All things considered, now is a very good time to invest in capital equipment in Canada. Economic indicators in North America are showing optimism, and the economy is adding jobs. According to a report from the National Association for Printing Leadership (NAPL), year over year commercial print sales numbers are on their way up, even if only modestly (1.1% three months ending October 2010 – NAPL’s State of the Industry 9th edition). As well, a recent report from Dr. Joe Webb, director of WhatTheyThink’s (www.whattheythink.com) Economics and Research Center indicates that in the U.S., January 2011 commercial printing shipments were up 2.5% (adjusted for inflation). Canada’s numbers for December 2010 were also up.
It is a good time for other practical reasons, too. The Canadian dollar is valued high in relation to both the USD and the Euro. With major industry manufacturers based out of the United States, or Europe, the improved buying power of the Canadian dollar means there are savings to be had on equipment. Now is a good time to evaluate your current plans, with an eye towards capital needs. Perhaps your strategy includes realizing efficiencies in production, or expanding products and services to existing customer base, or entering into new markets.
Better decisions will come from planning based on comprehensive knowledge and analysis, followed up with actionable plans to implement the strategy. The current economic environment means additional pressures to do more with less. The implications of decisions will be felt more finely than before; there is less room for error. A strong plan, well executed and monitored, is a strong predictor of future success.
Capital Investment Trends
The NAPL study, released at last fall’s Graph Expo in Chicago, painted an overall conservative picture of capital investment plans in the North American industry for the next three years. Perhaps somewhat understandable, given the impact of the economic conditions since late 2009, half of the respondents reported that they expect to invest less in the next three years, compared to what they had invested in the previous three years (the full study is available for purchase through the NAPL at www.napl.org).
Generally, following recessions, there is an increase in activity, the result of “pent up demand” that built up during the recession, as organizations and consumers conserved their resources and delayed non-essential spending. This creates a situation in which unrealized demand in the market place contrasts with the existing capacity. Maturing industries, such as graphics communications, typically see an increased level of mergers and acquisitions. This activity acts to take excess capacity, and therefore capital assets, out of production.
However, undercapitalization can be a concern in companies of all sizes, and at different stages of their development. Managers should plan to regularly reinvest in the company, at a minimum this should be equal to their annual depreciation. In bad economic conditions, some companies avoid reinvestment, which helps them appear more economical in the short term. However, this approach is obviously detrimental in the long term. If it’s applied continuously, it undermines the base of the company, and makes it even harder to finance the necessary capital investments.
Evaluating Capital Projects
Determining if a capital investment project makes sense for a company should be a financial decision, not an emotional one. Finance theory, using a simple return on investment (ROI) can quickly demonstrate the benefit you get from buying a new press, or other desired equipment.
An ROI analysis compares the gains against the costs of the capital investment, project, or new program. A simple ROI can be calculated by taking the gains – capital investment costs/investment costs = ROI percentage. Anything greater than 0.0% is a positive project.
However, relying purely on a simple ROI can mean bad decisions. According to Dr. Alan Goss, an assistant professor of finance with the Ted Rogers School of Management at Ryerson University, using straight ROI can lead companies to miss valuable opportunities. Over time, this approach tends to make companies more conservative in their capital/project plans, because it ignores the relative risks associated with the potential investments.
Companies analyzing their capital options should work with the “Time Value of Money” also known as Net Present Value (NPV), or Discounted Cash Flow analysis. This approach is based on the reality that a sum of money in the future is valued less than money today. A dollar today is worth more than the same dollar a year from now, because today’s dollar could be invested, or spent.
The cost of a future cash outlay, or value of a future cash income, given in today’s dollars is referred to as its “present value.” The percentage rate used to calculate the value of money through time is called a “discount rate.”
NPV calculations allow companies to compare alternative projects vying for capital resources; it allows a common metric to help determine which project makes the most sense from an economic standpoint for investment.
Companies should develop a “required rate of return” percentage, an internal hurdle rate, to help evaluate potential capital decisions. The rate serves as the bar to determine if an investment makes sense for the company, or not. This hurdle rate is calculated from the company’s cost of capital, and it also includes an adjustment for “risk factor.”
This risk factor allows companies to calculate a risk adjusted rate of return – the more risk there is to actually receiving the future benefit (profit), the less value the profit has in terms of today’s dollars. Companies can use their internal hurdle rate as their discount rate to compare projects.
These calculations are, by their nature, based on assumptions. How much revenue is the new equipment expected to bring in, or how much will it save in operations? Goss explains that performing a “sensitivity analysis” is critically important in making a capital investment decision.
Managers should review each assumption, and adjust the numbers, up and down, to gauge the relative impact of that assumption on the overall decision. This can be quickly done in a spreadsheet, and a quick search online will turn up several excellent Excel-based templates for more sophisticated evaluations (adjusting multiple variables at the same time).
Scenarios can be developed, and perhaps categorized as conservative, moderate, or aggressive, with their relative assumptions adjusted and their impacts on the NPV of the project evaluated. Goss explains that this analysis, by nature, removes the emotion from the decision, and allows for a “what if I’m wrong?” review.
Managers, financial analysts, and lenders can use a variety of financial comparisons (ratios) to determine the overall health of a company, and compare it to similar firms. If candidates don’t “hit their ratios,” they can be declined lending, or be in a breach of a previous lending agreement. Ratios can be used to measure a company’s relative liquidity, profitability and solvency (debt).
Two commonly used liquidity ratios are the current ratio and the quick ratio.
Current ratio is defined as current assets/current liabilities.The current ratio is a measure of the firm’s ability to pay off current liabilities, as they become due.
Quick ratio, or “acid test” is more conservative than the current ratio and is calculated as quick assets/current liabilities. Cash and accounts receivable are used to determine a company’s ability to meet its short-term obligations.
In both cases, the higher the ratio, the better position the company is in.
For measuring profitability, some popular ratios include:
- Return on assets (ROA) = net income/assets. ROA is a quick measure of the return on money provided by both owners and creditors; it reveals how efficiently all the resources are managed.
- Return on equity (ROE) = net income/equity. This is a measure of the return on money provided by the firm’s owners.
- Gross margin = gross profit/sales. Gross margin measures the profitability by using variable costs, and is a measure of the percentage of revenue that goes to fixed costs and profit.
Common solvency, or debt, ratios include:
- Debt total assets = total liabilities/total assets, this quickly lets people determine the percentage of a business currently financed by creditors.
- Debt to equity = total liabilities/owner’s equity. This ratio will provide a percentage showing how much of the business financed by creditors for each dollar of equity.
This is quick overview; there are a multitude of other ratios that can be calculated to measure and contrast a companies overall health.
You’ve based your decisions on an analysis of your customers, your company’s core competencies, and your overall goals and objectives for the future. Once the decision has been made to invest, sources of financing must be arranged. This can be done through reinvestment of existing capital into the company, or through external financing.
Types of external financing include loans and leases, and sources of external funding include traditional banks, manufacturers, or asset based lending companies.
Goss explains that, with the current low interest rates, the general market for borrowing money is competitive. However, Sonya Kopecky Duff, a key account manager with SL Financial Services Canada, cautions that today, for small- and medium-sized companies (half a million to 15 million in sales), lenders now want to see very strong credit. This is not particular to graphic communications companies, Kopecky Duff continues, that “since the meltdown,” the general criteria for lending have become more stringent across all industries; “anyone who has not been to market since June 2008” will find it is a very different environment.
Regardless of the source or previous relationship, small- and medium-sized company borrowers should now expect to be thoroughly reviewed, complete a full credit application and give up their financial statements. In addition, lenders are now typically requiring a personal guarantee in support of the application; they will run a credit bureau check to make sure the actual borrower has a good personal credit history.
Kopecky Duff explains that banks are now in effect, enforcing conditions that were always in place. In the past, if there was an existing relationship, and a borrower didn’t hit the predetermined ratios, it was not always acted upon.
Financers can review three levels of statements for private companies. First level statements are built from ongoing transaction records that are generated internally (revenues in, expenditures out, how much money was spent to make money). These are taken to an accountant and put into a format consistent with preparing financial reports, a report that is referred to as a Notice to Reader statement.
The next level of financial statement is a Review Engagement Report (RER), where the accountant reviews the details from the Notice to Reader statement, and may (or may not) format it according to Generally Accepted Accounting Principles (GAAP), a standard for financial reporting. Kopecky Duff explains that it is often worth the additional time and expense to have an RER created, as the additional assurance can allow lenders to offer companies lower borrowing rates.
The final option is more time consuming and expensive, and requires that financial auditors come into the company, and perform a complete audit.
Vendor financing is a loan between companies, which is used to buy goods and materials from the company providing the loan. It allows the vendor to increase sales, while possibly earning interest, or even acquiring an interest in the customer company. Vendor financing is generally at higher rates than “traditional” channels. Effectively the lending company is increasing its sales through buying its own products.
Graphics manufacturers can offer their own financing, or have a third party underwrite it on their behalf. They could underwrite the credit risk without the customer being aware of it. One benefit is that manufactures could allow for more flexibility in financing, allowing customers to build up the market with their new equipment.
Manufactures are a questionable source of information for companies evaluating capital investment projects; it’s a bit like going to a mechanic and asking if your car needs to be repaired.
In general, manufactures are feeling the effects of the economy as well, and are less directly involved in financing now.
Lease costs are generally less than borrowing costs, and are calculated from the purchase price, the interest rate applied, the residual value and the length of the term of the lease for the asset.
A capital lease, or finance lease, is an arrangement between two parties, where the lessee (the one borrowing the funds) works with a lessor, who actually buys the asset from the manufacturer. The lessee pays a series of monthly payments – length of terms vary depending on the amount of financing, and nature of the asset. Regardless, the lessee obtains full use of the asset for the term of the lease, as well as accepting the risks of ownership. Generally the equipment is leased for most of its useful life, and the lessee has the option at the end of the arrangement to acquire ownership.
A company that acquires an asset through a finance lease enters it on their balance sheet as a leased asset, and the payments become a liability.
Capital leases tend to have lower costs related to them, in part because there is a lower risk premium included with them by the lessor, to account for the disposition of the asset and the end of the lease.
For tax purposes, purchases and finance leases allow for a Capital Cost Allowance (CCA) tax deduction, as well a deduction can also be claimed for a calculated interest expense.
However, there is also an operating lease, which is generally used when the length of the lease is shorter than the expected useful working life of the capital asset. This is also referred to as an “off balance sheet lease.” Operating leases do not appear on a company’s balance sheet (although they may be included in the notes), the related payments are recorded as an operating expense. For income tax purposes, with an operating lease, the user of the equipment deducts the lease payments as an expense.
This financing technique allows companies to acquire capital assets without leveraging their balance sheet, which can be desirable if additional debt has the potential to challenge an existing bank covenant. This is not as big an advantage as it may have once been, as lenders tend to be reviewing full financial histories now.
The difference between a finance/capital lease and an operating lease is important for accounting purposes. Accountants review the lease, and ask the following questions. If the answer is no to all four, then the lease is considered an operating lease. First, is the lease term more than 75 percent of the equipment’s anticipated useful life? Next, does the lease include an option for the lessee to purchase the asset at less than its fair market value? Third, does actual ownership of the asset get transferred to the lessee at the end of the lease? Lastly, does the net present value of all the lease payments work out to greater than 90 percent of the fair market value of the equipment? (www.canadianequipmentfinancing.com/equipment-leasing/operating-lease-versus-capital-lease).
Alternative Leasing Options
Lending decisions are based on a company’s current cashflows, not the expected future ones from the investment. This creates an “incremental volume problem” for borrowers. Finance companies specializing in leases can arrange for modifications, which can appeal to companies in specific situations. These alternatives include the opportunity to have deferred payments, or stepped payments, which increase at a future point in time (to account for set up and efficiencies).
Industry specialized financing companies can also have practical knowledge of equipment capabilities, lifecycles and market values. This puts them in a position of being able to arrange financing for second hand equipment, offering further savings opportunities.
Depreciation, Tax Advantages, and CCA
Capital Cost Allowance (CCA) is a yearly deduction that businesses can claim on their income taxes, to account for the fact that capital assets decline in value as they are used. The percentage amount depends on which Canada Revenue Agency asset class the equipment belongs to (for example, Class: 43 is manufacturing and processing machinery and equipment and has a CCA rate of 30 percent).
Companies making capital investments can also use a NPV analysis, as they did to evaluate potential projects, to determine the relative cash flow advantages by comparing total cash outflows between leasing and purchasing options.
There are a variety of methods to calculate the amount of depreciation, and therefore the amount of CCA that can be claimed. Straight line is a basic method, and is determined by taking the purchase price, subtracting the salvage value and dividing this across the equipment’s useful life.
A more accurate method is the “declining” balance approach, which is calculated yearly by taking the capital cost of the equipment and subtracting the CCA claimed in the previous years. This is a more conservative approach, and takes into account that equipment loses more value in its earlier years.
It’s important to note that the Federal Government offers an Accelerated Capital Cost Allowance (ACCA), which is currently set to expire in December 2011. This program allows for a 50 percent straight-line accelerated CCA rate for capital investments in manufacturing or processing equipment. This allowance was designed to encourage capital investment, and makes it more attractive for businesses to write down their investments in new equipment. Several groups are lobbying for an extension in the next Federal Budget, due this spring, including the CPIA and the Canadian Manufacturers & Exporters.
While the economy since late 2009 would lend itself to a conservative approach to capital investing, current interest rates, the strong Canadian dollar, potential tax advantages and strategic choice for working through changing markets make this an excellent time to make the capital investments in the new equipment required to deliver on your new strategies.
Mangers should carefully review potential projects; evaluate the likelihood of their success, and engage the support and advice of their accountants and financial partners. Most importantly, they should set clear targets to measure progress and strengthen their post-investment evaluations to ensure that the project is a success.