3 ways to finance a large capital expense
It is essential to have a strategic plan for how you will allocate your businesses capital expenditure budget. It would be best to think about what physical assets need to be acquired, when and how you will use them. It is also essential to understand the expected ROI or payback period and how the purchases are paid.
The aim of financing capital expenditures should be to choose the best financing option that will leave you with the most efficient use of your working capital. It needs to provide you with the most flexibility when owning the assets.
There are three ways to finance a significant capital expense:
- Internal Financing – Cash
The simplest option may be to buy the assets outright in cash. The main benefit of this is the ownership of your working capital's current assets and efficient use. You will also avoid any interest expense. However, there are lots of factors to be considered when investing in a significant capital expense outright. For example, other purchased assets such as machinery, equipment and supplies all increase cash liquidity. It is essential to consider these before buying the considerable expense and examine whether it would be best to save up for the purchase for several years if you plan well. Finally, it would help if you also considered the opportunity cost of investing large sums of money in a depreciating asset than other uses for your cash.
Saving up to buy a large home or luxury good often makes sense because not going into debt to avoid interest adds to the capitals bottom line price. Saving up cash may make it possible to negotiate a better price, also known as 'bargaining', a tried-and-true tool with a long history when accepting money upfront.
- External Financing – Bank Loan
Borrowing the money from a bank instead of buying a significant capital expense outright will help to provide more flexibility rather than maxing out your cash flow. Taking out a term loan also helps to free up working capital whilst preserving credit capacity.
Bank term loans are usually sourced to finance capital expenditure purchases. By borrowing the money rather than buying assets outright, it frees up working capital to be used for other purchase intentions.
A business that involves ongoing investments in certain types of assets may be eligible for a pre-approved CAPEX loan from their bank. Pre-approved CAPEX loans provide a reputable and predictable financing level across the year, helping with CAPEX budgeting and repayments.
- External Financing – Equipment Lease
Leasing business equipment like taking out a bank loan frees up working capital and helps preserve credit capacity.
Leasing enables you to match your cash flow to the expected life of the significant asset being financed. Leasing allows you to opt for an early buy-out option potentially. For example, rather than investing your cash into a depreciating asset, you could instead invest your money to fund activities such as equipment ownership or other liabilities that may generate a higher return of investment.
Leasing helps to protect against obsolescence, as there may be significant tax benefits to a lease. A business may need to lease equipment to help generate a higher return without having to part with the cash in the first instance.
It is essential to observe the climate of interest rates and going ahead when the rates are low. Low interest rates may also make buying on time a better choice and might take a significant hike before you can save enough to make the purchase.
Deciding on how to finance a significant capital expense is crucial for any business to understand before purchasing. A business must conduct a strategic CAPEX plan before acquiring or significantly improving assets whilst considering the current activities on the statement of cash flows.
Ellie Harrop is the marketing executive at OfficeInsight. At Officeinsight, we understand that people are your companies most asset, that is why our team is passionate about delivering projects that create amazing workplaces where staff will thrive. Ellie regularly assists readers interested in a new office-fit out. You can find her on Linkedin