Making the most of money
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By A. N. WILLIAMS, South Western area manager, Lombank Ltd.
WITH all forms of capital investment hampered by recent drastic measures and the prospect of a more than usually severe squeeze, it pays to take a very close look at the intelligent use of capital and of credit facilities and to examine in detail the various alternative methods of financing assets such as plant and equipment and commercial vehicles.
CASH PURCHASE
A cash transaction may appear in some ways to be the cheapest method of purchase and we have all met people who do not believe in using credit facilities and who, on principle, prefer to save up for whatever it is that they want, ultimately buying it from the money saved.
This is sensible in relation to comparatively small purchases, but, laudable though the basic principle may be, its disciples have probably not stopped to consider the very drastic effect it would have on their lives if universally practised.
The price of any article depends primarily on the number which can be produced and sold. Because the variety of credit facilities available encourages greater sales, this in turn means more units produced, resulting in a lowering of the sale price per unit. The motor industry provides the best example of this, there being an obviously direct relationship between the number of units produced and the sale price per unit. Many may think that motor vehicles are expensive now but they would certainly cost far more if credit facilities were not both readily available and widely used.
Their use is simply a reversal of the "save up and buy for cash" principle. One enjoys possession and use of the article and saves for it afterwards. With commercial vehicles, for instance, "use" entails the making of a profit from which payment is made, in other words, a self-financing operation. As stated, cash purchase may appear in some ways to be the cheapest method but this assumes, first, that you have enough cash available and, secondly, that there is no better alternative use to which it can be put.
Cash purchase of capital assets makes great inroads into working capital—particularly disadvantageous at times like this when working capital is difficult to raise or replace. Cash purchase may also adversely affect the liquidity position of a company and leave too small a reserve in hand to cope with emergency operations.
Perhaps the most important point of all, however, is that cash so used always has an alternative investment value and that this value in many cases will exceed the cost of financing a purchase by the use of credit facilities. In this context, it is immaterial whether this alternative investment is made within the same company or in any entirely separate enterprise.
BANK OVERDRAFT
The majority of bank overdraft facilities by their very nature are repayable on demand and it is wise, therefore, to use them for day-to-day working capital rather than for investment in capital equipment for which payment needs to be spread over a given period of time.
Some people and companies tend to rely for their credit needs on one particular source and appear to think that there would be some element of disloyalty involved with the negotiation of any alternative or additional source of credit. This is very misguided. Every modem business needs credit, but what is not yet generally recognized is the multiplicity of individually different forms of credit which are vital to commercial and industrial life, and the fact that no one single financial organization can provide all of these different types of credit.
Certainly, ordinary banking facilities, including overdraft borrowings, are essential to every business. But quite separate from these are very many equally essential forms of credit which are provided by the bigger national finance houses whose speciality they are.
Bank borrowings are relatively cheap, averaging between I per cent and 1; per cent over Bank rate but their usefulness beyond the provision of day-to-day working capital is in some ways limited and involves complications.
First, in normal circumstances, the borrower will be required to provide some tangible security in the form of a charge on assets or property.
Secondly, overdraft borrowings are very vulnerable to credit squeezes and may be reduced or withdrawn at comparatively short notice, The security provided is generally greater in value than the total of borrowings and in the event of such reduction, this disparity in value becomes greater.
Thirdly, if used to buy expensive capital equipment, one's bank borrowing powers for the essential day-to-day working capital or for emergencies are immediately reduced by the amount of such capital expenditure.
The interest rate will vary with each movement of Bank rate and, of course, a credit squeeze may also cause the scale of repayment to vary, both of which factors make exact budgeting of expenditure over a given period more difficult and less precise.
In short, bank overdraft facilities are vitally important for every business within the sensible limits of their nature and purpose but there are many types of credit needs for which they are not suitable.
HIRE PURCHASE
The hire purchase method has been tried and proven over many years and most people are already familiar with its workings. Basically, you select whatever you want to buy and arrange for a finance house to buy it and hire it to you for a given period. The contract embodies an option-to-purchase clause which can be invoked at any stage of the contract.
It is worth emphasizing that in relation to commercial vehicles or industrial plant and machinery, the cost is very much less than it is for private cars.
Again, the Board of Trade controls which lay down minimum deposits and maximum periods for private cars and other purchases do not in any way affect hire purchase for commercial vehicles or industrial plant and machinery.
The rate is fixed at the beginning of the contract and is not in any way affected by variations in Bank rate. In addition, the exact monthly commitments for the whole of the contract period are known beforehand, thus making budgeting comparatively easy and precise.
The balance outstanding under any contract is not in the least affected by a credit squeeze and the advance cannot be either reduced or withdrawn during the contract period.
Hire purchase finance leaves one's working capital or bank overdraft availability untouched and allows one to take advantage of the alternative investment value of unexpended cash resources.
As with any other method of purchase, initial and annual (writing down) allowances are claimable against tax, the initial allowance being spread over the period of the contract in accordance with the capital repayment in each year, and the annual allowance being based on the full price in the first year and subsequently on the written down value at the end of each succeeding year.
Availability of investment grants is unimpaired on any qualifying asset and the full hire purchase charges are also claimable against tax.
Deposits and periods of repayment can be tailormade to suit individual needs and in certain circumstances a system of variable repayments can be applied. This usually entails lower repayments in that part of the contract period in which the vehicle or machine is out of warranty, and servicing, maintenance and running costs tend to increase. Conversely, the somewhat larger repayments in the earlier part of the contract period result in taking speedier advantage of tax allowances or of any investment grant for which the asset qualifies.
LEASING
Although not yet as widely known and understood as hire purchase, the use of leasing has grown considerably in recent years and it is well worth considering in relation to the type, probable life and cost of the asset which you seek to acquire. At present, it is most widely used for computers, all types of accounting machinery and for heavy commercial vehicles but there is little doubt that its use will extend into many other fields during the next few years.
Leasing is based on the theory that profit is derived from the use of an asset rather than from its ownership, and it follows, therefore, that any disadvantages which ownership may entail are automatically eliminated. It is particularly useful for assets with a fairly accurately predictable economic life and steady depreciation characteristics, as opposed to an asset with a particularly long economic life or one which does not depreciate steadily or may even appreciate in value.
Its main characteristics may be summarized as follows: (1) There is no intention, expressed or implied, that the lessee will ever become the owner, but during the period of the lease he enjoys all the benefits of possession and use of the asset.
(2) Whereas hire purchase involves the ultimate acquisition of an asset which will feature in the balance sheet, leasing rentals are simply a charge against revenue and appear only in the profit and loss account.
(3) While with both cash purchase and hire purchase the onus is on the buyer or hirer to claim his initial and annual allowances and any applicable investment grant, under a leasing contract such claims are made by the leasing company, and the anticipated benefit is passed directly to the lessee in the form of reduced rentals. The lessee therefore enjoys the benefit of such allowances and grants much earlier than he would using any other method of purchase, and with no effort or paperwork on his part.
At the end of the lease, the lessee may, if he wishes, renew it for a further period at purely nominal annual rentals. More probably, however, he will wish to renew the equipment itself rather than the lease and in this event, any part-exchange value will be acknowledged by reduced rentals on the new leasing contract.
In brief, the other main advantages are: (a) There is no disturbance of capital.
(b) The rentals are a charge against profits.
(c) Both the gross and net costs are known throughout the length of the lease.
(d) Leases are tailormade to suit the particular requirements of the lessee.
(e) Replacement programmes can be put into effect without delay.
Let me now illustrate the application of tax allowances to these different methods of acquiring assets, taking in this case a new commercial vehicle which attracts an initial allowance of 30 per cent and an annual (writing down) allowance of 25 per cent.
For simplicity, a unit of purchase price of £1.000 has been used