1-2-3 Financing

Finance theory basics

All investments in a company need to be financed. Here we will take a closer look at how the choice of method of financing could affect the company's profitability, liquidity and even its equipment fleet!

All in all, you have mainly three choices when you finance an investment:
  • To use your accumulated savings (equity)
  • To take out a bank loan
  • To lease
Which method of financing should you choose?
Most companies need to rely on all three methods of financing – and all at the same time. In some cases, they will choose to use their equity, while in others, the choice will fall on a loan or a lease. In other words, it is all about opting for the right source of financing for each individual investment. To shed further light on this, here is a maritime comparison.
Imagine you are the captain of a large sailing ship. You are about to dock in a narrow and perilous harbour teeming with reefs and islets – and you must decide if you should unfurl the sails, use the motor or ask the local pilot for help. You choose the last of the three options and are safely towed to the pier. But you have used both your motor and your sails earlier on the same day. When you left the pier at the previous harbour, you chose the motors. When you crossed the sea, you opted for the sails. Now as you are about to dock, you go for the pilot.
The issue at hand is therefore not to choose a specific method of financing. It is about deciding when to use each of the different methods of financing.
Do not let your feelings take the choice for you
It is part of Norwegian culture and tradition to own our things. The exception is our homes – this is where it is fine to borrow. But the reason why we prefer to own most likely has to do with our feelings. Ownership gives us a sense of control. But the day we need to sell our property and are left with almost nothing, we take a huge loss in stride and forget that this was caused by a poor financial sense to begin with. After all, we owned all these things, didn't we?
A good business executive does not allow his feelings to affect his choices. What is important is to find out is what it costs to own rather than borrow or lease. After all, the important thing is that you get your necessary equipment, not how you financed its acquisition.
The captain of the sailing ship did not let his feelings affect his choices. He made rational choices based on common sense. If he had opted to use sails in the narrow harbour because this gave him a good feeling, things might have ended up with a disaster.
Using accumulated savings does not come free of charge
Many people think that using equity is free of charge, but this is hardly so. When you use equity to purchase equipment, you must also look at what your returns would have been if you had used the money for other purposes. You will often get better returns if you invest in sales promotion measures. And even if you let the money stay in your account, it will accumulate interest.
These are the returns you give up when you choose to own the equipment yourself – which is what you should consider when you assess which is the most profitable method of financing.
The importance of having liquidity
The most expensive method of financing for a company is to tie up money in equipment. This is money that could have been used for increasing the sales proceeds. And without liquidity, everything grinds to a halt. There is no money for marketing, paying suppliers, etc. etc. This quickly turns into a negative spiral. On the day you finally decide to go to the bank to ask for a loan, it may be too late as the banks will already be looking at the negative figures under a magnifying glass.
The first order of business is therefore to maintain the existing liquidity so that it is always available when you need it. Having accumulated funds in an account is a buffer that gives a company life-saving flexibility.
Use capital in the right places
An astounding number of newly founded companies invest in equipment they do not need to own. The result is that their cash holdings are low and that they again have no money to spare to increase their revenues through either marketing or hiring. The loss of revenue often exceeds the possible interest on a loan or a lease. On the other hand, companies that lease their equipment have a number of advantages that are important in a competitive market:
  • They have predictable expenses, and predictability is always an advantage
  • They have lower taxes because the state pays a share of the interest
  • They have accumulated savings to use on marketing, hiring and other measures that can increase revenues
  • They have the freedom to upgrade to better equipment (see the following section)
Lower taxes, better equipment and sales promotion measures help companies achieve better results. In other words, using capital in the right places is a thing of vital importance.
Your choice of financing affects your company's equipment
The right equipment is an immense competitive advantage. The best equipment functions more rationally and more efficiently – while saving you time, money and worry. Operating expenses are naturally an important concern.
Leasing the equipment allows the company to regularly upgrade to better equipment without a corresponding increase in the monthly payment. The right equipment can also make many end customers be willing to pay more for what they view as a better overall product.
Companies that opt to buy the equipment often find themselves in a more restricted situation. They must divest of their retired equipment themselves and may need to keep both old and new equipment during a transitional period. This can be a challenge – in terms of money and lack of space, and companies will often get too little money back for their old equipment. Such companies ordinarily wait too long to upgrade their equipment. This results in losses in the form of inefficient operation and high operating costs.
Profitability analysis
To be able to determine what is the right method of financing for you, you have to run a profitability analysis. The analysis is supposed to answer which method of financing will yield the highest return for the company. A good profitability analysis takes into consideration the following items:
  • All future revenues as a result of the investment
  • All future expenses as a result of the investment
  • How the financing affects the company’s tax accounts
  • Your required rate of return (see the following section)
We can help you create such a model where leasing is compared with loan or equity finance.
Make sure that the required rate of return is proportional to the risk
If you withdraw your accumulated savings from the bank and use it to finance a purchase of equipment, you should define a rate of return that is a good deal higher than the bank interest. The reason why is that you are making a move that involves a risk.
The higher the risk, the higher the required rate of return. There is no good reason for investing money if you will never be able to benefit from your investment. The return must be proportional to the risk, and what is also important here is that you take into consideration what kind of risk you take. You should therefore formulate a reasonable rate of return that is well above the bank's interest rate.