What it means
The core idea is matching. A machine that will earn money for seven years is paid for over several of those years rather than out of one month's cash, so the cost of the asset lines up with the income it generates.
That keeps working capital free for stock, wages and the other things that cannot be financed. The main structures are hire purchase, where the business owns the asset at the end after a final payment, and finance or operating leases, where the funder retains legal ownership and the business pays for use.
Which one to pick depends on whether the business wants the asset long term, how quickly it will become obsolete, and how the arrangement lands in the accounts and tax computation. Lenders assess the asset as much as the borrower.
Standard items with a deep second-hand market, such as excavators, trucks and CNC machines, attract advance rates of 70% to 90% of value, while bespoke or fast-depreciating kit attracts less and sometimes nothing at all. The headline rate is not the whole cost.
Arrangement fees, documentation fees, an option-to-purchase fee at the end of a hire purchase, and any balloon payment all change the true cost, so the sensible comparison is total cash paid over the term rather than the advertised percentage. The real risk is financing an asset for longer than it earns.
A three-year vehicle on a five-year agreement leaves the business paying for something it has already replaced, which is why the term should never comfortably exceed the asset's productive life.
In practice
Real-world examples.
Example
A haulage firm replaces six tractor units on five-year hire purchase agreements with a 15% deposit each. The monthly payments are covered comfortably by the contracted freight revenue the new trucks are assigned to.
Example
A dental practice leases a $180,000 imaging scanner on an operating lease with a three-year term, because the technology is refreshed roughly every four years and the practice does not want to own an obsolete machine.
Example
A craft brewery buys $400,000 of fermentation tanks using asset finance rather than its overdraft, keeping the overdraft free to fund the seasonal stock build ahead of summer.
Formula
Calculation
Amount financed = Asset cost - Deposit, where Deposit is often set as (1 - Advance rate) x Asset cost
Monthly payment = Amount financed x r / (1 - (1 + r) to the power of -n), where r is the monthly interest rate and n is the number of months
Suppose a fabrication business buys a press for $250,000 with an 80% advance rate. The lender funds 80% x $250,000 = $200,000 and the business puts down the remaining $250,000 - $200,000 = $50,000. The agreement runs for four years, so n = 48 months, at 9% a year, so r = 9% / 12 = 0.75% per month. The monthly payment works out at roughly $4,977. Over the full term the business pays 48 x $4,977 = $238,896, so the total interest cost is $238,896 - $200,000 = $38,896. Adding the deposit, the press costs $288,896 in cash over four years against a $250,000 sticker price.Case study
Seen in the real world.
Thornebury Precision Engineering is a fictional company used to illustrate this concept. It won a three-year contract that required a $250,000 press it could not pay for outright without draining the cash it needed for materials and overtime. Its bank offered an unsecured loan at 14% but only for $120,000, which was not enough.
An asset finance provider took a different view because the press was a standard machine with an active resale market. It advanced 80%, or $200,000, at 9% over four years against a $50,000 deposit, with the press itself as security, giving payments of about $4,977 a month.
The contract generated roughly $19,000 a month of gross margin, so the payment was covered several times over, and in this illustrative example the total finance cost of $38,896 was a straightforward trade for a contract the business could not otherwise have taken. The finance director's one change was to shorten the term on the next machine from four years to three, after noticing the previous press had been retired at month 41.
Watch out
Common mistakes.
- Financing an asset over a longer period than it will actually be used. Paying for a replaced machine is a permanent drag on cash with nothing earning against it.
- Comparing agreements on the monthly payment alone. A lower payment usually means a longer term or a balloon at the end, and the total cash paid can be far higher.
- Overlooking the fees and the end-of-term option payment. These can add a meaningful amount to a deal that looked cheaper on rate alone.
Questions
People also ask.
Is asset financing the same as a bank loan?
Not quite, because the asset itself is the security, which usually means easier approval and a lower rate than unsecured borrowing.
Does the asset appear on our balance sheet?
Under current accounting standards most leases and hire purchase agreements put a right-of-use asset and a matching liability on the balance sheet, so the answer is usually yes.
What happens if we stop paying?
The funder can repossess and sell the asset, and if the sale does not cover the outstanding balance the business is normally liable for the shortfall.
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