is termed a “revolver,” a revolving line of credit in which a number of banks participate, and it can add up to hundreds of millions of dollars being available — the larger the company, the bigger the revolver.
That said, revolvers are usually used for the purposes described above. It is often the case that business units of a corporate entity do not fully understand the concept of cash flow.
Say the Alpha division of Corporate Enterprises, Inc. manufactures and sells a product. It is not unusual for the division’s management to give scant notice of overall cash flow.
A manufacturer’s cash sources are managed in several key areas:
Accounts receivable: monies owed to the division for product sold and shipped to buyers. For example, vehicle manufacturers sell vehicles to their dealer network, which finance their purchases with “floor plan” monies borrowed from either the OEM or another funding source. The manufacturer provides some period of time during which they subsidize the cost of those funds.
Accounts payable: monies owed by the division to its suppliers (again, vehicle OEMs have parts and assembly providers from whom they buy the parts they assemble into the finished vehicles).
Inventory: the accumulation of produced product which has yet to be sold.
A well-managed company will track all three of these elements very carefully. Accounts receivables are tracked in “days sales outstanding,” or DSO. The lower the DSO, the more cash the company will have. They will also track accounts payable, stretching out payments to suppliers as long as is possible without jeopardizing the relationship.
Finally, inventory is tracked in “turns,” which means how many times — and over what period of time — is the inventory “turned over” (sold and replaced with new product). All three of these cash sources should be tracked carefully; if not, the division itself may face the age old problem of running out of money before running out of month, so to speak. When this happens, it is the corporate parent, in thi case Corporate Enterprises Inc. which will have to dip into the previously described revolver to provide sufficient funds that will enable the Alpha division to meet payroll, and to pay suppliers.
In this structure, Corporate Enterprises cannot, and will not, allow the division to miss payroll, or skip payments to suppliers. But it will usually charge out “debt service” to any business unit for which it is forced to borrow funds. And if corporate management is smart, they’ll force Alpha division to squeeze every nickel of cash out of operations possible, to limit or eliminate the need to borrow. This is done, as described earlier, by collecting receivables on time, delaying payables as much as is reasonably possible, and turn that inventory as often as possible.
What this all means is that bank credit is a precious resource, and a cash shortfall that must be covered in order to make payroll or pay suppliers is usually a more important use of credit than replacing fleet vehicles on time.
Other funding sources, used primarily by mid-sized and smaller companies, are the vehicle manufacturers themselves. Most, if not all of them, have finance/leasing business units, and they often offer lines of credit geared toward the purchase of their products and services.
Commercial lines of credit offered by the OEMs are for use only to fund their products and services; thus they can be a nice addition to a company’s credit, with bank lines used for operations, and the CLOC lines for vehicles and other services. It’s a great option under the right circumstances.
Benefits of Ownership
Why would a company choose to own their fleet vehicles? After all, owning assets can clutter up a balance sheet, and if the numbers are large enough, can have an effect on key financial ratios that banks and other lenders use to determine creditworthiness. And whatever the business the company is in, they need the use of the vehicles, not to own them, so why pay for the full value, when the company will only be using a portion of that value?
There are two primary reasons:
As we previously mentioned, if the opportunity cost (net after tax profit margin) is lower than the cost of borrowing or leasing, it is more cost effective to use cash from operations and purchase vehicles.
Ownership provides maximum flexibility as it pertains to when to replace them.
The second reason is particularly true for companies that have professional, in house fleet management; fleet managers know the used-vehicle market, can track and enforce proper maintenance and condition, and thus maximize economies in vehicle use and replacement.
For a long time now, the most commonly used funding mechanism for fleets, at least for those of larger size, has been leasing. Leasing fleet vehicles keeps bank lines and revolvers untouched, to be used for operations, and for the time being, can be structured such that payments can be expensed on the company income statement, rather than the balance sheet.
For a long time, leasing was much like that which is familiar to most retail buyers: Vehicles were leased for a specific period of time, the contract contained mileage limits and charge backs for excessive wear and tear, and when the lease reached the contractual term, the lessee had the option of either purchasing the vehicle at a price established in the contract at lease inception or, with consideration for the mileage and damage penalties, turn the vehicle back to the lessor. The bottom line was that the residual value risk was with the lessor. This is commonly known as a closed end or net lease. The term is fixed. Early fleet closed-end leases (up until the early 1950’s) often included full maintenance services as well.
In or around 1951, though, a new form of vehicle leasing came about, the open-end or finance lease; this lease contained what is now known as a TRAC — a terminal rental adjustment clause. This is a clause that essentially transfers residual risk from the lessor to the lessee.
The TRAC states that the lessor and lessee either agree on a residual at a fixed-lease term, or alternatively agree on reducing the original cost, in equal monthly amounts, to an anticipated replacement point. This monthly reduction is called a depreciation reserve rate. In the latter case, the actual minimum lease term is a mere 12 months (sometimes 24 months).
In a fixed term TRAC lease, the lessee must make the full number of payments the contract requires (or some equivalent amount); in true open end TRAC lease, the lessee, after the minimum term, may terminate the lease at any time. In either case, there is a residual value remaining. The vehicle is sold, and if the proceeds exceed that residual, the lessor returns the excess to the lessee. If the proceeds from the sale are less than the residual, the lessee is billed for the shortfall.
The difference between the closed- and open-end lease is clear. While the closed-end lease can make budgeting easier, the TRAC lease offers, in the case of the fixed term TRAC lease, the cash flow benefits of leasing along with the equity benefits of ownership. The open-end TRAC lease adds flexibility to the equation.
Benefits of Leasing
As with ownership, there are two primary benefits to leasing:
- Pay for use, not for ownership. As with many other assets such as computers, phone systems, and other office equipment, companies need the use of these assets, not the ownership.
- Cash flow. It is simple arithmetic to find that purchasing a $40,000 truck costs more than leasing it, and paying only for that economic value the company will use, and having the market pay for whatever remains (residual).
There are other benefits to leasing, including the ability to obtain use of higher priced vehicles at a monthly cost at or even lower than it would cost to finance them, and the aforementioned financial reporting benefit when carefully structured (Important note: as of this writing, the accounting test for the financial reporting of leases, known as FASB 13, remains in effect. However planned changes in accounting standards will ultimately require all leases to be reported as balance sheet transactions, eliminating the off balance sheet treatment available for some current leases).
Choosing the Best Option
Ultimately, there are several considerations companies must review before choosing the best funding source and method for fleet vehicles. There is, obviously, no one “right” answer to the question.
Cash from operations: first, the company needs to have sufficient cash to meet other obligations, such as debt service, payroll, and accounts receivable, before considering paying cash for fleet vehicles.
That said, the simple exercise of determining if the opportunity cost of using cash is lower than what the cost of borrowing would be is the next step in the decision.
If it is determined that cash is not an option (for whatever reason), the second option is to borrow the money from a bank or other funding source (including the OEM financial business units)
One funding option is to use existing bank lines of credit (“revolvers”). But the company must be careful to make certain that those lines aren’t needed for other — some would say more important — obligations such as payroll.
If bank lines aren’t a good option, a company can always look to the OEMs financial arms to provide commercial lines of credit, which must be used for the acquisition of their products and services (lost, of course, is the flexibility that bank credit offers).
These options are for a company that chooses to own their vehicles. Many choose leasing.
Vehicle leases are of two general types, closed-end, where the lessor holds the residual risk, and the TRAC lease (both fixed term and open end), where the risk of the residual value is transferred to the lessee.
Leasing enables the company to pay only for that economic value of the vehicle that they will use, rather than paying for the full value and waiting three, four, five years or more to get the benefit of owning when the vehicle is sold
Leasing also currently offers the option of a transaction that can be treated as a monthly expense, rather than on the balance sheet, where it can impact key financial ratios that their banks use to determine creditworthiness
Once again: No matter what the economic climate is, companies which use vehicles to conduct business must determine the best way to fund them. There are a number of options, most depending upon the company’s financial situation, profitability, and the strength of their balance sheet. Fortunately, there are funding solutions available for just about every situation, and some simple tests will reveal the right one for the job.
Originally posted on Fleet Financials