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Past Issues

February 2005

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Finance

Is it better to buy, lease or rent trucks? There is no simple answer to this question. Changing road transport dynamics over time ensures there is no single best way to pay for trucks. If truck operators - whether hauling for reward or transporting their goods with their own vehicles - are to remain viable, competitive and affordable, their managements need to review and evaluate the various vehicle financing options that are currently available to fleets and operators of all sizes. FleetWatch correspondent Max Braun examines these options and spells out the advantages and disadvantages of each.

Due to changed and emerging circumstances, the best method of paying for vehicles a few years ago is not necessarily the best way now. This is especially so if vehicle replacements and additions to the fleet are to be available when needed to meet tightening standards imposed by legislation, shippers (consignors) and to combat intensifying competition.

New vehicles and trailing equipment are expensive. Interest rates are still relatively high and allowable wear and tear allowances are inadequate to cover future replacements without investing additional capital. Because most companies do not have the money or cash resources to pay for all the projects they plan to undertake, cash resources - including borrowed funds - are usually rationed to favour the projects and investments that yield the best returns. Hard working trucks fall into the category of "wasting assets" and are no longer popular with many financial managements.

While it is not necessary for operating managers, small fleet operators or owner-drivers to become 'accountants', it is vitally important that they have a sound understanding of the basics when it comes to paying for vehicles and why one method of paying for vehicles is, from time to time, favoured over others. When a case for replacing or adding vehicles cannot be convincingly motivated, or financially justified, this frequently results in operators and operating managements being left to work with outdated, inadequate, unreliable or insufficient equipment.

Regardless of how vehicles are payed for, the cost of financing is one of the largest expenses encountered in owning and operating trucks. The most popular ways to pay for vehicles include:

• Outright Purchase - paying the full amount in cash

• Instalment Sale - also known as suspensive sale. Pay a deposit and the balance in periodic equal payments over an agreed period.

• Financial Lease - No deposit. Equal, periodic rentals are paid over an agreed period to redeem all or part of the purchase price. This depends on the structure of the lease that may or may not include a final payment equal to the estimated residual value when the lease terminates

• Extended Rental Agreement - also known as an Operating Lease or a Full Maintenance Lease. Usually level rentals for an agreed period. Maintenance can be included.

Before discussing the advantages and disadvantages of the various methods, it is most important that each business has a solid financial strategy in place. A sound and sensible strategy in any transport business, or inhouse transport operation, is to strive to achieve the lowest total operating cost. To achieve this, getting to grips with financial aspects such ensuring the effective use of, and conservation of cash resources, while keeping the administrative aspects as simple as possible are as important as operating and technical aspects.

When sufficient funds are available and when there is no immediate alternative plan, many businesses prefer to purchase their trucks. The advantages of paying cash are basic and easy to understand.

Advantages of paying cash for vehicles

• Freedom to choose the suppliers. Creates opportunities to negotiate better discounts for cash.

• Immediate ownership. You decide when vehicles can be sold or replaced. This provides flexibility when deciding to acquire new or different makes and models.

• There are no additional amounts or fees to be paid.

• Can be financed by employing overdraft funding. This can be more cost-effective than raising a loan.

• Owned vehicles are included on the balance sheet as an employed asset.

Disadvantages of outright purchase:

• Probably a temporary reduction in working capital. Cash resources rely on shareholders investment in the business, undistributed after-tax profits and overdraft facilities.

• Possible lost opportunities to invest in a more profitable or strategic investment.

• The owner has sole responsibility for disposing of the vehicle at some future date.

• The Receiver of Revenue's (Receiver) wear and tear allowance - also known as depreciation - is frequently insufficient to fund a suitable replacement vehicle at some future date. 

• Any "profit" realised when the vehicle is sold for more than book value (the net amount after deducting allowable depreciation) will be taxed as income. The book loss on vehicles sold below book value is usually allowed as an expense and is written off. Whatever happens, it can only be determined in the last year of ownership.

For owners who prefer to pay for their vehicles over time, instalment (suspensive) sale has advantages. These include:

Advantages of Instalment Sale

• Usually only a small amount relative to the total purchase price is paid as a deposit. The balance is paid in equal periodic payments (usually monthly) for an agreed period. 

• The periodic payments (instalments) can be funded out of revenue generated by use of the vehicle.

• Depending on the credit rating of the borrower, the sale can be concluded without paying any deposit.

• The purchaser can opt for a high deposit if it suits their cash flow needs.

• Periodic payments can be monthly, quarterly or some other period acceptable to the financier.

• Interest rates applicable to the agreement can be fixed for the full period of the agreement or floated against an acceptable yardstick such as the prime bank overdraft rate.

• The Receiver allows the interest portion of the instalment sale to be deducted as an expense. Such interest charges can be deducted over the life of the vehicle and not the term of the instalment sale agreement.

• Instalment sale permits immediate access to and use of the vehicle.

• Ownership passes to the user when the final instalment has been paid. This is a potential hedge against inflation.

• The financiers cannot terminate the agreement or reduce the period of repayment. This has advantages in the event of a credit squeeze.

• Fixed instalments assist budgeting and control.

Disadvantages of Instalment Sale
The major disadvantages of instalment sale in its various forms include:

• Ownership only passes when the final periodic payment is made.

• Vehicles cannot be disposed of at owner's (user) discretion until the last payment is made.

• The risk of residual value (ultimate resale value) resides with the user irrespective of ownership.

• Interest rates are usually higher than overdraft rates.

• Instalments are fixed and must be paid on due dates.

In recent years, many fleet owners and operators have chosen to use the vehicles they operate rather than own them. This is especially so in the manufacture of and distribution of fast moving consumer goods (FMCG) where strong cash flows support the concept of paying for vehicles out of revenues generated by the fleet. Without the need to invest large amounts in vehicles, companies can provide additional equipment and facilities to handle expanding production and market shares. Leasing allows the lessee full, unrestricted use of vehicles just as if it had been purchased. 


Leasing Vehicles
On termination of an open-ended lease agreement, the lessee may choose what suits its operations and cash flows best. The options include:

• Decide to replace the vehicle with a new, more productive model.

• Take ownership of the vehicle that has been leased.

• Extend the period of lease for the same vehicle.

Such flexibility makes leasing a dynamic method of financing vehicles. There are more attractive features that allow leasing to be "tailored" to suit specific cash flow needs of individual companies and operators. Several critical factors that determine the size of the periodic lease rentals are subject to the lessee's decision before entering into the agreement. The lessee can decide, or at least influence:

1. Whether the insurance premiums can be included or paid for separately.

2. The rate of interest to be paid. Shopping around for the best rate can be worthwhile. If you are confident enough, you can negotiate a fixed or floating rate for the duration of the agreement.

3. Within reasonable parameters, the duration of the lease.

4. To make an initial payment in cash or by way of trade-in.

5. The structure of periodic payments. This means stepped, rather than level rentals when this is financially advantageous. Even skipped rentals can be applied where justified. (As an example, stepped rentals can start low in the first year and increase annually) 

6. The residual value or final balloon payment is usually the book value to which the financier will depreciate the vehicle in its books rather than the expected market value. This amount can be negotiated within reasonable parameters.

Advantages of Financial Leasing

• No upfront cash is needed to gain unrestricted use of vehicles.

• Use of vehicles is funded from revenue (cash flow).

• Payments and term are fixed and cannot be changed by the financier. This assists budgeting.

• Rentals can be structured to suit cash flows.

• Periodic rentals are deductible expenses.

• Fixed rentals are a hedge against inflation - you pay future rentals in depreciated Rands.

• VAT is paid on periodic rentals and not on the purchase price.

• Leasing can be an additional source of credit.

Disadvantages of Financial Leasing

• Ownership remains with the lessor.

• Interest must be paid on the full purchase price.

• Periodic rentals must be paid when due, regardless of cash flow status.

• Realisation of the residual value (ultimate resale value) resides with the lessee.

• Tax reconciliation, if any, resides with the lessee. (Note that tax liabilities can arise when the lessee takes ownership of the leased vehicle)

Operating Leases & Full Maintenance Leasing (FML)
Extended rental agreements - also known as operating leases - whether with or without maintenance, are now firmly entrenched as an important and desirable method of acquiring wasting assets such as trucks. The concept consolidates a number of trucking cost drivers into a single periodic rental. Even with its undoubted appeal, especially to operators of own transport fleets, operating leases are by no means a panacea for all trucking operations. However, it does deserve careful and objective evaluation of the pros and cons and to what extent it would be good, or best for your business.

Companies with few vehicles, owner-drivers and SMME operators in particular, whom are unlikely to have, or be able to develop the knowledge and skills to reasonably control the key vehicle operating costs, should consider these points before negotiating with FML providers:

• Analyse the job to be done. Determine the kilometres to be travelled, taking note of seasonal differences, topographical and traffic conditions. Working hours, loading and unloading procedures.

• The maintenance component of an FML will be based on the annual kilometres travelled and the operating conditions. Excess kilometres are charged for separately at a higher rate than the base rate in the contract. Should kilometres continue to be in excess of the limits negotiated for the agreement, the FML provider can recalculate the base rate and reduce the residual value. The consequence of this would be increased periodic rentals.

• Be aware of any clause entitling an FML provider to seek compensation under certain circumstances. An example of this would be after an accident or incident the FML provider is entitled to claim compensation to offset any reduction in the residual value.

• Ask the FML provider to explain what portion of the periodic rental is allotted to the maintenance component and how this will escalate over the period of the agreement.

• Establish who is permitted to undertake maintenance and repairs on the vehicle and what limits are in place without your authorisation.

• Be clear on exclusions, warranty and how disputes are to be settled.

• Investigate the merits of making use of the vehicle manufacturer's maintenance contract and whether it would be cost-effective and simpler to control.

• Make sure your insurance cover meets all the requirements of an operating lease or FML.

• Make sure you know and understand the correct procedures and who pays the charges in the event of breakdowns, towing, authorised repairers and access to a temporary replacement vehicle, if applicable.

• Responsible FML providers will ask for details of your accident and incident history. The magnitude and frequency of claims will be taken into account in formulating the rate.

• Should you decide to acquire the vehicle on termination of the agreement, VAT, based on the market value of the vehicle, will be payable.

Evaluating FML providers

• It pays to shop for the best deal. The best deal is not necessarily the one with the lowest rates.

• There are many active FML providers. They have differing views and perceptions of the resale values of various makes and models. Their perceptions are influenced by their ability to dispose of used vehicles quickly and profitably.

• Depending on their maintenance managers, FML providers have different perceptions of maintenance and repair costs and who is best suited to control it.

Checklist
Use this checklist to assist you in deciding whether FML, or an operating lease with a vehicle manufacturer's maintenance contract is an appropriate option for your business:

• Will FML enable you to improve and sustain your vehicle replacement programme?

• Will FML result in better trade-in prices than you are getting now?

• Will you be satisfied with the service and support from the nominated service provider?

• Do they have a comprehensive and up-to-date maintenance cost control system?

• Can you choose the makes and models of your choice? How good are they at selecting the right vehicle for the job?

• Does the FML provider have enough buying power to get the best deal?

• Will the advent of FML simplify or reduce administration of your transport operations?

How do the prospective FML providers you are considering measure up? These questions are vitally important for small operators/newcomers (SMME), owner-drivers and BEE situations that lack previous experience in trucking:

• Do they have a successful track record in working with vehicle suppliers and competent transport managers?

• Do they have access to competent transport managers willing to act as managing agents to assist in controlling administrative aspects such as PAYE, tax returns, basic financial controls, VAT, regional services levies, legislation in respect of the operator's licence, vehicle fitness, PrDP and other relevant RTQS regulations?

• Are they committed to their customers? What do current and recent customers say about their service? If you cannot build a long term mutually beneficial business relationship, your life will be miserable and frustrating.

• Do they respond quickly to situations? Or do they have so many of their own problems there's not much time to worry about customers?

• Are they financially stable, profitable and known for their professional approach to vehicle financing?

• Do they have a comprehensive range of services?

• Are they flexible or rigid in their approach to business?

• Are they in the right location(s) to suit your operations?

• How good is their price? If you are hung up on the rate and looking for an expedient short term solution, you are likely to miss out on some of the more important aspects of FML and operating leases.

If you are a larger operator engaged in several different transport operations, it may be wise to consider more than one method of vehicle financing. Whichever method(s) you choose, it will have a material affect on the cost of operating your trucks, the taxes you pay and the profits you make. Unless all your operating circumstances and the business environment remain static, there is no one best way to suit all companies. If you want to retain a sensible vehicle replacement cycle, acquire the vehicles best suited to your needs and keep your operating costs under control. It will pay you to undertake a regular, objective assessment of the various options available to transporter and fleet owners.