Hire purchase or outright purchase? Which is right for you?
When it comes to acquiring new assets for an organisation, one of the key questions that many businesses face is: should we purchase the asset or lease it?
The answer to this question depends usually on your attitude to asset ownership, with many companies preferring to lease their assets over time – where there is an even cash-flow over the lease period – rather than owning them, which usually requires a significant cash outlay upfront.
With assets like vehicles, for example, there has been a definite shift towards leasing since the last recession, not least because it provides known, easily budgeted costs with no hidden surprises.
When it comes to funding new assets, there are many facets to consider – in particular the cost of the asset itself and whether budgets will allow for an outright purchase. It pays to lay out the advantages and disadvantages of hire purchase, as well as the benefits of an outright purchase before committing to any agreement.
Should you buy business assets outright?
Some companies still prefer to purchase assets like plant and machinery, IT equipment and vehicles, as there is a certain reassurance in owning assets outright. However, there are a number of deciding factors to consider before taking the plunge and buying outright.
Capital upfront and depreciating value
Purchasing assets outright typically requires a high outlay of capital initially, which may mean tying up funds that could be better used elsewhere in your business, or by sourcing a bank or other loan to cover the costs.
Remember, too, that most assets you own are depreciating assets and your business is therefore exposed to any fluctuations in their residual value, which may be more severe than you would like.
Bank loans and interest rates
Another issue you should consider if acquiring assets via a bank loan is that the bank will typically insist on raising a charge over the other assets in your business as collateral or security against the loan.
Some may feel that it is unnecessary or unwarranted to tie up other assets of the business in this way just to secure an additional one.
Another factor to consider with a bank loan is that the rate of interest the bank will charge on the loan will depend on your status with that bank – whether you are a new customer or a new business start-up, and what credit rating you have with them.
This could determine whether the rate of interest you pay is relatively comfortable for your business or downright draconian, and it should not be underestimated.
Interest rates in the High Street are currently historically low, although may not be as low as some might think. And it’s also true to say that rates from second tier lenders are still relatively high, and could be as much as 8-10% for SMEs and other small businesses, depending on circumstances.
However, there are several disadvantages to buying equipment outright:
- you have to pay the full cost of the asset up front which can affect your cash-flow
- you may need to use an overdraft or loan to fund the purchase – overdrafts can be withdrawn at short notice and in some cases early repayment of loans can be demanded
- small businesses might not get the same interest rate as bigger businesses
- you can’t easily spread the cost to coincide with money coming into the business
- you are entirely responsible for the maintenance and repair of the asset, which can be a risk if the equipment breaks down or needs replacing
- you won’t be able to take advantage of the tax benefits of deducting the cost of lease rentals from your taxable income
- the value of the asset could depreciate over time and be worth less than you paid for it.
What are the benefits of buying outright?
One factor firmly in favour of owning rather than leasing assets is their tax treatment and the capital allowances that can be claimed against them. If employing outright purchase, you are treated as the owner for tax purposes and can claim capital allowances.
A case in point is the Annual Investment Allowance, which governs the amount of capital investment companies can make in business assets, such as plant and machinery, but not vehicles.
The threshold for the AIAs two years ago stood at just £25,000 per annum. Then, in 2013-14, the Government took the decision to increase this limit to £250,000 and then doubled it again to £500,000 for an extended temporary period until December 2015.
This means that, in the current tax year, any business that purchases its business assets can offset the value of the assets up to a maximum of £500,000 directly against their taxable profits in that year – a significant incentive for any small business.
What are the advantages and disadvantages of hire purchase in business?
One solution could be the use of hire purchase to acquire the asset instead, which can offer a more cost effective alternative than an outright cash purchase.
With hire purchase, you can fix the cost of acquiring an asset but spread the cost of the purchase over time. When comparing the value of money over time using a discounted cash flow analysis, hire purchase can therefore offer a more cost effective alternative to a cash purchase.
Hire purchase is an on-balance sheet method of funding the purchase of assets for business use. There is an initial deposit, typically 10% (though it can be more or less), and the remaining cost is spread across fixed monthly instalments – for some assets it is possible to include a balloon payment at the end of the hire purchase agreement which can be a real cash flow bonus.
What are the advantages of hire purchase?
Hire purchase offers a number of advantages:
- Fixed monthly costs spread over the course of the finance agreement
- Low deposit often available
- On-balance sheet funding allows you to maximise your asset base
- Business purchases may benefit from Annual Investment Allowance tax savings and VAT can be reclaimed on the purchase price of the asset
- Fixed and variable interest rates are usually available
- Frees up vital capital in the business
- The security taken by the lender is the asset not a charge over the business as a whole
However, there are also a number of disadvantages which should also be taken into account:
- You don’t own the asset until you’ve made your final payment, which could lead to the finance company taking it away if you get into financial difficulty
- The deposit and term length will affect the monthly payments, with higher monthly payments, the smaller the deposit and the shorter the term of the loan.
- Lenders will take credit references and it is likely that you’ll need to have traded for at least three years. If a company hasn’t been trading for long enough to have a decent credit rating then it may struggle to secure hire purchase funding – outright purchase may be the only choice.
So, if you prefer to own your business assets outright, there are a number of factors you need to carefully consider and weigh up before deciding upon the right course of action for you.
You may also be interested in reading our blog post: Finance lease or operating lease – what is the difference?