Own or Fund: Asset Finance Fundamentals

Financing business assets can provide ongoing value when done right with correct structuring.

The three main reasons to finance business assets are outlined below.

1. As an opportunity cost to using cash reserves, asset finance can preserve cash flow for other operational or expansion needs of the business.

2. Correctly structured asset finance can deliver favourable tax outcomes. Planning ahead of the financial year plays a key role here.

3. The availability of tax incentives, such as the ATO's instant asset tax write-off, offers more benefits for businesses to acquire assets valued under $20,000. The Instant Asset Write-off scheme applies to small businesses with an annual turnover of less than $10 million. 

The Fundamentals of Asset Finance

Before diving into different structuring options, it is best to have a grasp of asset financing fundamentals. Unfortunately, many businesses make asset purchasing decisions without considering the long-term impacts of the asset life cycle and how best to structure debt accordingly.

i) The Asset Life Cycle

Before you think about buying and financing assets, first consider the life cycle of the asset, which is the time over which the asset will contribute to business operations.

More broadly, the full asset life cycle refers to the acquisition, use and disposal of the asset within the business. The main aim of asset life cycle management is to reduce costs and increase productivity.

Businesses with larger, complex asset needs will use Asset Management Software to assist with managing the asset life cycle. 

ii) Debt Structure

Asset or Equipment Finance is often more flexible than longer-term financing structures such as mortgages. This results in a better ability to align repayments to suit cash flow and working capital management.

As outlined above, the term of the loan and its repayment program need to align with the asset's life cycle. This practice ensures that the repayment of the debt on the asset is finalised before the asset no longer exceeds its life cycle and value to the business.

All too often, a business will be left making payments on an asset that is no longer in use, while also needing to acquire a new asset to replace the aged asset.

TIP: Often, where businesses go wrong is funding long-term assets with short-term financing facilities or vice versa.

Types of Asset Finance Options

The differences in financing structures appear subtle, and indeed repayments look similar, but each one can be significantly different from an accounting and tax perspective.

Most structures allow 100% of the purchase price to be funded, secured by the asset itself, with a fixed loan term. The comparisons between the four main structures are explained below:

What is a Residual?

In both a Chattel Mortgage and a Hire Purchase, there can be a mandatory or optional residual (or balloon) amount to pay out at the end of the term. A residual is a way to significantly reduce the repayment amount of each installment. Another way to reduce repayments is to contribute a deposit to lower the amount to be financed.

The residual needs to be allocated in budgeting, to prevent the business from being caught off guard by the lump sum amount required to discharge the financing.

If there isn't enough cash in reserve to pay out the finance, the asset will need to be sold (perhaps at a loss), or the residual amount will require refinancing, incurring more fees and interest. For this reason, many financiers provide products with no residual, which does increase the repayments and term, but removes the need for a final cash reserve.

Asset Finance Types Explained

1. Chattel Mortgage

Often used in vehicle finance. In a chattel mortgage, you take ownership of the asset, but the financier keeps a security interest in that asset by providing a mortgage. Once the contract is completed, the security interest is removed, giving the customer a clear title to the vehicle.

The lender will register their interest on the Personal Property Securities Register (PPSR) for the duration of the agreement. Once the loan is repaid, the registration is removed.

The asset will sit on the business balance sheet as a fixed asset, and the loan will be a corresponding liability. This can be a gearing ratio distinction if applying for future debt.

Potential Benefits

• The ATO treats this as a purchase with a loan, allowing depreciation and loan interest to be claimed as a tax deduction. The principal portion of the loan is not tax-deductible.

• For businesses registered for GST on a cash basis, they may claim back any GST on the purchase in full in their next Activity Statement.

• The business has immediate ownership.

• If the asset is going to be sold while still under finance, it can be easier to do so with a chattel mortgage than with a commercial hire purchase.
• Popular for sole traders, SME businesses, and larger corporations in industries where hire purchase is not a common practise.

2. Commercial Hire Purchase

The financier purchases the asset on behalf of the customer and then hires it back to the business over an agreed term. The business is able to use the asset immediately upon delivery.

This is a popular option for specialised equipment, heavy machinery, trucks and other vehicles which hold their value over the term of the loan. If you think the asset will be sold before the end of the loan term, you will need to check the payout terms for this option before signing a hire purchase agreement and be aware of the fees involved.

The lender will register their interest as the owner on the Personal Property Securities Register (PPSR) for the duration of the agreement. Therefore, the lender retains ownership until the loan is repaid, and the registration is removed.

After all installments and any residual amount are paid, the business assumes ownership of the asset.

Potential Benefits

• Offers cashflow certainty and ownership at the end of a known timeline.

• The ATO treats this as a purchase with a loan, allowing depreciation and loan interest to be claimed as a tax deduction. The principal portion of the loan is not tax-deductible.

• For businesses registered for GST on a cash basis, they may claim back any GST on the purchase in full in their next Activity Statement.

• More popular for construction, transport, manufacturing and agribusiness.

3. Finance Lease

Similar to hire purchase, the financier retains actual ownership of the asset; however, ownership at the end of the term is optional. To keep using the asset, you can extend the lease or buy the asset outright (usually for the balloon amount). To stop using the asset, you return it at the end of the lease term.

Since the financier retains ownership of the asset, only the purchase is financed, excluding GST.

Potential Benefits

• Suitable if you update equipment or vehicles on a regular basis due to changes in technology, short-term projects, or other factors.

• Also suitable for start-ups or businesses without capital that need quick access to high-quality assets.

• A good option if the business does not want to assume immediate or delayed ownership for legal or accounting reasons.

• Lease payments are often fully tax-deductible, which can suit businesses with tax planning.

• Popular with I.T., communications, retail, research, manufacturing and medical health industries.

4. Operating Lease

With an operating lease, the business will not own the asset and can return the goods at the end of the term, such as when leasing retail space, vehicles, office equipment or short-term equipment. All operating costs, such as registration, maintenance and insurance, are included in the lease, but thresholds might apply, such as kilometre usage.

The operating lease is still recorded on the balance sheet as an asset, with repayments seen as expenses rather than liabilities. There may also be a residual amount at the end of the contract, but this is less likely.

However, an operating lease structure is usually provided at a higher cost, so always obtain qualified accounting and taxation advice that applies to your circumstances.

Potential benefits

• A useful option when you are turning over equipment regularly.

• Usually, no deposit is required, and interest is fixed over the term.

• Better if you need greater flexibility than a finance lease and want one regular repayment amount.

• Popular for trades, construction, start-ups, retail and professional services businesses.

Tax and Insurance Considerations

Equipment finance products can have accounting, taxation and legal implications. Areas to note are:

• The business will need to arrange adequate insurance for all financed assets and note the financier on the insurance policy.

• The taxation treatments associated with ownership of equipment can be unique to the needs and circumstances of the business. These include Fringe Benefits Tax, GST, Depreciation and Government schemes such as the Instant Asset Write Off Scheme. When considering debt of any kind, always seek professional accounting and legal advice.

• Specifically consider whether the benefits associated with asset ownership of equipment outweigh any benefits of a full deduction of payments through leasing.

Your commercial broker has the skills to assess your asset finance needs, along with other financing considerations. Ask for a banking review today.

Contact MCP

1300 510 816 or your Finance Partner
enquiry@mcpfinancial.com.au