Credit or Cash: What’s Best for Me?By Fernando Padilla | Thu, 03/11/2021 - 09:42
Every company, regardless of its size, location or business sector, owns and requires assets (equipment, machinery, furniture, computers) to operate. The strategy to keep them up to date and efficient and the strategy related to how you invest or use your money on them becomes key to success and standing out in an increasingly competitive and global world.
To get these assets right, you can do it in a number of different ways. It is essential to know these strategies in order to make the best decisions.
1. Cash up front
Paying cash up front is when you simply acquire the asset by paying for it in full. This depends on your company’s liquidity at any given moment.
2. Buy on credit
Credit is the right to dispose of someone else's money or capital in exchange for interest and repaying capital and interest within a set period. In this case, the asset only serves as collateral for the loan. You own the asset outright after the last payment.
3. Reward them, either with:
- Operating lease
- Financial lease
A lease is where you pay rent for the use of the asset. In the end, you have the option of returning the asset or buying it at a discounted cost from the lessor by paying its residual or depreciated value. The asset is the property of the lessor and the contract grants you the right to use it for a compulsory period, with other items such as accessories, insurance, commissions, procedures and holdings included.
The main differences that exist between pure, financial or renting leasing are based on the deductibility strategy.
But which is the most convenient for my company?
It depends on personal tastes or the flow and tax strategy of your company.
It should be in CASH when:
- You don't like owing money.
- You have money left over and you have a lot of liquidity.
- You like to be in control and negotiate with your provider with the strength of a cash payment.
- The maintenance and modifications of the asset are voluntary. You either do them or you don’t. The risk of it breaking down or deteriorating is yours.
- You like to pay taxes, mainly ISR, because you are going to slowly deduct the asset with depreciation.
- You do not like finances or you do not understand them and instead of money working for you, you prefer not to complicate your life and not owe it to anyone. And because your money is invested in an asset (car, machine, computer), the only thing you know for sure is that that money is worth less every day, so buying in cash guarantees that your money is worth less.
- You usually don't have new business or investment opportunities.
It should be CREDIT when:
- You want the asset to be yours, but you don't have excess capital and you prefer to take advantage of someone else's money to acquire it.
- You are not worried about the leverage / indebtedness of your company.
- You like to make advance payments. At the beginning, the credit will always require a down payment; normally it is above 25%.
- You would like to pay it in advance.
- You like to pay taxes and normally do not use tax strategies to reduce your ISR charge, since you will deduct it as dictated by accounting depreciation.
- You are a natural person and you do not pay taxes or do not pay them directly.
- You like the asset so much and you plan to keep it to leave it to your grandchildren. You want to feel like the owner of the iron, so it is a very good option for those who like cars that are going to become classics.
It should be with a LEASE when:
- You like the smell of new and being at the cutting edge of technology; that is, you want your cars, machines, computer equipment to keep up to date, to face world competition. For example, you like to change your cars every two or three years, modernize your machinery every three or five years, or your computer equipment every one or two years.
- You don't like paying down payments or high advance payments. Depending on the institution, you could start the lease without a down payment or advance payments. Although in practice a guarantee deposit is requested that normally does not exceed 10 percent of the value of the asset.
- You want your monthly payments to be as low as possible. In leasing, the payments are lower than in credit because in reality you are only paying a part of the value of the asset (what is depreciating). What remains in the residual you do not have to pay, therefore, you do not need to decapitalize.
- You want the maintenance cost to be low, since when the asset is new, its costs are usually low. This is a good option for people who don't know much about mechanics and hate dealing with garages.
- You are not sure that you want to keep the asset, and you prefer to decide at the end of the contract and not at the beginning. You do not know how it will turn out, so you better use it and then decide.
- Although you pay your taxes, you implement legal tax strategies that help you reduce your tax burden. The direct impact on the reduction of tax payments can reach up to 40 percent, which means the treasury pays your rent or a large part of it.
- Initially, you do not want to leverage the company, at least if you contract pure leasing or renting, since this is not recorded in the company's liabilities because it is a rental contract.
- You like to keep your assets in good shape. The landlord will force you to keep them in good condition.
Economic Analysis of the Differences
Let's suppose you are going to buy a personnel transport truck that costs US$120,000.00. According to the accounting law of your country you can deduct it in five years, that is US$24,000 per year. Let's look at having a credit option, a pure leasing option and a financial leasing option, where, in the credit product they give you an interest rate on the outstanding balance of 15 percent, in the financial leasing they establish 0 percent down payment and a residual value of 1 percent of the current value, that is, you will only have to pay US$1,200 to keep the truck; and in the pure leasing, they establish no down payment and a residual value of 60 percent, that is, if at the end of 12 months you want to keep the truck you will only pay US$72,000 for it.
And at the end of the 12 months, regardless of the financial product, you want to keep the truck and pay for it.
This is approximately how your financial product would behave (this is not an exact calculation; it is an approximation).
Your first conclusion will be if I pay cash, I pay less. Obviously, if you buy the truck at the end because if you don't buy it, that is to say you don't pay the residual value in the pure lease, this would be the option that requires less payment. But financially this is not how money works. Let's see it in cash flow; that is, how your bank account behaves.
Now see what your bank account looks like at the end, and more importantly, which one has more money on average per month. Pure leasing. If we understand that we live in times when they say that "CASH IS KING," liquidity is the king of the game, so you tell me in which product you have more power.
In the exercise, I assumed a very conservative decision to invest the average balance in CETEs (Mexican Federal Treasury Certificates), but what would happen if you used that liquidity for something else; for example, if you opened a new branch that increased your sales 15 percent, you invested the money in a system that increases the productivity of the company 20 percent or you achieved a reduction in raw material cost of 10 percent by paying cash. Tell me where you paid less for the truck, some will say, but in the credit option, cash and AF, you own the truck and you could sell it. Let's see that exercise.
I am assuming that the commercial value of the truck is US$72,000 and that is its sale value. In the case of leasing, I discounted the US$1,200 payment from its residual. Probably the higher final balance will again be in cash but the average balance remained the pure lease as the highest, again the one that gives you the most power. Now, let's put the impact in taxes, to see which option, in the end, really cost more and which less.
In this exercise, I again assumed that you buy the car at the end of both leases, but in the final number I discounted the taxes you stop paying for deductibility and the expense. The pure lease becomes the cheapest way to buy the truck.
Again, if you don't buy in the lease term, even better.
Why leave your money in an iron that is worth less every day? Better to be in control of your finances and your business by keeping the money in your bank.
So, what is the best decision when buying your assets, lease, credit or cash?