How Wrong Can You Be? (Pt I)

After 25 years of advising businesses on vehicle finance I'd like to think that very little in this arena still surprises me.

Except for one thing; the number of businesses that sleep-walk into funding for their fleet, and that's irrespective of fleet size or the nature of the underlying business (multi-national companies are just as capable of making the wrong vehicle funding decision as your local florist or electrician).

Sadly, misconceptions abound when it comes to choosing vehicle finance, so if you are going to make the right funding decision for your vehicles, where do you start?

In this series of articles I'll show you how to go about creating a #vehiclefunding strategy for your business which will fit with your core operational goals and actually contribute to business success, rather than hindering it by tying up time and money where it's not productive.

So let's get started.

Decide Your Priorities And Stick To Them

At a strategic level your approach to vehicle finance has to meet some basic requirements so that it contributes to success rather than acting as a drag on it. In my experience, far too many businesses still take a 'product' approach to vehicle finance rather than investing time in matching finance to the needs of the business.

By 'product' approach what I mean is that it's all to easy to just get an off-the-shelf 'one-size-fits-all' finance package and use it across the board to fund a fleet, irrespective of the operational requirements for individual vehicles or vehicle groups/types. And if things have started to go wrong at that fundamental strategy level then the impact can cascade all the way down through a fleet's operating costs and its contribution to the success of a business.

Spending a little time determining your priorities for vehicle finance and the strategy by which you will achieve those priorities will pay dividends, both literally, in terms of reducing operating costs/improving the bottom line, and in meeting business objectives in the longer term (and let's face it, in today's fast changing business environment, vehicle finance is longer term, with most finance methods requiring a lock-in to a 3-4 year funding contract for a car or van).

So, if you're going to strap yourself into a finance method for the longer-term, it will pay you to go back to Boot Camp and apply some original thought to what you want vehicle finance to do for your business.

OK then, where to begin?

Well, for most businesses the key decision criteria to consider can be summed up as #Risk, Affordability, Cash-Flow and Accounting/Taxation.

The traditional forms of business funding for cars and vans each have their own advantages and disadvantages in these key categories. We'll look in detail at the pros and cons for each of the main finance products in a later article, or you can read more about them now by following this link, but for the moment let's focus on the first of these key criteria for identifying your vehicle finance priorities.

Risk

Risk and your business's tolerance of it, or aversion to it, is at the heart of any vehicle funding decision.

Risk, in essence, comes down to how much you think you know about the second-hand market for vehicles.

Put in other words, do you want to take the risk on potential losses from vehicle resale values when cars or vans come to the end of their working lives in your business? In the extreme, can your business stand the financial impact of an unexpected drop in vehicle resale prices (known as 'residual values') when the time comes to sell?

'Ah yes', you might say, 'But what about the potential profits? What if I can beat the second-hand market and sell above typical residual values?'. Well, just keep in mind that even residual value specialists in finance and leasing companies get it wrong from time to time, and some of those who got it wrong are no longer in business.

Look at it another way. With some very rare exceptions, you loose money on cars and vans used in your business; this fundamental principle is recognised the world over. Accountants even have a word for it - 'depreciation'.

But you can manage your residual value risk and your exposure to depreciation. Funding products exist that fix depreciation and avoid uncertainty, though as with all 'each-way' bets these products come at a price. Someone else, the finance company, will charge you money for the privilege of you being able to lay off your potential exposure to adverse fluctuations in residual values. In effect, to allow you to 'fix' your risk at a known amount.

The method by which the finance companies do this is a little complex, but stay with me on this.

In vehicle finance products with a fixed risk, the finance company puts a residual value forecast into the calculation of the monthly finance repayments for a vehicle, so all you repay is forecast depreciation during the contracted life of the vehicle, not the whole of the purchase price of the vehicle.

However, the residual value they use in the finance contract will be less than the finance company's real expectation of the vehicle's residual value at the end of the finance agreement. This difference between the two values is known as the 'spread'.

The spread will vary between finance companies according to factors such as the mix of vehicles on their fleet and their appetite for risk, but for the sake of explanation here, let's say it is between 5-10% of the finance company's real expectation of vehicle residual values.

On this basis, the residual values built into fixed-risk finance products might end up being only 90-95% of how much the finance company really thinks a given vehicle will be worth at the end of a finance agreement (e.g. 100% less the spread of 5-10%).

Because this difference in the residual value increases the monthly payments charged to you on a fixed-risk finance agreement, think of it as an insurance premium that you are paying to the finance company to take on the risk of the residual value.

Now, let's assume the residual value ends up at 100% of the value the finance company really expected. The finance company will then make a 5-10% profit on the sale of the vehicle, because the finance company built into the finance repayments an expectation of a residual value lower than that actually achieved and then pocketed the difference in values when the vehicle was sold.

However, the finance company could get the residual value wrong by using a forecast value higher than that achieved when the vehicle is sold. In that case they lose and you win, because your monthly finance payments were lower to take account of the better residual value/lower depreciation forecast used to calculate the monthly payments. You fixed your risk at the finance company's forecast residual value and they took the hit when the forecast residual value didn't materialise on the sale of the vehicle.

But there's a reverse side to this principle. If the finance company wins because residual values on disposal of the vehicle were higher than their 100% value forecast, it means you lost. Twice. The finance company first made money on your car at the end of the finance contract (instead of you) and you still paid them a 5-10% 'insurance' premium to take the risk. It's a double-bubble pay-day for the finance company.

So, there's an upside and a downside to fixing your risk on vehicle residual values.

But what does this mean in reality for your fleet?

For the moment, think of it as 'How much are you prepared to pay someone else to limit your exposure to vehicle depreciation without always losing the bet?'.

For one vehicle or a small fleet, the price of fixing your residual value risk may not be a major issue relative to the peace-of-mind it brings.

However, if you have hundreds of cars or vans the price of fixing your potential losses from a major drop in residual values could, in itself, have a significant impact on annual business profits.

So how do you resolve this conundrum?

Well, the answer is measurement.

Measurement is the way you capture and tame your risk; it's how you determine risk's scope and extent. Measurement helps you decide if you are prepared to face risk head on or pay someone else to do it for you.

So what do I mean by 'measurement'?

Measurement is the technique you use to identify the extent of your exposure to depreciation compared to the cost of fixing it. Measurement includes forecasting depreciation, predicting potential variations from your forecast and then calculating the cost of insuring against those variations by fixing.

Whoa! By now some of you may be thinking 'Is all that is really, really necessary, just for me, and my little fleet?'.

The bad news is yes, it really is. It's probably true that, the smaller the fleet, the smaller your business, so making the wrong decision on vehicle finance can proportionately be just as bad for the bottom line in a small company as for a major fleet operator.

The good news is that there are tools available to do the hard work in measurement for you. These tools will

1. calculate your risk;

2. compare your risk to the cost of fixing it; and

3. show you the difference in costs between taking on risk or fixing it through others (leasing companies).

We'll look at these tools in more detail in a later article, but armed with them you can reach an informed decision on how to approach risk and establish the price you are prepared to pay for someone else to take it on for you.

For now, all you need is to be aware of risk and what's involved. The fact that you now recognise risk as a factor in deciding your approach to vehicle funding is enough.

And it's probably also enough for this first article too!

In Part II of this article we'll look at the criteria Affordability and Cash-Flow, including how to balance the cost of using external finance for your vehicles against the business opportunities created by freeing up capital for profit generation.

In Part III we'll look at Accounting/Taxation and in Part IV how you bring all the criteria together to formulate your strategy for vehicle funding and then apply your strategy to selecting the right vehicle finance product(s) for your business.

#companycars #companyvans #carfinance #fleetfinance #cashflow