05/05/2002

Why purchase technology equipment? Arguments for the technology operating lease

By John Carey – Summit Asset Management Limited

In today's highly competitive and rapidly changing business environment, technology systems play a critical role in the success of an organisation. Integrated network systems – notebooks, desktop PCs, EPOS systems, printers, servers, storage systems, hubs, routers and switches – are essential tools that determine a business's efficiency and competitive edge. Additional investment at frequent intervals becomes necessary because existing systems, however sophisticated, have to be upgraded or replaced regularly in order to maintain or improve productivity.

Increasing numbers of financial decision-makers have found that they can save their businesses tens, even hundreds, of thousands of pounds in lower direct costs, lower risks of obsolescence and greater operational efficiency, by using cost-effective and flexible financing solutions for rapidly depreciating technology equipment. An operating lease scheme for IT assets, provided by a specialist financier, such as Summit Asset Management, can bring measurable cost savings, as well as qualitative benefits, to your business.

Significant cost savings

An operating lease transfers risks of ownership to the lessor, so the anticipated residual value of the leased equipment will be reflected in the calculation of the rental payments. The comparative costs of lease and purchase can be measured by discounting the lease rentals at the lessee’s alternative cost of borrowing, or the rate of return it would receive on funds which could otherwise be invested elsewhere.

For example, new IT equipment can be purchased for £1,000,000, or leased at £84,500 per quarter over a term of three years:

 If the lessee has surplus cash which would otherwise be placed on deposit at 4% per annum, the net present value of the lease rentals is £960,565, a saving of 4% of cost over the term of the lease
 If the cash is borrowed from external sources at 8% per annum, the net present value of the lease rentals is £911,489, a saving of nearly 9% of cost
 If the alternative use of the cash is investment in revenue-generating activities, the opportunity cost could be 15% per annum (or more) giving a net present value of £834,843 and a saving of 16.5% of cost


The above analysis assumes that the lessee will replace the equipment after three years. However, if the lessee chooses to extend the lease, the cost will usually be less than the cost of leasing new replacement equipment.

Cash generation and conservation

Cash is the lifeblood of any business. Even a profitable company may suffer the severe consequences that flow from insufficient cash generation. Purchases of IT equipment, often not directly employed in the revenue-earning activities of the business, deplete the company's cash resource. A financing solution that reduces the initial outflow of cash, while allowing the acquisition and use of the technology assets required in the business, must surely be worth a second look. Operating leases conserve vital cash resources by eliminating initial cash outlays. Payment for the use of the equipment acquired is spread evenly over its useful life, leaving cash generated in the business available for investment or simply employed in revenue generation.

If external cash sources are used for investment in new equipment, these credit lines are preserved and available for use in the core activities of the business. In this case, an operating lease can be viewed as an additional source of finance which does not affect other facilities.

A sale and leaseback transaction, where equipment already purchased is sold and leased back over its remaining useful life, generates immediate, positive cash flow. If cash required for investment in business growth is not available, sale and leaseback provides a potential solution.

Off-balance sheet finance
Various interested parties - investors, analysts, lenders and creditors - measure the performance of businesses using key financial ratios, such as gearing and return on capital employed. These external perceptions of performance require careful management because they can have a material impact on the business, affecting (for example) the cost of capital and the ability to raise external finance.

It is a widely held view that revenue-earning assets should be recorded on the balance sheet, perhaps regardless of the finance method that supports their acquisition. In the case of non-revenue-earning assets, the use of an off-balance sheet financing solution can improve performance measures, showing the business in the best possible light, without distorting the overall view of the business. Although recent examples of the misuse of off-balance sheet structures have cast a shadow on the validity of some financing techniques, this has not extended to transactions where a genuine transfer of risk has taken place.

Applied to technology assets, a properly structured operating lease will satisfy the transfer of risk test, allowing the business to secure the benefits, some of which are described above, of off-balance sheet finance.

Upgrade management
However compelling the business reasons for upgrading technology assets, there is often internal resistance to committing additional, perhaps unforeseen, expenditure from limited capital budgets. This may delay the introduction of new technology or result in a compromise, which fails to satisfy the technological need. This, in turn, may lead to impairment of performance and productivity or loss of competitive advantage.

The resistance to early replacement of technology assets often stems from the situation known as the "net book value trap". If purchased assets are depreciated on the basis of a predicted full life of (say) four years, their net book value at any intermediate time is likely to be substantially higher than their realisable market value. The disposal of a large number of assets after only two or three years will result in a substantial book loss, which will be unwelcome at best and, at worst, may lead to an important project being deferred or cancelled.

Operating leases help to overcome this problem. The term of the lease will be agreed as the anticipated minimum useful life of the assets in the lessee’s business. In the case of IT equipment, this is typically three years. New equipment, or capacity upgrades, can be introduced at the end of this term or earlier, when the time is right for the business, without any loss on disposal of existing assets. If additional costs are incurred where equipment is upgraded or replaced early, these can be spread over the term of a new lease.

Refresh discipline
An ageing technology estate can cost a business far more than the costs saved by under-investment in new technology. Apart from the costs of deteriorating productivity, older systems are far more expensive to maintain and service than more recently installed systems. Some authoritative studies have shown that hardware purchase costs are only a fraction of the total cost of owning technology equipment. The productivity gains and lower maintenance costs that accompany a regular technology refresh programme can easily exceed the additional costs of replacement.

An operating lease provides a natural technology refresh cycle, while allowing the flexibility to extend or shorten the cycle as needed in response to prevailing business circumstances and technology needs.

European regulations
EU regulations on the disposal of electrical and electronic equipment (the WEEE Directive) are both complex and far-reaching. Keeping track of these regulations and ensuring compliance with them is time-consuming, costly and easily overlooked. However, there are severe financial penalties for non-compliance. If technology assets are acquired under an operating lease, ownership of the assets, together with the burden of compliance, falls on the lessor.

Conclusion
The choices of when and if to acquire, upgrade and, ultimately, replace technology assets have become critical to business success. This article sets out to show that the choice of how to acquire the use of such assets can also have important consequences.

Acquiring the use of technology assets through a flexible operating lease programme can offer significant direct savings over the alternative of outright purchase. Rental payments, fully tax deductible, are paid over the term of the lease, conserving cash resources for core, revenue-earning business activities. The company's balance sheet and performance indicators can be materially improved by taking these non-revenue-earning assets off-balance sheet.

The removal of traditional resistance to the early upgrade of technology assets, and the creation of a natural technology refresh cycle, can simplify and shorten decision-making processes, improving the business’s ability to respond to competitive pressures. Time and costs spent in monitoring and complying with current EU legislation can also be avoided.

Does your company still purchase technology equipment? This article gives some reasons to consider whether the benefits and flexibility of an operating lease provide a better solution.